An Interview with Attorney Michael F. Magistrali, esq.
The Community Foundation recently sat down with Michael Magistrali, esq. of Michael F. Magistrali & Associates to discuss giving locally and simple planned giving options. Read more
An Interview with Attorney Michael F. Magistrali, esq.
The Community Foundation recently sat down with Michael Magistrali, esq. of Michael F. Magistrali & Associates to discuss giving locally and simple planned giving options.
NCCF: How do you advise clients who want to give back to their communities?
MM: Most people who want to leave a bequest have given to different charities throughout their lifetime, and they want to continue that giving through their will. Others really haven’t given much in the past, but have accumulated some wealth and want to do something helpful through their estate planning. Most of my clients are local people who want to support local nonprofits.
The charitable giving conversation comes up most of the time—not all of the time—with clients who don’t have any children or living siblings. If a client seems unsure about what they want to do with their estate, I sometimes ask, “Have you thought about charitable giving?” Many people have specific charities in mind. Others have a general interest, such as food insecurity, childcare, homelessness, or animal-care issues.
Clients often think in terms of a fixed gift amount. If it’s important to them to ensure that all of the nonprofits they care about receive a gift, I suggest they think in terms of percentages of their residual estate. For instance, if you give $50,000 to Nonprofit A and divide the remainder of the estate among Nonprofits B, C, and D, and the day you pass away, you have $50,000 total, Nonprofits B, C, and D will not receive anything. But, if you break your gift up into percentages, each nonprofit will get something. It’s important to think about the consequences of how you frame your bequest.
NCCF: What are some misconceptions about planned giving?
MM: You don’t have to have millions of dollars to give charitably. Most of my clients are not high-wealth individuals. It’s rare for me to have a client who has more than $500,000 in their estate planning. Many have less, but even a small percentage of a small estate can be a very nice gift to a nonprofit.
Another misconception is that you need to be very specific about how a gift can be used. Clients sometimes have the idea that they should restrict their gift to a specific program or item, in essence dictating how the nonprofit can use the gift. I advise clients that they may be unintentionally making things difficult for the nonprofits they want to help.
Most nonprofits want gifts to be unrestricted, so they can use them where they have the need. Nonprofits often have specific bequest language available for use in wills. When the nonprofit receiving the bequest provides the bequest language it ensures that the gift will provide the greatest benefit.
NCCF: You have mentioned that you advise your clients to keep their giving simple. Tell us more about that.
MM: I try to simplify things for clients. Sometimes clients have elaborate plans for their estates. They may want an inheritance to be held in trust and then awarded to recipients at specific ages, or tied to a series of accomplishments on the part of the recipients. Complicated wills, whether they be for inheritances, charitable giving, or both, are very difficult to administer. They take a lot of time, a lot of energy, and clients are not high-wealth individuals, I don’t create charitable lead or charitable remainder trusts. In many cases, charitable giving can be as simple as designating a nonprofit as the beneficiary of a life insurance policy.
NCCF: When do you recommend your clients give through the Northwest Connecticut Community Foundation?
MM: I have been recommending clients give through the Northwest Connecticut Community Foundation since its inception in 1969. When I have a client who wants to make a charitable bequest, but has broad interests or isn’t sure where they want their gift to go or for what cause, I always refer them to the Northwest Connecticut Community Foundation.
Community Foundation staff are able to provide language for wills that ensures the bequest will be used as my client intends. Whether a client wants to support specific causes, establish a fund in a family member’s name or support local nonprofits when and where they need it the most, I recommend the Community Foundation.
Charitable Lead Truts in a Low Interest Rate Environment
Charitable lead trusts are a creative estate, income and charitable tax-planning strategy for high-net-worth individuals. Lead trusts often involve significant legal and administrative costs and are more complex in nature than other charitable vehicles. However, with historically low applicable federal rates (AFRs), charitable lead trusts have become more attractive as a planning tool.
A charitable lead trust (CLT) is an irrevocable charitable trust where the annuity or unitrust payouts are made at least annually to a selected charity or charities. Reg. 20.2055-2(e)(2)(vi). Because the charity receives the interest first, it has the “lead” interest. After the lead interest terminates, the trust corpus will return to the grantor of the trust or to beneficiaries selected by the grantor, usually family members. If the lead trust is qualified and makes an annuity or unitrust payment to charity, the donor will qualify for a gift, estate or income tax charitable deduction equal to the present value of the income stream to charity. Reg. 25.2522(c)-3(c)(2).
While many charitable trusts are tax exempt, lead trusts are not. The taxation of the lead trust and the benefits to the donor will depend on the drafting of the lead trust. It is the structure that creates unique income, estate or gift planning opportunities for the grantor of the trust. This article is Part I in a two-part series. This article will discuss the structure and taxation of the three different types of lead trusts: grantor lead trusts, non-grantor lead trusts and intentionally defective grantor lead trusts. Part II will discuss the unique planning opportunities currently available with CLTs with a focus on the historically low applicable federal rates (AFR).
