Section 170(c)(2) allows a charitable deduction for contributions to —
A corporation, trust, or community chest, fund, or foundation —
(A) created or organized in the United States or in any possession thereof, or under the law of the United States, any State, the District of Columbia, or any possession of the United States;
(B) organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals;
(C) no part of the net earnings of which inures to the benefit of any private shareholder or individual; and
(D) which is not disqualified for tax exemption under section 501(c)(3) by reason of attempting to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.
Contributions allowed by Section 170(c)(2) are limited to those made to domestic organizations.
Note that Section 170(c)(2) does not contain a cross-reference to Section 501(c)(3). The language of Section 170(c)(2)(B) through (D) is quite similar to (but not identical too) that of Section 501(c)(3). (For example, Section 501(c)(3) exempts organizations organized and operated for the purpose of “testing for public safety”; that phrase is omitted from Section 170(c)(2). Thus, there is a remote possibility that a contribution to a domestic organization that is in fact tax-exempt under Section 501(c)(3) may not be deductible under Section 170(c)(2).
In the case of corporations, contributions are deductible under Section 170(c)(2) only if “used within the United States or any of its possessions exclusively for purposes specified in subparagraph (B).” This precludes corporations from donating to a U.S. domiciled charity that intends to transfer the funds to, for example, Ireland, Israel, or tsunami relief.
Governmental Units
Section 170(c)(1) allows a charitable deduction for contributions to “a State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes.”
Nature of Governmental Units. Texas Learning Technology Group v. Comm’r, 958 F.2d 122 (5th Cir. 1992), involved an unincorporated association created by agreement between eleven Texas public schools pursuant to a Texas statute that allows any local government to contract with other local governments to perform governmental functions.
While the actual issue decided in this case was whether the Technology Group was a public charity or a private foundation, the Technology Group argued that it was neither because it was a governmental subdivision, and the court’s discussion of this issue is instructive.
The Fifth Circuit relied on Comm’r v. Shamberg’s Estate, 114 F.2d 998 (2d Cir. 1944), to hold that, in order to be considered a political subdivision, an entity must possess some sovereign powers. Shamberg’s Estate discussed the three principal sovereign powers – the power of eminent domain, the power to levy or collect taxes, and the power to issue government bonds. While the court in Texas Learning Technology Group noted that this was not an exhaustive list, it also concluded that the power to establish and regulate curricula constitutes and to collect membership dues and operating deficits did not constitute sovereign powers.
In addition, the Fifth Circuit noted that an organization cannot be regarded as a political subdivisions merely because it is an “integral part” of a governmental unit.
Public Purpose Requirement. Charitable contributions to governmental units are deductible only if made “exclusively public purposes.”
Revenue Ruling 81-307, 1981-2 C.B. 28, held that parents of a murdered individual could deduct a contribution made to a city’s police department to establish a fund to provide a reward for information leading to the arrest and conviction of their son’s killer. The ruling noted that “the establishment of the reward in this case helps the police department … maintain the public safety and assists it in carrying out its governmental functions” and that it therefore “serves an exclusively public purpose.” The ruling further held that any benefit that the parents might receive from their contribution (and its successful application to the conviction of their son’s murderer) would be “incidental in comparison to the benefits accruing to the public at large.”
Conversely, a contribution to a committee that was in charge of fund-raising affairs and other activities in connection with a Presidential inaugural ceremony was held not deductible in Revenue Ruling 77-283, 1977-2 C.B. 72. The committee was appointed by the President-elect and sponsored the inaugural parade, the inaugural ball, receptions for distinguished governmental and other officials, an inaugural concert, and the inaugural gala. Some of the committee-sponsored activities were open to the public while admission to others was by invitation only. The ruling concluded that the contribution was not a gift “to or for the use of” the United States for” exclusively “public” purposes. Cf. Revenue Ruling 58-265, 1958-1 C.B. 127 (contribution to “an official committee to receive unsolicited voluntary contributions and to disburse the fund thereby created in defraying the expense of providing state units for a parade incident to a Presidential Inauguration, with any unexpended balance remaining in the fund to be deposited in the general fund of the state”).
Indian Tribal Governments. Under Section 7871, Indian tribal governments are considered to be a State for purposes of Section 170, but, under Section 7871(d), subdivisions of Indian tribal governments are considered to be political subdivisions of a state only if the Internal Revenue Service (after consulting with the Secretary of the Interior) determines that such subdivision has been delegated the right to exercise one or more of the substantial governmental functions of the tribal government.
War Veterans Organizations. Section 170(c)(3) allows a charitable deduction for contributions to —
A post or organization of war veterans, or an auxiliary unit or society of, or trust or foundation for, any such post or organization —
(A) organized in the United States or any of its possessions, and
(B) no part of the net earnings of which inures to the benefit of any private shareholder or individual.
Domestic Fraternal Lodges. Section 170(c)(3) allows individuals only to claim a charitable deduction for contributions to —
A domestic fraternal society, order, or association, operating under the lodge system, but only if such contribution or gift is to be used exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals.
Cemetery Companies. Section 170(c)(3) allows a charitable deduction for contributions to —
A cemetery company owned and operated exclusively for the benefit of its members, or any corporation chartered solely for burial purposes as a cemetery corporation and not permitted by its charter to engage in any business not necessarily incident to that purpose, if such company or corporation is not operated for profit and no part of the net earnings of such company or corporation inures to the benefit of any private shareholder or individual.
Percentage Limitations – Cash And Long-Term Capital Gain Property
Introduction
Unlike Section 642(c), which allows a trust to deduct distributions to charity in an amount up to 100 percent of its taxable income, and unlike the federal estate and gift tax deductions, which provide that up to 100 percent of an estate or gift passing to charity may be deductible, there are limits on the amount that taxpayers can deduct for federal income tax purposes in any particular year.
The present discussion concerns what are known as the “percentage limitations.” These are limits on the amount of a taxpayer’s income in any particular year that may be sheltered by the federal income tax charitable deduction. These rules are different from, and supplemented by, other rules (discussed later) that limit the portion of the value of property that may be claimed as a charitable deduction.
Contributions of Money to 50 Percent Charities
In the case of contributions to “50-percent charities,” an individual may claim a deduction of up to 50 percent of adjusted gross income each year. Any excess may be permitted as a deduction in succeeding years under the carryover rules discussed below.
Eligible Donees. “50-percent charities” are defined in Section 170(b)(1)(A) and are limited to the following —
Churches
Schools
Hospitals and certain medical research organizations
Foundations for the benefit of public colleges and universities
Governmental units described in Section 170(c)(1)
Certain “publicly supported organizations” described in Section 170(b)(1)(A)(vi)
“Special case” private foundations described in Section 170(b)(1)(E)
private operating foundations described in Section 4942(j)(3)
“pass through” foundations, that is, private foundations which distribute 100 percent of the contributions they receive by March 15 of the following year
private foundations that accept contributions into a pool from which the donor or the donor’s spouse may designate the recipients (which must be Section 509(a)(1) public charities) of the income and corpus from the donor’s share of the fund, so long as all income is distributed annually not later than March 15 of the year following the year in which it is earned and all corpus is distributed no later than one year after the death of the donor (or, in certain cases, the death of the donor’s spouse).
