Year-End Tax Guide For 2011 - Part 2 - Property Taxes

Executive compensation

Whether you're an executive at a private or public company — or an employee-owner of an enterprise — you've likely come face to face with some complex executive compensation decisions. You've got to think beyond salary, fringe benefits and bonuses. You need to make sure you've got a grip on the tax consequences of more complex pay plans, such as stock options, deferred compensation plans and restricted stock.

Benefiting from incentive stock options

Stock options remain one of the most popular types of incentive compensation, and incentive stock options (ISOs) deserve special attention in your tax planning. If your options qualify as ISOs, you can take advantage of favorable tax treatment.

ISOs give you the option of buying company stock in the future. The price (known as the "exercise price") must be set when the options are granted and must be at least the fair market value of the stock at that time. It is customary for the exercise price to be set at exactly the fair market value. Therefore, the stock must rise before the ISOs have any value. If it does, you have the option to buy the shares for less than they're worth. ISOs have several tax benefits:

There is no tax when the options are granted.
There is no tax when the options are exercised.
Long-term capital gains treatment is available if the stock is held for more than one year after exercise. (If the stock isn't held for at least two years after the option's grant date, and at least one year after the exercise date, then the increase in value over the exercise price as of the exercise date is taxed as ordinary compensation income rather than as a capital gain.)

There is potential alternative minimum tax (AMT) liability when the options are exercised. The difference between the fair market value of the stock at the time of exercise and the exercise price is included as income for AMT purposes. The liability on this bargain element is a problem because exercising the option alone doesn't generate any cash to pay the tax. If the stock price falls before the shares are ultimately sold, you can be left with a large AMT bill in the year of exercise even though the stock actually produced no income. Congress has provided some relief from past ISO-related AMT liabilities, and a new more generous AMT credit is also available (see Chapter 3 for more information on the AMT credit). Talk to a Grant Thornton tax adviser if you have questions about AMT-ISO liability.

As noted above, if the stock from an ISO exercise is sold before certain holding period requirements are met (referred to as a "disqualifying disposition"), the gain is taxed at ordinary income tax rates. The employer is entitled to a compensation deduction for ISOs only if the employee makes a disqualifying disposition.

If you've received ISOs, you should decide carefully when to exercise them and whether to sell immediately or hold the shares received from an exercise. Acting earlier can be advantageous in some situations:

Exercise earlier to start the holding period for long-term capital gains treatment sooner.
Exercise when the bargain element is small or the market price is low to reduce or eliminate AMT liability.
Exercise annually and buy only the number of shares that will achieve a breakeven point between the AMT and regular tax.

But be careful, because exercising early accelerates the need for funds to buy the stock. It also exposes you to a loss if the value of the shares drops below your exercise cost and may create a tax cost if the exercise generates an AMT liability. If you exercise an ISO and later feel that the stock price will fall, you can consider selling the stock in the same year as the exercise (i.e., resulting in a disqualifying disposition, as described above) in order to pay the higher ordinary income rate. In this situation, the AMT does not apply to the exercise. Tax planning for ISOs is truly a numbers game. With the help of Grant Thornton, you can evaluate the risks and crunch the numbers using various assumptions.

Considerations for restricted stock

Restricted stock provides different tax considerations. Restricted stock is stock that is granted subject to vesting. The vesting is often time-based, but can also be performance-based so that the vesting is linked to company and/or individual performance.

Normally, income recognition is deferred until the restricted stock vests. You then pay taxes on the fair market value of the stock at the ordinary income rate. However, there is an election under Section 83(b) to recognize ordinary income when you receive the stock. This election must be made within 30 days after receiving the stock and can be very beneficial in certain situations.

Action opportunity: Consider an 83(b) election on your restricted stock

With an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted. In exchange, you don't recognize any income when the stock actually vests. You only recognize gain when the stock is sold, and it is taxed as a capital gain.

So why make an 83(b) election and recognize income now, when you could wait to recognize income when the stock vests? Because the value of the stock may be much higher when it vests. The election may make sense if the income at the grant date is negligible or if the stock is likely to appreciate significantly before income would otherwise be recognized. In these cases, the election allows you to convert future appreciation from ordinary income to long-term capital gains income.

