Many of the activities in which charitable organizations have engaged for the purpose of raising funds — athletic events, auctions, bake sales, banquets, bingo games, cocktail parties, dinner parties, fashion shows, raffles, and so on — are not intrinsically charitable in nature and may, in certain cases, be indistinguishable from similar activities carried on by commercial enterprises.
The problem is that Treasury Regulation § 1.501(c)(3)-1(e) denies exemption to an organization that is organized and operated for the primary purpose of carrying on an unrelated trade or business. If special fundraising events of this nature are the exclusive or even just the primary activity in which an organization engages, and are not just incidental activities intended to finance other, more traditionally functional charitable programs which the organization conducts, questions arise as to whether the organization is genuinely organized and operated for acceptable purposes within the meaning of Section 501(c)(3).
A second source of concern to the Service is that Section 502 denies exemption to so-called “feeder organizations,” that is, those operated for the primary purpose of carrying on a trade or business and then paying all of their profits over to one or more exempt organizations. In the case of organizations that simply raise funds through the sponsorship of special events and then turn the profits over to another organization (for example, a hospital auxiliary), classification as a “feeder” organization under Section 502 is possible.
Finally, even if sponsoring a special fundraising event is not the organization’s sole activity, there remains a possibility that the income it realizes from the event may be regarded as unrelated business taxable income.
The Internal Revenue Code does not provide a precise definition of what constitutes a “trade or business.” However, Treasury Regulation § 1.513-1(b) interprets the term “trade or business,” for purposes of imposing the tax on unrelated business taxable income, as having the same meaning as it has under Section 162. In general, under Section 162, a trade or business can be regarded as any activity carried on for the production of income from the performance of services or the sale of goods. In light of this expansive interpretation, many fundraising events must be regarded as business activities.
Rationale for Exempting Most Special Events.
Fortunately, the Service has expressed a willingness to develop a conceptual distinction between ordinary trades or businesses and many charitable fundraising events. See Internal Revenue Service, Exempt Organizations Continuing Professional Education Technical Instruction Program for 1982, p. 103. Influencing the Service’s attitude in this respect is the fact that many charitable fundraising affairs are somewhat sporadic, that they are largely supported through the efforts of volunteers, and that many of the goods and services used in the fundraising activity may be donated.
Not Regularly Carried On. First, the Service tends to look favorably upon fundraising events that are not carried on with any degree of regularity.
Under Treasury Regulation § 1.513-1(c)(1), whether activities conducted for the production of income are regularly carried on depends on their frequency and continuity and the manner in which they are pursued, viewed in light of the objective of placing otherwise exempt organizations on the same tax basis as the for-profit enterprises with which they may compete.
Therefore, if the activities in question are of a sort that are normally conducted by nonexempt commercial organizations on a year-round basis, they will not be “regularly carried on” by an exempt organization that conducts similar activities over a period of days or a few weeks. Treasury Regulation § 1.513-1(c)(2) illustrates this principal by noting that a hospital auxiliary’s operation of a sandwich stand at a two-week long state fair would not be a business regularly carried on, but that the operation of a parking lot each Saturday all year would be.
If the activities are normally conducted on a seasonal basis by commercial enterprises, such as the operation of an outdoor swimming pool, then an exempt organization’s conduct of that activity over a significant portion of the season would constitute the regular conduct of a trade or business.
Other activities that are engaged in only on an intermittent basis, such as the sale of advertising in the program for a musical performance, will not be considered regularly carried on unless they are promoted and pursued with the systematic and consistent efforts characteristic of commercial activities. Treasury Regulation § 1.513-1(c)(ii).
Second, the Service has applied the principles of Section 513(a)(1) and (3) in several of its rulings granting exemption to fundraising charities.
Volunteer Labor Exception. Any trade or business in which substantially all of the work is performed without compensation is not considered an unrelated trade or business. Section 513(a)(1). However, the Service takes the position, with the approval of the courts, that even a relatively negligible level of compensation may result in forfeiture of this exception.Waco Lodge No. 166 v. Comm’r, 696 F.2d 372, 83-1 U.S.T.C. ¶ 9165 (5th Cir. 1983) (bingo games sponsored by an Elks Lodge were not conducted substantially through the use of volunteer labor, since the lodge hired a paid bartender and provided $435.50 worth of free drinks to collectors and cashiers, which incidentally amounted to an average of 3 mixed drinks, or 6.3 beers, per worker per night).
