BDQ #4: Why Is There a Charitable Deduction and How Does It Work?

The income tax charitable deduction has been around since 1917, just four years after the 16th Amendment created the modern Federal Income Tax. But why are charitable contributions deductible? And, can a donor actually save money by making a charitable contribution? First, let’s review the history of the income tax, then we’ll explore how the charitable deduction works in practice.

The Federal Income Tax

The Constitution limited the ability of Congress to impose taxes by requiring that “direct taxes” be levied in proportion to each State’s population. Direct taxes are those, such as the income tax, that apply directly to persons or property. However, there was no limitation on indirect taxes, those that apply to an event including duties and tariffs. As a result, during our nation’s first century, tariffs were the largest source of Federal revenue.

In an effort to reduce tariffs, in 1894 Congress imposed a Federal Income Tax of 2% on income of $4,000 or more (about $138,000 in today’s dollars). A year later, the Supreme Court ruled that a Federal tax on income from property (interest, dividends, or rent) was a direct tax, which had to be apportioned according to each State’s population. The requirement to apportion made it impractical to impose a Federal tax on income from property, and Congress was not willing to limit the Federal Income Tax to wage income only.

Nine years later, in 1913, the Sixteenth Amendment changed the Constitution to eliminate the apportionment requirement for all income taxes – whether direct or indirect. Later that year Congress adopted the Federal Income Tax levying a 1% tax on incomes above $3,000 (about $91,000 in current dollars), with seven progressive rates reaching 7% on incomes of $500,000 or more (about $15.1 million in current dollars).

The Charitable Deduction

Four years later, in 1917, Congress adopted the income tax charitable deduction. At the time, income tax rates were increasing in order to pay the costs of World War I, and there was concern that taxpayers might reduce their charitable giving in order to pay their income tax bills. 

The initial charitable deduction was limited to 15% of adjusted gross income. Over the years the charitable deduction limit has changed several times, including a period beginning in 1924 when there was a 100% charitable deduction for taxpayers who contributed 80% or more of their income. Today taxpayers can deduct contributions of cash up to 60% of adjusted gross income with a five year carry forward for unused deductions. Gifts of appreciated property are deductible up to 30% of adjusted gross income and also have a five year carry forward for unused deductions.

How Does the Charitable Deduction Work?

Like all deductions, the charitable deduction reduces the amount of income that is taxable. Deductions are not tax credits; they do not directly reduce the amount of income tax due, they reduce the amount of income that is subject to tax.

When claiming any deduction, the taxpayer must substantiate the deduction with receipts or other documentation. In the case of the charitable deduction, substantiation for gifts of $250 or more usually involves obtaining a written receipt from the charitable organization verifying the contribution.

Can a Donor Save Money by Making a Charitable Contribution?

The charitable deduction can reduce taxable income and, therefore, save taxes. However, a donor does not save money by making a charitable contribution, because, at a macro level, the donor is giving away more than she is saving in taxes. The charitable deduction is not a tax credit. It provides an incentive for giving by reducing the amount of taxable income, which saves taxes and effectively reduces the cost of the contribution.

Who Can Take Advantage of the Charitable Deduction?

In 1944 Congress introduced the “Standard Deduction,” an amount that taxpayers can deduct without providing any substantiation or documentation. In practice, a taxpayer should add up her itemized deductions, compare the total to the Standard Deduction amount, and then reduce her taxable income by whichever is higher, itemized deductions or the standard deduction.

Today, about 90% of taxpayers no longer itemize their deductions. Taxpayers who claim the Standard Deduction receive no benefit from the charitable deduction.

Do not despair! This does not mean that the majority of donors don’t care about the charitable deduction. The 90% figure includes all of the 150 million or so tax returns filed each year. More affluent taxpayers are more likely to itemize. In other words, those most likely to be prospects for significant contributions are more likely to itemize. And, as we all know, donors at all levels always seem to want to know, “Is my gift deductible?”