The biggest drawback may be that any taxes you pay because of the election can't be refunded if eventually you forfeit the stock or the stock's value decreases. But if the stock's value decreases, you'll be able to report a capital loss when you sell the stock.

Understanding nonqualified deferred compensation

Nonqualified deferred compensation (NQDC) plans pay executives in the future for services being performed now. But they don't have the restrictions of qualified retirement plans such as 401(k) plans. Specifically, NQDC plans can favor certain highly compensated employees and can offer executives an excellent way to defer income and tax.

However, there are drawbacks. Employers cannot deduct any NQDC until the executive recognizes it as income, and NQDC plan funding is not protected from an employer's creditors. Also, employers must be in full compliance now with IRS rules under Section 409A that govern NQDC plans. The rules are strict, and the penalties for noncompliance are severe. If a plan fails to comply with the rules, plan participants are taxed on plan benefits immediately with interest charges and an additional 20 percent tax.

The new rules under Section 409A make several important changes. Executives generally must make an initial deferral election before the year they perform the services for the compensation that will be deferred. So an executive who wanted to defer some 2011 compensation to 2012 or beyond generally must have made the election by the end of 2010.

Additionally, there are the following rules:

Benefits must either be paid on a specified date according to a fixed payment schedule or after the occurrence of a specified event — defined as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.
The decision about when to pay the benefits must be made at the same time the election is made to defer the compensation.
Once that decision is made, the timing of benefit payments can be delayed, but generally cannot be accelerated.
Elections to delay the timing or change the form of a payment must be made at least 12 months in advance of the original payment commencement date.
New payment dates must be at least five years after the date the payment would have been made originally.

It is also important to note that employment taxes generally are due when the benefits become vested. This is true even though the compensation isn't actually paid or recognized for income tax purposes until later years. Some employers withhold an executive's portion of the tax from the executive's salary or ask the executive to write a check for the liability. Others pay the executive's portion, but this must be reported as additional taxable income.

Managing the pay plans in your business

Your executive compensation plan is the key to attracting, retaining and motivating your top employees. Your management employees likely expect cash incentives and equity-based rewards for meeting company goals. Key company goals can include earnings targets, share price appreciation, total shareholder return and top-line growth.

But in this down economy, companies are struggling to provide meaningful incentives to attract and retain their talent, who may be able to move to another company for the promise of future wealth accumulation, even in the down economy. At the same time, the fallout from the financial crisis has created a regulatory and legislative feeding frenzy on executive pay and governance. Regulators, shareholder advocacy groups and lawmakers are challenging traditional performance objectives and the risks associated with them.

These requirements are beginning to take effect. Call your Grant Thornton compensation and benefit professional to make sure you are ready to comply.

Now more than ever, equity awards to executives need to be linked with shareholder interests. Equity and bonus pay should also have a long-term focus. Vested stock grants and exercised stock options should be subject to meaningful holding periods, and incentives need to be linked to long-term performance objectives.

Dealing with underwater stock options

Historically, stock options have played a big role in most compensation programs, making up the lion's share of equity compensation granted to employees and executives. But many companies across the economic spectrum have watched their stock plummet since 2008. When company stock goes through the floor, stock options are left underwater — meaning the stock is worth less than the exercise price of the option.

These options no longer provide any meaningful retention or performance incentive for employees, as the stock value would have to rise significantly before the options are "in the money." Underwater options are a big problem when they threaten to drive away top talent. There are a variety of viable approaches to address underwater options.

Tax law change alert: New executive compensation rules

Lawmakers in 2010 enacted a sweeping financial reform bill (Dodd-Frank Wall Street Reform and Consumer Protection Act) that imposes strict new executive compensation restrictions on public companies, including the following:

Say-on-pay: Mandates a nonbinding shareholder vote on executive pay levels and design
Compensation committee independence: Requires members of the compensation committee to be independent and have the authority to engage independent compensation consultants
Clawback policies: Requires companies to include clawback policies to recover incentive-based compensation if it was earned based on inaccurate financial statements that require a restatement
Enhanced disclosures: Requires the Securities and Exchange Commission (SEC) to amend disclosure rules to require companies to compare executive compensation to stock price performance over a five-year period
Internal pay ratio: Requires the SEC to amend disclosure rules to require companies to compare CEO compensation to the median annual total compensation for all other employees.