Thrift Shop Exception. Any trade or business which is the selling of merchandise, substantially all of which has been received as gifts or contributions is not considered an unrelated trade or business. Section 513(a)(3).
Commensurate Test. In addition, in Revenue Ruling 64-182, 1964-1 C.B. 186, the Service announced (or more accurately, invented) what has come to known as the “commensurate test.” That ruling dealt with an organization whose income was principally derived from the rental of space in a large commercial office building it owned. The organization then made distributions and grants to other organizations carrying on active charitable programs. The Service concluded that the organization was entitled to exemption, even though its principal activity was the rental of office space, because it was “shown to be carrying on through such contributions and grants a charitable program commensurate in scope with its financial resources.” Similarly, an organization whose principal activity is the sponsorship of a charitable fundraising event may argue that it carries on a charitable program commensurate with its resources, if the amounts that its turns over to other active charities or in the form of direct distributions to charitable beneficiaries are significant.
Use of Professional Fundraisers.
United Cancer Council, Inc. incorporated in 1962 for the purpose of conducting research, educating the public and professionals, providing service to patients, and facilitating the exchange of ideas among similar organizations with respect to the cause and cure of cancer. By 1984, however, many of UCC’s member agencies, on which it had been dependent for dues, had withdrawn, precipitating a budget crisis, and UCC was struggling to avoid bankruptcy. UCC then entered into a contract with a professional fund-raiser, Watson & Hughey. The agreement required Watson & Hughey to advance funds to UCC sufficient to permit UCC to remain operational and to start up a direct mail campaign and specified that Watson & Hughey would administer the direct mail campaign for a period of five years. UCC gave Watson & Hughey joint ownership of its mailing list. While the agreement prohibited UCC from selling, exchanging, or renting its mailing list, Watson & Hughey was free to do so. UCC did not renew the contract at the end of its five-year term. UCC filed for bankruptcy protection on June 1, 1990.
Characterizing the relationship between UCC and Watson & Hughey as a “joint venture” and “symbiotic,” the Service revoked UCC’s tax-exemption. The Service has asserted that UCC has engaged in a transaction resulting in private inurement and that it has failed the operational test, since “more than an insubstantial part of its activities is not in furtherance of an exempt purpose.”
Expert witnesses from both sides have presented testimony regarding the propriety of joint ownership of mailing lists and of direct mail fundraising campaigns.
On March 11, 1993, the Tax Court denied UCC’s motion for summary judgment on the grounds that the Service’s revocation of its tax-exempt status violated due process. Towards the close of this stage of the trial, on April 26, the judge suggested that the Service might wish to discuss the issues with UCC and develop regulations dealing with the problems of nonprofit organizations that employ professional fundraisers.
In an extraordinarily long 1997 decision, the Tax Court upheld the revocation of UCC’s exempt status. United Cancer Council, Inc. v. Commissioner, 109 T.C. 326 (1997). That decision was subsequently reversed, 83 AFTR2d ¶ 99-416 (7th Cir. 1999).
Summary of Rules Regarding Deductibility and Disclosure
The Taxpayer’s Burden Regarding Deductibility. The deductibility of contributions to charitable organizations depends on the gratuitous nature of the transfer, as much as it does on the charitable character of the recipient.
In order to qualify for a deduction, the payment must truly be a gift, that is, constitute a voluntary transfer of money or property made without consideration or an expectation of any benefit in return.
The Singer Company v. U.S., 449 F.2d 413 (Ct. Cl. 1971). The company sold sewing machines to various charitable organizations at a discount, the value of which it attempted to claim as a charitable deduction. The court stated that “if the benefits received, or expected to be received, are substantial, and meaning by that, benefits are greater than those that inure to the general public from transfers to charitable purposes (which benefits are merely incidental to the transfer), then in such case we feel that the transferor has received, or expects to receive, a quid pro quo sufficient to remove the transfer from the realm of deductibility under Section 170.” Finding that the plaintiff’s predominate motive in selling its machines to schools at a discount was to “[encourage] those institutions to interest and train young women in the art of machine sewing; thereby enlarging the future market of developing prospective purchasers of home sewing machines, and more particularly, Singer machines,” the court denied the deduction.
