Charitable Giving: Tax Effective Charitable Strategies
STEVE NYVIK, SENIOR PORTFOLIO MANAGER AT LYCOS ASSET MANAGEMENT
If you plan to give a substantial amount (say more than $25,000), you should do it as tax effective as possible. Doing so can substantially reduce the amount it costs you out of your pocket. Here you might consider:
- Giving Appreciated Securities instead of cash (you give away the tax liability so it is better than giving cash)
- Charitable Insured Annuity;
- Charitable Remainder Trusts;
- Giving an unneeded Life insurance policy.
Where you wish to make substantial gifts, but don’t want to give away money you need to provide for your living needs throughout your lifetime, you might consider:
- Will bequests;
- RRSP/RRIF beneficiary designation.
(I) Give Appreciated Qualifying Securities
It’s better to donate certain types of appreciated investments to charity as opposed to giving cash. That’s because the gain on these qualifying donated investments may be exempt from tax. So, you’re in effect giving away your tax payable on the capital gain, and you still get the same receipt amount for the same value of donation. That’s the tax angle that makes donating shares cheaper than cash.
However, for individuals or corporations to get this preferential tax treatment, there are a few hitches:
- the investment must be donated directly to the charity – you can’t sell the shares and donate the proceeds. You’ll need to transfer the investment certificates in your name to the charity’s name or transfer your investment from your investment account to the charity’s investment account.
- the investment must be donated to a Canadian public foundation, Canadian private foundation[1] or a Canadian registered charitable organization (there are some exceptions[2]).
- the investment has to be a “qualified security”. Not just any investment can be donated to qualify for this special tax treatment. The type of investments that qualify include:
- shares listed on most Canadian and foreign stock exchanges[3] and stock options[4] of those listed shares;
- bonds and debentures of listed companies of most Canadian and foreign stock exchanges;
- Canadian government bonds;
- Units or shares of a Canadian public mutual fund;
- insurance segregated funds (these are similar to mutual funds); and
- ecologically sensitive land[5].
Example (See Table 1 for summary)
Assume George, a resident in British Columbia, is planning to donate $20,000 to charity. If he donates cash, he’ll get his charitable credit worth up to $8,740 (= $20,000 x 43.7%) in tax savings. That would bring the cost of donation after the tax credit down to $11,260 (= $20,000 donation – $8,740 tax savings).
If George didn’t have the cash, but was planning on selling a publicly traded stock worth $20,000 (with a tax cost of $10,000) and donate the net proceeds, then he’d have a $10,000 capital gain (assuming no transaction costs). Assuming George is at the highest tax bracket, then he’d have capital gains taxes of $2,185 (= $10,000 gain x ½ inclusion rate x 43.7% tax rate) and charitable credit of $8,740 resulting in a net tax refund of $6,555. Because of the capital gains taxes to pay, the cost of donation rises to $13,445.
Now, let’s assume George makes an in-kind donation of the $20,000 investment. The result is just like having donated cash, but the tax on the accrued capital gain is eliminated. So, when we factor in this tax savings of $2,185 (= $10,000 x ½ inclusion rate x 43.7%), the cost of the donation drops to $9,075.
There may also be additional savings through an in-kind donation as there might be less of an OAS clawback and a lower Pharmacare threshold as you’d have $5,000 less in taxable income.
| Scenario 1: Donate cash |
Scenario 2: Sell stock and donate cash |
Scenario 3: In-kind donation |
|||
| Proceeds of disposition | $20,000 | $20,000 | |||
| Tax Cost | ($10,000) | ($10,000) | |||
| Capital gain (loss) | $10,000 | $10,000 | |||
| Taxable Capital Gain | $5,000 | $0 | |||
| Tax @
43.70% |
($2,185) | $0 | |||
| Charitable tax credit | $8,740 | $8,740 | $8,740 | ||
| Taxes Payable / Refund | $8,740 | $6,555 | $8,740 | ||
| Summary | |||||
| Donation | ($20,000) | ($20,000) | ($20,000) | ||
| Tax Payable / Refund | $8,740 | $6,555 | $8,740 | ||
| Taxes saved on giving away capital gain | $2,185 | ||||
| Net cost of donation | ($11,260) | ($13,445) | ($9,075) | ||
| Cost per dollar of donation | ($0.56) | ($0.67) | ($0.45) | ||
(II) Charitable Insured Annuity
If you need income and are charitably inclined, you can boost your income on GICs, bonds or other fixed income investments you hold personally and also provide a nice endowment to your favorite charity.