Encouraging performance with restricted shares

As noted above, restricted stock is stock that's granted subject to vesting, and it has emerged as a useful tool for providing executive compensation and long-term incentives. In the past, restricted stock was often considered a giveaway by investors and shareholder activists. But the vesting of restricted stock does not have to be time-based — it can also be linked to company performance. In the brave new world of executive compensation, performance shares can be a key component to linking pay to shareholder interests.

Performance shares link the vesting of restricted stock to company performance. This strategy has become more popular in the down economy as companies seek ways to incentivize their employees with noncash awards. As discussed earlier, restricted stock also gives employees the option of controlling taxation with a Section 83(b) election. And the strategy benefits from a number of potential approaches to develop meaningful but achievable performance goals that motivate participants and drive shareholder value:

Market performance: Based on meeting a specified target such as stock price
Operational performance: Based on specified operational goals such as increasing operating profits
Absolute performance: Based on absolute performance such as targeted growth or return percentage
Relative performance: Vesting occurs if performance measures are above a peer group
Balanced scorecard: Considers both quantitative and qualitative or strategic performance
Corporate focus: Vesting occurs only if corporate goals are achieved
Business unit focus: Vesting conditions are specific to individual business units

ISO employer costs and benefits

The tax benefits of incentive stock options for employees (discussed earlier) make them a very attractive form of compensation for the executives receiving them. But they can be less useful from the employer point of view because of the following:

The employer receives no income tax deduction for ISOs unless the employee makes a disqualifying disposition.
There is a per-employee limit of $100,000 on the amount of ISOs that can first become exercisable for the employee during any one year. The limit is based on the value of stock at the grant date.

There are strict requirements employers must follow for stock options to qualify as ISOs:

The exercise price cannot be less than the fair market value of the stock at the time the option is granted.
The option term cannot exceed 10 years from the date the option is granted.
The option is exercisable only by the executive and cannot be transferred to anyone else except upon the executive's death.
At the time the option is granted, the executive cannot own more than 10 percent of the total combined voting power of all classes of stock of the employer, unless:

the exercise price is at least 110 percent of fair market value on the grant date, and
the option term does not exceed five years.

The option plan must be approved by the employer's stockholders within 12 months before or after the date the plan is adopted.

Finally, ISOs may be granted only to employees. ISOs may not be granted to individuals such as board members or independent contractors.

Privately held business strategies

Privately held businesses often face unique executive compensation challenges. Many owners and shareholders want to give key employees and managers the benefits of equity ownership without actually giving up any actual equity share.

If you have a privately held business, consider a phantom stock plan or performance-based cash as a solution. These offer opportunities for your company to share the economic value of an equity interest without the equity itself. A typical phantom stock plan simply credits selected employees with stock units that represent a share of the firm's stock. Essentially, it is a promise to pay the employee the equivalent of stock value in the future. Alternatively, a stock appreciation right (SAR) can be issued to provide an employee with a payment equal to only the appreciation in the stock value between the date the right is granted and some future date, rather than the full value of the stock.

You can value your stock by a formula or by formal valuation. The phantom stock or SAR can be awarded subject to a vesting schedule, which can be performance-based or timebased. A phantom stock plan must comply with restrictions on nonqualified deferred compensation unless the employee is paid for the value of the phantom stock shortly after vesting. The same holds true for SARs, but unlike phantom stock, SARs can meet certain other conditions that exempt them from the restrictions on nonqualified deferred compensation.

Performance-based cash similarly promises employees a cash bonus in the future for time-based or performance goals. If you have a partnership, be careful about granting a profits or "carried" interest. Congress recently abandoned legislation that would raise taxes on the carried interests in a partnership, but it could be revived in the future.

Business ownership

Whether you're an executive, shareholder or owner in a privately held business or public corporation, it's not just your own tax burden you're worried about. You also need to consider the business tax burden at the entity level. The soft economy has presented a number of challenges, but with adversity comes opportunity.