American Bar Endowment Foundation, 477 U.S. 105 (1986). The American Bar Endowment was a Section 501(c)(3) affiliate of the American Bar Association which offered group life insurance to members of the ABA at competitive premiums. The Endowment retained excess premiums that the insurer rebated and applied them to finance charitable programs. The Supreme Court affirmed the Service’s denial of a charitable deduction claimed by several participants measured by the difference between what they paid for the policies and the actual costs of insurance coverage, reasoning that the participants failed to demonstrate that they intentionally paid more to the Endowment than what they received in return.
The Charity’s Responsibility – Revenue Ruling 67-246. Revenue Ruling 67-246, 1967-2 C.B. 104, originally set forth the Service’s analysis of the proper tax treatment of payments made to charitable organizations in exchange for admissions to, or participation in, fundraising activities such as charity balls, banquets, musical or other artistic performances, athletic events, and the like.
In general, the ruling asserted that there is a presumption that the total amount of any payment made to a charity for the purchase of an item, privilege, or service represents the fair market value of the benefit received, resulting in no gift whatsoever for charitable contribution purposes.
In order to rebut the presumption, the burden of proof is on the taxpayer to demonstrate that the payment exceeds the fair market value of the benefits received, and, in the absence of such a demonstration, a deduction will be denied.
Obviously, donors will have little conception of the value of the events that they have attended or participated in, and, much more alarming from the Service’s perspective, when preparing their annual income tax returns either will have forgotten the real purposes of the payments they have made or will simply ignore the value of the benefits they received.
For this reason, Revenue Ruling 67-246’s real innovation was its shifting to charitable organizations the burden of establishing the fair market value of benefits provided to donors and communicating that information in a timely and memorable fashion:
In those cases in which a fund-raising activity is designed to solicit payments which are intended to be in part a gift and in part the purchase price of admission to or other participation in an event of the type in question, the organization conducting the activity should employ procedures which make it clear not only that a gift is being solicited in connection with the sale of admissions or other privileges related to the fund-raising event, but also, the amount of the gift being solicited. To do this, the amount attributable to the purchase of admissions or other privileges and the amount solicited as a gift should be determined in advance of the solicitation. The respective amounts should be stated in making the solicitation and clearly indicated on any ticket, receipt, or other evidence issued in connection with the payment.
Revenue Ruling 67-246 then assigned charities three vital responsibilities:
determine both the “amount attributable to the purchase of admissions or other privileges” and the amount solicited as a gift;
make that determination in advance of the solicitation; and
state both amounts when making the solicitation and in any receipts or other documents furnished to donors.
Examples Of Unacceptable Representations. It is no longer (and probably never has been) acceptable to make ambiguous or misleading representations such as the following:
“Your contribution is deductible to the extent permitted by law.”
“The [ABC] charity is a tax-exempt organization (or a Section 501(c)(3) organization, or any such variant).”
“Thank you for your tax deductible contribution.”
Invitations that contain a line such as “enclosed is my $ contribution for admission...” or requesting that potential attendees send in a “$ donation.”
Written Acknowledgments Required. Section 170(f)(8) of the Internal Revenue Code provides that no deduction for any charitable contribution of $250 or more will be allowed, “unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgment of the contribution by the donee organization.” In other words, it will no longer be adequate for a taxpayer to rely on a canceled check alone as evidence of a large charitable contribution.
Contributions to Which the Requirement Applies. Separate contributions made by the same taxpayer throughout the year (such as by payroll deductions) need not be aggregated, and only individual contributions exceeding the dollar threshold will be subject to the new substantiation requirements. The Internal Revenue Service is, of course, authorized to issue regulations designed to prevent abuse of this threshold (such as multiple checks, each written for $249).
Contents of the Acknowledgment. The written acknowledgment must include all of the following information:
An indication of the amount of cash that the donor contributed and, if the donor contributed any property other than cash, a description of the property contributed. The description does not have to include an estimate of the value of any property contributed.
Description of Benefit to the Donor. A statement whether the charity provided any goods or services in consideration, in whole or in part, for the contribution.
Note that the disclosure relates to “whether” and not “if” the charity provided any consideration. The Senate Finance Committee Report states that, even if the donee organization provided no goods or services in exchange for the taxpayer’s contribution, the acknowledgment needs to contain a statement to that effect.
Since most contributions are made on a totally gratuitous basis, without the donor realizing any tangible benefit in return, such a requirement would represent a significant departure from the sorts of acknowledgments charities have been accustomed to providing to donors.