“Public charities” described in Sections 509(a)(2) and (3)
Treasury Regulation § 1.170A-8(a)(2) distinguishes between contributions “to” a Section 170(b)(1)(A) charity, and contributions “for the use of” a Section 170(b)(1)(A) charity. Only the former are eligible for the 50-percent limitation. For example, the regulation explains, if a donor establishes a charitable remainder trust that will continue in existence for the benefit of the charitable remaindermen after the expiration of the private life estates, then a contribution to such a trust will not be considered a contribution “to” a Section 170(b)(1)(A) charity.
Contributions of Money to 30 Percent Charities
A deduction for all other contributions is limited to 30 percent of the taxpayer’s contribution base.
Any excess may be carried over and deducted (subject to the same limitation) in the following five years.
Contributions of Long-Term Capital Gain Property
General 30-Percent Limitation. Section 170(b)(1)(C) provides that, in the case of a contribution of “capital gain property” to which Section 170(e)(1)(B) does not apply, the amount which may be deducted is limited to 30-percent of the taxpayer’s contribution base. Note that, in this case, the value of the donor’s contribution is the fair market value of the property contributed.
“Capital gain property” is defined in Section 170(b)(1)(C)(iv) as meaning any asset the sale of which would result in long-term capital gain. The term includes Section 1231(b) assets (real estate and depreciable property held for more than one year and used in a trade or business, other than inventory, property held primarily for sale to customers, and copyrightable property held by the taxpayer that produced it.)
Section 170(e)(1)(B) describes —
tangible personal property that is used by the charitable donee for an unrelated use
property donated to a private foundation
intellectual property, except software sold to the general public and copyrights held by their creator. (Note that copyrights held by their creator are not “capital gain property” in any event, however, because they are not Section 1231(b) assets.)
Election to Deduct Basis Only. A taxpayer may elect, however, to have Section 170(e)(1) apply to all contributions of capital gain property donated during the year. In that case, the 30-percent limitation does not apply, and the 50-percent limitation does apply, but the amount that the amount that the taxpayer is treated as having contributed is limited to the taxpayer’s basis in the property. If such an election is made, the amount of any carryovers of long-term capital gain property contributions from prior years is similarly reduced, even though the taxpayer may not have made such an election in such prior years.
20-Percent Limitation for Contributions of Capital Gain Property to Non-Section 170(b)(1)(A) Donees. In the case of a contribution of capital gain property to any donee other than one described in Section 170(b)(1)(A) (that is, a 50-percent donee), the amount of the taxpayer’s deduction in any year is limited to 20 percent of the taxpayer’s contribution base.
Carryover of Excess Contributions
Section 170(d) states that, if an individual makes Section 170(b)(1)(A) contributions (that is, those subject to the 50-percent limitation) in excess of 50 percent of the taxpayer’s contribution base for any year, then the excess is treated as a charitable contribution in each of the following years, subject to the lesser of two limitations.
The first limitation is (obviously) the amount of the excess that is not consumed by this rule in any of the succeeding five years.
The second limitation coordinates the carryover of 50-percent contributions from prior years with the 50-percent limitation for the current year. In other words, in any year to which an excess 50-percent contribution is carried over, the taxpayer is allowed to deduct that year’s 50-percent contributions first, together with carryovers from even earlier years (all subject to the 50-percent limitation), and then, only if there remains some portion of the taxpayer’s 50-percent limitation, are carryovers from past years permitted.
Example: A taxpayer with $500,000 of adjusted taxable income in 2007, 2008, 2009, and 2010 makes a $2,000,000 cash contribution to a Section 170(b)(1)(A) charity in 2007, a $300,000 cash contribution to a § 170(b)(1)(A) charity in 2009, and a $100,000 cash contribution in 2010. The amount that the taxpayer may deduct in each of those years is as follows:
2007:
Current Year
Carryover
50% adjusted gross income
$250,000
Current year contributions
$2,000,000
$2,000,000)
Allowable current year
$250,000
($250,000)
Carryover balance
$1,750,000
2008:
50% adjusted gross income
$250,000
Current year contributions
$0
$0
Allowable current year
$0
$0
Allowable from 2007
$250,000
($250,000)
Carryover balance
$1,500,000
2009:
50% adjusted gross income
$250,000
Current year contributions
$300,000
$300,000
Allowable current year
$250,000
($250,000)
Allowable from 2008
$0
$0
Carryover balance
$1,550,000
2010:
50% adjusted gross income
$250,000
Current year contributions
$100,000
$100,000
Allowable current year
$100,000
($100,000)
Allowable from 2008
$150,000
($150,000)
Allowable from 2009
$0
$0
Carryover balance
$1,400,000
Similar rules apply for purposes of cash contributions to 30-percent charities, as well as to contributions of capital gain property. In other words, the Code says that excess contributions of this nature are to be treated “in a manner consistent with” the rules applicable to cash contributions to Section 170(b)(1)(A) charities.
Coordinating the Contribution Limitations
The Code sets forth a complicated series of rules designed to coordinate the various percentage limitations.
Contributions subject to the 50-percent limit are determined first. If the taxpayer has made cash contributions in a year to Section 170(b)(1)(A) charities that exceed 50 percent of his or her contribution base, then no further contributions are deductible for that year.
Contributions subject to the 30-percent limitation are determined second. These will be deductible to the extent that the taxpayer has not used up the 50-percent limitation for the year. Technically, Section 170(b)(1)(B) defines the amount deductible as the lesser of —
30 percent of the contribution base, and
the excess of 50 percent of the taxpayer’s contribution base over the amount of contributions allowable under Section 170(b)(1)(A) (determined without regard to subparagraph (C)).
For example, if a taxpayer’s adjusted gross income is $100,000, and the taxpayer contributed $40,000 in cash to a Section 170(b)(1)(A) charity and $20,000 in cash to a Section 170(b)(1)(B) charity, then the taxpayer may deduct the $40,000 contribution in its entirety and $10,000 of the $20,000 contribution. The remaining $10,000 of the $20,000 contribution may be carried over to the following five years.
Contributions of capital gain property to Section 170(b)(1)(A) charities are determined next. However, if the donor makes the Section 170(b)(1)(C)(iii) election to deduct only the basis of donated property, then such property is treated in the same order of priority as cash contributions.
The parenthetical “determined without regard to subparagraph (C)” in Section 170(b)(1)(B) operates to coordinate the 50-percent limitation of Section 170(b)(1)(A), the 30-percent limitation of Section 170(b)(1)(b), and the 30-percent limitation of Section 170(b)(1)(C), but in a very non-intuitive fashion.
What it does is to treat all contributions of capital gain property to Section 170(b)(1)(A) charities as if they were cash contributions. It is then only any portion of the 50-percent limitation that would thus remain that can be claimed as a contribution under Section 170(b)(1)(B).
Example 1: If a taxpayer’s adjusted gross income is $100,000, and the taxpayer contributed $40,000 in cash and $30,000 in capital gain property to a public charity (a Section 170(b)(1)(A) charity) and $20,000 in cash to a private foundation (a Section 170(b)(1)(B) charity), then the taxpayer may deduct —
the $40,000 cash contribution to the public charity in its entirety,
$10,000 of the $30,000 property contribution to the public charity, and
none of the cash contribution to the private foundation.
The reason is that “the amount of charitable contributions allowable under subparagraph (A) (determined without regard to subparagraph (C)” is $40,000 plus $30,000, or $70,000. When that number is factored into the formula of Section 170(b)(1)(B) (“the excess of 50 percent of the taxpayer’s contribution base for the taxable year over the amount of charitable contributions allowable under subparagraph (A) (determined without regard to subparagraph (C)”), there is no excess of 50 percent of the taxpayer’s contribution base over $70,000.
