TaxProf Blog

Editor: Paul L. Caron
Pepperdine University School of Law

Friday, February 24, 2017

Weekly SSRN Tax Article Review And Roundup

This week, Daniel Hemel (Chicago) reviews a new working paper by David M. Schizer (Columbia), Subsidies and Nonprofit Governance: Comparing the Charitable Deduction with the Exemption for Endowment Income (Columbia Univ. Sch. of Law, Ctr. for Law & Econ. Studies, Working Paper No. 558, 2017).

HemelDavid Schizer’s new paper offers a fresh take on two long-running debates in tax law: should we allow a deduction for charitable contributions, and should we exempt the passive investment income of charities from tax? Schizer’s central claim is that the exemption (but not the deduction) distorts donors’ decisions as to the timing of charitable contributions—and, specifically, that the exemption inefficiently encourages donors to accelerate their giving. This post summarizes Schizer’s argument and then offers a reason why the deduction, at least in its current form, might distort donors’ decisions as to the timing of charitable contributions in the opposite direction.

The tax exemption for passive investment income earned by charities “creates an important inconsistency,” writes Schizer: “If donors keep an investment, their return (generally) is taxable. But if they donate the investment to charity, the return is no longer taxed” (p. 16). This gives the donor “a tax incentive to transfer assets to charities, and thus to give up control of these resources” (p. 20). That “can have two unfortunate effects,” according to Schizer: “it can erode the motivation and ability of charities to change with the times, and also can impede the ability of donors to monitor the performance of managers.” And while acknowledging that endowments might be desirable under some circumstances, Schizer writes that “it is hard to see why the tax law should put a thumb on the scale” (p. 24). 

All this might sound like it’s leading up to an argument for taxing charities on their investment income. But as Schizer notes, there is a problem with that approach too: it would distort a charity’s decision to spend now or save and spend later, just as a tax on investment income distorts an individual’s choice between present and future consumption. Schizer’s suggested solution is instead to relax the rules governing donor-advised funds and private foundations so that donors can earn tax-free returns in those vehicles while controlling the timing of grants to charities. With respect to donor-advised funds, Schizer suggests that Congress could give donors formal power to decide which charities receive grants. (As a practical matter, the largest donor-advised funds already give donors that ability.) Alternatively, Congress could lift the 2% excise tax on the net investment income of private foundations, as well as the more stringent limits on the deductibility of contributions to private foundations. Such changes, Schizer says, “would be an improvement” over the status quo, though he adds that “there are no bulletproof solutions here” (p. 47).

Schizer’s article does not mention the potential for the charitable contribution deduction to distort the timing of gifts in the opposite direction. The distortion arises from the fact that a taxpayer who donates capital gain property to charity can claim a deduction for the property’s fair market value even if she never pays tax on the capital gain. This rule means that donors who hold onto risky assets with the intention of giving those assets to charity in the future can achieve a negative tax rate on investment income.

An example will illustrate. Imagine that a taxpayer (T) wishes to contribute $60 of after-tax income to a charity. Imagine, moreover, that T has a choice among: (a) giving to the charity today; (b) investing in a risk-free asset that will pay 10% interest during the relevant period and then giving the proceeds to the charity at the beginning of the next period; or (c) investing in a risky capital asset that with probability 0.5 will grow to 2.2X in the next period and with probability 0.5 will lose all of its value, and giving whatever she is left with to the charity. Assume that T is in the 40% tax bracket (39.6% rounded up for arithmetic simplicity), and that T faces a 20% rate on long-term capital gains. (Assume, moreover, that the relevant period is at least a year and a day, so any gain or loss will be long-term capital gain or loss.)

If (a) and (b) are T’s only options, then T has an incentive to give the money to charity today. If T wants the after-tax cost of her contribution to be $60, then she can make a $100 gift to charity and claim a deduction ($60 = $100 – 40% x $100). The charity can then use the $100 to buy a risk-free asset, in which case the charity will earn $10 interest and have $110 next period. If T instead buys a $60 risk-free asset and holds it herself, then she will earn $6 in interest, pay $2.40 in tax, and have $63.60 in the next period. She can then afford to make a $106 contribution to the charity ($63.60 = $106 – 40% x $106). That’s less than what the charity will have if T makes the gift today.

But now add option (c) to the mix. Let’s say that T invests $60 today in the risky capital asset. With probability 0.5, the $60 asset grows to 2.2x, or $132, in the next period, and T can make a $220 gift to charity ($132 = $220 – 40% x $220). With probability 0.5, the $60 asset loses all of its value, T claims a long-term capital loss, and—assuming she has long-term gains to offset—she claims a deduction worth 20% x $60 = $12. She then can make a $20 contribution to the charity ($12 = $20 – 40% x $20). As above, T sacrifices $60 in after-tax terms, but now the expected value to the charity in the next period is 0.5 x $220 + 0.5 x $20 = $120. That’s more than the charity will have in expected value terms if T makes the gift today.

Put differently (and with less math): A taxpayer who buys risky capital assets and sets them aside in a taxable account with the intention of donating them to charity at a future date has the option of harvesting losses when she has losses while not paying taxes on capital gains when she has gains. The result is the reverse of the incentive that Schizer identifies: a tax incentive to delay the transfer of assets to charity.

Do the conflicting incentives balance out in the end? Alas, no. As Schizer illustrates, the exemption gives donors an incentive to transfer risk-free assets earlier rather than later (especially if the risk-free assets generate ordinary income). And as the above example illustrates, the deduction gives donors an incentive to transfer risky assets later rather than earlier (especially if the risky assets are zero- or low-dividend growth stocks). So we have opposite distortions with respect to different assets rather than an equilibrium.

Perhaps we might not be displeased with the status quo insofar as we think that individual donors enjoy an advantage over charities in managing risky-asset portfolios but no advantage in managing risk-free investments. But again, it is hard to see why the tax law should be putting a thumb on the scale. Fortunately, on the deduction side, there is a straightforward solution: limit the donor’s charitable contribution deduction to adjusted basis unless the donor also pays tax on the unrealized capital gain.

All of which is to say: Schizer’s paper will give readers much to think about—and for anyone interested in the deduction/exemption debate, it is a must-read. Indeed, on the last point, there is indeed a reason to put a thumb on the scale: the sooner, the better.

Here’s the rest of this week’s SSRN Tax Roundup::

Scholarship, Tax, Weekly SSRN Roundup | Permalink


Donor-advised funds and private foundations are easy solutions to the problem of donors who would like to have their donations be deductible now and then appreciate tax-free while retaining control over how the donations are used. As the review notes, formal control isn't necessary for this to happen with donor-advised funds. It's extremely easy to do--I have a Vanguard fund of this kind myself, which I started when I wanted to take a lot of capital gains in one year but didn't know which charity I wanted to give the money to yet.
On the other hand, there is a big problem with nonprofits piling up assets and never using them. A big part of this is because then the nonprofit's managers can get illegal but uncatchable private inurement from bigger endowments. So what we really need is a requirement that nonprofits spend, say, 15% their endowment income each year.

Posted by: Eric Rasmusen | Feb 24, 2017 5:49:07 PM

Oops--- not 15% of income--- 15% of principal.

Posted by: Eric Rasmusen | Feb 24, 2017 5:49:58 PM