Individual taxpayers, who have two options when they file their personal federal income tax returns — take a standard deduction or itemize deductions — usually select the option that reduces their overall tax liability the most. Under P.L. 115-97, known as the Tax Cuts and Jobs Act, the standard deduction available for taxpayers became much larger — almost twice what it was previously. This change makes it less likely that the sum of a taxpayer's itemized deductions will exceed the larger standard deduction, especially with new limits in place on deductible state and local taxes (SALT, including real and personal property taxes, state and local income taxes, and sales taxes) and mortgage interest. The Tax Policy Center estimates that, under the new tax law, the number of taxpayers that itemize their deductions will fall from 46.5 million in 2017 to 19.3 million in 2018.
A potential side effect of fewer taxpayers itemizing their deductions is that these taxpayers may choose to reduce or eliminate charitable contributions to not-for-profit organizations because their contributions will no longer reduce their personal income taxes. The Joint Committee on Taxation estimates that individuals will reduce charitable giving by $13 billion annually because their donations will no longer be tax deductible.
What can taxpayer-donors do to retain the tax deductibility of donations?
One strategy that allows individuals to continue to donate and receive tax benefits is to "bunch" donations to charities in specific years, while limiting donations in other years. When individual taxpayers contribute by bunching donations, they combine multiple years of "normal" annual charitable contributions into a single year. In the bunch years, the relatively large charitable contributions, in combination with other itemized deductions that cannot be timed this way — generally, mortgage interest and SALT taxes — will increase the likelihood of exceeding the standard deduction and thus provide the taxpayers with additional tax savings.
Not-for profits face greater uncertainty
In addition to the risk of declining donations, not-for-profit organizations also face increased volatility in revenue from donors. While bunching charitable contributions may be an effective planning tool for an individual taxpayer, it can cause disruptive planning issues for nonprofit organizations that rely on donations. Let's say taxpayers reduce contributions in 2018 and 2019 and then bunch contributions in 2020, not-for-profits will experience revenue shortfalls in 2018 and 2019, followed by revenue surpluses in 2020. Alternatively, if taxpayers decide to bunch contributions in 2018 and reduce giving in 2019 and 2020, not-for-profits may experience a (perhaps surprising) revenue surplus followed by a shortfall.
What can charities do to mitigate uncertainty?
Not-for-profit organizations can prepare for the new tax act in several ways. First, they can consider adopting a multiyear budget, which incorporates predicted volatility in revenue and allows long-term planning. Multiyear budgeting supports a not-for-profit's ability to incorporate strategic and operational planning into its management control systems. As the external environment becomes less certain, and the technology of predicting donor behavior becomes more personalized, a multiyear budget is likely to improve nonprofit planning.
For example, multiyear budgeting allows not-for-profits to perform "what if" scenario planning, including planning for potential fundraising shortfalls (or surpluses), and building or depleting cash reserves to smooth revenue volatility. It can also help plan for alternative levels of services to the organization's charitable beneficiaries given a range of revenue outcomes.
Second, not-for-profits can improve communication with their donors. They can explain the uncertainty they face under the new tax law, and how bunching can be mutually beneficial for donors and not-for-profits. Open communication regarding the timing and size of planned bunched contributions provides charities with critical information, allowing them to make important programming decisions and more accurately forecast revenue for midterm and long-term planning. Communication between donors and not-for-profits may also ease donor concerns over large changes in their previous giving behavior.
Finally, if communication with donors is not feasible or fails despite valiant attempts, charities can attempt to predict donor behavior by stratifying available data by, for example, size of past donations, consistency of donations, and the donor's home state. Consider the average size of a taxpayer's donations. If his or her donations have been consistent but small, the nonprofit may reasonably assume that the donor is less affected by tax considerations. However, if the donations have been large, the nonprofit may reasonably assume that the taxpayer likely itemized deductions in prior years but that the taxpayer is more likely to take the larger standard deduction in 2018. That taxpayer may be more likely to change the frequency and size of his or her donations.
Charities may also consider the donor's level of commitment to the organization's mission. If the commitment is strong, as indicated by consistent donations over time, the donor may continue to give regardless of whether the donor receives a tax deduction. Finally, not-for-profits can note the tax status of the donor's home state as an indicator of whether the donor is less likely to itemize in 2018. Donors from high-tax, high-income states, like California, Connecticut, New York, and New Jersey, are likely to be most affected by the new caps on the deductibility of SALT taxes, and therefore may be more likely to consider bunching (or reducing contributions) in response to the new standard deduction.
What can tax or financial advisers do to help both clients and nonprofits?
Financial advisers can facilitate communication between their client and the not-for-profits their client supports regarding their client's planned frequency and size of donations. The adviser can fill a unique roll, helping the individual and the nonprofit through the initial years of increased uncertainty resulting from the new tax act.
The Tax Cuts and Jobs Act of 2017 has many implications for the behavior of individual taxpayer-donors and not-for-profit organizations. Taxpayers are uncertain about the deductibility of their donations, and not-for-profits are uncertain about the effect of these tax law changes on their revenues — and thus their ability to achieve their missions. Not-for-profits can plan for — and perhaps reduce — this uncertainty by adopting multiyear budgeting, improving communication with donors (including explaining the mutual benefits of donation bunching), and improving prediction models of donor behavior.
Many accounting professionals are in a unique position to mitigate these uncertainties. Tax professionals obviously have a direct role in advising clients about the tax act. Other accounting professionals may volunteer as board members or advisers to not-for-profits. They can help bridge the gap in the side effects of the new tax law.
Sarah Lyon, M.S. Accounting, Ph.D. (slyon@SanDiego.edu) is an assistant professor of accounting at the University of San Diego School of Business in San Diego. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.