Grantor Lead Trust
The goal of a grantor lead trust is to generate a current income tax deduction. The grantor of a grantor trust retains certain powers over the trust. With a grantor lead trust, the remainder of the trust corpus reverts to the grantor or to the grantor’s estate at the end of the trust term. These powers make the trust includable in the current assets or the estate of the grantor. If a lead trust is created with a reversion of trust assets that exceed 5% of value to the grantor, the lead trust will be deemed a grantor trust. Sec. 673(a). The grantor trust is subject to the grantor trust rules of Sec. 671-678.
The primary benefit of the grantor lead trust is an income tax charitable deduction. With a grantor lead trust, the donor (or grantor) will receive an up-front income tax deduction for the present value of the income that is projected to be paid to charity. Sec. 170(f)(2). The donor must pay all taxes during the term of the trust for any taxable events that occur within the trust. The donor will recognize all income and capital gain on the donor’s Form 1040. The income distributed to charity will be reported in the donor’s personal adjusted gross income. This means for each year of the duration of the trust, the donor will be responsible for the tax implications of the trust. Sec.170(f)(2)(B).
The assets in the trust are usually invested in such a way as to minimize recognition of income (such as income that occurs on the payment of stock dividends or the sale of highly appreciated capital assets). Because the donor is personally paying these taxes during life, the trust corpus is preserved from tax depletion. Note that if a grantor passes away during the trust term, there is a recapture of part or all of the income tax deduction, because the trust ceases to be a grantor trust. The recaptured amount must be reported as gross income on the donor’s final income tax return. Reg. 1.170A-6(c)(4).
A grantor lead trust is usually funded by a high-income donor who could benefit from an immediate income-tax deduction. Such a donor may have had one single large income-generating event that will create a large tax bill in a year, which may be offset by the charitable deduction. Alternatively, the donor may presently be in a high-income tax bracket where the donor will benefit from a charitable deduction now, and anticipates being in a lower tax bracket in the future when the remaining assets will be transferred back to the donor or the donor’s estate. The distribution of the trust corpus to the grantor is not a taxable event because the tax implications are handled throughout the duration of the trust.
Non-Grantor Lead Trust
The non-grantor lead trust is often referred to as a family lead trust because the remainder passes from the trust to the grantor’s family members. The goal of a family lead trust is to generate a gift or estate tax deduction which allows assets to be passed to family or other beneficiaries at a reduced gift or estate tax cost. One of the greatest benefits of a family lead trust is that the charitable deduction generated by the gift may reduce future estate taxes.
A family lead trust is its own taxable entity and must file IRS Form 1041. This means that the trust itself pays taxes on all income generated, including capital gains income, in excess of the charitable payments. If the family lead trust is funded with appreciated property and that property is sold by the trust, the payment of capital gains tax could cause a significant reduction in trust corpus.
Unlike the grantor lead trust, there is no up-front income tax deduction for a family lead trust. The family lead trust generates an up-front gift tax deduction if it is an inter vivos trust or an estate tax deduction if it is a testamentary trust. In addition, the trust itself is able to deduct charitable payments made each year against income generated from the trust.
Example: Caroline plans to create a $15 million non-grantor charitable lead annuity trust (CLAT). The CLAT will have a fixed payout of $300,000 per year, a 20-year term and Caroline’s children will be the remainder beneficiaries. Caroline funds the trust with $15 million of stock.
If Caroline funds the lead trust with her stock, the annual annuity payment will consist of dividend income and realized capital gain, totaling $280,000. Because the trust will pay out $300,000 per year to charity, it will be able to deduct the entire $280,000 from its taxable income. The trustee may sell $20,000 of the stock each year to make up the difference to charity. The tax on the $20,000 is offset by the Sec. 642(c) charitable income tax deduction.
The third type of lead trust is called a defective grantor lead trust by tax professionals. A better marketing term is a lead supertrust. The same rules generally apply as to a grantor lead trust, however instead of the trust assets reverting to the grantor at the end of the term, the remainder passes to the grantor’s family. Defective grantor lead trusts are sometimes called lead supertrusts because they achieve the goals of generating a current income tax deduction and a gift-tax deduction.
With a lead supertrust, the donor receives an up-front income and gift-tax deduction for the present value of the income projected to go to charity. The donor pays all taxes during the term of the trust for any taxable events that occur within the trust, in a manner similar to a standard grantor lead trust. However, instead of the trust corpus reverting to the grantor or the grantor’s estate at the end of the trust term, the remaining trust corpus will pass to the donor’s family. Additionally, the lead supertrust is not included in the grantor’s taxable estate.
In order to qualify as a lead supertrust, the trust must qualify as a grantor trust, which allows the income-tax deduction. But, unlike the requirements for a standard grantor lead trust, the trust must also qualify as a complete gift. The grantor must not retain certain powers over the trust, which will allow the trust to be excluded from the donor’s estate. The grantor must not retain a right of reversion of trust assets or the right to control the distribution of income. Sec. 2036(a). The preferred retained power to allow the trust to qualify as a grantor trust, but exclude the trust assets from the grantor’s estate is the power of a non-adverse party to reacquire trust assets. Sec. 675(4). A non-adverse party may be any party not subject to the self-dealing rules under Sec. 4941. While a grantor could argue that retaining and exercising such a power would be permitted under the “incidental exception” to the self-dealing rules (Reg.53.4941(b)-3), a more conservative option is often to give a sibling of the donor the power to reacquire the trust assets. The Sec. 4941 disqualified persons category includes spouses, children, grandchildren and their spouses, but not brothers or sisters, so this provision would not violate the self-dealing rules. Sec. 4946(d). The sibling would also need to be able to exercise this power in a non-fiduciary capacity to cause the lead trust to be a grantor trust. See PLR 200010036.
