Many of our clients make regular charitable contributions.  The tax laws can be fairly complicated in this area, but there are ways to give more efficiently that are worth knowing if you have charitable inclinations.  While these strategies apply to most of our clients, please contact us or an appropriate tax professional before taking action as there may be differences in your individual situation that may limit your deduction, or the appropriateness of a particular strategy. I have also had to omit some details to keep this to a reasonable length and comprehension level. The tax code, as I’m sure you know, is what is known here in the south as a “hot mess.”

Charitable Gifts. First, here are two ways to make charitable gifts with generally better tax outcomes than a traditional cash gift:

1. Qualified Charitable Distributions (aka QDCs). If you are over 70½ years old and have an IRA you may redirect some or all of your Required Minimum Distribution (RMD) to a charity (up to $100,000). Note that this must be a public charity (not a private foundation) and it also cannot be a Donor Advised Fund (more on these below). This option is best for taxpayers who have large impacts from a higher AGI (Adjusted Gross Income). For example, taxability of Social Security, itemized deduction phaseouts, personal exemption phaseouts, etc. are all based on AGI. This is a particularly good option for taxpayers who do not itemize or who would not itemize in the absence of charitable contributions. If your IRA has basis (i.e. after-tax contributions) QDCs are considered to use the taxable portion first (this is a good thing).

2. Donation of Appreciated Securities (DAS). Frequently the best gift to make to a charity is a donation of appreciated securities that you own in a taxable account (not a retirement account).  Suppose 100 shares of stock were acquired many years ago for $5,000 and the value has subsequently grown to $50,000.  The position may be transferred to a charity and (with some limitations) a deduction taken for the current value.  The charity can sell the securities, and as a non-profit will pay no taxes on the appreciation.  The $45,000 gain is never taxed in this case.  This is a particularly good strategy if you have a position you would otherwise sell (for diversification perhaps), that has a very low cost basis.  It is also nice for positions where you are unsure of your exact cost basis since it never needs to be determined. The example I gave was securities but any property that is long-term capital gain property can work but the rules are very specific so please contact us or another qualified professional in that case. If the taxpayer plans to leave these assets intact to heirs the advantage of gifting these securities is removed as under the current tax code all of the appreciation will be eliminated on inheritance anyway (this is known as a “step-up in basis”).

Assuming the taxpayer has the choice of either (i.e. they are over 70½ and have securities with long-term capital gains) here is my simplified flowchart of the optimal choice:

1. Does the taxpayer itemize?
   1. No, not even with the prospective DAS → QCD
   2. Yes, or only with the prospective DAS → go to next question
2. Is the taxpayer’s LTCG rate greater than 0% (including through a future step-up)?
   1. No → QCD
   2. Yes → go to next question
3. Is the taxpayer subject to SS or other phaseouts?
   1. No → DAS
   2. Yes → uncertain (you have to run the numbers)

Charitable Bequests. Under current law, at death most holdings will be “stepped-up” in value so heirs will have a cost basis equal to the current value.  Thus, leaving a bequest of securities as mentioned above doesn’t have an income tax advantage.  (In fact, if the estate is not large enough to be taxable, and most estates are not, it would be better to leave the property to an heir and have them make the charitable contribution so that they can have an income tax deduction rather than wasting it by leaving the property to the charity directly.)  For bequests, the best gift is generally assets in a retirement account that has only pre-tax contributions.  This would include most IRAs, 401(k) plans, etc.  To do this, simply name the charity on the beneficiary designation for the account.

Alternatively, to maintain flexibility it is possible to name the charity as a contingent beneficiary and have the primary beneficiaries disclaim the amount they would like to go to charity at that time.  Disclaimers are frequently not executed properly, so discussing the plan beforehand and involving competent advisors would be prudent.