Lawmakers have responded to the economic downturn with a nearly unprecedented slew of tax incentives designed to help the economy recover. Many of these incentives are timesensitive and come with detailed restrictions. It won't always be easy or simple to take advantage of the opportunities, but that's no excuse to ignore them. You need to examine your business activities and investments so you can leverage every new tax opportunity and help your company recover or expand. Any business tax discussion should begin with the options for structuring, buying and selling business interests in the most tax-efficient manner possible.

Tax treatment of business structures

Business structures generally fall into two categories: C corporations and pass-through entities. C corporations are taxed as separate entities from their shareholders and offer shareholders limited liability protection. See Chart 10 for corporate income tax rates.

Pass-through entities effectively "pass through" taxation to individual owners, so the business income is taxed at the individual level. (See Chapter 2 for more on individual taxes and the individual rate schedule.) Some pass-through entities, such as sole proprietorships and general partnerships, don't provide limited liability protection, while pass-through entities such as S corporations, limited partnerships, limited liability partnerships and limited liability companies can.

Because many pass-through entities offer the same limited liability protection as a C corporation, tax treatment should be a major consideration when deciding between the two structures. (See Chart 11 on the following page for an overview of key differences.) The biggest difference is that C corporations endure two levels of taxation. First, a C corporation's income is taxed at the corporate level. Then the income is taxed again at the individual level when it is distributed to shareholders as dividends. Generally, the income from pass-through entities is only taxed at the individual owner level, not at the business level.

Although this benefit is significant, it is not the only consideration. There are many other important differences in the tax rules, deductions and credits for each business structure. You always want to assess the impact of state and local taxes where your company does business, and owners who are also employees have several unique considerations. The choice of business structure can affect the ability to finance the business and may determine which exit strategies will be available. Each structure has its own pluses and minuses, and you should examine carefully how each will affect you. Call a Grant Thornton adviser to discuss your individual situation in more detail.

Action opportunity: Organize or convert into a QSB

Legislation enacted in 2010 presents a unique opportunity for eligible enterprises to organize as or convert into a qualified small business (QSB) in 2011. The benefits of investing in QSB stock from an individual investor's perspective were discussed in Chapter 4, but the opportunity may be even more valuable from the business side. The new legislation offers an excellent opportunity for eligible enterprises to raise capital at a reasonable rate or provide owners with a tax-efficient growth opportunity.

Under the new law, 100 percent gain exclusion is available for QSB stock purchased after Sept. 27, 2010, and before the end of 2011, meaning this stock will never be subject to tax if it is held at least five years and all other requirements are met. QSB stock must be original issue stock in a C corporation with no more than $50 million in assets (and meet several other tests).

The exclusion provides an obvious opportunity for a business already established in the C corporation structure or considering establishment as a C corporation for nontax reasons (such as a future public stock offering). These businesses, if they meet the business activities and asset tests, should consider organizing or issuing stock before the end of 2011 to take advantage of the full exclusion.

But the opportunity isn't just for C corporations. Under QSB tax rules, partnerships may perform a conversion into a C corporation in which the converted partnership interests are treated as stock acquisitions that can qualify for the QSB stock gain exclusion. S corporation stock cannot be converted QSB stock, but any new stock issued after a revocation of S status or a C conversion can be eligible for the exclusion.

But be careful before acting on this strategy because there are many reasons why the pass-through structure may still offer a better result. QSB stock must be held for five years, and the ongoing earnings of the business in the meantime will be subject to tax both at the corporate level, and to the extent it is distributed, at the individual level. And if the end game is to exit the business, most buyers will prefer an asset sale that will be taxed at only one level when sold by a pass-through. Contact a Grant Thornton tax professional if you want to know more about this opportunity.

If you work in a business in which you have an ownership interest, you need to think about employment taxes. Generally all trade or business income that flows through to you from a partnership or limited liability company is subject to self employment tax — even if the income isn't actually distributed to you. But if you're an S corporation or C corporation employee-owner, only income you receive as salary is subject to employment taxes. How much of your income from a corporation comes from salary can have a big impact on how much tax you pay.

Action opportunity: Set salary wisely if you're a corporate employee-shareholder

If you are an owner of a corporation who works in the business, you need to consider employment taxes in your salary structure. The combined employee and employer 2.9 percent Medicare tax (increasing to 3.8 percent in 2013 for income over $200,000 for single filers and $250,000 for joint filers) is not capped and will be levied against all income received as salary. S corporation shareholder-employees may want to keep their salaries reasonably low and increase their distributions of company income in order to avoid the Medicare tax. But C corporation owners may prefer to take more salary (which is deductible at the corporate level) because the Medicare tax rate is typically lower than the 15 percent tax rate they would pay if they instead received the income as a dividend.