In the year when the assets are transferred to the trust, the donor will receive an income and gift tax deduction for the present value of the remainder interest to charity. The donor must file a Form 709 gift tax return. On the gift tax return the donor will report the trust value, the charitable gift deduction and the taxable transfer to the remainder beneficiary. The donor may use gift exemptions to cover the taxable transfers.
Example: John sold a commercial building this year that he inherited many years ago from his parents. He has a spike in his taxable income due to the sale and would like to generate a charitable deduction to offset some of the taxes. John would also like to provide a nice inheritance for his children, but he wants to give his children time to mature and make their own way before receiving a large lump sum.
John decides to transfer $3,000,000 to a 15-year lead supertrust. The present value of the annual 3% payout to charity is $1,350,000. Because his income is about $3,300,000 this year, John will be able to use $990,000 of the deduction this year under the 30 percent of adjusted gross income limit. He will carry forward the remaining $360,000 to use in the next year. He can carry forward his deduction for up to five years.
The trust remainder will be transferred to his children at the end of the trust duration. John does not retain control over the income or a reversion in the trust. He gives his sister, Rebecca, a Sec. 675(4) power to reacquire the trust assets, enabling the trust to qualify as a grantor trust. In the year the trust is funded, John must file a Form 709 gift tax return. He will report a charitable gift tax deduction of $1,287,342, which reduces the taxable transfer to his children from $3,000,000 to $1,712,658. He uses part of his unified estate and gift exemption ($10 million plus indexed increases) to cover the $1,712,658 gift.
Over the 15-year period of the trust, assuming the invested assets produce a total return of 6 percent, the trust will grow to over $5,000,000. John will benefit from a sizeable income tax deduction, receive a gift tax deduction and be able to transfer over $5,000,000 to his children. The $5,000,000 to the children will be tax-free upon receipt, as John has paid all taxes during the term of the trust. The combined benefits of the plan make this an effective planning strategy for John.
Due to the multiple ways to structure a lead trust, individuals with high net worth may find a charitable lead trust to be a good solution for estate, gift or income tax planning. The structure of the lead trust determines the unique income, estate or gift planning opportunities for the grantor of the trust. This article is Part I of a two-part series. Part II will discuss the unique planning opportunities currently available with CLTs with a focus on the historically low applicable federal rates (AFR).
Charitable Class and Disaster Relief
In order to qualify as a charity under IRS Code Sec. 501(c)(3) and obtain or maintain tax-exempt status, a non-profit organization must serve a "charitable class." In the wake of natural and man-made disasters, and now in the midst of the coronavirus pandemic, many charities are created. In addition, existing charities are reaching out to serve those who are in need due to current events. However, charities need to ensure they are protecting their tax-exempt status by assisting an appropriate charitable class.
Nevertheless, guidance from the IRS is unclear as to what constitutes a charitable class. In many instances, guidance from IRS Regulations and individually issued Private Letter Rulings (PLRs) determine what does not qualify as a "charitable class," as opposed to a definition stated in the affirmative. This article discusses the historical requirement of a charitable class, specific IRS and Congressional guidance issued after September 11, 2001, the prohibition against private benefits and a different route for qualification for tax-exempt status based on the standard of "lessening the burdens of government."
Tax Code Charitable Class Requirement
To maintain tax-exempt status under Sec. 501(c)(3) of the Internal Revenue Code (IRC), an organization must be organized and operated exclusively for exempt purposes set forth in Sec. 501(c)(3), and none of its earnings may inure to any private shareholder or individual. Exempt purposes are defined in Sec. 501(c)(3) as charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. The IRC explains that "charitable" purpose is used in its generally accepted legal sense and includes relief of the poor and the distressed, or the underprivileged; and lessening the burdens of government. Reg. 1.501(c)(3)-1(d)(2).
However, the IRS acknowledges that these categories can and have changed over time since the regulations were issued in 1959. Additionally, the tax regulations do not specifically mention a charitable class. As scholars have noted, there is a lack of guidance on point regarding a charitable class and private benefits. Essentially, the IRS requires a charity to serve a charitable class without providing much guidance for charities on how to ensure compliance with the requirement.
According to IRS Publication 3833, "Disaster Relief: Providing Assistance Through Charitable Organizations," a charitable class is "a group of individuals that may properly receive assistance from a charitable organization. A charitable class must be either large enough that the potential beneficiaries cannot be individually identified, or sufficiently indefinite that the community as a whole, rather than a pre-selected group of people, benefits when a charity provides assistance."