What is an Annuity?
An annuity is a contract providing you with periodic cash receipts (usually paid monthly, quarterly or annually) in exchange for an up-front lump sum payment. There are two types of annuities:
- those that pay for only a specific period of time (term certain annuities), and
- those that pay as long as you live (life annuities).
A life annuity that meets the following conditions of:
- not indexed,
- bought from personal monies (non-RRSP/RRIF or non-company money), and
- begins payments to its owner from the time of purchase
may qualify as a Prescribed Annuity which is entitled to beneficial taxation. In this type of annuity, the taxation of the periodic receipt is deemed for tax purposes to be a fixed amount of income and non-taxable return of capital for one’s lifetime. The amount allocated to a return of capital is based on a life expectancy table – the older you are, the lesser the expected remaining life expectancy and the greater amount of non-taxable return of capital.
For a non-Prescribed Annuity, it works similar to a mortgage with each payment having a different mixture of income and return of capital. The earlier payments will have more income. Through time the mixture of each receipt will become more non-taxable return of capital until the annuity purchase amount is fully repaid.
What is an Insured Annuity?
The problem with Life Annuities with no guarantees is that the capital is exchanged for a stream of monthly annuity payments. So on your death (or that of the surviving spouse for a Joint Annuity) the capital is gone and the annuity payments are terminated.
When you want the annuity capital for your loved ones after you’ve passed away, you may replace the annuity capital through the purchase of life insurance. With life insurance, the annuity capital will be paid as a death benefit to your loved ones at your passing away. But to provide this return of annuity capital on death, a portion of the annuity cash receipts are used to pay life insurance premiums.
Where some portion of the insurance is to go to charity, the Insured Annuity becomes a Charitable Insured Annuity.
How Much Charitable Donation Tax Receipt is Received?
Where one simply designates a charity as the beneficiary or part beneficiary of a life insurance policy, the donation receipt is not received until your death when the charity receives their portion of the insurance proceeds. The amount of the charitable receipt at that time would equal the amount of the proceeds the charity receives.
Alternatively, you might have two life insurance policies – one which you own to replace the annuity capital and the other to be owned by the charity as an endowment. In this case, your payment of insurance premiums on the policy owned by the charity constitutes a charitable donation where you receive a charitable donation tax receipt in the amount of the premium.
Note that on your death you don’t get another charitable receipt as the charity already owns the policy.
Disadvantages
Annuities are wonderful. Everyone should have some pension or annuity that keeps paying no matter how long you live. However, there are some downsides. The key disadvantage is the lack of liquidity. Once you buy the annuity, you’re locked-in and no longer have access to the capital. Your only entitlement is the monthly receipts. So, annuities make sense only for those funds where you don’t need the capital but desire higher guaranteed income for life.
Also, where a charitable annuity is considered where you retain ownership of the life insurance, you need to do some estate tax planning to make sure that there will be enough income in your final return to fully utilize the charitable donation credit. Otherwise, the tax benefit may be lost.
(III) Charitable Remainder Trust
So, you’d like to make a substantial gift to charity but you need an income from your assets to meet your living needs? A Charitable Remainder Trust might be the thing for you.
A Charitable Remainder Trust is created by transferring assets into an irrevocable (inter-vivos) Trust. (Normally this results in a disposition for taxes.) You will receive a charitable tax credit at the time of the transfer of assets to the Trust. The amount of the charitable credit is based on the difference between the amount settled in the Trust and the cost of buying you a life annuity. The Trust provides income to you for your lifetime and, on your death, the remaining capital passes to the charity.
