AMT & Donations
Changes to the Alternative Minimum Tax (AMT) rates and rules are scheduled to take effect on January 1, 2024. For the first time AMT will apply to charitable donations from high-income individuals, which is worrying for charities and donors. Simply, targeting donations is poor tax policy that will produce unintended community harm.
There is now a wealth of information on these changes from the charitable and planning community. I have provided links to some of these resources below and am grateful for the thought put into them. This commentary is not intended to be a definitive technical source on the tax changes (see the PWC link). Instead, it addresses charitable policy and philanthropic planning issues that arise from these changes.
There is widespread concern is that these changes are complex, will discourage major lifetime donations from individuals, and will, as a result, hurt charities and the communities they serve. In its submission to the Department of Finance, the Canadian Association of Gift Planners (CAGP) has estimated it could affect up to 35% of donations made annually, which reflects the increasing importance of donations from assets. That’s a lot at stake.
Current Donation Incentive
Before exploring the changes, it’s helpful to understand the existing tax benefits for donations to registered charities. Starting in 1996, a series of tax incentives was introduced to encourage Canadians to donate assets, not just income.
These tax incentives include contribution limits of up to 75% of annual net income during life, and up to 100% of net income in the final two lifetime tax returns. There is also a five-year carry forward during life and five-year claim period after death. Why can donations only be claimed against 75% of net income, rather than 100%? The reason is to ensure the taxpayer pays some tax. The contribution limit is the charitable version of the AMT, and it has worked well since 1997.
The donation tax credit is the basic tax incentive. It is applicable to all donations made by individuals, but varies by the amount of the donation, income of the donor, and province. For high income taxpayers, it can be up to the highest marginal tax rate in the province. In Alberta it is higher than the marginal rate at 54%; in Ontario it is lower at 50.3%. Under the current rules, a donation tax credit can offset income for both non-AMT tax and AMT purposes.
Another key incentive is available for in-kind donations of public securities. Since 2006, the Income Tax Act provides two tax benefits for donations of publicly listed securities:
100% of the non-refundable charitable tax credit based on a receipt for the fair market value of the property donated.
Nil capital gain. This also applies to non-AMT and AMT tax.
AMT Basics
Since 1986, the AMT has provided a floor tax rate – overriding certain deductions, exemptions, and credits. The underlying policy idea is that all Canadians should pay a basic minimum percentage of tax.
The current AMT rate is 15%. The new rate is 20.5%. Previously, AMT started at $40,000 in annual income. Starting in 2024, the new income floor will be $173,000.
From a policy perspective, AMT is designed to promote fairness in the tax system. Since 1986, donation incentives have been exempted from AMT. Why? In tax policy, charitable donations are an acceptable alternative to taxation. A self-directed contribution to society. This is changing.
AMT Donation Impact
When AMT hits in 2024, the tax benefit from donations will be reduced in two ways. First, there is a 50% reduction in the non-refundable tax credit. Second, for in-kind donations of public securities, there is a 30% reduction in the capital gains exemption. These reductions only apply when AMT is triggered. A few commentaries have focused on the double hit to donations of public securities, or even to the reduced tax efficiency of flow-through share donations. But even ordinary cash donations can be caught once the AMT floor kicks in.
Who will be affected?
As a recent Miller Thomson article notes, “AMT targets high-income individuals who would otherwise take advantage of sufficient tax preferences (i.e. receiving income from tax efficient revenue sources or benefitting from certain credits and deductions) to reduce their tax liability to extremely low levels.” AMT and the new donation rules will most affect business owners and retirees who have significant income from dividends and capital gains. Taxpayers who receive employment income, which is taxed at a higher rate, will be less affected by AMT and the donation clawbacks. The Moody’s Tax Law article on the subject addresses this well with some helpful tax illustrations.
The most penalized group of high-income taxpayers will be those selling a business or other capital asset and who wish to make a large donation in the same year as the sale. This is a common and important source of major, or in the language of the charitable sector, “transformational” donation. The best time to give is when you have liquidity and a big tax liability. A donation traditionally could offset a portion of that liability, directing money to one or many favourite charities.
The greatest loser will be charities, not all, but many of the largest and most impactful. It will especially hit charities that receive a high percentage of funding from government. For the last 28 years, a series of tax incentives to encourage gifts of assets from high-net worth donors have created a model of private-public support. Donations have become bigger, and charities have become more dependent on them. These new rules will create more unfunded needs and requirements for additional funding from government, at all levels. Tax policy is social policy, and the Department of Finance is messing with a social support system that is more complex than they seem to realize.
Why the change?