While potentially helpful in deciphering the definition of a charitable class, it is important to note that IRS publications are not authoritative, but merely instructive. The IRS holds, and a line of court cases agree, that the authoritative tax law is embodied only in official statutes, regulations and judicial decisions. Unraveling IRS requirements can leave charities in a dilemma when trying to assist individuals in need, especially when the need is due to a disaster that requires swift assistance.
IRS and Congressional Guidance After September 11
The IRS and Congress have set forth parameters on the topic of charitable classes in the past. Following the events of September 11, 2001 (9/11), the IRS issued Notice 2001-78, 2001-2 C.B. 576 to clarify disaster relief requirements for charities attempting to assist 9/11 victims and first responders. The Notice stated, "While Congress is considering legislation, the Service recognizes the need to provide interim guidance to charities regarding payments made by reason of the death, injury or wounding of an individual incurred as a result of the September 11, 2001 terrorist attacks against the United States."
In terms of a charitable class, the Notice provided "the Service will treat such payments made by a charity to individuals and their families as related to the charity's exempt purpose provided that the payments are made in good faith using objective standards." This guidance allowed charities to react quickly to the communities that needed assistance the most. Charities were able to mobilize using good faith, objective standards.
After the Notice's release, Congress enacted the Victims of Terrorism Tax Relief Act of 2001 (VTTRA). The VTTRA allowed charitable payments made by charities assisting those affected by 9/11 to "be treated as related to the purpose or function constituting the basis for such organization's exemption under Section 501 of such Code if such payments are made in good faith using a reasonable and objective formula which is consistently applied." This legislation statutorily solidified the IRS' earlier guidance for charities.
However, this legislation and IRS guidance are only applicable for charitable distributions made in response to 9/11 and the following anthrax attacks. Therefore, charities attempting to assist those in need due to other disasters, including the current pandemic, may not be able to use the "good faith objective" standard. Charities must instead follow the general standards set forth in the tax code.
Providing a Private Benefit
Congress has established through regulations (and the IRS has provided examples within regulations and PLRs, which are only binding on the parties seeking a ruling, but can be used to provide insight into IRS decision-making) that charities providing a "private benefit" risk their tax-exempt status. An organization is "not organized or operated [for a charitable purpose] unless it serves a public rather than a private interest. Thus…it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests, such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests." Reg. 1.501(c)(3)-1(d)(ii).
The requirement to provide a public rather than a private benefit is meant to serve a charitable class with a large group of potential beneficiaries, or the community as a whole, rather than a pre-selected group of people. However, the IRS does not always directly connect the charitable class requirement to the prohibition against private benefit.
Public Rather than Private Benefit
Scholarships are frequently an issue the Service examines to ensure there is not a private benefit conferred upon an individual. In Reg.1.501(c)(3)-1(d)(iii), the Service provides the example of an educational organization whose purpose was to study history and immigration. However, the focus of the organization's study in history was the genealogy of one family. The organization solicited membership only for members of that one family and the organization performed research to locate members of that family and connect them with one another. The Service notes that the interests in a case like this primarily serve a private rather than a public interest. Therefore, tax-exempt status for this organization would be denied. While an organization may potentially have a large charitable class, if the facts and circumstances demonstrate that a private benefit rather than a public interest is being served, tax-exempt status may be jeopardized.
Indefinite Rather than Preselected Beneficiaries
Common law recognizes the need for a charitable class to include a group of indefinite beneficiaries. This means that charities set up for the public benefit - and therefore qualifying for tax exemption - must aid an indefinite number of people who cannot be particularly identified. However, this common law understanding has not been defined or codified by the IRS or Congress in any official documents. The absence of a large, indefinite class of beneficiaries may then cause problems for organizations attempting to assist a small, but potentially deserving group of people.
The case of Wendy L. Parker Rehabilitation Foundation Inc. v. Commissioner examines private benefit, but has also been cited in later cases as providing a benefit to a particularly identified individual. In Wendy L. Parker, the Tax Court examined private benefit in relation to a purportedly indefinite charitable class. The family of Wendy Parker, a coma victim, established a foundation to assist coma victims. However, 30% of the foundation's income was anticipated to be spent assisting Parker. The foundation was denied tax-exempt status because "a child of the founder and chief operating officer of the Foundation is a substantial beneficiary of the services contemplated by the organization. This constitutes inurement which is prohibited under Code Section 501(c)(3) and the Regulations there under."
While the class of individuals was indefinite, the anticipated private benefit to Parker defeated the request for exempt status. The Tax Court noted "the 'operated exclusively for exempt purposes' test and the 'private inurement' test are separate requirements, although there is substantial overlap." While the result may have been different with the exclusion of the private inurement to a disqualified person, the Service has also noted in other cases citing Wendy L. Parker that the services of a charity must not be provided for a preselected individual.
In PLR 201923026, the IRS cited Wendy L. Parker in denying an exemption to an organization formed to host a fundraiser for five orphaned siblings whose parents died within a year of each other under tragic circumstances. The fundraiser was to help offset the children's living expenses. The IRS held that the fundraiser was operated for the "private benefit of one family rather than operating to provide a public benefit. Despite the fact that funds are raised and expensed for orphaned children the beneficiaries are pre-selected and all from one family. This serves private rather than public interests."