There are four key criteria for a Trust to qualify as a Charitable Remainder Trust:
- the terms of the Trust must not provide for a power of encroachment (i.e. you can’t “eat the capital”).
- the terms of the Trust must name a charity as beneficiary of the remaining interest in the Trust. This interest must vest in the charity at the time the property is transferred to the Trust.
- the Trust must be irrevocable.
- the transfer of property to the Trust by the Settlor must be voluntary and the Settlor must have no expectation of benefit (beyond the Trust income) from the charity.
This strategy may be suited where you are at least 70 years of age (so your life expectancy is considered short) but you are healthy and have good longevity.
(IV) Gifts Made by a Will
On your death, Canada taxes you in your final income tax return where assets, not bequested to your spouse, are deemed disposed at fair market value. Also your RRSPs and RRIFs, for which your spouse isn’t the beneficiary, are matured and brought into income.
Where your Will provides for the distribution of an ascertainable sum of money or property to one or more named charities (with the specific portions that may be specified by you or portions to be allocated by your Executor), the gift is deemed to have been made at the time of your death.
To the extent that your Executor has discretion as to the identity of unlisted charities (those charities that are not explicitly named in your Will) or even whether a gift is to be made at all, the Canada Revenue Agency takes the position that the gift is made by your Estate. In other words, the gift does not occur at the time of your death and cannot be included in your final return.
So it is important that you use the appropriate wording in your Will so the donation credit will be generated in your final return where you have your deemed dispositions. Otherwise, you might end up paying income tax in your final return and have no donation credits to offset the taxes.
The advantage of a Will bequest is that you need not have to make a life commitment of funds as in a charitable insured annuity or lose access to your capital as in a charitable remainder trust. However, you should regularly review your estate tax plan to make sure there’s enough income to utilize the donation credit.
(V) Designating a Charity as your RRSP/RRIF beneficiary
By designating a charity directly as beneficiary of your RRSP/RRIF, the gift is eligible for the charitable donation tax credit and is deemed to have been made immediately before your death. Since the balance in an RRSP/RRIF is treated as income in the year of death, the charitable credit should eliminate the entire tax on the RRSP/RRIF as there’s no net income limit in the year of death.
If you’ve designated a charity as the beneficiary, the proceeds flow directly to the charity from your RRSP/RRIF. As such, the probate fee on your RRSP/RRIF for these designated gift proceeds are avoided.
For many people this option of designating a charity as the beneficiary is attractive as you don’t commit to giving monies that are needed to meet your living needs during your lifetime. So, if you live longer than expected or you happen to have higher living expenses, the RRSP/RRIF monies are still there to take care of you. The charity simply gets any residual.
(VI) Giving through Life Insurance
Gifts of a permanent form of life insurance with a cash value (like a Whole Life or Universal Life policy) can be used for making: (1) an immediate gift to charity, or (2) a donation at the time of your death (where you are the insured person).
Where the need for life insurance no longer exists, there is a cost to terminating or transferring a Whole Life or Universal Life policy.
When you terminate a policy or transfer its ownership, the policy is considered to have been disposed (a taxable disposition), so you would be liable for tax on the difference between the surrender value and the Adjusted Cost Base of the policy. This amount is taxed like interest income.
Where the policy has been in effect for a long time, the Adjusted Cost Base may be small or nil, resulting in your receiving a substantial amount of income for the year in which the policy is terminated or transferred.
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Life Insurance Policy Donation – Tax Receipt for Policy CSV and Premiums
If you’d like to give to charity while you’re alive and you don’t wish to continue making premium payments, you might consider donating the policy.
Where you choose to donate the policy, you’ll have to transfer the ownership of the policy to the charity in order to be entitled to the donation receipt. The charity, as the new owner, will then name itself as beneficiary.
