CRS REPORT EXPLORES TAX TREATMENT OF CHARITABLE CONTRIBUTIONS OF APPRECIATED ASSETS.

                          Louis Alan Talley

Changes in the tax law that affect charitable contributions of appreciated assets were made under provisions of the Tax Reform Act of 1986 (TRA86), the Revenue Reconciliation Act of 1990 (RRA90), and the Tax Extension Act of 1991 (TEA91). Prior to the passage of the TRA86, a taxpayer who itemized deductions was permitted to deduct the full market value of gifts of property to qualified tax-exempt organizations. The donor escaped income taxation on the appreciation in the asset's value and through the use of the charitable deduction (of the untaxed appreciation) sheltered from taxation otherwise taxable income. The TRA86 provided that the appreciation was to be included in the alternative minimum tax (AMT) base. The congressional rationale was that taxpayers with substantial income should not be able to avoid all tax liability through the use of tax incentives even when provided for worthy goals.

Media reports and arguments made by the tax-exempt community resulted in Congress reexamining its position of including the appreciated value of charitable contributions as a tax preference item. The result was passage of two laws which combined have provided a year and a half period during which gifts of appreciated property were not subject to the AMT. While not explicitly stated, this special tax treatment was restricted by the Congress as a method of limiting future revenue losses during a time of large Federal budget deficits. President Clinton calls for a permanent exclusion from AMT of the appreciated value of all types of property gifts.

Perhaps the single most important point made in support of the law prior to the change in 1986 was that there is social value in having high income taxpayers contribute appreciated assets for public purpose or use, and high income taxpayers are usually assumed to be strongly influenced by the tax deduction for charitable contributions. It was argued that the minimum tax provision negatively affects donors of unique assets and results in an overall reduction in charitable contributions. It was also argued that it is the recipients of charitable services who suffer most from the loss of charitable gifts.

The purpose of subjecting charitable gifts that have appreciated in value to the AMT is to prevent what many see as an abuse by wealthy taxpayers who used such deductions to keep from paying their "fair" share of Federal tax revenues. Questions arise as to how scarce Federal tax revenues should be allocated and possible distributional implications of restoring the exemption. A reversion to prior law would favor institutions such as museums and libraries over community groups or social service agencies. Prior tax treatment encouraged taxpayers to make contributions in the form of property rather than in cash even though many tax-exempt organizations would prefer cash donations. Since there are few requirements and no costs borne by the donee for acceptance, some tax-exempts have encouraged this tax shelter. Finally, the Internal Revenue Service's limited resources for exploration into proper valuation has been questioned.

                              CONTENTS

Prior to the passage of the Tax Reform Act of 1986 (TRA86), a taxpayer who itemized deductions was permitted to deduct the full market value of gifts of property to qualified tax-exempt organizations. For property that has appreciated in value, this provision allows the donor to deduct the appreciation (capital gain) twice, first by excluding it from income and then by deducting it from income from other sources. The TRA86 retained this provision in the regular tax but provided that the appreciation (capital gain) was to be included in the alternative minimum tax (AMT) base. Current AMT tax rates are 24 percent for individuals and 20 percent for corporations. ¹

For example, let us look at the tax consequences of a charitable gift of a painting to a tax-exempt art museum. The donor purchased a painting for $100,000 with the value subsequently increasing to $1,000,000. Prior to the passage of the TRA86, the donor paid no tax on the $900,000 of capital gain and deducted $1,000,000 as a charitable contribution. Under the TRA86, the donor pays an AMT on the $900,000 in appreciated value (previously not taxed) and deducts a charitable contribution of $1,000,000. During tax year 1991 and the first half of 1992 (special periods when the 1986 rules did not apply) the donor was not subject to the AMT but deducts the fair market value as a charitable contribution. Thus, the donor escapes tax on $900,000 of income plus shelters $1,000,000 of other income from tax. Current tax law follows the TRA86 rules.

In general, those taxpayers affected by the change in tax law under the TRA86 provisions fall within two categories. The first category consists of taxpayers whose gifts of appreciated property are large in relation to their income for the tax year. The second category consists of taxpayers who make use of tax breaks predominately available to high-income taxpayers and, thus, are already subject to the alternative minimum tax.

Since passage of the TRA86, the Congress has provided two periods when gifts of appreciated property by individuals were not subject to the AMT calculation. The initial period was provided with passage of the Omnibus Budget Reconciliation Act of 1990 and ran from January 1, 1991, until December 31, 1991. This period was later extended for an additional six months with passage of the Tax Extension Act of 1991 (TEA91). Thus, this second extension expired on June 30, 1992.