The Service directly compared the case to Wendy L. Parker and stated, "You have set up a process whereby pre-named beneficiaries are able to collect funding. Regardless of whether the…children are related to any board members, or meet the definition of needy, they have been predetermined to receive your funding without documented cause, making them a direct beneficiary and recipient of your income, resulting in inurement."
Although the children were not disqualified persons to the organization, the Service held that the class of beneficiaries was too small and predetermined to receive aid to qualify. The results in Wendy L. Parker and PLR 201923026 are instructive as scenarios charities should avoid. Educational institutions often provide support to what may be a small class of individuals in the form of grants and scholarships, but the recipients are not typically pre-selected. When educational scholarship recipients are chosen, it is required that the recipients are selected based on objective qualifications with the goal of avoiding private benefit.
Determination of Need on an Individual Basis
In PLR 201509039, the IRS denied tax-exempt status to a nonprofit organization that was created to offer funds to small businesses in areas affected by natural or man-made disasters. The organization's purpose was to assist small businesses impacted by disasters by connecting them with consumers so that the business would be able to avoid closure and employee layoffs. According to the PLR, "In order for an organization to fulfill a charitable purpose, it generally must assist a charitable class of individuals. If an organization allows its activities to benefit individuals beyond a charitable class, then it is not a charitable organization. See Wendy Parker Rehabilitation Foundation, Inc. v. Commissioner. Small businesses in areas affected by a disaster are not a charitable class, per se. Some of these businesses may have large sums of cash in reserve." Therefore, the Service ruled that because the organization did not make a determination of need on an individual basis, the organization did not qualify for exempt status.
However, the requirement to determine individualized need is often burdensome for charities, especially those wishing to offer expedient assistance after disasters. For charities to assist those in need due to disasters, IRS guidance would require charities to perform an assessment to discover the individual needs of recipients. Many organizations are not equipped to determine individualized needs, especially when time may be of the essence in providing assistance.
IRS guidance in the past has focused on individualized needs because "maintaining a person's standard of living at a level satisfactory to that person rather than at a level to satisfy basic needs would overly serve private interests" and "an outright transfer of funds based solely on an individual's involvement in a disaster without regard to meeting that individual's involvement in a disaster or without regard to meeting that individual's particular distress or financial needs would result in excessive private benefit." IRS Disaster Relief Guidance Memorandum, in response to Oklahoma City Bombing, Aug.25, 1995.
This particularized determination of need can be difficult for charities to make, especially in the wake of disaster when quick action is necessary. After the Boston Marathon Bombing in 2013, One Fund Boston was established to assist those affected by the tragedy. The Fund distributed over $80 million received in donations to survivors and families on a "need-blind basis."
The One Fund team created a strategy, working with the mayor and the City of Boston to meet the criteria for tax-exempt status based on "lessening the burdens of government." This strategy is one method of qualifying as a Sec. 501(c)(3) organization where the IRS does not examine the extent of the charitable class. Instead, the IRS will seek to determine if 1) there is a certain activity the government considers to be its burden and 2) if the activity lessens the government's burden.
While this method was successful for this instance, it should be used with caution. This method has not been tested extensively in the area of disaster relief. Charities should seek further guidance from their counsel to determine if this route is appropriate.
Unless and until more guidance in the form of regulations and statutes is released, charities will need to continue to abide by current IRS rules. In order to follow the limited guidance related to charitable class, charities must avoid providing a private benefit and must seek to establish an individualized determination of need, otherwise their tax-exempt status may be compromised. The rules promulgated after the 9/11 attack through the VTTRA only applied for that particular disaster. For COVID-19 or other disaster situations, charities must look to general IRS requirements for guidance or request that Congress pass laws, as it did after 9/11, to provide clear instructions for charitable distributions.
Protection From COVID-19 Scams
As part of the Security Summit, the Internal Revenue Service published a guide on how to protect yourself from phishing scams. The new scams attempt to prey on taxpayers and tax advisors using COVID-19, Economic Impact Payments, and taking advantage of teleworking by tax professionals.
IRS Commissioner Chuck Rettig stated, "The coronavirus has created new opportunities for cybercriminals to use email to try stealing sensitive information. The vast majority of data thefts start with a phishing email trick. Identity thieves pose as trusted sources – a client, your software provider or even the IRS – to lure you into clicking on a link or attachment. Remember, don't take the bait. Learn to recognize and avoid phishing scams."
The Security Summit emphasized four general phishing strategies. These include an urgent message, a delayed notice, COVID–19 fears, and posing as a client.
1. Urgent message
A common phishing scam is to send a message that appears to be urgent. It may claim to be from one of the victims' financial institutions and explains that an account password or log in information has expired. The victim is directed to click on the link to restore account data. The phishing email often comes from a site that is one letter or number different from the official website. When the user clicks on the link, malware is installed on the computer, which enables the thief to steal personal information and passwords.
2. Delayed notice
After the thief has installed malware on a computer, he or she may delay taking action for a period of time. One tax preparation firm had thieves on their network for 18 months without any indication. The thieves downloaded and accessed taxpayer information during that entire timeframe prior to the discovery of the information technology breach.
