Gifting to Donor Advised Funds (DAFs) and gifting to Charitable Lead Annuity Trusts (CLATs) are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies offset ordinary income tax at least to some extent.
• DAFs are a Charitable Giving Strategy with Ancillary Tax Benefits: People often think of DAFs as a tax-saving strategy. While gifting to a DAF can reduce your tax bill, you won’t come out ahead personally by doing so. You might get back 40 or 50 cents for every dollar you put in a DAF. But that’s okay, because DAFs are vehicles for charitable giving. Assuming you’re looking to support charity in a significant way, DAFs can make a lot of sense. The tax benefits just aren’t that large.
• CLATs Yield Similar Tax Savings Plus Additional Returns: When a donor contributes to a conventional charity, like a Donor Advised Fund, they receive a charitable deduction, typically equal to the fair market value of the amount contributed. But the donor to a conventional charity doesn’t receive anything in return aside from the deduction. With a CLAT, a donor can receive not only a 100% upfront charitable deduction, but also a future return for either themselves or their loved ones.

What are Donor Advised Funds (DAFs)?

A Donor Advised Fund (DAF) is a charitable giving account. When a donor contributes cash, securities, or other assets to a DAF, the donor receives an immediate tax deduction. That deduction can offset capital gains or ordinary income. The donor can then recommend grants to charities from the fund. DAFs are popular because they provide immediate tax benefits while allowing for strategic charitable giving at the donor’s leisure.

What are a DAF’s Tax Consequences?

While a DAF is a relatively tax-efficient and flexible way of supporting charity, it is not a pure tax play. If your goal is just to save taxes, giving to a DAF will not make sense. Someone in the 40% marginal tax bracket who gives $100 to a DAF will only receive $40 in tax savings. The charity will get the full $100, but the taxpayer will be out, on net, $60 (perhaps a little less if the asset was appreciated and would have generated capital gain on a sale).

Benefits of DAFs:

1. Immediate Tax Deduction: Donors receive a tax deduction in the year the contribution is made, regardless of when the funds are distributed to charities.
2. Tax-Free Growth: Contributions to a DAF can grow tax-free, allowing for potentially larger future charitable donations (though you do not receive an additional charitable deduction for this growth).
3. Flexibility in Giving: Donors have the flexibility to make grants to multiple charities over time and don’t need to decide which charities to support until at some point after the assets have been contributed to the DAF.

Drawbacks of DAFs:

1. Irrevocable Contributions: Once assets are donated to a DAF, they cannot be reclaimed by the donor.
2. Fees and Management Costs: DAFs are managed by sponsors, which may charge administrative fees.
3. Negative Financial Transaction: The assets you give away will be worth more than the tax benefits you receive in return, which is why you need to be philanthropically minded for this to make sense!

What is an Ideal Use Case?

Astrid is a married New Yorker earning $1,200,000 per year. Her annual tax bill is $550,000. She isn’t particularly focused on tax mitigation, but she’s passionate about her favorite charity: the Boys & Girls Club. Astrid wants to give six figures to charity each year, ideally in a relatively tax-efficient way. Astrid could sell $250,000 of her appreciated investments, pay $50,000 in taxes and donate the remaining $200,000, or she could directly donate $200,000 of stock to the DAF, have the DAF sell the stock tax free, and then the DAF could donate the money to the Boys & Girls Club! Using the DAF allows Astrid to avoid capital gains taxes. Of course, Astrid would have been better off personally if she had just kept the stock for herself. But given her philanthropic goals, gifting to a DAF may make sense for her.

What are Charitable Lead Annuity Trusts?

A Charitable Lead Annuity Trust (CLAT) is an irrevocable trust designed to provide annual distributions to a charity for a specified period, after which the remaining assets are distributed to non-charitable beneficiaries, typically family members but sometimes the donors themselves. In most cases, the CLAT is structured so that the taxpayer receives a charitable deduction equal to the value he or she contributes to the trust. In this way, gifting to a CLAT is similar to gifting to a conventional charitable vehicle, like a Donor Advised Fund. The difference is that, with a CLAT, the donor or his or her family can keep the charitable vehicle’s investment returns to the extent they exceed the IRS hurdle rate, which is typically 2-5% per year. If you contribute $1 million to a CLAT and the CLAT generates 10% annual returns, you may be able to not only claim a $1 million deduction upfront but also walk away with a six-figure or even seven-figure remainder interest at the end of the term.

Factors that Influence the Desirability of a CLAT

CLATs tend to work best if some combination of these factors are true:

Benefits of CLATs:

Drawbacks of CLATs:

What is an Ideal Use Case?

Benjamin, a married California resident, earns $1,200,000 per year. Because his annual tax bill is $550,000, Benjamin is focused on tax mitigation. Benjamin is charitable; going forward, he hopes to give $120,000 a year to his religious institution. He could give away $120,000 outright each year. Or, he could set up a CLAT in a year when he has a particularly high income, and then use the resulting charitable deduction to offset a substantial chunk of his income in that year while also setting up a $120,000 annual income stream for charity. In this way, he’ll be able to accelerate his charitable deductions while also potentially keeping a portion of the excess returns on the amount that puts into the CLAT. Compared to some other tax-mitigation strategies, CLATs tend to have a lower ROI because the donor is giving away a chunk of his or her assets. But they have a higher ROI than simply gifting to a Donor Advised Fund or most other charitable vehicles, so they make a lot of sense for people who are charitably inclined. You can estimate your potential returns here!

Why Choose One Strategy or the Other?

Gifting to Donor Advised Funds and gifting to Charitable Lead Annuity Trusts are similar in many respects. Both allow a donor to support charity. Both allow a donor to claim up to a 100% upfront charitable deduction. But there are also important differences between these two strategies. From the donor’s perspective, a CLAT is probably the higher-return choice. Not only does it yield a charitable deduction, it also allows the donor or the donor’s family to benefit from the remainder interest when the term ends. In some cases, that remainder interest will be quite large. On the other hand, a DAF that makes large distributions to charity in the first few years after being funded may be more attractive to a charitable beneficiary. assuming that the DAF makes large distributions to charity in the first few years after it’s funded. If the contributions to the DAF instead sit inside the DAF rather than being distributed to charity, then a CLAT will be the better approach from the perspective of a charity looking for donations.

Conclusion

Gifting to Donor Advised Funds and gifting to Charitable Lead Annuity Trusts are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

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