Only gifts of tangible personal property that were related to the exempt use of the qualified organization were eligible for exclusion from the AMT calculation during these two periods. Gifts of real or intangible property were not eligible for this exclusion. One example of a qualifying contribution would have been the donation of a painting to a tax-exempt art museum. A gift of the same painting to, for example, a hospital probably would have not qualified because the painting is not related to the hospital's exempt function. Likewise, the gift of appreciated stock to the same art museum would not have qualified for this special tax treatment because stock is not tangible personal property. All of the above examples would have qualified prior to the changes made in the TRA86.

CONGRESSIONAL RATIONALE

In enacting the AMT rules, the Congress seemed especially concerned over the vertical equity issue. Stated as the congressional rationale for the change made in the TRA86 was the following:

Congress concluded that the minimum tax should serve one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions and credits. Although these provisions may provide incentives for worthy goals, they become counterproductive when taxpayers are allowed to use them to avoid virtually all tax liability. The ability of high-income taxpayers to pay little or no tax undermines respect for the entire tax system and, thus, for the incentive provisions themselves. In addition, even aside from public perceptions, Congress concluded that it is inherently unfair for high-income taxpayers to pay little or no tax due to their ability to utilize tax preferences. ² . . .

In addition, Congress concluded that certain items, not presently treated as preferences, must be added to the minimum tax base in order for it to serve its intended purpose of requiring taxpayers with substantial economic incomes to pay some tax. The items as to which Congress reached the determination include . . . untaxed appreciation deducted with respect to charitable contributions . . . ³

In addition, congressional debate has shown a concern for horizontal equity. Let us compare the after tax cost of a gift of money from the sale of a painting versus a donor directed gift of a painting. Consider two individuals with equal pre-tax incomes, both taxpayers in the 31 percent tax bracket. (This example assumes that the charitable gift will not move either taxpayer into a lower tax bracket.) In each case, the taxpayers own paintings with an original acquisition cost of $100,000 have appreciated in value to $1,000,000. The first taxpayer sells the painting with the $1,000,000 in proceeds given to an art museum. The $900,000 appreciation is subject to a 28 percent tax rate (the maximum tax rate on capital gains) or $252,000 in taxes. The taxpayer receives a tax deduction for the $1,000,000 gift, saving $310,000 in tax (the maximum tax rate of 31 percent times $1,000,000). Thus, the taxpayer's after tax cost of the gift will be $942,000 ($1,000,000 gift + $252,000 in taxes - $310,000 in tax savings). Like the example on page 1, the gift of the second taxpayer of a similar painting which originally cost the donor $100,000 and has since increased in value by $900,000 is made directly to the art museum and qualifies (if given in 1991 or the first half of 1992) as a gift of appreciated property not subject to the AMT. Like the first donor, the second donor receives a charitable contributions deduction the value of which is $310,000, but the second donor is not subject to tax on the appreciated value. The aftertax cost of the second donor's gift is $690,000. (This example does not take into account the limitation on itemized deductions instituted under the Omnibus Budget Reconciliation Act of 1990 (OBRA90). In 1991, allowable deductions were reduced by 3 percent of the amount by which the taxpayer's adjusted gross income exceeds $100,000. Deductions may not be reduced by more than 80 percent; the adjusted gross income limit is indexed, and the provision sunsets in five years.)

This different tax treatment of gifts has the effect of distorting market decisions about what form -- money or appreciated property -- the donor may make a gift. Most tax-exempt organizations would prefer donations of cash rather than property. Often the gift may not be the finest available in the market or may fall within a collecting category of limited interest to the recipient. For example, a fine painting by a noted French artist may be given to a museum that specializes in paintings by Americans. Typically, the tax-exempt institution will accept the donation and store the artwork, with the intent to sell the piece in the future. The funds obtained after the sale are typically used to acquire objects of interest to the tax-exempt organization and within the scope of its collection.