Example 2: If a taxpayer’s adjusted gross income is $100,000, and the taxpayer contributed $20,000 in cash and $15,000 in capital gain property to a public charity and $10,000 in cash to a private foundation, then the taxpayer may deduct —
the $20,000 cash contribution to the public charity in its entirety,
all of the $15,000 property contribution to the public charity, and
$5,000 of the cash contribution to the private foundation.
Here, “the amount of charitable contributions allowable under subparagraph (A) (determined without regard to subparagraph (C)” is $20,000 plus $15,000, or $45,000. When that number is factored into the formula of Section 170(b)(1)(B) (“the excess of 50 percent of the taxpayer’s contribution base for the taxable year over the amount of charitable contributions allowable under subparagraph (A) (determined without regard to subparagraph (C)”), the result is $5,000.
Under Section 170(b)(1)(D), contributions of capital gain property to charities other than those described in Section 170(b)(1)(A) are determined last. To coordinate contributions of this nature with the 50-percent limitation of Section 170(b)(1)(A) and the 30-percent limitations of Sections 170(b)(1)(B) and (C), Section 170(b)(1)(D)(i) provides that the deduction for contributions of capital gain property to organizations other than those described in Section 170(b)(1)(A) is limited to the lesser of —
20 percent of the contribution base, or
the excess of 30 percent of the contribution base over the amount of contributions of capital gain property to which the 30-percent limitation of Section 170(b)(1)(C) applies.
Beyond that, Section 170(b)(1)(D) only states that “contributions of capital gain property to which this subparagraph applies shall be taken into account after all other charitable contributions.” Neither that sentence nor the “lesser of” formula set forth in Section 170(b)(1)(D) necessarily even implies that 20-percent limitation contributions must be further reduced by all other cash contributions under Sections 170(b)(1)(A) and (B), but that is how the Internal Revenue Service interprets the interrelationship of all these provisions. Specifically, Publication 256, “Charitable Contributions” (rev. December 2005), p. 13, states that the Section 170(b)(1)(D) limitation is the lesser of all the following:
20% of adjusted gross income,
30% of adjusted gross income minus your contributions subject to the 30% limit,
30% of adjusted gross income minus your contributions of capital gain property subject to the special 30% limit, or
50% of adjusted gross income minus the total of your contributions to 50% limit organizations and your contributions subject to the 30% limit.
Corporate Contributions
Limitations on Deduction. Under Section 170(b)(2), corporations may claim a deduction for charitable contributions in an amount that does not exceed 10 percent of their taxable income. Taxable income for these purposes is computed without regard to the charitable deduction, Section 241 through 247, Section 249, any net operating loss carryback, and any net capital loss carryback.
Carry Forwards of Excess Contributions. Like individuals, corporations may carry forward any unused charitable deductions for the succeeding five years. The deductions carried forward are subject to similar limitations as apply in the case of individuals. Section 170(d)(2).
Contributions Of Property – Special Cases
Introduction
The percentage limitations discussed above establish limits on the maximum amounts of charitable contributions that a taxpayer may deduct in any year. They have nothing to do, however, with the value or portion of the value of property that may be deducted (with the exception of the special Section 170(b)(1)(C)(iii) election).
The general rule is that a donor may deduct the fair market value of property contributed to charity. In the case of appreciated property, this rule offers a donor two benefits – a full fair market value deduction and avoidance of any tax on any unrealized gains.
Section 170(e), however, deals with a number of special cases and limits the value of certain types of property that may be taken into account when computing charitable deductions. It does so generally by limiting the value of the charitable deduction to the taxpayer’s basis in contributed property. Under the application of these rules, the donor is not subject to tax on any unrealized gain or income associated with contributed property, but the taxpayer also realizes no benefit from donating the appreciation component. Note that the following rules are an absolute denial; there is no carry forward or other similar relief available with respect to the portion of a contribution denied under the following rules.
The following rules must be applied before the application of the Section 170(b) percentage limitations. Only once the donor has determined how much of the value of contributed property is deductible does the donor determine whether the deduction will be further limited by Section 170(b).
Contributions of Ordinary Income and Short-Term Capital Gain Property
Section 170(e)(1)(A) provides that the amount of any charitable contribution must be reduced by “the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value.” In other words, if the contributed property either would generate short-term capital gains if sold or is ordinary income property, the amount deductible is limited to the donor’s basis or cost of goods sold.
Contributions of Long-Term Capital Gain Property to Private Foundations
Section 170(e)(1)(B)(ii) states that the amount of any charitable contribution must be reduced by the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value, in the case of any contribution to or for the use of a private foundation. For these purposes, private foundations are any organization that is not described in Section 509(a), but the term does not include the three special case foundations described in Section 170(b)(1)(E).
The implications of this rule are wide-ranging. It limits a donor’s deduction, to no more than the donor’s basis in such assets, for contributions to private foundations of such assets as real estate, closely held business interests, and artwork held by a private collector.
Contributions of Qualified Appreciated Stock to Private Foundations
The only exception to the Section 170(e)(1)(B)(ii) rule is set forth in Section 170(e)(5), which states that Section 170(e)(1)(B)(ii) does not apply (and thus that the donor may deduct the fair market value of such stock) in the case of a contribution of “qualified appreciated stock.”
This is defined as any stock of a corporation which is capital gain property (as defined in Section 170(b)(1)(C)(iv)) and “for which (as of the date of the contribution) market quotations are readily available on an established securities market.”
However, this special rule is not available to the extent that the donor contributes (when aggregated with all prior contributions by the donor of stock in the same corporation) stock representing more than ten percent of the value of all stock in the corporation. For these purposes, all contributions of the stock by all the members of the donor’s family (as defined in Section 267(c)(4)) are combined.
Contributions of Tangible Personal Property for an Unrelated Use
Section 170(e)(1)(B)(i) states that the amount of any charitable contribution must be reduced by the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value, in the case of any contribution of “tangible personal property, if the use by the donee is unrelated to the purpose or function constituting the basis for its exemption under section 501 (or, in the case of a governmental unit, to any purpose or function described in subsection (c)).”
Treasury Regulation § 1.170A-4(b)(3)(i) contains several examples —
If a painting contributed to an educational institution is used by that organization for educational purposes by being placed in its library for display and study by art students, the use is not an unrelated use; but if the painting is sold and the proceeds used by the organization for educational purposes, the use of the property is an unrelated use.
If furnishings contributed to a charitable organization are used by it in its offices and buildings in the course of carrying out its functions, the use of the property is not an unrelated use.
If a set or collection of items of tangible personal property is contributed to a charitable organization or governmental unit, the use of the set or collection is not an unrelated use if the donee sells or otherwise disposes of only an insubstantial portion of the set or collection.
Treasury Regulation § 1.170A-4(b)(3)(ii) then states that a donor may treat property as not being put to an unrelated use if he or she can in fact establish that the charity has put it to a related use or —
At the time of the contribution or at the time the contribution is treated as made, it is reasonable to anticipate that the property will not be put to an unrelated use by the donee. In the case of a contribution of tangible personal property to or for the use of a museum, if the object donated is of a general type normally retained by such museum or other museums for museum purposes, it will be reasonable for the donor to anticipate, unless he has actual knowledge to the contrary, that the object will not be put to an unrelated use by the donee, whether or not the object is later sold or exchanged by the donee
As required by Section 6050L(a), the Internal Revenue Service has designed Form 8282 on which charities must report the fact that they have sold, exchanged, consumed, or otherwise disposed of property within two years after their receipt of it by donation.