3. COVID–19 Fears
Another common phishing attack is for the fraudster to claim to be a provider of face masks or personal protective equipment (PPE). The scammer explains that the face masks or PPE are in such short supply that you need to order immediately from his or her organization. When you click to order, the scammer loads malware on your computer.
4. Posing as a client
Many tax professionals are in daily communication with large numbers of existing clients. A fraudster may hack the email account of a client and then send an email to the tax professional. The tax professional may be expecting contact from that client and does not realize that the email has been sent from a different web site or server. When the tax professional clicks on a link, malware is downloaded. Tax professionals are urged by the Security Summit to make contact with clients by phone or video conference if they receive a suspicious email.
Everyone needs to be aware of the risk of phishing emails. Most successful fraudster attacks start with a phishing email. Tax professionals must continually educate their staff on the "dangers and risks of opening suspicious emails – especially during the COVID-19 period."
Additional security recommendations are available in IRS Publication 4557, Safeguarding Taxpayer Data and in the Small Business Information Security: The Fundamentals by the National Institute of Standards and Technology.
Final Regulations on SALT Charitable Workarounds
On August 10, 2020, Treasury published final regulations (T.D. 9907) on the state and local tax (SALT) workarounds involving charitable gifts and state tax credits.
New York, Connecticut, New Jersey, and other states were concerned about the Tax Cuts and Jobs Act $10,000 limit on SALT deductions. They created several "workaround" programs that would allow individuals to make charitable gifts to government entities and report the charitable deduction on their federal tax return. The State then granted the individual a reduction in state taxes through a credit.
Charitable contributions are generally deductible under Sec. 170(a)(1). This deduction is permitted for gifts to a nonprofit or a governmental entity such as a state or a political subdivision of a state.
Business entities are permitted a deduction for ordinary and necessary expenses under Sec. 162(a). Regulation 1.162–15(a) limits business ordinary and necessary deductions if there has been a deduction under Section 170 or another code provision.
Section 164(a) permits deductions for state and local taxes. Section 164(b)(6) limits the SALT deduction to $10,000 per year.
To limit the use of a charitable workaround to provide SALT deductions in excess of $10,000, in 2019 Treasury published final regulations on the topic. The final regulations state, "If a taxpayer makes a payment, or transfers property to or for the use of an entity described in Section 170(c), and the taxpayer receives or expects to receive a State or local tax credit in return for such transfer, the tax credit constitutes a return benefit to the taxpayer, or quid pro quo, reducing the taxpayer's charitable contribution deduction." Reg. 1.170A–1(h)(3).
Businesses were concerned that the anti–SALT regulations would limit their ordinary and necessary expense deductions under Sec. 162. The IRS final regulations are designed to clarify the deductibility of transfers by business entities. The final regulations state, "A transfer to a Section 170(c) entity may constitute an allowable deduction as a trade or business expense under Section 162, rather than a charitable contribution under Section 170."
The final regulations also provide safe harbors for a C corporation or pass-through entity to qualify for a deduction under the ordinary and necessary business expense standard of Sec. 162. The safe harbors apply only to gifts of cash and cash equivalents. For some passthrough entities, the safe harbor does not apply if there is a state or local income tax credit.
The final regulations retain the Sec. 164 safe harbor. If a portion of a contribution is disallowed under Reg. 1.170A–1(h)(3), it is still deductible under Sec. 164, provided it is not excluded by the $10,000 tax limitation under Sec. 164(a)(6).
Finally, the regulations apply the quid pro quo rule to cover donors who receive benefits either from a donee or a third party. The final regulations "amend the language in Reg. 1.170A–1(h)(2)(I)(B) to state that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee."
Editor's Note: The regulations are generally effective August 11, 2020. These regulations are consistent with efforts by Treasury to limit the effectiveness of the SALT workarounds, while continuing to permit businesses to deduct ordinary and necessary expenses.
An Interview with Audrey Blondin and Rose Blondin Shea
The Community Foundation recently sat down with Northwest Connecticut attorneys Audrey B. Blondin, recently named Connecticut Bar Association 2020 Citizen of the Law, and her daughter, Rose A. Blondin Shea, who is currently completing a certificate in non-profit management from UCONN, to discuss their work advising charitably inclined clients on leaving a legacy. Read more
An Interview with Audrey Blondin and Rose Blondin Shea
The Community Foundation recently sat down with Northwest Connecticut attorneys Audrey B. Blondin, recently named Connecticut Bar Association 2020 Citizen of the Law, and her daughter, Rose A. Blondin Shea, who is currently completing a certificate in nonprofit management from UCONN, to discuss their work advising charitably inclined clients on leaving a legacy.
NCCF: Tell us about your experience working with nonprofits in Northwest Connecticut.
AB: I have tried to instill in my children and grandchildren the idea of service over self, and leaving the world a better place than when you found it. I am blessed to have the opportunity to help others. My husband, Dr. Matthew Blondin, and I have worked with VOSH (Volunteer Optometric Services to Humanity) CT, for more than 20 years. In our personal philanthropy, and in advising clients as they leave their legacies, I am always aware that all of us are part of a bigger picture.