TAXPAYER RESPONSE

Because the TRA86 provided lower tax rates, many individuals can make a larger after tax profit by selling the item now than they could have prior to tax reform. In addition, the lowering of tax rates provided by the 1986 tax reform raises the after tax cost of making a charitable contribution, which reduces the incentive to give that varies directly with the marginal tax rate of the giver. ⁴ Thus, the decline in tax rates alone could have reduced charitable giving since the after tax cost is greater. There are a number of studies which find significant price elasticities, and estimates of reduced giving as a result of passage of the TRA86 have ranged from 10 percent to 25 percent. ⁵⁶

Further, it was predicted that higher income giving would be more affected and, thus, the types of organizations, such as art and educational institutions, to which the wealthy typically make donations. Since many were aware of the tax changes brought about by passage of the TRA86, appreciated property gifts may have been made before the effective date of the change. It appears that at least in part the reported decline in gifts after the TRA86 may be attributable both to the change in the tax treatment of appreciated property as well as other tax changes made by that act.

A number of studies including those by the American Association of Museums, the Association of Art Museum Directors, and Charles T. Clotfelter for the National Bureau of Economic Research, Inc., reported a substantial decline in donations of appreciated property following passage of the TRA86. ⁷⁸ This initial decline in the giving of appreciated assets also could have been the result of factors other than the passage of the TRA86 frequently not taken into consideration. For example, art prices had for several years following the passage of the TRA86 spiraled upward in value. Some individuals may have been holding onto such art work until the market peaked in order to obtain the largest possible charitable contribution deduction. ⁹

Anecdotal evidence indicates that gifts of appreciated property have soared during tax year 1991 in response to the initial one year period when such gifts were not included in the alternative minimum tax computation. ¹⁰ However, one would expect that those tax incentives with limited time horizons would be used to a greater degree by taxpayers than if the tax provision were a permanent part of the Code and available over a longer time horizon.

TEMPORARY TANGIBLE PERSONAL PROPERTY EXEMPTION FROM AMT

As a result of increased media reports and arguments by tax- exempt organizations, including museums, concerning the decline in gifts of appreciated assets, the Congress reexamined its position of including the appreciated value as a tax preference item. The Revenue Reconciliation Act of 1990 (RRA90) contained an amendment, introduced by Senator Daniel Patrick Moynihan, which provided for the initial one-year period when gifts of "tangible personal property" would not be subject to the AMT. This one-year period was extended for an additional six-month period by the Tax Extension Act of 1991 (TEA91).

The stated purpose of passage of TEA91 was to provide time so that the Congress could make a reasoned judgment with respect to a number of tax incentive provisions. Many of these provisions had previously been extended, and it was the hope that a determination could be made as to which tax provisions should be extended permanently, provided that APPROPRIATE REVENUE SOURCES could be found to pay for the revenues lost if the provisions were to be made permanent. In the last session of Congress, a permanent extension of AMT treatment of gifts of appreciated property was passed twice. However, in both cases, President Bush vetoed the tax package of which this provision was a part.

Both the RRA90 and the TEA91 limit the tax benefit to tangible personal property and, thus, excludes gifts of stock and land, effectively limiting the revenue loss. Like limiting the benefit to tangible personal property, it is generally believed that limiting the period of special tax treatment (rather than returning to pre 1986 tax law) was a method to help prevent continuing revenue losses in future years because of current large Federal budget deficits.

GIFTS OF APPRECIATED ASSETS ADVANTAGES AND DISADVANTAGES

When Congress considered the addition of gifts of appreciated property to the AMT base, a number of advantages were cited in support of retention of then current law. Perhaps the single most important point made in support of the law prior to the 1986 change was that there is social value in having high income taxpayers contribute appreciated assets for public purpose or use, and they are usually assumed to be strongly influenced by the tax deduction. In particular, Lawrence B. Lindsey has stated that the minimum tax provision "will significantly affect" donors of "unique assets" ¹¹ (such as an Old Master's painting). Bruce Hopkins, the author of a textbook on the taxation of nonprofit organizations, "criticized the proposal because it would result in an overall reduction in charitable contributions." Hopkins indicated that "to take away incentives such as capital gains exclusion hurts only the taxpayer who receives the benefit of rate reduction, . . . however, in the case of charitable incentives, it is the recipients of the charity's services who suffer most." ¹² Thus, the policy goal is to transfer "unique assets" from those with higher-incomes to guardianship by museums, libraries, etc., for general public access.

It is generally conceded that donors of appreciated assets are most likely to be wealthy. While the majority of charitable giving goes to religious organizations, the wealthy typically fund "high culture" institutions. It would appear that donations of appreciated property would (as they have in the past) be given predominantly to organizations which the wealthy typically support, e.g., prestigious, traditional institutions in which the donor has a specific interest or where the donor's family and friends are personally involved. Often, wealthy donors support such institutions as the opera, symphony, ballet, theater, art gallery, or museum. The wealthy also tend to support educational institutions where family members have attended. Organizations less likely to receive gifts from the wealthy or to receive gifts in the form of appreciated property include community groups or social service agencies.