You’ll then receive a donation tax receipt for the cash surrender value and any accumulated dividends and interest, less any outstanding policy loans as of the time the ownership transfer is made.
Note that if your policy doesn’t have enough cash to fund remaining policy costs for the rest of your life, it is likely that the charity would want to terminate your policy and take the cash. But if you choose to make a premium payment, you’ll receive a charitable donation receipt from the charity for each year in which a premium is paid.
On your death (where you are the life insured), the charity receives the death benefit proceeds directly – so the insurance isn’t subject to probate in your estate. (Note that you don’t get another charitable receipt as the charity already owns the policy)
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Charity as Beneficiary – Tax Receipt at Death for Death Benefit
Where you just change the beneficiary of the life insurance policy to the name of a charity, there is no policy disposition. As the owner of the policy (where you are the life insured), on your death you will be deemed to have made a donation to charity immediately before your death. This may be of benefit to you as it ensures that the charitable tax credit arising from the gift may be used in your final return to offset any tax liability arising from the deemed dispositions of property and the collapse of your RRSP/RRIF on your death.
Note that under this alternative, any policy premiums you pay will not be considered charitable donations.
Final Note
There are many considerations for charitable giving. Let us know your thoughts and questions – we would be happy to assist you with this decision.
Footnotes
[1] The 2007 Federal Budget, which received royal assent on June 22, 2007, eliminated capital gains tax from donations of qualifying securities to Private Foundations.Also, for donations of publicly-listed securities by an arm’s length employee who acquired the security under an option granted by the employer, the associated employment benefit has become exempt from taxation.
[2] For personal or corporate donations to qualify, they must be made to a Canadian registered charity, registered Canadian amateur athletic association, the Canadian federal government, a Canadian province or territory, Canadian municipalities or public bodies performing government functions, United Nations or any of its agencies, foreign universities listed in Schedule VIII of the Income Tax Regulations, certain low-cost housing corporations for the elderly, or certain charitable organizations outside that have received donations from the Government of Canada (see IC 84-3R5).
Also, under the Canada – U.S. Tax Treaty, donations to U.S. charitable organizations qualify for the credit or deduction provided you also have a U.S. source of net income that is taxable in Canada. Any donations to such U.S. charitable organizations are eligible for credit subject to the donation limitation formula where only U.S. source income is considered (i.e. up to 75% of your U.S. source income).
[3] Prescribed Stock Exchanges include the Toronto and Montreal exchanges, tiers one and two of the TSX Venture Exchange, the NYSE, NASDAQ (excluding the Over-the-Counter Bulletin Board) and most other major foreign exchanges. See Regulation 3201 of the Income Tax Act.
[4] The income inclusion is reduced to nil for employee stock options where the options are exercised and the shares are donated in the year they are acquired, and within 30 days after their acquisition.
Where raising cash to pay for the stock is an issue, an employee may be able to exercise the stock option and direct the broker or dealer to sell the shares immediately, and then immediately donate all or part of the proceeds to charity.
[5] The federal budget also reduces the capital gains inclusion rate to nil for gifts of ecologically sensitive land and related easements, covenants and servitudes. To qualify:
- the land that is the subject of the gift must be certified by the Minister of Environment to be ecologically sensitive land, the conservation and protection of which is important to the preservation of Canada’s environmental heritage; and
- the gift must be made to Her Majesty in right of Canada or a province or a municipality in Canada, or a registered charity (other than a private foundation), one of the main purposes of which is the conservation and protection of Canada’s environmental heritage.
The value of ecological gifts must be determined by the federal Minister of the Environment.
[6] A split dollar life insurance policy is an arrangement where the premium and policy values are split between two or more parties. Canada Revenue Agency’s interpretations (2003-018265 dated April 17, 2003, 2003-0004315 dated May 6, 2003 and 2003-0004115 dated June 2, 2003) suggest that, subject to a case by case review, a split dollar scenario could qualify as a donation if the charity owns part of the policy.
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