Charitable Deduction Under Scrutiny

The growing pressure on Washington to restrain the spiraling federal debt has once again put the future of the charitable deduction into question.

After Congress rebuffed President Obama’s call to limit the tax break for charitable gifts to help pay for last year’s health-care overhaul, many nonprofit advocates hoped that lawmakers would consider the deduction off-limits.

But new proposals now swirling around Washington suggest that it will remain fair game, along with other once-sacrosanct measures, as policy makers struggle to balance the federal budget.

“The conversation has shifted from ‘We can’t touch the charitable deduction’ to ‘The charitable deduction is on the table and we have to think seriously about [it],’” says Roger Colinvaux, a former top aide to Congress’s Joint Committee on Taxation who is now an associate law professor at Catholic University.

Two sets of recommendations issued in November, one by the co-chairs of a deficit commission appointed by President Obama and the other by a committee that includes former Democratic and Republican government officials, suggested either limiting or ending charitable deductions as part of a package of spending cuts and tax increases designed to get the country on sounder economic footing.

Nonprofits Urged to Prepare

Both plans include other ideas that have in the past been politically toxic, such as measures that would limit the mortgage-interest deduction and raise the amount of wages that are subject to Social Security taxes, so it is unclear how far they will get. But experts say nonprofit groups need to be prepared for the changing political momentum.

“There are scenarios that we are very concerned about in which changes to the charitable deduction could take place,” says Steve Taylor, vice president for public policy at United Way Worldwide, who believes limiting the tax break would seriously dampen giving at a time when more Americans are turning to charities because of the bad economy. “The most obvious scenario is that some massive tax-reform package that is somehow set up as a take-it-or-leave-it package might include changes to the charitable-deduction law.”

Michael W. Peregrine, a lawyer in Chicago who advises nonprofits, says he is telling his clients to prepare for possible revenue losses because of changes to the charitable tax break. What’s more, he tells them, if lawmakers “in full deficit-reduction mode” find it too politically difficult to tamper with the charitable deduction, they might try instead to tighten restrictions on tax-exempt organizations, like they did in the health-care-overhaul law by requiring nonprofit hospitals to provide certain services to their communities. “I’m telling boards, It may be five years away, it may be 10 years away; you’ve got to start planning this now,” he says.

The deduction’s future is on the line primarily because of concerns about the growing budget deficit, which has been aggravated by the recession and given top priority by the increasingly influential small-government Tea Party (although it prefers spending cuts to tax increases).

But it also reflects a debate over just how fair the tax break is.

One of the deficit-reduction plans—issued by a committee of the Bipartisan Policy Center, a think tank set up by four former Senate majority leaders—called the way the deduction is structured “perverse”: Because the percentage that taxpayers can write off for their donations is the same as their tax rate, wealthy taxpayers in the highest brackets get the biggest subsidy for their giving. Furthermore, only taxpayers who itemize can get the tax break, which means that people who don’t own homes or have other reasons to claim deductions, don’t get any tax benefit at all. The committee—headed by Pete V. Domenici, the former Republican Senate Budget Committee chairman, and Alice Rivlin, the former Democratic director of the Office of Management and Budget—suggested ending the deduction completely and replacing it with a 15-percent credit that would apply to all donations, regardless of whether a donor owed any taxes. In a system modeled after Britain’s “Gift Aid” system, the credit would be claimed by the charity rather than the taxpayer.

The organization would get 15 percent of two figures added together: the donation it received plus the money the donor would have received if he or she had gotten a 15-percent tax credit. So if a donor sent $85, the charity would get an additional $15.

Three Options

The other plan, offered by the co-chairmen of President Obama’s commission—Erskine Bowles, the former Democratic chief of staff to President Clinton; and Alan Simpson, the former Republican senator from Wyoming—proposes three options that would be phased in starting in the 2012 fiscal year.

One would almost triple the standard deduction for married couples to $30,000, while taxpayers who itemize could get charitable deductions only after they had donated 2 percent of their adjusted gross income.

Another calls for an end to all tax breaks in exchange for slashing tax rates to a range of 8 percent to 23 percent (compared with 10 percent to 35 percent today). If Congress wanted to add back any of the breaks, it would have to pay for them by raising the tax rates.

A third would limit the percentage of itemized deductions that taxpayers could take if Congressional committees and the Treasury Department have not adopted a plan to overhaul and simplify the tax system by the end of 2012.

Some fund-raising experts criticized the plans, saying the proposal to return tax credits to charities would be far too cumbersome and those to end or drastically curtail the deduction would discourage certain kinds of giving.

“I work with donors all the time on complex philanthropic gifts in which typically the income-tax deduction is a motivating factor,” says Jill Dodd, a lawyer in San Francisco who advises both donors and charities. She said cutting the tax incentive could, for example, diminish gifts to community foundations, Jewish federations, and universities.

Seeking Simplicity

All of the proposals seek to make the tax code far simpler than it is today.

Rob Reich, an associate professor of political science at Stanford University—and a vocal critic of the current charitable-deduction system—urges the nonprofit world not to react “like an interest group” defending its entitlements in responding to the new proposals.

Instead, he says, “it should behave as the diverse constituency it is to champion different ideas, to be the staging ground or convening ground for a robust conversation.”

Mr. Reich argues that the tax code should treat donors the same regardless of income and offer bigger tax breaks for gifts to nonprofits that serve the poor.

Independent Sector, the coalition of charities and foundations, plans to put together a special group by early spring to examine the deficit-reduction plans, says Diana Aviv, the organization’s president. “The only way this kind of thing will move forward is if every industry that is affected by these proposals instead of saying no, no matter what, looks at this against the larger backdrop—and we think the charitable sector should do that.”

While many of her organization’s members oppose changes to the charitable deduction, the new group will also include members with a different perspective, she says.

Tim Delaney, president of the National Council of Nonprofits, which represents small and medium-size charities, says all Americans, including those working at nonprofits, should avoid “knee-jerk” reactions to the proposals.

However, he says, they should consider how changes to the tax code could affect people in need. “We shouldn’t be asking whether nonprofits will be hurt by some of these proposals,” he says, “but whether the people we as nonprofits serve would benefit or suffer.”

Once President Obama’s deficit commission issues its final report, endorsing or rejecting the proposals from its co-chairmen, all eyes will be on Congress.

Republicans, who have won control of the House in the Congress that starts work in January, were highly critical of Mr. Obama’s effort to curb tax breaks for wealthy donors, an idea that he revived in his 2011 budget proposal after proposing it a year earlier to finance health-care legislation. But Mr. Colinvaux wonders if they will take a different approach now that they are sharing power.

“When the Democrats controlled both houses and Obama had the presidency, they opposed just about anything Obama said,” he notes, and it was not always clear how much of that was on the merits. In any case, he adds, “There’s some protection for both sides when attacking sacred cows as part of a package.”