There are a couple of unspoken policy rationales for including donations in the new AMT rules. First, there appears to be a goal of reducing the tax effectiveness of public securities donations. In the mid-1990s when I was involved with securing the incentive, I remember how the Department of Finance tried to block it, but the politicians overruled. Finance viewed the extra capital gains exemption as too rich, but it has transformed philanthropy in Canada. Finance feared there would be donation substitution: public securities would replace cash donations to produce a better tax outcome. In this way Finance was right.
The second unspoken policy rationale is reducing donations to private foundation and foundations with donor advised funds. Foundation assets have increased by over 300% in the last 15 years. In response, last year the disbursement quota was increased to 5% to distribute more money into the community. Now the AMT will reduce inflows. While there are good reasons to promote higher outflows, discouraging the use of foundations will hurt the whole charitable sector and the communities they serve.
Donors of transformational donations often face a tax deadline. They donate to a foundation to gain time to make thoughtful grants to charities of their choice. This bridging function of foundation is built into trust law and Income Tax Act. It is more important than ever because regular donations are in decline – with just 17.7% of taxpayers claiming a donation in 2021. Foundations have become both transformational and gap funder. All levels of government rely on their contributions in healthcare, education, the arts, and human services.
Seven-Year Recovery Period
The new AMT rules have a seven-year recovery period for lost donation credits. In future years when there is more tax payable, the lost or unused credits can be claimed. This may work in some situations, but it is an imperfect, theoretical remedy. In addition, there is the regular five-year carry forward period. Both assume donors have all the time in the world to claim their tax benefits and avoid AMT.
As mentioned, transformational lifetime donations are typically timed to coincide with major tax events (i.e. sales of a business, real estate or securities). The tax benefits are claimed in the year of the gift up to the maximum claim limit. There is no logical reason to delay the claim in this common scenario. Moreover, the seven-year recovery period may not be helpful as income drops post tax event.
There is another group of major donors who donate annually at a high level. They need the donation contribution room, and again, the seven-year recovery period is no help. There is a present value cost to a deferred tax claim, especially if there is a risk of not getting the savings at all.
Who won’t be affected
It is worth noting that some donors, thankfully, will not be affected by the new AMT rules. Donations in the final year of life, especially estate donations such as gifts by will, are not caught. Donations by corporation, including investment holding companies with public securities, are also exempt. These differences will influence how altruistic taxpayers arrange their affairs.
Finally, it is worth noting that many taxpayers with income of more than $173,000 who make donations of cash or public securities donations will not be affected by AMT. Why? They pay tax at higher rates than 20.5%. AMT, the floor rate, will not apply.
Donation Killing Complexity
The problem with the new AMT rules is they are so darn complex. I recently spoke to a tax accountant friend who said, in despair, that the rules will create uncertainty and deter donations, even for those who are exempt. “You can’t predict any more,” she said. “Every donation must be modelled before it is made.” The old assumption of reasonably straightforward donation tax incentives will vanish. A chill will descend.
What to do?
For the donor who may be affected, the first line of defense is to donate more in 2023. This may involve creating taxable income with a RRIF withdrawal or another method to enable a larger donation of public securities. Affected donations made in 2023, but claimed over a number of years will likely be caught by AMT after 2024. At Aqueduct Foundation, we’re seeing a marked increase in donations this fall. The donor’s logic: give now to establish a donor advised fund and distribute to favorite charities over the next few years.
There is also protest, advocacy, and thoughtful public policy work to get the Government to make amendments. This fall look for articles, initiatives, ads, and public policy campaigns that are trying to head off the implementation in 2024.
Donations aren’t tax evasion
The fundamental concern about these changes is they treat charitable donations as tax evasion or personal expenditure. There is a valid policy rationale for reducing tax evasion or personal expenditures. It may not be universally accepted, but it can be understood. Charitable donations are different. Donors make irrevocable gifts to benefit charity and the community. They reduce their wealth by doing so.
As CAGP’s submission to Finance noted: “Unlike preferential tax items such as the personal amount, age amount, tuition amounts, medical expense amounts, and child care expenses, which represent personal consumption expenditures and preferential tax items such as interest expense and partnership losses which represent expenditures incurred to generate wealth, charitable donations are in a category of their own — they represent neither personal consumables or wealth-enabling expenditures.”
At heart, charitable donations and charities are essential tools in our society to provide public good. Governments are important contributors to societal well-being, but they do not have a monopoly as funder or priority setter. Charitable giving is self-directed social good – well supported by tax incentives for almost 30 years. Donations impoverish the donor and enrich the community. They need to be encouraged.