Lower marginal tax rates, one product of the 1986 tax reform, were largely achieved through base broadening. Base broadening is generally achieved by either subjecting to tax income not previously included in the definition of taxable income or by restricting deductions (or credits) in computing tax liability. One inclusion in the broader tax base was the addition of the appreciated value of charitable gifts of appreciated property to the computation of the AMT. If this change is to be reversed, a number of public policy questions arise.

A simple fact often forgotten is that if an appreciated asset is sold it results in Federal income tax revenue. When that asset is given away, the Federal government provides a subsidy not only in the tax revenues that are forgiven but also provides a loss of public revenues from other taxable income by the amount of the charitable contribution deduction.

Congress is faced with large Federal budget deficits which often result in a closer examination of how limited Federal resources should best be allocated. For example, some may question whether Federal revenues losses should be incurred for paintings donated to a museum when other pressing problems need to be addressed. The question becomes one of priorities: a Monet for a museum or increased Federal spending on homelessness, emerging democracies, infrastructure needs, education, etc. In addition, Congress under self-imposed rules must offset tax legislation which loses revenues with other measures to restore the lost revenues. Thus, restoration of pre-1986 tax law (for appreciated property gifts) would likely result in changes to other Code provisions to compensate for the revenue loss. The changes in tax code provisions may affect different taxpayers, with different distributional consequences.

The purpose of subjecting charitable gifts that have appreciated in value to the AMT was to prevent what some saw as an abuse by wealthy taxpayers who used such deductions to keep from paying their "fair share" under the Federal tax laws. Additionally, it has been noted that the prior tax treatment encouraged taxpayers to make contributions in the form of property rather than in cash even though many tax-exempt organizations would prefer the donation in cash. However, since there are few requirements and no costs borne by the donee for acceptance of gifts, some tax-exempts have encouraged this type of sheltering. ¹³

Another important consideration is that the Internal Revenue Service has had difficulty in the past with taxpayers overstating the value of items donated. Stocks, bonds, and real estate are more easily valued than art and collectibles since such items may be unique. The markets in which art and collectibles are sold often have few participants, further making it difficult to properly determine worth. Some have questioned the use of the Internal Revenue Service's limited resources for exploration into proper valuation.

LEGISLATIVE PROPOSALS FOR CHANGE

President Clinton's tax proposals include the permanent removal of the appreciated value of property as a tax preference item from the AMT computation. This provision would be effective for gifts of personal property made after June 30, 1992, and for gifts of real and intangible property made after December 31, 1992. To partially pay for this repeal of a portion of the 1986 tax law, the President has called for increased substantiation and disclosure requirements for donations made to charities.

This component of the tax plan requires individuals to obtain and retain written substantiation from the donee for contributions of $750 or more. The onus for substantiation is upon the donor -- and not the donee -- with the explanation noting that a canceled check will not fulfill the substantiation requirement of the law. Such substantiation must be obtained before tax return filing. Substantiation is not required in those cases where the donee reports deductible contributions directly to the Treasury Department in accordance with regulations to be issued. Further, under the proposal, donees are required to disclose "quid pro quo contributions" when the contribution consists partly of an exchange for goods or services. It is the responsibility of the donee to provide an estimate of the value of such goods or services. An itemized deduction for the contribution is allowable to the extent that the contribution exceeds that value. Failure by the donee to substantiate will result in penalties of $10 per contribution with a maximum penalty of $5,000 per event.

The Joint Committee on Taxation has estimated that the AMT provision will lose $417 million during the five fiscal years of 1994-98. The substantiation and reporting requirements provisions are expected to generate $273 million during this same period.

In addition, it might be noted that under President Clinton's tax proposal marginal tax rates would rise. A number of studies have found significant price elasticities and estimates of giving based on marginal tax rates. As such, the combination of rate increases, along with the removal of the appreciated value from the AMT computation, could be expected to stimulate charitable giving of appreciated property.

A similar group of provisions (minus the tax rate increases) was suggested by President Bush. Substantiation requirements, under the Bush proposal were lower ($500). However, organizations with annual gross receipts of more than $25,000 were required to file information returns with both the Internal Revenue Service and the donor. The Bush proposals also included reporting requirements by the donee for "quid pro quo contributions." The final tax bill, H.R. 11, later vetoed by President Bush, contained provisions identical to the Clinton proposal.