There is certainly nothing wrong with a charity’s disposing of contributed property at any time, and with only limited exceptions, any such disposition is likely to be nontaxable.
Therefore, the only real purpose of the form, although not articulated in the form itself, is to permit the Internal Revenue Service to argue that any property disposed of within two years after its donation presumptively cannot have been devoted to a related use.
Along these lines, it is enlightening that the instructions to the form state that filing to form is not required if the charity disposes of or consumes the donated property in the course of fulfilling its function as a tax-exempt entity, for example, if a disaster relief organization consumes or distributes medical supplies.
Contributions of Intellectual Property
Section 170(e)(1)(B)(iii) states that the amount of any charitable contribution must be reduced by the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value, in the case of any contribution of “any patent, copyright (other than a copyright described in section 1221(a)(3) or 1231(b)(1)(C)), trademark, trade name, trade secret, know-how, software (other than software described in section 197(e)(3)(A)(i)), or similar property, or applications or registrations of such property.”
This provision was added by the American Jobs Creation Act of 2004, P.L. 108-367), effective with respect to contributions made after June 3, 2004, to eliminate perceived abuses relating to the valuation of donated intellectual property.
However, in the case of contributions to any public charity or special case private foundation described in Section 170(b)(1)(E), the donor may be entitled to additional charitable deductions in the following ten years equal to a sliding scale percentage of the income that the donee realizes with respect to the contributed property. Section 170(m).
Corporate Contributions of Inventory and Other Special Cases
Section 170(e)(3) – contributions by corporations (but not S corporations) to public charities (but not any of the Section 170(b)(1)(E) special cases) of inventory (defined as Section 1221(a)(1) or (2) assets) that is used by the donee charity for an exempt purpose (that includes only the care of the ill, needy, or infants).
Section 170(e)(4) – contributions by corporations (but not S corporations, personal holding companies, and service organizations) of tangible personal property described in Section 1221(A)(1) to a school or scientific research organization (described in Section 41(e)(6)(A) or (B)), if the property was constructed by the donor, contributed no later than two years after construction was completed, and consists of scientific equipment or apparatus to be used by the donee for research or experimentation or research training in the physical or biological sciences.
Section 170(e)(6) – contributions by corporations of certain computer equipment and software to schools, other educational organizations, and libraries. This provision has been repealed with respect to contributions made after December 31, 2005.
Contributions of Partial Interests in Property
Section 170(f) contains several rules that disallow a charitable deduction in the case of partial interests in property.
In the case of transfers of remainder interests in trust, no deduction is available unless the trust is a charitable remainder annuity trust or a charitable remainder unitrust.
In the case of transfers of income interests in trust, no deduction is available unless the income interest is in the form of a guaranteed annuity or unitrust interest and the grantor is treated as the owner of the income interest under Section 671.
In the case of any other contribution (not in trust) of less than the taxpayer’s entire interest in the property, a deduction is allowable only to the extent that the value of the interest would be allowable as a deduction if the interest had been transferred in trust. For these purposes, a contribution of the right to use property is treated as a contribution of less than the taxpayer’s entire interest in the property.
For example, a taxpayer might loan a painting to a museum, to be displayed for six months out of the year. No deduction is available.
Or, a taxpayer might allow a charity to occupy office space in a building the taxpayer owns, rent free or at a below-market rental rate. No deduction is available.
There are several exceptions to the partial interest rule —
A contribution of a remainder interest in a personal residence or farm
A contribution of an undivided interest in the taxpayer’s entire interest in the property
A qualified conservation easement.
Bargain Sales
Definition. A sale or exchange of property to a charitable organization where the amount that the donor/seller receives is less than the property’s fair market value. Treasury Regulation § 1.170A-4(c)(2)(ii).
Note that a bargain sale can result when the donor simply conveys to a charitable organization property that is subject to a mortgage. Even if the charity does not pay anything to the donor and does not even agree to assume or pay the mortgage, the outstanding balance of the debt secured by the property will be regarded as sales proceeds to the donor. Treasury Regulation § 1.1011-2(a)(3).
Calculation of Deductible Amount and Taxable Gain
A bargain sale is treated for tax purposes as a part gift/part sale. The donor is required to allocate the property’s basis between the sale element and the gift component of the transaction. The amount of basis that must be allocated to the sale portion equals the amount which the donor receives, divided by the fair market value of the property. Treasury Regulation § 1.1011-2(b).
The donor is then taxable on the difference between the amount realized (generally the amount paid by the charity) and the portion of the property’s basis thus allocated.
The difference between the fair market value of the property and the amount paid by the charity for its acquisition is then deductible as a charitable contribution.
However, the donor is also required to allocate his or her basis in the property to the contributed portion in exactly the same manner, as well as any long-term capital gain and ordinary income that is not recognized on the bargain sale but that would have been realized upon the sale of the contributed portion, for purposes of applying any Section 170(e) reductions. Treasury Regulation § 1.170A-4(c)(1)(iii).
Example. A donor purchased 100 shares of stock in XYZ Corp. in 2004 for $6,000, and the shares are worth $15,000 at the time of a contemplated contribution. The donor is willing to sell the stock to charity for $10,000, and thus will make a $5,000 gift. Two-thirds of the donor’s $6,000 basis ($10,000/$15,000, times $6,000 = $4,000) must be allocated to the sales component, and so the donor will be taxable on $6,000 of long-term capital gains (the $10,000 sales proceeds, minus the $4,000 of basis allocated to the sale component). The remaining $5,000 gift portion is deductible (subject to the percentage limitations and Section 170(e) restrictions).
Charitable Gift Annuities
Definition
A transfer of cash or property by a donor to a charitable organization in exchange for the organization’s contractual promise to pay to the donor or some other person, or both, a specified dollar amount for life, in annual or more frequent installments.
The annuity may be either immediate (that is, scheduled to begin within one year from the date of the transfer) or deferred (scheduled to begin at some later certain date).
Note that if the property transferred has appreciated, then the transaction also takes on the character of a bargain sale.
Calculation of the Annuity and Deductible Amounts
The fixed payment to the donor (the annuity) is calculated on the basis of the donor’s age on the date the annuity is scheduled to commence.
As is the case with commercial annuities, the older the annuitant, the larger the periodic payments will be.
Unlike commercial annuities, most charitable gift annuities are based on interest rate assumptions recommended by a voluntary membership organization known as the American Council on Gift Annuities. See www.acga.web.org. These rates are substantially less than prevailing market rates, generally result in a residual gift to charity of approximately 50 percent, and therefore enable charitable organizations to compete for contributions on the basis of the merits of their programs, rather than anticipated investment performance.
Thus, a charity might pay to an individual under age 35 at the time of the gift an annual annuity equal to 4.5 percent of the value of the property transferred, but 11.3 percent to someone age 90 or over.
The donor’s charitable deduction equals the total amount transferred to the charity for the annuity, minus the donor’s “investment in the contract,” which is essentially the discounted present value of the lifetime of annuity payments and which is determined under tables issued by the Internal Revenue Service. (These tables bear no relation to the rates released by the American Council on Gift Annuities.)
Income Tax Consequences to Donor
A portion of each annuity payment is regarded as a tax-free return of principal, and the balance is taxable as ordinary income. However, if the property used to purchase the annuity had appreciated in value, then a portion of the otherwise tax-free amount is considered to be capital gains.
The portion of each annuity payment that is not subject to tax is measured by the donor’s “exclusion ratio.” This ratio is a fraction, of which the numerator is the donor’s “investment in the contract,” and the denominator is the “expected return multiple.”