But remember to tread carefully. You must take a reasonable salary to avoid potential back taxes and penalties, and the IRS is cracking down on misclassification of corporate payments to shareholder-employees. There are also legislative proposals to apply the Medicare tax to more S corporation income, so check with a Grant Thornton tax adviser for a legislative update.

Don't wait to develop an exit strategy

Many business owners have most of their money tied up in their business, making retirement a challenge. Others want to make sure their business — or at least the bulk of its value — will be passed to their loved ones without a significant loss to estate taxes. If you're facing either situation, now is the time to start developing an exit strategy that will minimize the tax bite. An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money. To pass on your business within the family, you can give away or sell interests. But be sure to consider the gift, estate and generation-skipping transfer tax consequences (see Chapter 10 on estate planning).

A buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner's retirement, disability or death. Buysell agreements are complicated by the need to provide the buyer with a means of funding the purchase. Life or disability insurance can often help but can also give rise to several tax and nontax issues and opportunities.

One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary's taxable income. There are exceptions to this, however, so be sure to consult a Grant Thornton tax adviser. You may also want to consider a management buyout or an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan created primarily so that employees can purchase your company's stock. Whether you're planning for liquidity, looking for a tax-favored loan or supplementing an employee benefit program, an ESOP can offer you many advantages.

Assess tax consequences when buying or selling

When you do decide to sell your business — or are acquiring another business — the tax consequences can have a major impact on your transaction's success or failure.

The first consideration should be whether to structure your transaction as an asset sale or a stock sale. If it's a C corporation, the seller typically will prefer a stock sale for the capital gains treatment and to avoid double taxation. The buyer generally will want an asset sale to maximize future depreciation write-offs.

Sellers should also consider whether they prefer a taxable sale or a tax-deferred transfer. The transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization, but the transaction must comply with strict rules. Although it's generally better to postpone tax, there are advantages to executing a taxable sale:

Tax rates are scheduled to increase in 2013.
The seller doesn't have to worry about the quality of buyer stock or other business risks that might come with a taxdeferred sale.
The buyer benefits by receiving a stepped-up basis in the acquisition's assets and does not have to deal with the seller as a continuing equity owner, as would be the case in a taxdeferred transfer.
The parties don't have to meet the stringent technical requirements of a tax-deferred transaction.

A taxable sale may be structured as an installment sale if the buyer lacks sufficient cash or the seller wants to spread the gain over a number of years. Contingent sales prices that allow the seller to continue to benefit from the success of the business are common. But be careful, the installment sale rules create a trap for sellers if the contingency is unlikely to be fulfilled. Also, installment sales may not be as advantageous as usual because tax rates are scheduled to go up in 2013.

Careful planning while the sale is being negotiated is essential. A Grant Thornton tax adviser can help you detect certain traps and find the exit strategy that best suits your needs.

New tax incentives

Limited time only! Lawmakers have given businesses a slew of new temporary tax incentives in order to boost the economy. Many are aimed at narrow sectors of the business community such as small businesses, but others can be taken by all businesses.

Tax law change alert: No built-in gain tax for certain S corporations

When a C corporation converts to an S corporation, it generally must pay a built-in gains tax on any appreciated assets sold in the first 10 years after the conversion (if the asset was held when the corporation converted). This threat of corporate-level built-in gains tax often forces S corporations to inefficiently hold onto assets they would otherwise sell to reallocate capital.

Lawmakers recognized this problem during the economic downturn and reduced the 10-year holding period for dispositions in 2009 through 2011. For tax years beginning in 2011, no built-in gains tax will be imposed on an S corporation that converted at least five years earlier.

General business credits

Under a new temporary provision, sole proprietorships, partnerships and nonpublicly traded corporations with $50 million or less in average annual gross receipts over the last three years can carry back their 2010 general business credits for five years and carry them forward for 25 years. These credits may also fully offset the alternative minimum tax (AMT). The general business credit encompasses most business-related credits in the tax code, including the research credit, work opportunity tax credit, and alternative energy and conservation credits. Normally, it can be carried back just one year and carried forward only 20 years.