The reason these retirement accounts are optimal for charitable bequests is that they generally have no cost basis at all, and as IRD (Income in Respect of a Decedent) property they do not receive a step-up in basis as discussed above.  Thus a $50,000 traditional IRA left to someone in the 25% marginal tax bracket would only provide them $37,500 after taxes if they withdrew the funds immediately.  Conversely, the entire $50,000 would be available to a charity as a tax-exempt entity.  This is an even better strategy than the gift of appreciated securities above because 1) rather than simply a “low” basis, these retirement accounts typically have a cost basis of zero, and 2) the taxes saved are ordinary income taxes rather than the lower capital gains taxes.

Donor Advised Funds (DAF). Sometimes referred to as a “poor man’s foundation” a Donor Advised Fund is a charity and a gift to the DAF is a completed charitable gift that qualifies for a current tax deduction. (Family foundations are generally not recommended unless they will be funded with initial gifts of at least $1,000,000 and there is a reason a simple DAF wouldn’t work to meet the family’s charitable goals.)  The DAF account can be invested and the donor, who is no longer technically the owner of the funds, may advise the fund where and when to make contributions, and in what manner (within limits) it should be invested in the meantime.  It would be extremely rare for a DAF to disregard the donor’s wishes in regard to gifts to a public charity.  DAFs can be opened with as little as $5,000-$10,000 and successor advisors (typically the donor’s spouse or children) may be named as well.

Here are a few specific cases where DAFs can be very useful:

1. Timing
   1. A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which puts him/her in a high tax bracket so they want to make a gift to get maximum tax savings, but there isn’t time to figure out what organization would be the best recipient before year end.
   2. A taxpayer sells a business or has some other transaction that temporarily raises their income level this year, which raises AGI. They want to make significant charitable contributions thus need the high AGI to be able to get the deduction (given the AGI limitations a five-year carry-forward limitation).

2. Simplicity/Lack of sophistication of the recipient charities
   1. A taxpayer wants to give $5,000 each to three very small country churches and wants to use appreciated securities (because their advisor has coached them in previous years that that is the optimal way to do it) but these churches don’t have brokerage accounts, have never accepted stock donations, and are frankly confused by the whole thing.  Solution, send $15k of appreciated securities to the DAF, sell the securities and have the DAF send checks to each of the churches.  (This is a true story, I was despairing of getting the churches on board when I realized we could just use a DAF.)
   2. A taxpayer wants to give a large amount to a charity but fears a lump sum would overwhelm them (and be used poorly) and thus uses a DAF to make donations over time while getting the deduction today.

3. Post-mortem/Legacy planning
   1. A family has charitable intent and a taxable estate (over $5,450,000 for an individual – double that for a married couple – in 2016) and prefer leaving funds to charity particularly from an IRA that would be subject to income taxes as well as estate taxes.  By naming the DAF as the contingent beneficiary of the IRA, the heirs can use disclaimers to contribute the exact amount the client’s estate is over the estate tax threshold, and the decision doesn’t have to be made until that time.  This adds significant flexibility as future estate tax rates, thresholds, and even the family’s finances change over time.
   2. A family wants giving to continue for many years, and would like younger generations to be able to direct some of those gifts. A DAF with successor advisors can continue the legacy.

4. Privacy or Memorials
   1. A DAF can be named the “Emerson Jones Memorial Fund” or whatever the taxpayer desires.
   2. A DAF can also be used to preserve the donor’s anonymity. By routing a large gift through a generically named DAF to the eventual recipient charity, no one need know from whom the gift actually originated.

Of necessity, the above discussion has been very superficial.  As I noted at the beginning, before implementing these strategies it would be prudent to consult with an appropriate professional for advice and guidance.

While many of the financial planning issues that small business owners face are the same as everyone else’s, there are some differences – primarily in the area of risk management.