As stated above, the “investment in the contract” represents the discounted value of all payments which the donor is expected to receive during his or her lifetime, based on IRS present value tables.
The “expected return multiple” is the amount of the annual annuity, multiplied by the annuitant’s life expectancy, also based on IRS mortality tables.
Planning Considerations
Property that is suitable as payment for a charitable gift annuity includes cash, securities that are traded on an exchange and thus easily valued, and possibly tangible personal property that the charity is able to put to use in its exempt activities.
Charities will typically refuse to accept property that is not readily marketable, such as real estate and stock in a closely held business, in exchange for a gift annuity.
The charity may wish to assure itself that the property can be promptly sold at the date of gift value so that reinvestment of the proceeds will be adequate to fund the annuity obligation.
Both donors and donees are subject to rigorous rules relating to the valuation of donated property having a value in excess of $5,000.
Mortgaged property is generally unsuitable as payment for a gift annuity, whether or not the charity assumes or agrees to pay the mortgage, because, under certain circumstances, the income that the charity receives from the property may be taxable to it as unrelated business income.
Note that a charitable gift annuity is a contractual obligation by the recipient charity to make payments to the donor over an extended period of time.
Therefore, although the charity must make the annuity payments without regard to the earnings from the transferred property, from the charity’s perspective, the annuity rate should be sufficiently conservative that the charity will not find it necessary to invade its other assets.
From the donor’s perspective, the continued annuity payments depend on the charity’s continuing solvency, and so a donor is not likely to acquire a gift annuity from a charity whose finances are questionable.
Contributions of Services and Unreimbursed Out-of-Pocket Expenses
Treasury Regulation § 1.170A-1(g) clarifies that individuals may not claim a charitable deduction for contributions of services. That result is appropriate, since a donor should not be in any better position from donating services than he or she would be from providing the same services for a fee and then donating the fee right back to the charity that received the services.
However, donors may be entitled to a deduction for the value of unreimbursed expenses incurred in connection with rendering services to a charity, including transportation expenses and reasonable expenses for meals and lodging while away from home.
Charitable Trusts
Wholly Charitable Trusts
A contribution to a trust, all of the interests in which are devoted to charity, is not subject to the partial interest rule, and is fully deductible. Section 170(f)(2)(D).
If the trust does not apply for or receive Section 501(c)(3) status, it will be a taxable trust, but is allowed an unlimited deduction under Section 642(c) for all amounts of gross income which are properly paid for any purpose described in Section 170(c).
On the other hand, if the trust does not apply for or receive Section 501(c)(3) status, even though it may be effectively tax-exempt by virtue of the Section 642(c) deduction, a number of hazardous consequences may result, since, in all likelihood, such a trust would have been classified as a private foundation were it in fact a Section 501(c)(3) organization
Section 4947(a)(1) provides that a trust, all of the interests in which are devoted to one or more of the purposes described in Section 170(c)(2)(B) and for which any deduction was ever allowed under any of the federal income, estate, or gift tax charitable deduction provisions, will be considered to be a Section 501(c)(3) organization, but not for purposes of tax exemption under Section 501(c)(3), only for purposes of all the burdensome restrictions imposed on Section 501(c)(3) organizations – including the private foundation termination tax provisions of Section 507 and the private foundation excise tax provisions of Sections 4941 through 4945.
Section 508(d)(2) then provides that no income, estate, or gift tax charitable deduction is allowed for any gift or bequest to a trust described in Section 4947 for any year in which it fails to meet the requirements of Section 508(e) or to any other organization in a period in which it is not treated as an organization described in Section 501(c)(3) by reason of Section 508(a).
Section 508(e) is the provision that states that a private foundation is not exempt from tax unless its governing instrument contains provisions the effect of which is to require its compliance with the private foundation excise tax provisions of Section 4941 through 4945. Fortunately, C.R.S. § 15-1-1002 and 1003 essentially incorporate those private foundation excise tax rules into the governing instrument of every charitable trust that is deemed to be a private foundation.
Section 508(a) is the provision that states that an organization will not be treated as an organization described in Section 501(c)(3) unless it has applied to the Internal Revenue Service for recognition of that status.
The possible result of all these rules is that an entirely charitable trust that fails to obtain Section 501(c)(3) status is not a tax-exempt organization, must rely on distributions of all its income each year to eliminate its tax liability, will nonetheless be subject to all the onerous private foundation rules. If a federal income tax deduction for contributions to such a trust are allowable at all (and they may be denied by Section 508(d)(2)), they will be deemed contributions “for the use of” the charitable beneficiaries and thus not eligible for the 50-percent limitation.
Finally, Section 642(c)(4) states that the deduction allowed to the trust by that section is subject to Section 681. That section in turns provides that no deduction under Section 642(c) is available to the extent that the income of a trust consists of income that would be regarded as unrelated business taxable income if the trust were a Section 501(c)(3) entity.
Charitable Remainder Trusts
Application of Partial Interest Rule. A gift in trust of less than the taxpayer’s entire interest in property would ordinarily fail the partial interest rule and would therefore be nondeductible.
In fact, Section 170(f)(2)(A) states that an income tax deduction will be allowed with respect to a remainder interest in property transferred to a trust only if the trust is in the form of a charitable remainder annuity trust, a charitable remainder unitrust, or a pooled income fund.
Section 170(f)(2)(B) provides that no deduction is available for the value of any other interest in property, other than a remainder interest, transferred in trust unless the interest is in the form of a guaranteed annuity or a fixed percentage distributed yearly of the fair market value of the trust estate, valued annually, and the grantor is treated as the owner of the trust.
General Planning Considerations.
Charitable remainder trusts are private vehicles, and any obligation to pay any annuity or unitrust amounts is that of the trust, not the charity. This alternative has an obvious appeal to the charity, for a variety of reasons:
The charity’s assets are not at risk for the payment of the annual amounts to the donor, as they are in the case of bargain sales and gift annuities.
The trust might hold assets which the charity might prefer not to own outright, such as stock in a closely held corporation or real estate with possible environmental liabilities.
On the other hand, while charitable remainder trusts are generally more complicated to establish and administer and may therefore be somewhat less attractive to donors, they will also provide a significant degree of flexibility to donors.
Charitable Remainder Annuity Trusts.
Definition. Must provide that a stated, fixed amount of money will be paid, in all events, to one or more specified private beneficiaries on at least an annual basis. Upon termination of the private interests, the balance remaining in the trust must be paid to, or held in perpetuity for the use of, one or more charitable organizations. See, generally, Revenue Ruling 72-395, 1972-2 C.B. 340.
No additional contributions may be made to a charitable remainder annuity trust. If the donor wishes to make other gifts to charity through such a vehicle, it will be necessary to establish additional trusts.
That stated annuity amount cannot be less than five percent or more than 50 percent of the initial fair market value of the property transferred to the trust. The annuity amount can be described as a fraction or percentage of the initial fair market value of the property contributed to the trust.
In fact, specifying a simple dollar amount in the trust agreement, estimated to be more than five percent of the initial fair market value of the trust assets, may be problematic if the initial fair market value of the property contributed is later determined to have been too low.
If the annuity payment is described as a fraction or percentage, then the trust agreement must contain a provisions for subsequent adjustments to reflect corrections to the determination of the initial fair market value of the trust estate. Revenue Ruling 78-283, 1978-2 C.B. 243.
The annuity payments cannot be reduced by trustee commissions or other administrative expenses. Revenue Ruling 74-19, 1974-1 C.B. 155.