Estimate of Value Provided to the Donor. A good faith estimate of the value of any goods or services provided and a description of those goods or services. In the case of any contribution made to a religious organization in return for which the taxpayer receives only an intangible religious benefit that generally is not sold in a commercial transaction outside the donative context (presumably, such things as pew rentals, votive offerings, and the like), the acknowledgment need only include a statement to that effect.
Manner and Timing of Receipt. A “contemporaneous” written acknowledgment is one delivered to the taxpayer before the date for filing his or her tax return (including extensions).
In other words, the donor cannot file a tax return claiming the deduction until he or she has received such an acknowledgment.
According to the House Ways and Means Committee Report, the acknowledgment does not need to contain the donor’s taxpayer identification number.
The acknowledgment must be made in such a manner reasonably likely to come to the attention of the donor. It cannot be buried in fine print in the middle of a newsletter or other lengthy document.
Information Return Alternative. Section 170(f)(8)(D) provides that charities may be relieved from the obligation to send written acknowledgments to contributors, if the charity files a return with the Service containing the information that would have been required to be set forth in the acknowledgments. It is difficult, however, to determine how such a return could be of much benefit to donors, since they would in all likelihood need to receive some sort of notice anyway that the charity had filed the return; otherwise, those donors would have no way of knowing that they could permissibly claim a deduction
Penalties. The penalty for a charity’s failure to provide the necessary written acknowledgment will be the denial of its donors’ charitable contribution deduction. The House Ways and Means Committee Report on the Act also specifically states, however, that Congress expects the Service to assert the penalties set forth in Section 6701 of the Internal Revenue Code, relating to aiding and abetting understatements of tax liability, at $10,000 per occurrence, if a charity knowingly provides a false substantiation document.
Example 1 (gratuitous contribution):
“Thank you for your December 29, 2002 contribution of $500 (or 100 shares of the common stock of Central Power and Gas) (or your condominium located at 123 Main Street, Unit 100, Vail, Colorado) to the Rocky Mountain Cultural Museum. We would like to remind you that the Internal Revenue Code requires you to substantiate charitable contributions of $250 or more by means of a written acknowledgment. This letter is intended to serve as your acknowledgment for this purpose, and we would recommend that you retain it with your permanent income tax records. The Rocky Mountain Cultural Museum also confirms that it did not provide you with any goods or services in exchange for your contribution.”
Example 2 (quid pro quo contribution):
“Thank you for your December 29, 2002 payment of your 2003 membership dues to the Rocky Mountain Cultural Museum. Your $500 payment entitles you to a one-year membership in our Benefactors’ Club. The Internal Revenue Code requires us to inform you that the amount of your payment that is deductible for federal income tax purposes is limited to the excess of your payment over the value of any goods or services to which you may be entitled as a result of your payment. Membership in our Benefactors’ Club entitles you to a one-year subscription to our monthly newsletter, Qualities, free admission to all regular and special exhibits at the museum for you and your family, and a 15-percent discount on all purchases from the museum gift shop. We estimate the value of these membership benefits to be $60. We would also like to remind you that the tax laws require you to substantiate charitable contributions of $250 or more by means of a written acknowledgment. This letter is intended to serve as your acknowledgment for this purpose, and we would recommend that you retain it with your permanent income tax records.”
Disclosures Relating to Quid Pro Quo Contributions in Excess of $75.
A “quid pro quo” contribution is defined as a payment that is made partly as a contribution and partly in consideration for goods or services provided to the donor by the donee organization. It does not include any payment made to a religious organization, in return for which the taxpayer receives nothing more than an intangible religious benefit that generally is not sold in a commercial transaction outside the donative context.
Disclosure Statement Required. Section 6115 of the Internal Revenue Code requires, effective January 1, 1994, that all organizations eligible to receive charitable contributions (as defined in Section 170(c)(2) through (5), which includes certain war veterans’ organizations) must provide a written statement to each person who has made a quid pro quo contribution in excess of $75.
The requirement applies to payments in excess of $75, not to contributions in excess of that amount. For example, a written statement must be provided in the case of an $80 payment, even if only $30 of it represents a contribution.
Section 170(f)(8) substantiation requirement, on the other hand, applies to contributions of $250 or more. In the case of a total payment of $500, for example, only $200 of which represents a charitable contribution, the disclosure requirement would apply (because the total payment exceeds $75), but the substantiation rules would not (because the contribution element was not $250 or more).