OTHER LEGISLATIVE CHANGES AFFECTING CHARITABLE CONTRIBUTIONS

The Revenue Reconciliation Act of 1990 provided for other changes in the area of charitable contributions. A limitation on certain itemized deductions (such as those for charitable contributions) was included in the law. As such, beginning in 1991, to the extent that a taxpayer's adjusted gross income exceeds $100,000 his itemized deductions were reduced by 3 percent of adjusted gross income in excess of $100,000. (The phaseout threshold is adjusted for inflation in future years; for tax year 1992 it stood at $105,250.) However, itemized deductions subject to the 3 percent limitation cannot be reduced by more than 80 percent. This provision is scheduled to sunset after 1995, but the Clinton tax proposals also call for its permanent extension.

² U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514). Washington, U.S. Govt. Print. Off., 1987. p. 432- 433.

³ Ibid., p. 434.

⁴ A study which finds that rate cuts do not necessarily hurt charitable contributions was Briston, Ralph B. Tax Cuts and Charitable Giving. Tax Notes, July 15, 1985. p. 323-326.

⁵ For example, Auten, Gerald and Rudney, Gabriel. Charitable Deductions and Tax Reform: New Evidence on Giving Behavior. Committee on Federal Taxation and Finance of the National Tax Association-Tax Institute of America, November 26, 1983. Another study of interest is Lindsey, Lawrence B. The Effect of the Treasury Proposal on Charitable Giving: A Comparison of Constant and Variable Elasticity Models. Cambridge, Mass., National Bureau of Economic Research, Inc., March 1985 (NBER Working Paper #1592). An overview of major studies can be found in Clotfelter, Charles T. Federal Tax Policy and Charitable Giving. Chicago, University of Chicago Press, 1985. A table of these studies is provided on pages 57-59.

⁶ A study presented at the National Tax Association Symposium in Crystal City, Virginia, on May 18-19, 1992, by Gerald E. Auten, James M. Cilke, and William C. Randolph of the Office of Tax Analysis, U.S. Department of Treasury (see National Tax Journal, Vol. XLV, No. 3, September, 1992. p. 267-290), found (1) that contributions rose in the 1980s partly due in part to population increases, (2) high-income taxpayers responded to the increase in the tax price of giving by decreased contributions but not as much as predicted by cross-section regression estimates, and (3) high-income taxpayers responded to the change in the tax price of giving of cash and noncash contributions by an increase in cash giving relative to noncash giving after TRA86.

⁷ Glueck, Grace. Donations of Art Fall Sharply After Changes in the Tax Code. New York Times, May 7, 1989. p. 1, 32.

⁸ Clotfelter, Charles T. The Impact of Tax Reform on Charitable Giving: A 1989 Perspective. Cambridge, Mass., National Bureau of Economic Research, 1990. p. 19-20. (NBER Working Paper No. 3273)

⁹ Alternatively, it was suggested in Moynihan, Art, and the AMT, Tax Notes, v. 49, December 31, 1990, p. 1579 that "the ability to claim a contribution deduction at inflated values without reporting gains may be a prop to selling prices."

¹⁰ In the Tax Report column (front page) of the Wall Street Journal of June 10, 1992, it was reported that the National Gallery of Art in Washington received 2,444 works in 1991 as compared to 295 works in 1990.

¹¹ Lindsey, Lawrence B. Gifts of Appreciated Property; More to Consider. Tax Notes, January 5, 1987. p. 69.

¹² Tax Reform: Treatment of Appreciated Property Focal Point of University Opposition to Treasury Plan. The Bureau of National Affairs. Daily Tax Report, No. 248, December 26, 1984. p. G-2 -- G-4.

¹³ After a period, the tax exempts usually sell such donated items for acquisition funds to acquire more appropriate items for their collections. In Moynihan, Art, and the AMT, Helvering von Eisner alleges "Even the prestigious Smithsonian itself had previously participated in tax shelter scams in which sophisticated investors (such as doctors and dentists) bought nonprecious gemstones at wholesale and contributed them to the Smithsonian after a short wait, claiming a deduction at retail. See Rev. 90-69, 1980-1 C.B. 55; R.C. Chiu, 84 T.C. 722; and other cases collected at 3 CCH Std. Fed. Tax Rep. at Para. 1864.0311."