Expensing business investments

In an effort to jump-start business investment, Congress and the president expanded the ability of taxpayers to immediately deduct the cost of many types of investments in their businesses. Legislation enacted in 2010 doubles a bonus depreciation tax benefit for property placed in service after Sept. 8, 2010, and before the end of 2011 — meaning taxpayers can fully deduct the cost of eligible equipment the year it is placed in service. To qualify for bonus depreciation, property must generally have a useful life of 20 years or less under the modified accelerated cost recovery system (MACRS).

This tax benefit is generally only available for property placed in service before the end of the year (there are different rules for certain property with long production periods and most airplanes), but Congress could extend it. If no legislation is enacted, property placed in service in 2012 will qualify for regular bonus depreciation, in which 50 percent of the cost is deductible in the year it's placed in service and the rest is depreciated using normal rules.

The amount of business investment that can be expensed under Section 179 was also increased. Businesses can expense up to $500,000 under Section 179 in tax years beginning in 2010 and 2011, and this limit will not begin to phase out until the total amount of Section 179 property placed in service for the year exceeds $2 million. In addition, qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property will qualify under Section 179 up to a limit of $250,000.

Charitable giving

The economic downturn did surprisingly little to blunt charitable giving. That may be because giving to charity remains one of the most popular tax planning opportunities: You enjoy not only sizable tax benefits, but also the satisfaction of helping others. Plus you can control the timing to maximize your tax benefits. Well-planned gifts can trim the estate tax while allowing you to take care of your heirs in the manner you choose.

Choosing what to give

The first thing to determine is what you want to give to charity: cash or property. There are adjusted gross income (AGI) limits on how much of your gift you get to deduct depending on what you give and who you give it to. Contributions disallowed due to the AGI limit can be carried forward for up to five years (see Chart 12 for the deduction limit by donation and the type of charity).

Outright gifts of cash (which include gifts made by check, credit card or payroll deductions) are the easiest. The key is to make sure you substantiate them. Cash donations under $250 must be supported by a canceled check, credit card receipt or written communication from the charity. Cash donations of $250 or more must be substantiated by the charity. Despite the simplicity and high AGI limits for outright cash gifts, it may prove more beneficial to make gifts of property. Gifts of property are a little more complicated, but often provide more tax benefits when planned properly. Your deduction depends in part on the type of property donated: long-term capital gains property, ordinary income property or tangible personal property.

Ordinary income property includes items such as stock held less than a year, inventory and property subject to depreciation recapture. You can receive a deduction equal to only the lesser of fair market value or your tax basis.

Long-term capital gains property includes stocks and other securities you've held more than one year. It's one of the best charitable gifts because you can take a charitable deduction equal to its current fair market value.

But beware. It may be better to elect to deduct the basis rather than the fair market value because the AGI limitation will be higher. Whether this is beneficial will depend on your AGI and the likelihood of using — within the next five years — the carryover you'd have if you deducted the fair market value and the 30 percent limit applied.

Action opportunity: Give directly from an IRA if 70½ or older

Congress recently extended through 2011 a helpful tax provision that allows taxpayers 70½ and older to make tax-free charitable distributions from individual retirement accounts (IRAs). You don't get to take a charitable deduction for the gift, but making a tax-free IRA distribution could save you more in taxes.

A charitable deduction erases taxable income after you've already calculated your AGI and can be reduced by limitations and phaseouts. If you instead make the gift straight from an IRA distribution, the amount of the gift won't be included in income at all, lowering your AGI. You'll see the difference in many AGI-based computations where the below-the-line deduction for charitable giving doesn't have any effect.

Action opportunity: Give appreciated property to enhance savings

Consider donating appreciated property to charity because you avoid paying tax on the long-term capital gain you'd incur if you sold the property. So donating property with a lot of built-in gain can lighten your tax bill.

But don't donate depreciated property. Sell it first and give the proceeds to charity so you can take both the capital loss and the charitable deduction.