No income, gift, or estate tax charitable deduction will be allowed if there is more than a five percent probability that the trust assets will be exhausted before the charitable beneficiary will take its interest.
Revenue Ruling 77-374, 1977-2 C.B. 329, illustrates this requirement with a charitable remainder annuity trust having an initial corpus of $400,000 and paying an annuity of $40,000 per year to a 61 year-old widow. Using the then applicable six percent interest rate assumption, the ruling notes that only $384,000 (1.06 * $400,000) - $40,000) will remain at the end of the first year, and continues with a similar calculation for each succeeding year until determining that the entire $400,000 will be depleted in less than 16 years. Since the probability that a female aged 61 would be alive for 16 more years was then 63 percent, the ruling concluded that the likelihood that the charitable beneficiary would receive any distribution was more than negligible.
See also Revenue Ruling 70-452, 1970-2 C.B. 199; Cf. Moor v. Comm’r, T.C.M. ¶ 12,732 (1982).
Charitable Remainder Unitrusts
Definition Must pay a fixed percentage (again not less than five percent or more than 50 percent) of the net fair market value of the trust assets to the private beneficiaries, and the percentage must applied against the fair market value of the trust assets on a year-to-year basis, not just the initial value of the assets contributed to the trust.
By their very nature, the unitrust payments cannot be described as a fixed dollar amount.
This means that the interest of the income beneficiaries will fluctuate from year to year as the trust assets appreciate (or depreciate) due to inflation and investment performance.
In view of the fact that the rate of inflation has, over the past 40 years, averaged around four percent, the interests of the beneficiaries will only erode unless the trust achieves internal capital growth and passes the benefit of that internal growth through to the beneficiaries by means of annual valuation readjustments.
Because the value of the trust assets must be redetermined annually, additional contributions in subsequent years are permitted, so long as the trust agreement provides for revaluing the newly contributed assets and a recalculation of the unitrust amount on a daily prorated basis through the end of the year.
There are four different variations among charitable remainder unitrusts:
Fixed Unitrusts: those that pay the unitrust amount in all events, regardless of whether the income of the trust is sufficient to do so. Treasury Regulation § 1.664-3(a)(1)(i)(a).
Net Income Unitrusts: those that pay the lesser of the fixed unitrust amount or the net income of the trust. Treasury Regulation § 1.664-3(a)(1)(i)(b)(1).
Net Income With Makeup Unitrusts: those that pay the lesser of the fixed unitrust amount or the net income of the trust, but that also provide for subsequent “catch-up” payments to reimburse the beneficiaries for deficiencies between past years’ fixed unitrust amounts and actual net income. Treasury Regulation § 1.664-3(a)(1)(i)(b)(2).
Flip Unitrusts: those that operate as either a net income or cumulative net income unitrust for some initial period and then convert or “flip” to a fixed unitrust for the remaining term of the trust. Treasury Regulation § 1.664-3(a)(1)(i)(c).
This alternative is useful in cases where the property initially contributed to the trust may be illiquid or may generate income that is less than the desired unitrust percentage, but where it is expected that the property will eventually be sold and the proceeds reinvested in other investments with an appropriate yield.
The event that triggers the conversion from one of the net income variants to a fixed unitrust must be one that occurs on a specific date or that is not discretionary with or under the control of the trustee or any other person.
Treasury Regulation § 1.664-3(a)(1)(i)(d) states that a triggering event that is based on the sale of unmarketable assets or upon the marriage, divorce, death, or birth of a child will not be considered to be one within the discretion or control of any person,.
The effective date of the conversion must be the beginning of the first taxable year that follows the occurrence of the triggering event, and, from that date forward, the trust may only pay a fixed unitrust percentage.
Restrictions Equally Applicable to Annuity Trusts and Unitrusts
Required Payments. The stated annuity or unitrust amount must be paid in all events. If the trust income is insufficient to pay the annuity or unitrust amount, then corpus must be invaded to satisfy the payment obligation. This requirement, however, is not applicable to a charitable remainder unitrust that provides for “net income” feature.
Substantial Charitable Remainder Interest. The value (determined under section 7520) of the charitable remainder interest must at least 10 percent of the initial net fair market value of all property placed in the trust, in the case of an annuity trust, or, in the case of a unitrust, 10 percent of the net fair market value of all property contributed to the trusts as of the date contributed.
Duration. The annuity or unitrust amounts must be paid either for a definite period of years (not in excess of 20 years) or for the lives of the specified income beneficiaries.
Nature of Present Interest Beneficiaries. The trust may provide for concurrent or successive noncharitable beneficiaries, and it may also make current income distributions or payments concurrently to charitable beneficiaries so long as no amounts other than the required annuity or unitrust payments are paid to any noncharitable beneficiary.
If a portion of the trust is paid to a charitable beneficiary on the death of one noncharitable beneficiary, then the annuity or unitrust payments to any remaining noncharitable beneficiaries must be reduced proportionately.
The donor may not generally retain the right to sprinkle the annuity or unitrust payments among various noncharitable beneficiaries, if doing so would cause the trust to be treated as a grantor trust, although such a power may be given to an independent trustee.
The donor may retain a testamentary power to revoke the interest of any noncharitable beneficiary, in which case there will have been no completed gift subject to gift tax on the funding of the trust during the donor’s lifetime.
A noncharitable beneficiary who succeeds to the annuity or unitrust interest of a deceased grantor of an inter vivos trust must be required to pay all death taxes otherwise owed by the trust at the grantor’s death. In other words, the assets of the trust cannot be depleted by death taxes attributable to inclusion of the trust in the grantor’s estate.
Charitable Remainder Beneficiaries. The remainder interest must pass to a charitable organization described in Section 170(c).
In order to assure the availability of a gift and estate tax deduction, the trust agreement should also require that the beneficiary be described in Sections 2055(a) and 2522(a) or (b). Revenue Ruling 76-307, 1976-2 C.B. 56; Revenue Ruling 77-385, 1977-2 C.B. 331.
It is also advisable to specify that the charitable remainder beneficiary must be a public charity, and not a private foundation, so that the contribution to the trust will qualify for the maximum percentage limitation of deductions. Revenue Ruling 79-368, 1979-2 C.B. 109.
Either the donor or the trustee, or both, may reserve the right to designate alternate charitable beneficiaries.
Investment Restrictions. The trust agreement may not contain any provisions that would restrict the trustee from investing trust assets in a manner that prevents realizing a reasonable investment return. Therefore, it would not be possible to require the trustee to retain an underproductive asset.
Various of the private foundation restrictions apply to charitable remainder trusts:
The trust may not engage in an act of self-dealing. Section 4941.
The trust cannot hold any excess business holdings (essentially more than 20 percent of the stock in any incorporated entity or a more than 20 percent profits or capital interest in a partnership). Section 4943. However, this restriction is not applicable during the period when the annuity or unitrust payments are being made to the noncharitable beneficiaries, so long as no concurrent income distributions are being made to any charitable beneficiary. Section 4947(b)(3).
The trust may not engage in any speculative investments. Section 4944. However, this restriction is also not applicable during the period when the annuity or unitrust payments are being made to the noncharitable beneficiaries, again so long as no concurrent income distributions are being made to any charitable beneficiary. Section 4947(b)(3).
