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Reduce Taxes With a Private Foundation
By Roger D. Silk, PhD, CFA
and CEO of Sterling Foundation Management
March 13, 2002 7:00 am ET
A private foundation can cut your client's tax bill by up to 30%. But you'd better get started.
It happens every year about this time-I get phone calls from advisors asking if their clients can reduce their taxes by contributing to a foundation. They generally go something like this:
"Roger, I need you to set up a foundation so my client can fund it by April 15. Will that be a problem?" asks Jim, an advisor whom I've known for some time who advises high-net-worth individuals.
"Not at all. What's the story?"
"Well, we got the 1099s, and after we added up all the dividends, interest, and realized gains, it came to well over $1 million. Tom is looking at a half a million in taxes, and he's sick of it. So this year we're going to do something about it."
We then proceed to discuss the case. The client, Tom, has total assets of about $18 million, consisting of $10 million in bonds, and the rest in a portfolio of equities. Tom and his wife are both in their 50s, and their two children are 27 and 24.
"Tom and his wife are planning to leave most of their estate to charity," says Jim. "Right now, they figure they'll give each kid $2.5 million. Assuming they survive to get the full exemption each from the estate tax, that would leave $13 million for charity, before growth."
"It sounds like a no-brainer for a foundation," I agreed. "How did you present it to Tom?"
"I started with the up-front income-tax deduction. I asked Tom how he would like it if the government matched every dollar he put into his foundation. That piqued his interest. I showed him how since he's in nearly a 50% bracket between state and federal income taxes, each dollar he puts in really only costs him about 50 cents," said Jim.
"Tom loved that. Even though he has long known about the deduction, he'd never thought of it quite that way. So he decided to take the plunge and set up the foundation. Now we have to figure out what to fund it with and when. I'd like your thoughts."
Jim and I then discuss the financial considerations that go into these decisions.
The first question is always how much to put in. Since Tom is leaving a large amount to charity anyway, we kick around several ideas on how much to start it with now. We end up agreeing that it makes sense for Tom to fund it now with the amount he can deduct this year, plus several more. Assuming Tom's income will remain steady at $2 million, we calculate that Tom could deduct $600,000 a year (i.e. 30% of his income). He gets a deduction for this year, and then carries forward the unused portion for up to five more years.
Since the assets in the foundation grow income-tax-free, the more Tom puts in now, the more income he'll be able to shelter. But to avoid losing deductions, he'll put in this year's deductions plus five more years, or a total of $3.6 million to start. He can always add more as his income rises. After reaching this conclusion, Jim and I discuss timing.
"Does April 15 make sense as a funding deadline?" Jim asks.
"Well," I replied, "there's nothing magical about the 15th from a technical point of view. But to maximize the tax benefits, the sooner Tom funds it the better."
We then do a back-of-the-envelope calculation to see how much in taxes it would cost Tom to wait. We look at the fact that assets Tom puts into the foundation will earn income free of income tax. The longer he holds onto them in his own name, the more income will be subject to tax.
We assume that the assets in the foundation would produce about 6% taxable income and gains, and that Tom's tax rate would be about 45% for this income. It works out to a tax savings-just from sheltering the income inside the foundation-of about $8000 a month.
After coming up with the number, Jim asks another question: "Can you create the foundation by March 31st?"
Nothing like cutting it close.
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