The disclosure requirement does not apply to payments made without any donative intent whatsoever, such as tuition payments to a private school, charges for hospital services, and purchases from a museum gift shop.
Contents of Disclosure Statement. The disclosure statement must —
inform the donor that “the amount of the contribution that is deductible for federal income tax purposes is limited to the excess of the amount of money and the value of other property other than money contributed by the donor over the value of the goods and services provided by the donee organization,” and
provide the donor with a good faith estimate of the value of the goods or services provided.
Time for Delivery of Disclosure Statement. The disclosure statement can be made in connection with either the solicitation or receipt of the contribution.
A penalty of $10 per contribution (with a maximum of $5,000 per fundraising event or mailing) can be imposed for failure to make the required disclosure or for making an incomplete or inadequate disclosure, unless the failure was due to reasonable cause.
“The Toys for Tots Foundation thanks you for your $200 purchase of two tickets to the October 15, 2002 benefit performance by the City Ballet Company. The Toys for Tots Foundation estimates that the fair market value of admission to that performance is $60 per person. The Internal Revenue Code requires that we inform you that the amount of your payment that is deductible for federal income tax purposes is limited to the excess of your payment over that amount.”
Special Disclosure Problems and Unresolved Issues.
Methods of Determining Fair Market Value. The most problematic aspect of the new substantiation and disclosure requirements relate to calculating the value of any goods or services provided to donors.
Good Faith Estimate. Both Section 170(b)(8) (donor substantiation) and Section 6115 (disclosure statements) require only a “good faith estimate” of value, not the depth and precision of a comprehensive appraisal.
Comparable Goods or Services. Revenue Ruling 67-246 provides some continuing guidance and suggests that amounts charged for reasonably comparable events at which there is an established admission fee can be used to fix the purchase component of any payment. Similarly, the purchase price of similar items sold in a commercial context should furnish a clear value. Otherwise, an honest and reasonable estimate of the fair market value should be sufficient.
Relevance of the Charity’s Cost. What must be determined and communicated is the value of the benefit that the donor receives, not the expense that the charity incurs in connection with providing that benefit.
Thus, an estimate of value and its disclosure to donors is necessary even if the cost of a fundraising event has been fully underwritten or if all the benefits provided to donors have been contributed by third parties.
Nonetheless, in the case of events or goods for which there are no commercial counterparts, the use of cost data may be the only way of approaching the fair market value determination.
Difficulties with Cost Data.
The Elusive Denominator. If a charity determines that the only way to estimate the value of admission to a special event (such as a banquet, theatrical performance, and the like) is by means of the cost of sponsoring the event, then that total cost must be allocated somehow on a per-person basis. The raises the issue of whether the allocation can be made by dividing total costs by the number of persons who are expected to attend, the number of tickets sold, or the number of persons who actually do attend.
Costs Taken Into Account. Nor is there any clear guidance as to which costs should be taken into account, for example, the expense of mailing invitations, staff time planning the event, and general overhead expenses. Apparently, under generally accepted accounting principles, costs such as these are considered fundraising costs, not direct event costs, but it is uncertain whether the Internal Revenue Service would adopt a similar approach.
Inability to Develop Any Estimate. To the extent that the charity is unable to developany good faith estimate of value, a continuing application of the principles of Revenue Ruling 67-246 suggests that the value of any benefits provided is equivalent to amounts paid for them, and thus no portion of any so-called contribution is deductible.
For example, consider the problem of estimating the market value of the benefits provided upon payment of an entrance fee to a “run for charity.” Obviously, the value of t-shirts and other memorabilia of a similar nature typically given to participants can be measured easily. More troublesome might be the value (if any) associated with the race administration (e.g., marking the course, providing medical personnel, and timing the entrants). If there are no comparable commercial events, and assuming that the entrance fee is not vastly disproportionate to the cost of sponsoring the event, no part of the entrance fee may be deductible.
Unused Tickets. The fact that the donor/recipient does not in fact take advantage of the benefits resulting from a contribution does not necessarily convert an otherwise nondeductible payment into a deductible one.
As Revenue Ruling 67-246 states, “[t]he test of deductibility is not whether the right to admission or privileges was exercised but whether the right was accepted or rejected by the taxpayer.” Thus, if a taxpayer who has purchased an admission to a fundraising event chooses not to attend, he or she should return the ticket to the charity in advance of the event, in sufficient time to permit the charity to resell it.
