One of the tax changes that increased the tax liabilities of high-income taxpayers in 2013 was the reintroduction of the limitation on itemized deductions. This limitation is commonly referred to as the “Pease limitation,” and is named after Donald Pease, the Ohio Congressmen who introduced it. Although the Pease limitation was initially introduced in 1990, subsequent tax acts had gradually phased out the Pease limitation and by 2010, it had been completely repealed. When it was restored in 2013, the Pease limitation generally had the effect of a 1% income tax surcharge to the tax liabilities of those taxpayers who were affected by it.
For 2014, the Pease limitation applies when AGI exceeds $305,040 for joint filers and $254,200 for individuals. Income over these threshold amounts will trigger a limitation on most itemized deductions (including charitable contributions, mortgage interest, state and local income taxes, real estate taxes, and miscellaneous itemized deductions). The limitation generally is equal to 3% of AGI above the applicable amount; however, the limitation can never exceed 80% of the amount of the itemized deductions otherwise allowable for the taxable year.
We sat down with Karen McCarthy and Natalie Takacs of Meaden & Moore’s Personal Tax Advisory Group to discuss the impact of the Pease limitation – and, in particular, its potential impact on charitable giving.
Takacs begins by illustrating the operation of the Pease limitation with an example of a single taxpayer whose AGI is $500,000 and who has itemized deductions totaling $63,000, as follows:
Mortgage Interest - $12,000
State and local income taxes - $21,000
Charitable contributions - $30,000
TOTAL - $63,000
Explains Takacs, “Since the taxpayer’s AGI exceeds the $254,200 phaseout threshold by $245,800 ($500,000 - $254,200), and 3 percent of $245,800 is $7,374, the taxpayer’s itemized deductions will be reduced by $7,374.”
Takacs points out, “It is important to note that the limitation generally is driven by AGI – not the size of the taxpayer’s itemized deductions. Going back to the example, since the taxpayer had more than $7,374 of mortgage interest and state and local income taxes, the tax benefit of his charitable contributions was not affected by Pease limitation.”
McCarthy emphasizes, “This is an important point to understand. Many taxpayers assume that they should reduce their charitable giving in years in which they are subject to the Pease limitation. But in most cases, the opposite is actually true.” McCarthy continues, “The value of a charitable contribution deduction generally increases as the taxpayer’s marginal tax bracket increases. Thus, in a year in which a taxpayer is subject to the top marginal tax rate of 39.6% (that applies to ordinary taxable income in excess of $450,000), the taxpayer generally would want to maximize his charitable giving.”
“Unfortunately,” Takacs adds, “part of the complexity of planning for the Pease limitation is that it is a two-prong limitation. While most taxpayers are subject to Pease’s 3% limitation (which generally does not impact charitable deductions), a small group of very high-income taxpayers is subject to the 80% limitation of Pease.”
Takacs provides the following example of the 80% limitation:
“Assume that the single taxpayer from our earlier example had AGI of $2,500,000 (instead of $500,000). In this case the 3% limitation would reduce the taxpayer’s itemized deductions by $67,374, which would completely eliminate the taxpayer’s $63,000 of itemized deductions. In this case, however, the 80% Pease limitation comes into play and would cap the itemized deduction limitation at $50,400 (80% of $63,000).”
Takacs observes, “We typically only see the 80 percent limitation in a year in which a client’s income is abnormally high – perhaps an executive who exercised a lot of stock options or a business owner who sold a business. But when the 80 percent limitation applies, it can dramatically reduce the tax benefit of charitable contributions.”
“Fortunately,” McCarthy comments, “clients often have significant flexibility with respect to the timing of their charitable giving. For example, a client might be able to accelerate charitable giving by prefunding contributions in a high-income year using a donor-advised fund or a family foundation. Alternatively, a client might chose to reduce charitable giving in a year in which he is subject to a lower than usual marginal tax rate or in which the 80% Pease limitation is in effect.”
Takacs concludes, “Proper timing of charitable contributions is one of the most powerful ways to minimize taxes. We encourage clients with significant charitable giving goals do multi-year tax projections. This allows us to identify potential opportunities to concentrate charitable giving in a high tax bracket year and to mitigate the impact of the Pease and other limitations on charitable giving.”
If you would like to discuss strategies to manage the impact of the Pease limitation or other 2013 tax changes on your charitable giving, please contact Karen McCarthy at 216-928-5414 or Natalie Takacs at 216-928-5403. Natalie Takacs is a Senior Manager is our Personal Tax Advisory Group. With over 20 years of experience working in the areas of individual, trust, and estate and gift tax, Natalie is skilled in managing the complex tax issues and transactions that her clients encounter when making financial and business decisions. In her free time, Natalie enjoys traveling and spending time with her family.
Another post by Karen & Natalie on charitable giving:
'Tis the Season (for Charitable Giving): learn 3 strategies for leveraging the tax benefits of charitable giving