The trust may not make any “taxable expenditure,” a term that includes [1] any amount paid to carry on propaganda or otherwise to attempt to influence legislation, [2] any amount paid to influence the outcome of any specific public election, or to carry on any voter registration drive, [3] any amount paid as a grant to an individual for travel, study, or other purposes, unless the grant-making procedures are approved by the Service in advance, [4] any grant to any other organization, unless the recipient organization is a public charity or the grantor foundation exercises expenditure responsibility with respect to the recipient to ensure that the grant is spent as directed, or [5] any amount spent other than for a charitable, education, religious, or similar exempt purpose. Note that once the annuity or unitrust amounts become payable to a noncharitable beneficiary, they are not subject to these restrictions and are not considered taxable expenditures.
Income Tax Treatment of Noncharitable Beneficiaries. Payments by a charitable remainder trust to the noncharitable recipients of annuity or unitrust amounts are taxable on a “WIFO” (worst-in, first-out) accounting basis. Each distribution is deemed to carry out amounts having the following character, and only when all items in each tier for the current and all prior years have been exhausted do subsequent distributions begin to carry out items in a lower tier:
Ordinary income
Long-term capital gains
Tax-exempt income
Principal
Tax-Exempt Status
Charitable remainder annuity trusts and unitrust are not entitled to tax-exempt status under Section 501(c)(3) (principally because the payments to private beneficiaries prevent their operation exclusively for charitable purposes), but Section 664(c) states that they are nonetheless exempt from federal income taxes for any year unless the trust has unrelated business taxable income.
Avoidance of Capital Gains. For this reason, one of the most significant advantages that a charitable remainder trust (annuity or unitrust) presents to a donor is the trust’s ability to sell appreciated property contributed to the trust and to reinvest the proceeds without diminution for income taxes on the resulting capital gains.
Internal Tax-Free Compounding. In the case of a charitable remainder unitrust, a related advantage results from the fact that, to the extent that the trustee of a unitrust is capable of investing the trust assets at a rate which, net of expenses, is greater than the unitrust payment that would be made to the income beneficiaries, then the excess can accumulate within the trust tax-free, increasing the principal upon which future years’ unitrust payments will be based.
Need to Avoid Unrelated Business Taxable Income. Charitable remainder trusts are exempt from taxes, “unless such trust … has unrelated business taxable income.” Section 664(c).
Leila G. Newhall Unitrust v. Comm’r, 105 F.3d 482 (9th Cir. 1997), held that the quoted portion of the Code is unambiguous. The trust involved in that case, which had invested in certain publicly traded limited partnerships, argued that it should be taxable only “to the extent that” it realized unrelated business taxable income. The court, however, held that the trust would be taxable in its entirety, that all its income would be taxable if it realized any unrelated business taxable income.
For this reason, proprietorships are a totally unsuitable asset for contribution to a charitable remainder trust. One possible solution might be to incorporate the proprietorship and then to contribute the stock to the trust.
Debt-Financed Income. Property that is subject to any indebtedness is also generally unsuitable for contribution to a charitable remainder trust, since any income generated by the property will likely be unrelated debt-financed income. This is true whether the trust merely takes the property subject to the debt (and does not agree to pay it) or whether the trust assumes the debt. The only exceptions arise in cases where the trust acquires the property subject to a mortgage by bequest or devise or when the trust acquires the property by gift, the donor owned the property for more than five years prior to the gift, and the property has been subject to the mortgage for more than five years prior to the gift. In either case, the exception from unrelated debt-financed income is available only for the ten-year period following the trust’s acquisition. Section 514(c).
Charitable Lead Trusts
Structure. A charitable lead trust is just the reverse of a charitable remainder. trust. Here, the annuity or unitrust interest is paid to charity, and the remainder eventually passes to one or more private individuals.
Taxable Status. Unlike charitable remainder trusts, a charitable lead trust is not tax-exempt.
However, if the charitable lead trust is not a grantor trust, the trust will be entitled to am unlimited deduction under Section 642(c) for that portion of its income that is distributed to charity. The grantor is not entitled to a charitable income tax deduction for contributions to such a trust. Section 170(f)(2)(B).
If the charitable lead trust is treated as a grantor trust (which means that the grantor is taxable on all trust income), then the grantor is entitled to a charitable income tax deduction upon the funding of the trust, but neither the grantor, the trust, nor any other person may claim a charitable income tax deduction for any distributions made by the trust to charity. Section 170(f)(2)(C).
Estate Planning Uses
Charitable lead trusts are generally used only as a wealth transfer mechanism. The value of the intervening charitable interest is deductible for gift and estate tax purposes, thus reducing the transfer tax costs of transferring the trust corpus to future generations. However, because no distributions may be made other than to charity during the “lead” term, the use of a charitable lead trust for estate planning purposes is usually only feasible where the family members who will eventually acquire the remainder interest have sufficient financial resources of their own. Nonetheless, if the yield on trust investments can be expected to exceed the charitable distributions and the assumed interest rate used to calculate the charitable deduction, the present value of the trust corpus available to the remaindermen at trust termination may exceed the actual value of the assets used to fund the trust.
In the case of a charitable lead annuity trust, where only a fixed dollar amount is paid to charity each year, any appreciation in the value of the trust assets benefits the private remaindermen alone. In 1987, Congress determined that these economic circumstances unduly allowed grantors to leverage any generation-skipping transfer tax exemption allocated to the trust and modified the computation of the “inclusion ratio” in such cases. See Section 2642(e).
Private Foundations
Donor Objectives
In some respects, a private foundation is the ideal vehicle for conducting a donor’s charitable giving program.
There are no restrictions on who the managing body of a private foundation must be. Private foundations can be controlled by their donors and their family members, with no involvement by any outsiders. To some donors, the opportunity to appoint their children to the foundation board may be perceived as enhancing their financial maturity, cloaking them with some prominence in the community, and the like. Within reason, a private foundation may even pay compensation to its board members and pay other administrative expenses out of funds donated to the foundation and for which the founders have claimed a tax deduction.
Private foundations are also not limited to making distributions to a defined set of charitable recipients. They may “pick and choose” the recipients of their charitable distributions each year and vary those recipients from year to year.
Disadvantages
Significant limitations on the availability of income tax deductions for transfers to the foundation. See Parts II and III above.
Section 4940 imposes a modest income tax on the earnings of a foundation, and Sections 4941 through 4945 set forth exceedingly technical rules that govern their conduct.
Section 4941, for example, imposes a penalty tax on each “disqualified person” and possibly on foundation managers (board members) in the case of certain acts of self-dealing involving the foundation. Unlike the intermediate sanctions rules applicable to public charities, that impose a similar tax only when such a transaction generates an “excess benefit,” the private foundation prohibited transaction rules prohibit almost all kinds of self-dealing transactions altogether, even if they are fair and reasonable to the foundation.
Section 4942 requires a private foundation to distribute an amount equal to five percent of the net fair market value of its assets each year. These distributions normally must be made to a public charity, not to another private foundation.
Section 4943 prohibits a private foundation from owning more than 20 percent of the stock in any corporation, 20 percent of the profits interest in any unincorporated organization, and any interest in a sole proprietorship.
Section 4944 imposes a penalty tax on any investments by a private foundation that jeopardize its charitable purposes.
Section 4945 imposes a penalty tax on a variety of “catch-all” activities of a private foundation – political campaign and lobbying activities, scholarship grants the procedures for which have not been approved in advance, and distributions to non-charitable recipients.
Private foundations are nor eligible to make the Section 501(h) election regarding permissible lobbying expenditures.
Private foundation are required to file a tax return, Form 990PF, for each year of their existence. There is no minimum threshold of assets below which a foundation can be exempted from the filing requirement.