Tangible personal property can include things like a piece of art or an antique. Your deduction depends on the type of property and the charity, and there are several rules to consider:

Personal property valued at more than $5,000 (other than publicly traded securities) must be supported by a qualified appraisal.
If the property isn't related to the charity's tax-exempt function (such as a painting donated for a charity auction), your deduction is limited to your basis in the property.
If the property is related to the charity's tax-exempt function (such as a painting donated to a museum), you can deduct the property's fair market value.

Benefit yourself and a charity with a CRT

A charitable remainder trust (CRT) may be appropriate if you want to donate property to charity and would like to receive (or would like someone else to receive) an income stream for a period of years or for your expected lifetime. The property is contributed to a trust and you, or your beneficiary, receive income for the period you specify. The property is distributed to the charity at the end of the trust term.

So long as certain requirements are met, the property is deductible from your estate for estate tax purposes and you receive a current income tax deduction for the present value of the remainder interest transferred to charity. You don't pay capital gains tax immediately if you contribute appreciated property. Distributions from the CRT generally carry taxable income to the non-charitable beneficiary. If someone other than you is the income beneficiary, there may be gift tax consequences.

A CRT can work particularly well in cases where you own non-income-producing property that would generate a large capital gain if sold. Because a CRT is a tax-exempt entity, it can sell the property without having to pay tax on the gain. The trust can then invest the proceeds in income-producing property. This technique can also be used as a tax-advantaged way to diversify your investment portfolio.

To keep CRTs from being used primarily as tax avoidance tools, the value of the charity's remainder interest must be equal to at least 10 percent of the initial net fair market value of the property at the time it's contributed to the trust. There are other rules concerning distributions and the types of transactions into which the trust may enter.

Reverse the strategy with a CLT

A grantor charitable lead trust (CLT) is basically the opposite of the CRT. For a given term, the trust pays income to one or more charities, and the trust's remaining assets pass to you or your designated beneficiary at the term's end. When you fund the trust, you receive an income tax deduction for the present value of the annual income expected to be paid to the charity. (You also pay tax on the trust income.) The trust assets remain in your estate.

With a non-grantor CLT, you name someone other than yourself as remainder beneficiary. You won't have to pay tax on trust income, but you also won't receive an income tax deduction. The trust assets will be removed from your estate, but there may be gift tax consequences. Alternatively, the trust can be funded at your death, and your estate will receive an estate tax deduction (but not an income tax deduction). A CLT can work well if you don't need the current income but want to keep an asset in the family. As with other strategies, consider contributing income-producing stocks or other highly appreciated assets held long-term.

Keep control with a private foundation

Consider forming a private foundation if you want to make large donations but also want a degree of control over how that money will be used. A foundation is particularly useful if you haven't determined what specific charities you want to support. But be aware that increased control comes at a price: You must follow a number of rules designed to ensure that the private foundation serves charitable interests and not private interests. There are requirements on the minimum percentage of annual payouts to charity and restrictions on most transactions between the foundation and its donors or managers.

Violations can result in substantial penalties. Ensuring compliance with the rules can also make a foundation expensive to run. In addition, the AGI limitations for deductibility of contributions to nonoperating foundations are lower.

Provide influence with a donor-advised fund

If you'd like to influence how your donations are spent but you want to avoid the tight rules and high expenses of a private foundation, consider a donor-advised fund. They are offered by many larger public charities, particularly those that support a variety of charitable activities and organizations.

The fund is simply an agreement between you and the charity: The charity agrees to consider your wishes regarding use of your donations. This agreement is nonbinding, and the charity must exercise final control over the funds, consistent with the charitable purposes of the organization.

To deduct your contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed.

Key rules to remember

Whatever giving strategy ultimately makes the most sense for you, keep in mind several important rules on giving:

If you contribute your services to charity, you may deduct only your out-of-pocket expenses, not the fair market value of your services.
You receive no deduction by donating the use of property because it isn't considered a completed gift to the charity.
If you drive for charitable purposes, you may deduct 14 cents for each charitable mile driven.
Giving a car to charity only results in a deduction equal to what the charity receives when it sells the vehicle unless it is used by the charity in its tax-exempt function.
If you donate clothing or household goods, they must be in at least "good used condition" to be deductible.

To read Part 3 of this article please click next page.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

United States: Year-End Tax Guide For 2011 - Part 2