The hook that will bring wealthy clients into philanthropy is tax efficiency, writes Simon Mumme.
There are two types of wealthy philanthropists, according to John King, partner with Mallesons Stephens Jaques in Sydney.
The first type grew up in a family or faith-based culture of giving generously, and in continuing that practice, like to rack professional advisers’ brains about the most effective ways to donate money.
The other type, who have usually built their wealth from humble beginnings and have featured in the BRW Rich 200 List, “think giving $25,000 out of $150 million each year is generous”.
But King says that compared to most wealthy donors, it isn’t generous at all.
The most appealing incentive for these highnet- worth (HNW) people to give more is the realisation that philanthropy is a more desirable way of using money that would otherwise be captured by Canberra as tax.
“For these people, you have to say that they should be giving away about $1 million [annually],” King says.
“Those conversations are very difficult and a lot of financial advisers don’t have the courage to enter into them.
“But the hook that will get them in is tax efficiency.”
The most appropriate time to discuss philanthropy with clients is when they are selling a large asset, inheriting a lot of money or becoming subject to any other transaction that will trigger a large capital gain – which can be offset by a philanthropic commitment.
For example, if a client receives a discount capital gain of $100,000, where half the capital gain is included in their assessable income, a $23,250 tax payment is usually incurred (assuming the top marginal tax rate, plus Medicare levy). But if they donate that amount, plus an extra $26,750, which takes the total donation to $50,000, their tax liability is eliminated.
The donor has given away $26,750 plus the money they would otherwise have sent to Canberra anyway. They are effectively “giving away” their tax liability, along with some of their wealth.
“If you give away $1, it’s like the government putting in another dollar. And people love that,” King says.
The type of large capital gains experienced by HNWs enable these donors to set up a philanthropic vehicle, such as a prescribed ancillary fund (PAF) or a donor-advised fund with a trustee company or community foundation.
While setting up a PAF can take a month or more, and requires a bare minimum of $500,000 to be effective, a donor-advised fund can be “done in a week”.
Over time, repeated tax-effective donations from capital gains can supply considerable funds to the philanthropic sector.
“So you’ve got a lot of money going into a PAF, going to charitable causes over time, and I think that’s a win for the community,” King says.
“The person parts with $26,750 from each $100,000 in discount capital gains, but it’s painless.”
But all this can go wrong if, close to the end of the financial year, a HNW donor wrongly believes that the realisation of a capital gain occurs when the transaction is settled.
For instance, if a client signs a contract agreeing to sell their business on May 1, but the transaction settles on July 2, and they wait until then to commit money to philanthropy, they will be disappointed.
This is because CGT law states that capital gains are made when transactions are signed, not settled.
“If your client comes in on July 2 and says, ‘I’ve sold my business and want to put the [capital gain] into a PAF’, they’re too late,” King says.
“When you settle, the gain is back-dated to when you signed the contract.”
Financial advisers to HNW individuals should be aware of these kinds of significant financial events well in advance; and discussions with clients about how they aim to use capital gains should also happen far ahead of the pay day. And if a client wants to give some of their gain away, it falls to advisers to ensure the transaction and settlement are completed before the end of the financial year.
If the transaction and settlement dates straddle the end of the financial year, clients will need to find money through another means – like refinancing a mortgage, for example – and put this debt into the PAF, and then use their capital gain to pay the bank back as soon as possible. But they will lose the tax benefit.
HNW people running family businesses through a corporate structure can also eliminate tax on the retained earnings in their business by donating some of its capital, King says.
Money can’t ordinarily be taken out of the company without incurring “top-up” tax of about 23.5 per cent, so retained earnings are often left within the company and sometimes left for descendants to deal with.
Delaying the withdrawal of retained earnings “is like pretending you’re not going to die”.
But tax on retained earnings can be written off if the tax liability plus some of their personal wealth is used for philanthropy. Similar to the discount capital gains scenario, of each $100,000 in retained earnings realised, the client can donate their tax bill of approximately $23,500 plus another $26,500 and then access the remaining $50,000.
The Government subsidises the donor dollar-for-dollar, while the donor is not deferring the retained earnings “day of reckoning”.
Simon Mumme is editor of ‘Investment’ magazine – www.investmenttechnology.com.au