• Many small business owners have a large portion of their net worth tied up in their business and thus are not properly diversified.
• The owner generally works in the business also which means his or her wage income is extremely correlated with their investment in the business.
• Frequently the spouse and other family members work in the business as well, further exacerbating the risk to the family as a whole.
• A number of psychological biases cause the owner to dramatically underestimate the risk he or she is taking:
  • Illusion of control is the tendency for people to overestimate the amount of control they have over situations – even when those situations are completely random and they have no control whatsoever. For example, many people have a marked preference for picking their own lottery numbers (and stocks for that matter).
  • Illusory superiority, also known as the Lake Wobegon effect, is the tendency for people to overestimate their abilities relative to others. For example, well over 80% of people believe they are above average drivers, will finish in the top half of their class in school, or that they are better looking than average.
  • Optimism bias causes people to believe there is a smaller chance that something bad will happen to them compared to other people. For example, in one study 81% of new business owners thought their business had at least a 70% chance of success, but only 39% thought a business like theirs would be likely to succeed.

While a comprehensive list of financial planning issues is impossible, following is a good sample:

• Business continuity – there should be a buy/sell agreement in place, a well-thought-out plan to transfer the business to the next generation or next owner, etc.
• Key person risk – in the case where there is one individual upon which the business is unduly dependent, frequently the owner, the risk of that individual leaving (voluntarily or perhaps due to premature death, illness, etc.) should be been planned for with insurance products, non-solicitation or non-compete agreements, etc.
• Retirement – a retirement plan should be established (and funded) for the owner and the employees (if appropriate).
• Disability – disability insurance should be in place for the owner and available to employees (if appropriate).
• Liability – this risk can be mitigated by prudent choice of entity type (C-Corp, S-Corp, LLC, etc.) and appropriate property & casualty insurance. In addition owners should be cautious in personally guaranteeing business loans and may want to structure their lives so as to shield a spouse in the event of catastrophe (having the personal residence only in the spouse’s name for example).
• Estate taxes – successful small business owners may find their net worth has become large enough to create a significant potential estate tax liability. Not only are the common estate tax mitigation strategies available, but business owners also have opportunities specifically for them such as special tax treatment available under IRC § 6166, 303, and 2032a. In addition, having an existing business makes the utilization of strategies such as discounts on valuations of gifts easier not only to do, but to defend to the IRS.
• Income taxes – in addition to typical income tax planning, business owners also have some discretion over the form in which they recognize income (wages vs. salary while working and capital gains vs. interest upon disposition) and can frequently take advantage of fringe benefits including health insurance, business travel and entertainment, employer-provided cell phone or car, etc. In addition, since the business owner frequently has more erratic income than an employee, there may be opportunities to shift income and expenses between tax years to the taxpayer’s benefit.
• Liquidity – many businesses have erratic cash flow and all of them have the possibility of facing tough times, thus it is of vital importance to have adequate sources of liquidity (credit lines, etc.) set up before they are needed.
• Leverage – both financial leverage (debt vs. equity) and operational leverage (variable vs. fixed costs) increase the risks (and potential returns) and must be evaluated carefully. Frequently an increase in one type of leverage would make a decrease in another prudent.
• Complexity – frequently business owners have very complicated financial and legal situations with a variety of contracts, agreements, guarantees, business entities, etc. in place, many of which may simply be legacy items that could be eliminated. Simplification may be appropriate to not only enable better management now, but also to aid heirs in the future.
• Other risks – small business owners also frequently neglect to adequately secure their intellectual property, use employment contracts, conduct background checks, drug tests, credit checks, etc.

The best known (and most parsimonious) rule of ethics is what is known as the “golden rule” which most of us learned as “Do unto others as you would have them do unto you.” This maxim is found throughout history and in almost all religions. For example,

In ancient Greek philosophy:

• Do not to your neighbor what you would take ill from him. – Pittacus
• Avoid doing what you would blame others for doing. – Thales
• What you do not want to happen to you, do not do it yourself either. – Sextus the Pythagorean
• Do not do to others what would anger you if done to you by others. – Isocrates
• What thou avoidest suffering thyself seek not to impose on others. – Epictetus
• It is impossible to live a pleasant life without living wisely and well and justly (agreeing ‘neither to harm nor be harmed’), and it is impossible to live wisely and well and justly without living a pleasant life. – Epicurus
• One should never do wrong in return, nor mistreat any man, no matter how one has been mistreated by him. – Plato’s Socrates