A private foundation can only be terminated, under Section 507, in a very limited number of ways.
Supporting Organizations
Definition
Supporting organizations are described in Section 509(a)(3) and must meet three requirements —
Organized and operated “exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more specified organizations” that are themselves public charities described in Sections 509(a)(1) or (2) (that is, the “supported organizations”).
“Operated, supervised, or controlled by or in connection with” the “supported organizations.”
Not controlled by disqualified persons.
The Service’s regulations have parsed the “operated, supervised, or controlled by or in connection with” requirement and determined that it really describes three separate sets of relations, which are now known by convention as Types I, II, and III supporting organizations. Treasury Regulation § 1.509(a)-(4)(f)(2).
“Operated, supervised, or controlled by” – Treasury Regulation § 1.509(a)-(4)(g) explains that this relationship is “comparable to that of a parent and subsidiary,” where at least a majority of the members of the supporting organizations governing body are appointed by the supported organization.
“Supervised or controlled in connection with” – Under Treasury Regulation § 1.509(a)-(4)(h), this relationship requires that the control of the supporting organization be vested in the same persons that govern or control the supported organization.
“Operated in connection with” – This is the most subjective and the loosest type of relationship, one that requires that he supporting organization be “responsive to” and occupy an “integral part” of the supported organization’s affairs.
Donor Objectives
Supporting organizations, since they are public charities, avoid all the restrictions of private foundations, but at the cost of the donor’s relinquishing control. Nonetheless, in practice, donors may exercise substantial influence, particularly since charity representatives serving on the supporting organization’s board are not likely to wish to antagonize the founders of what is usually a substantial source of financial support to the supported organization.
Supporting organizations, like private foundations, can give the donor a substantial “presence” in the community and at least an identity somewhat separate from the charity or charities that it supports. The supporting organization can be named after the donor, maintain a separate investment portfolio, and have a perpetual existence.
Disadvantages
Supporting organizations are largely confined to making distributions to the specified supported organizations. Treasury Regulation § 1.509(a)-4(c)(3).
Only under limited circumstances may a supporting organization make grants to individuals. Treasury Regulation § 1.509(a)-4(e)(1).
Endowment Funds
Definition
These are funds held by and owned by a charity, but that are subject to some restrictions that prevent the charity from spending the fund in its entirety on a current basis.
C.R.S. § 15-1-1103 defines an endowment fund as “an institutional fund, or any part thereof, which is not wholly expendable by the institution on a current basis under the terms of the applicable gift instrument.”
See Part IX below for further definitions.
Variations
Unrestricted
Donor Restricted or Donor Designated – restrictions or conditions are imposed in the governing instrument at the time that the gift is made. Restrictions may apply as to the purposes for which the fund may be spent and what portion of the fund may be spent each year.
Donor-Advised Funds
Definition
There is no definition of a donor advised fund in the Code or Regulations. Instead, operational guidance must be borrowed from certain regulations that define community foundations and that deal with the termination of private foundations.
As described in Treasury Regulation § 1.170A-(9)(e)(10), while community foundations typically have a “governing body comprised of representatives of the particular community or area, its contributions are often received and maintained in the form of separate trusts or funds, which are subject to varying degrees of control by the governing body.”
Treasury Regulation § 1.170A-(9)(e)(11)(ii) then states that a separate trust or fund will be regarded as a “component part” of the community foundation (so that contributions to the separate trust or fund may be counted as public support to the community foundation, rather than to a separate, standalone entity, for purposes of the Section 170(b)(1)(A)(vi) test), so long as the separate fund or trust has not been “directly subjected by the transferor to any material restriction or condition (within the meaning of § 1.507-2(a)(8)) with respect to the transferred assets.”
Section 507 deals with the termination of private foundations and allows a private foundation to terminate if it distributes all its assets to one or more public charities. Treasury Regulation § 1.507-2(a)(8), however, is designed to prevent a private foundation from attempting to terminate its status by distributing all its assets to a public charity, but then retaining sufficient “strings” over the transferred assets so that control has not been entirely relinquished.
Specifically, Treasury Regulation § 1.507-2(a)(8) states that “in order to effectuate a transfer of all of its right title and interest in and to all of its net assets …, a transferor private foundation may not impose any material restriction or condition that prevents the transferee … public charity from freely and effectively employing the transferred assets, or the income derived therefrom, in furtherance of its exempt purposes.”
Treasury Regulation § 1.507-2(a)(1) then sets forth a number of considerations for determining whether a donor foundation has imposed material restrictions or conditions on transferred assets when the transferor foundation has reserved the right to render advice as to how the transferred assets are to be used, as follows:
(1) With respect to distributions made after April 19, 1977, the transferor private foundation, a disqualified person with respect thereto, or any person or committee designated by, or pursuant to the terms of an agreement with, such a person (hereinafter referred to as donor), reserves the right, directly or indirectly, to name (other than by designation in the instrument of transfer of particular section 509(a) (1), (2), or (3) organizations) the persons to which the transferee public charity must distribute, or to direct the timing of such distributions (other than by direction in the instrument of transfer that some or all of the principal, as opposed to specific assets, not be distributed for a specified period) as, for example, by a power of appointment. The Internal Revenue Service will examine carefully whether the seeking of advice by the transferee from, or the giving of advice by, any donor after the assets have been transferred to the transferee constitutes an indirect reservation of a right to direct such distributions. In any such case, the reservation of such a right will be considered to exist where the only criterion considered by the public charity in making a distribution of income or principal from a donor’s fund is advice offered by the donor. Whether there is a reservation of such a right will be determined from all of the facts and circumstances, including, but not limited to, the facts contained in paragraph (a)(8)(iv)(A) (2) and (3) of this section.
(2) The presence of some or all of the following factors will indicate that the reservation of such a right does not exist:
(i) There has been an independent investigation by the staff of the public charity evaluating whether the donor’s advice is consistent with specific charitable needs most deserving of support by the public charity (as determined by the public charity);
(ii) The public charity has promulgated guidelines enumerating specific charitable needs consistent with the charitable purposes of the public charity and the donor’s advice is consistent with such guidelines;
(iii) The public charity has instituted an educational program publicizing to donors and other persons the guidelines enumerating specific charitable needs consistent with the charitable purposes of the public charity;
(iv) The public charity distributes funds in excess of amounts distributed from the donor’s fund to the same or similar types of organizations or charitable needs as those recommended by the donor; and
(v) The public charity’s solicitations (written or oral) for funds specifically state that such public charity will not be bound by advice offered by the donor.
(3) The presence of some or all of the following factors will indicate the reservation of such a right does exist:
(i) The solicitations (written or oral) of funds by the public charity state or imply, or a pattern of conduct on the part of the public charity creates an expectation, that the donor’s advice will be followed;
(ii) The advice of a donor (whether or not restricted to a distribution of income or principal from the donor’s trust or fund) is limited to distributions of amounts from the donor’s fund, and the factors described in paragraph (a)(8)(iv)(A)(2) or (i) or (ii) of this section are not present;
(iii) Only the advice of the donor as to distributions of such donor’s fund is solicited by the public charity and no procedure is provided for considering advice from persons other than the donor with respect to such fund; and
(iv) For the taxable year and all prior taxable years the public charity follows the advice of all donors with respect to their funds substantially all of the time.
The assumption has been that contributions to endowed funds, with respect to which the donor retains an advisory role that would have been permissible for a transferor private foundation under the Section 507 regulations, should be equally permissible when made by individuals.