RBS: I became an attorney because I wanted to help people, and I wanted to help people give back. As a law student, I worked with Education Advocacy and the Animal Legal Defense Fund. Here in Northwest Connecticut, I have worked with the Little Guild of St. Francis, Kitty Quarters, and School on the Green. I recently established Friends of Litchfield Dog Park, a nonprofit with the goal of building a dog park in Litchfield. I work with local nonprofits as general counsel, assisting with employment contracts, waivers for events, bylaws, grant writing, bequest brochures, and with nonprofit incorporation.
NCCF: How do you advise your clients in Leaving a Legacy?
AB: The conversation starts with our initial intake forms. We ask how they would like their estate to be passed on, if they would like to leave a bequest. Some clients have children and grandchildren, and younger brothers and sisters. Charitable giving is not part of their legacy, but we always encourage clients to think about it.
RBS: Clients who know they want to leave a bequest usually want to leave a bequest to an organization they have a personal connection with. Often, they come in with a list of names and addresses of specific nonprofits they would like to support. There is sometimes discussion around whether the gift should be for something specific or left to the discretion of the nonprofit. When we have a client with no children who hasn’t mentioned leaving a bequest, we ask “have you thought about charitable giving? What are you passionate about?” Sometimes they just haven’t thought about it. It’s crucial that we have the conversation early in the estate planning process. We don’t want to get to the end and have a client say, “I just decided I want to leave a bequest.”
NCCF: Are there specific giving vehicles you recommend, such as charitable remainder trusts or charitable lead trusts?
AB: My philosophy is to keep it simple. If you believe in a nonprofit enough to leave them money, let them use it when and where they need to. The simpler and broader the gift, the easier and less costly it is for a nonprofit. Similarly, we encourage our clients to give a larger percentage of their estate to a smaller number of nonprofits, rather than giving, two percent of their estate to 30 nonprofits. I might suggest giving 30 percent to two or three nonprofits. The cost to communicate with all of those nonprofits about the bequests as well as preparing and mailing the checks comes out of the estate.
NCCF: You mentioned that you encourage your clients to keep it simple when it comes to charitable giving. How does the Community Foundation fit into that philosophy?
AB: This is a long-term partnership. When you are 30, you are writing wills that will be probated when you are 60. Over the years, we have seen bequests made to charities that no longer exist. I encourage clients to give to nonprofits that are stable, nonprofits that have a long history in the community. The Northwest Connecticut Community Foundation offers options that make that easier. Clients can leave a bequest to the Community Foundation to benefit specific nonprofits, or within a field-of-Interest, for example organizations that help animals, provide basic needs to homeless families or support education. They can even create a discretionary fund that can be used when and where there is the most need in their community. It’s crucial when leaving a bequest that there is a good structure in place where the bequest is received. The Community Foundation can provide that structure.
IRS Appraiser Qualifications
The Internal Revenue Service requires donors who claim charitable income tax deductions to substantiate the value of their charitable contributions. Charitable gifts of noncash assets valued in excess of $5,000 require a qualified appraisal for substantiation purposes. The current rules regarding qualified appraisals are the result of changes to the Internal Revenue Code from the American Jobs Creation Act of 2004 and the Pension Protection Act of 2006. Following those statutory changes, the Service developed proposed regulations in 2008. Nearly a decade later, the IRS published final regulations in T.D. 9836 (27 July 2018).
The Service's substantiation rules are strict. If these rules are not closely followed, a donor may lose his or her entire charitable deduction. Advisors should be prepared to explain these requirements, guide their clients through the process of substantiating charitable gifts and work with charities to meet the Service's requirements.
Gifts valued above a certain threshold require the donor to obtain a qualified appraisal of the asset. This article will cover the general qualified appraiser requirements and explore the professional designations and education available for appraisers of various types of property.
General Appraiser Qualifications
In order to be considered a qualified appraisal, the valuation must be conducted by a qualified appraiser. Under Sec. 170(f)(11)(E), in order to be a qualified appraiser, an individual must earn “an appraisal designation from a recognized professional appraiser organization” or meet education and experience requirements set by the regulations. The individual must also regularly perform appraisals of this type and meet any other requirements in the regulations. The individual must also “not be prohibited from practicing before the Internal Revenue Service . . . at any time during the 3-year period ending on the date of the appraisal.” Sec. 170(f)(11)(E).
A “qualified appraiser” is defined in Reg. 1.170A-17(b)(1) as an individual with “verifiable education and experience in valuing the type of property for which the appraisal is performed.” The education and experience requirements may be met one of two ways. First, the appraiser may satisfy the requirement by successfully completing college-level or professional-level coursework in valuing the type of property being appraised and having two or more years of experience valuing that type of property. Reg. 1.170A-17(b)(2)(i)(A). Under Reg. 1.170A-17(b)(2)(ii), the coursework must be obtained from one of three sources: a professional or college-level educational organization, a generally recognized trade or appraiser organization or an employee apprenticeship or educational program similar to the educational options above.
Alternatively, the appraiser may satisfy the education and experience requirement by earning a “recognized appraiser designation” for the type of property to be valued. Reg. 1.170A-17(b)(2)(i)(B). This designation must be obtained from a generally recognized professional appraiser organization and the individual must earn the designation through demonstrated competency. Reg. 1.170A-17(b)(2)(iii).