In the Bible, the Apocrypha, and Torah (those three overlap in what is considered canonical):

• Thou shalt not avenge, nor bear any grudge against the children of thy people, but thou shalt love thy neighbour as thyself: I am the LORD. – Leviticus 19:18
• But the stranger that dwelleth with you shall be unto you as one born among you, and thou shalt love him as thyself; for ye were strangers in the land of Egypt: I am the LORD your God. – Leviticus 19:34
• Therefore all things whatsoever ye would that men should do to you, do ye even so to them: for this is the law and the prophets. – Matthew 7:12
• And as ye would that men should do to you, do ye also to them likewise. – Luke 6:31
• Do to no one what you yourself dislike. – Tobit 4:15
• Recognize that your neighbor feels as you do, and keep in mind your own dislikes. – Sirach 31:15
• That which is hateful to you, do not do to your fellow. That is the whole Torah; the rest is the explanation; go and learn. – Talmud, Shabbat 31a

In the eastern religions of Confucianism and Hinduism:

• Do not impose on others what you yourself do not desire. – Confucius, Analects XV.24
• One should never do that to another which one regards as injurious to one’s own self. This, in brief, is the rule of dharma. Other behavior is due to selfish desires. – Brihaspati, Mahabharata (Anusasana Parva, Section CXIII, Verse 8)

Some of these formulations are superior to others. Those worded in the positive (“Do unto others as you would have them do unto you.”) are unworkable. There is no natural limit to the amount of self-sacrifice involved. (E.g. I would like it if everyone gave me all their money, so I must give away all my money to others.) The negative formulations are superior (“Do not do unto others what you would not have them do unto you.”) but still have a problem in that people’s desires can be, and generally are, different.

As George Bernard Shaw said in Maxims for Revolutionists in 1903, “Do not do unto others as you would that they should do unto you. Their tastes may not be the same.” In other words if we should treat others as we want to be treated, then a masochist following the golden rule becomes a sadist.

Perhaps a better ethical formulation can be found in Immanuel Kant’s categorical imperative, which can be stated, “Act only according to that maxim whereby you can, at the same time, will that it should become a universal law.” This is a deontological (as opposed to utilitarian) view of the world, which holds that ends cannot justify means. Indeed as Emerson believed, the ends pre-exist in the means.

Thus, the fundamental code of ethics here at Financial Architects is Kant’s. In addition, the myriad designations and memberships held by principals at Financial Architects subject us to numerous other codes of ethics and standards of professional conduct including:

• CFA Institute
• CFP Board
• Financial Planning Association (FPA)
• Investment Management Consultants Association (IMCA)
• National Association of Personal Financial Advisors (NAPFA)
• The American College

I occasionally teach a 36-hour estate planning class to advisors seeking to become Certified Financial Planners, and we spend about 95% of the course on understanding and developing strategies for dealing with estate taxes. This applies only to a trivial percentage of the population since (under current law) estate taxes aren’t an issue until a person’s net worth exceeds $5 million (plus adjustments for inflation since 2011). If you do happen to fall within that parameter, you should seek qualified help immediately (if you haven’t done so already). Estate taxes are very complex, and without advance planning, the family of someone dying today with a net worth greater than the current exemption will pay 40% (or more depending on the state) in taxes on the excess.

The other 5% of my estate planning class applies to most everyone and deals with all the other issues besides taxes. The main purpose of estate planning (for those without estate tax issues) is simply making sure that things unfold as desired. Following are some areas to review:

1. Make sure you have appropriate insurance. Not everyone needs insurance, but too often people don’t make conscious decisions about life insurance, disability insurance, or long-term care insurance. Most of us are either prone to inertia or simply don’t want to think about the issues and therefore ignore them.  Having appropriate insurance can prevent an estate from being decimated by rare calamities.  (Living a long time is not a rare calamity.  The death of the primary family breadwinner in his or her prime is a rare calamity.)