Ruling 74-348, 1974-2 C.B. 80, dealt with a taxpayer who had returned one of his season tickets to a theatrical performance back to the organization for resale. The ruling holds that the returned ticket was deductible, since the taxpayer had absolutely relinquished control, but that the deduction was limited to the pro rata cost of the single ticket in the taxpayer’s season ticket package, not the price of admission to an individual performance.
Time for Determining Value.
Ruling 67-246 clearly contemplated that the value of any benefits to be conferred upon donors would be determined in advance and that the value so determined would be communicated to donors when the solicitation was made. In other words, the disclosure was to be made in all invitations mailed, newspaper announcements published, solicitations mailed, and so on, as well as in any tickets, receipts, or other materials subsequently distributed to contributors. The requirement that the respective amounts be stated in the original solicitation materials was apparently intended to prompt donors to add an appropriate notation to their checks at the time they were written.
6115 now provides that the necessary disclosure statement quid pro quo contributions can be delivered in connection with either the solicitation or the receipt of the contribution.
To the extent that disclosure regarding a quid pro quo contribution must be made in a written acknowledgment required by Section 170(f)(8), the necessary document can be delivered to the donor before the due date for the donor’s return.
Deferred and Planned Giving Opportunities
Pooled Income Funds.
A pooled income fund is a fund maintained by an organization, that accepts gifts of money or property from donors, and that pays a percentage of the fund’s income each year to each donor for life. At the death of a donor, that donor’s interest in the fund passes to the organization.
The donor is entitled to a deduction in the year of the transfer to the fund equal to the present value of the interest that will pass to the charity, computed using tables developed by the Treasury Department.
Because pooled income funds are relatively complicated to establish and administer, there usefulness is generally confined to larger charitable organizations.
Gifts of Closely-Held Stock.
Palmer v. Comm’r, 62 T.C. 684 (1974), approved of a transaction in which a donor contributed closely-held corporate stock to a charity and in which the corporation, which held substantial retained earnings, subsequently redeemed the shares.
The advantages from this transaction are:
The donor was entitled to a deduction for the full fair market value of the stock;
The donor did not receive a taxable dividend;
The corporation reduced its earnings and profits, avoiding the possible imposition of an accumulated earnings tax;
The charity did not recognize any gain on the redemption;
The charity ended up with cash; and
The donor’s ownership in the corporation remained undiluted.
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 Committee on Gift Annuities. 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 6.0 percent of the value of the property transferred, but 14.0 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 Committee 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.
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, Rev. Rul. 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. Rev. Rul. 78-283, 1978-2 C.B. 243.
The annuity payments cannot be reduced by trustee commissions or other administrative expenses. Rev. Rul. 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.
Rev. Rul. 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 Rev. Rul. 70-452, 1970-2 C.B. 199;Cf.Moor v. Commissioner, 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 three differentvariations among charitable remainder unitrusts:
those that pay the unitrust amount in all events, regardless of whether the income of the trust is sufficient to do so (“fixed unitrusts”),
those that pay the lesser of the fixed unitrust amount or the net income of the trust (“net income unitrusts”), and
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 (“cumulative net income unitrusts”).
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). Rev. Rul. 76-307, 1976-2 C.B. 56; Rev. Rul. 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. Rev. Rul. 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. Because charitable remainder trusts are nontaxable entities only if they do not have any unrelated business taxable income, avoidance of any income of this nature is vital.
Unsuitability of Active Businesses. 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.
Examples and Analysis
Conversion of Unproductive Appreciated Property. Margaret A. Byte is a 40 year old single mother of two small children. Until recently, Meg had been employed as a computer software engineer with Digital Design Systems, Inc. and was responsible for writing the user interface for its highly acclaimed page layout program. Prior to her termination from Digital Design because of her unfortunate habit of spilling coffee on the company’s network hard drive, Meg had faithfully exercised every stock option the company had ever granted to her and now holds a block of 4,500 shares of Digital Design common stock. Digital Design has just competed its first public offering, and Meg’s stock, in which she has an average cost basis of $2.50 per share, is now trading at around $50.00 per share, adjusted for previous various stock splits. Ms. Byte, who has been unable to find other employment, would very much like to dispose of her stock, since it currently pays no dividend, but is prevented by the federal securities laws from doing so for another 18 months and realizes that even then she will incur a substantial capital gains tax.
