With the Giving Pledge, the Devil is in the Details

Bloomberg Business recently dug into the track record of billionaires who have signed the Giving Pledge, which was developed by Bill Gates and Warren Buffett. Thus far, 193 individuals have made the promise to give away half or more of their fortunes either during their lifetimes or at death. It turns out that the fulfillment of this promise is not as simple as the charitable world expected. Why is that? 

First, understand that the Giving Pledge is not a pledge you are contractually bound to honor. Those who sign the pledge are under no legal obligation to donate any of their money to charity. Moreover, giving away 50 percent of your wealth is not the simple calculation that many may think.

I'm a CPA, so one of the paragraphs of the Bloomberg article caught my eye. A paragraph near the end of the article indicated that the IRS plays a big role in every donor’s gift program and in their Giving Pledge. The article noted that a person with a $1 billion fortune, subject to the 40 percent estate tax actually has only $600 million of funds after tax. In that case, his or her 50 percent Giving Pledge amounts to $300 million and not $500 million that most everyone assumed was the case.

I thought it would be worthwhile to examine this comment a little more closely to help you understand the tax code and its impact on philanthropy.

Going back to the person with the $1 billion fortune. When they pass away, the estate tax kicks in. This is essentially a tax that says you have accumulated much during your life and the government deserves some when you die. The fact that this $1 billion has been accumulated over the years with dollars remaining after you have paid annual income tax is irrelevant (to everyone except those trying to eliminate the estate tax).

Since the estate tax is one of the laws that the current administration chooses to enforce, the billionaire must pay the 40 percent tax on his or her $1 billion fortune. However, charitable contributions can be deducted from the $1 billion fortune before applying the 40 percent tax to the remainder.

If you want to see how this works, take your Excel spreadsheet and set it up as follows:

A

Value of Estate at Death

   $ 1,000,000,000

B

Charitable contribution

 

C

Remaining Taxable amount (A – B)

 

D

Estate tax rate

   40%

E

Estate Tax payable to US Treasury (D x C)

 

F

Amount left for heirs (C – E)

 

 

On Line C, include a formula that subtracts Line B from Line A.
On Line E, include a formula that multiplies Line D times Line C.
On Line F, include a formula that subtracts Line E from Line C.

Now, if you use trial and error to enter a value in Line B and view the computational result in Line F, you will see the impact of the charitable contribution on the amount of funds available to the heirs. Keep changing the amount on Line B until the amounts on Line B and F are equal, and you will have computed how much of the $1 billion fortune is available for charity, assuming the billionaire promised to give half of his or her fortune away to charity.

If you do the math, you will see that the donation figure for a $1 billion fortune is $375 millionsubstantially less than $500 million, which represents half of the original $1 billion fortune. This is why the charitable community is surprised at the contribution amounts made under the Giving Pledge.

Why is tax such a motivator for charitable giving? Again, let’s look at our individual with the $1 billion fortune. With no charitable giving, the estate tax would be $400 million, leaving $600 million for his or her heirs. While $600 million is substantially more than the $375 million the heirs have after donating $375 million to charity, the charitable contribution has provided the family with a good deal of intangible benefitsgood will, testimonials, etc. And their $375 million gift to charity actually only cost them $225 million; the difference between inheriting $375 million vs. inheriting $600 million. The family gets to spend an extra $150 million on the charities of their choice (the difference between $225 million and $375 million) and it was all paid for by the Internal Revenue Code.

The charitable world is divided on the value of the estate tax in charitable giving. There are those who believe philanthropic individuals will give regardless of the tax impact as well as those who believe that the tax savings is a great motivator. But that will be a subject for a future post.