2. Make sure the beneficiary designations on your insurance policies, retirement plans, etc. reflect your current desires. Even if the beneficiary designations are current, it is probably worth actually getting the insurance company, custodian, or employer to confirm it in writing. Sometimes those organizations do lose paperwork, so it is helpful to have a copy from them on file. In addition, many people are mistaken about who they have named as beneficiaries, particularly if it was a long time ago. It may be easier to simply fill out a change of beneficiary form and keep a copy rather than try to get the institution to confirm your previous choices.

3. Make sure your assets are titled correctly. As with beneficiary designations, don’t just assume that your home or other assets are titled a particular way. It is worth checking.

4. Make sure someone can manage your property if you are unable to. A durable power of attorney and/or a living trust (that has actually been funded) may be required to do this efficiently.

5. Make sure someone will be able to make end-of-life decisions if you can’t. A durable power of attorney for healthcare is often required for this to happen.

6. Make sure you have a living will (as well as the durable power of attorney for healthcare mentioned previously) so your wishes are clearly indicated.  Some states have combined both this item and the previous one into one document called an advance medical (or healthcare) directive.

7. Make sure you have an up-to-date will. In the case of minor children, the parent will undoubtedly want to name a guardian rather than allow a court to choose someone. In addition, an individual who has a blended family or non-traditional family, or wishes to make charitable bequests, or would simply prefer assets to be distributed in a particular way needs either a will or the aforementioned living trust.

8. Consider trusts. If you wish to provide for someone who for some reason should not be given money outright (perhaps they are minors or known to act irresponsible with money), a trust may be an appropriate solution. In addition, trusts are frequently a good solution in cases where the state of domicile has an expensive probate process (California most notoriously) or where there is ownership of real estate in another state. Holding real estate in another state in trust (or in an LLC or in joint tenancy with right of survivorship) will avoid ancillary probate (additional probate in that other state).

9. Consider writing a letter of instruction. This is not a legal document but simply a letter that tells survivors where to find things, who to contact for various things, and any other information they will need that they may not know. This may be particularly important in families where one person has handled all of the financial arrangements and others may not be as knowledgeable in those areas.

10. Make sure your heirs don’t fight over the estate. A few simple steps can help prevent strife later. First, it can be a good idea to have open discussions with your heirs to let them know what to expect. The reading of the will is not the best time for them to find out they have been disinherited or otherwise treated differently than they expected. Second, it may be advantageous to begin gifting during life while heirs can make their desires known. Very often people don’t know the emotional attachment their children (or others) may have to a particular item. Giving things away prior to death also provides the pleasure of seeing the heirs actually get enjoyment out of the gift. Third, many families have started using a type of auction to distribute things equitably. For example, assume a case where there are three children who are each to get 1/3 of the estate. Each one may be given 100,000 points with which to bid on items from the estate (no money is used). Each item is then auctioned off to the highest bidder. Everything that isn’t bid on is sold and the proceeds divided evenly between the heirs.

Dollar Cost Averaging (hereafter DCA) is the technique of periodically investing a fixed dollar amount to reduce risk. Proponents claim this “drastically reduces market risk” by purchasing fewer shares when prices are high and more shares when prices are low. Financial research has shown, however, that DCA does not perform better than investing randomly.

What most people call DCA is more accurately thought of as investing as soon as you have money. In other words, they are systematically investing in their 401(k) or other retirement vehicle as they get paid each month. Investing as soon as you have funds is a prudent strategy.

However, if you have a lump sum to invest, entering the market slowly will decrease risk simply because the funds aren’t invested. Cash is less risky than stocks, but also earns less. Investing immediately in the appropriate asset allocation is the mathematically correct decision.

If DCA worked, as soon as you were fully invested you should immediately withdraw the funds to begin the strategy anew. Obviously, that makes no sense.

Notwithstanding the previous paragraph, from a psychological perspective, investing a large lump sum all at once may lead to strong feelings of regret if the market subsequently declines. Since research (prospect theory)  shows we feel the pain of losses about twice as strongly as the pleasure of an equal-sized gain, mitigating those feelings may be prudent. Make no mistake though; the strategy is sub-optimal for wealth accumulation.