No gain will be recognized on a contribution of the stock to a charitable remainder trust (unless, of course, Meg first pledges the stock as security for a loan);
For purposes of computing her income tax charitable deduction, the stock will be valued at its current fair market value, although Meg will be able to claim a deduction for only an amount equal to 30 percent of her adjusted gross income; any excess may be carried over for the following five years (and may offset a portion of any income distributed to her from the trust), subject to the same limitation;
A sale by the trust of the stock will not be taxable (unless the trust has unrelated business income);
Because of the restrictions on the sale of the stock, which will also prevent the trustee from selling the stock, a net income or cumulative net income unitrust might be the most suitable type of charitable remainder trust;
Distributions to Meg will consist of ordinary income (to the extent of the income of that nature realized by the trust) and then long-term capital gains.
Meg’s children could succeed her as income beneficiaries of the trust. If Meg did not retain the right to revoke their income interests, she will have made a taxable gift upon funding the trust; otherwise, the gift to her children becomes complete at her death, in which case the trust agreement must require her children to pay all the estate taxes attributable to the transfer to them.
Meg could also consider creating an irrevocable trust to hold life insurance the proceeds of which would be structured to reimburse her children for the eventual loss of the value stock contributed to the trust. If properly established, the trust assets would pass to her children free from any income, gift, or estate tax. However, the feasibility of such an insurance trust also depends on:
Inflation;
Insurability;
The possibility of estate tax rate changes or the inclusion of life insurance in a decedent’s estate
Retirement Accumulation Unitrust. Dr. Gregory Tucker is a successful plastic surgeon in his fifties. He has accumulated a net worth of $2.6 million, which includes an $800,000 home, a $500,000 mountain resort condominium (subject to a $400,000 mortgage), $750,000 in his pension and profit-sharing plans, an antique car collection worth approximately $175,000, and various marketable securities.
Dr. Tucker might consider establishing a net income charitable remainder unitrust that invests in low-yield, growth securities until the his retirement age, at which time the assets could then be invested to produce a high yield. So long as the unitrust is a “net income” type, pre-retirement distributions will be small, while distributions after retirement will be based on the highly appreciated principal.
Unlike individual retirement accounts or qualified retirement plans, there are no limits on the amount that may be contributed to a unitrust.
Perhaps only the marketable securities may be suitable for contribution to such a trust. Either the home or the condominium would result in self-dealing transactions that would jeopardize the qualification of the trust, while a donation of the antique car collection would generate an income tax deduction equal only to the Doctor’s basis in his cars.
Short-Term Educational Benefits Trust. Jason Archibald Fairweather, III, is the only surviving heir to the Presto collapsible umbrella fortune. His son, also named Jason, who recently graduated from college with lackluster grades and a major in monastic manuscript painting of the twelfth century, has expressed a desire to proceed on to business school. Jason, Sr., who is willing to finance his son’s graduate education to whatever extent may be necessary, has just run into the business school’s senior admission’s officer and planned giving director at the Club.
Jason, Sr., might volunteer to create a charitable remainder annuity trust for his son’s benefit for the purpose of paying support to his son while still in school, with the remainder to pass to the school on his graduation.
Advantages include a relatively sizable charitable deduction due to the short-term nature of the trust, avoidance of capital gains on any appreciated securities used to fund the trust, and taxation of income distributions at the son’s lower income tax rates.
Jason, Sr. will incur a gift tax on funding the trust equal to the present value of the annuity payments to be made to his son, but will also be entitled to one annual exclusion.
Charitable Lead Trusts.
A charitable lead trust is the reverse of an annuity trust or unitrust. The income interest is payable to a charitable beneficiary for a term of years, at the end of which the corpus reverts to the donor or another beneficiary.
Private Foundations.
Advantages
No limits on composition of governing body
Donor retention of control
Disadvantages
Lower limits on deductibility of contributions
Unavailability of Section 501(h) lobbying election
Section 4940 et seq. private foundation restrictions
Complexity of tax returns and unavailability of $25,000 threshold
Supporting Organizations.
Advantages
treated as a public charity
Disadvantages
Donor and other affiliated persons may not retain control
Potential grantee organizations are narrowly circumscribed
Grants may not normally be made to non-supported organizations