The regulations define “type of property” as “the category of property customary in the appraisal field for an appraiser to value.” Reg. 1.170A-17(b)(3). Therefore, it is important to not only meet the education and experience requirements, but those requirements must be met specifically for the type of asset that is being valued. In other words, a qualified appraiser of real estate is not necessarily qualified to appraise life insurance. The appraiser must meet the requirements for each type of property in order to be recognized as a qualified appraiser of that type of asset.
The term “qualified appraisal” is defined as an appraisal “prepared by a qualified appraiser in accordance with generally accepted appraisal standards.” Reg. 1.170A-17(a)(1). The Treasury Regulations define generally accepted appraisal standards as “the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of the Appraisal Foundation.” Reg. 1.170A-17(a)(2).
The Appraisal Foundation was created in 1987 to guide the promulgation of the Uniform Standards of Professional Appraisal Practice (USPAP). Congress adopted the USPAP in 1989. The Appraisal Foundation has an independent board, known as the Appraiser Qualifications Board (AQB), which establishes requirements and criteria for appraisals of real and personal property. The AQB’s Real Property Appraiser Qualification Criteria governs licensing for three different real estate appraiser qualifications: Licensed Residential, Certified Residential and Certified General.
Examples of Recognized Appraiser Designations
According to the AQB’s Real Property Appraiser Qualification Criteria, there are three classifications of real estate appraisers: Licensed Residential Real Property Appraisers, Certified Residential Appraisers and Certified General Appraisers.
Prior to obtaining one of these three classifications, an appraiser is classified as a Trainee Appraiser. The Trainee Appraiser must have 75 hours of qualifying education in the last 5 years and must work with a Supervisory Appraiser. No prior experience is required for Trainee Appraisers.
Licensed Residential Real Property Appraisers are qualified to appraise “non-complex one-to-four residential units having a transaction value less than $1,000,000, and complex one-to-four residential units having a transaction value less than $250,000,” per The Real Property Appraiser Qualification Criteria and Interpretations of the Criteria, effective May 1, 2018 (RPAQC). According to the AQB, a “complex one-to-four unit residential property appraisal” is “one in which the property to be appraised, the form of ownership, or the market conditions are atypical.” In order to qualify as a Licensed Residential Appraiser, an individual must attain 150 credit hours of qualified education, 1,000 hours of experience in no less than 6 months and pass an examination.
A Certified Residential Real Property Appraiser is qualified “to appraise one-to-four residential units without regard to value or complexity,” per the RPAQC. Individuals must complete 200 credit hours of qualified education, obtain 1,500 hours of experience in no less than 12 months and pass an examination in order to achieve this certification.
Finally, a Certified General Real Property Appraiser is qualified “to appraise all types of real property,” per the RPAQC . This certification requires the appraiser to complete 300 credit hours of qualified education, obtain 3,000 hours of experience and pass an examination.
Additionally, the Appraisal Institute, a real estate appraisal association, offers an MAI designation. Short for “Member Appraisal Institute,” this designation is open to Certified General Real Property Appraisers who meet various requirements, including being of good moral character, holding a bachelor’s degree or higher and passing a comprehensive examination.
Real estate appraisers must also meet certain continuing education requirements. The USPAP offers two courses for continuing education: the 15-Hour National USPAP Course and the 7-Hour National USPAP Update Course. The 15-hour course is intended as an introductory course to the field, while the 7-hour course is a required update course, taken every two years.
Various organizations offer professional designations for valuations of business interests. These include the American Society of Appraisers, the American Institute of CPAs (AICPA) and the National Association of Certified Valuators and Analysts (NACVA). Each organization maintains its own standards for education and experience required to receive that organization’s certification.
The American Society of Appraisers offers two levels of credentials, the Accredited Member (AM) and the Accredited Senior Appraiser (ASA). Candidates for the ASA credential may apply to receive a designation in Business Valuation (BV). The BV designation requires a four-year college degree (or its equivalent) and either two years of full-time experience toward the AM designation or five years of full-time experience toward the ASA designation.
The AICPA offers an Accredited in Business Valuation (ABV) credential. This credential is offered to AICPA members who hold either a CPA license or a bachelor’s degree or its equivalent plus completion of AICPA’s course on professional conduct and standards. Candidates are required to achieve a passing score on the ABV examination. Individuals who have passed certain other examinations, including the ASA examination are not required to take the ABV examination prior to applying for the ABV credential.
Individuals who pass the ABV examination must then obtain the requisite experience. For CPAs seeking the ABV credential, 1,500 hours of experience in valuations in the preceding 5 years is required. Non-CPA candidates are required to reach 4,500 hours of experience within the preceding 5 years.
NACVA offers the Certified Valuation Analyst (CVA) credential. The CVA certification requires an active, valid CPA license or either a business degree or masters of business administration (MBA) plus “substantial experience in business valuation.” NACVA defines “substantial experience” as having two or more years of full-time business valuation experience, having performed 10 or more business valuations, or “being able to demonstrate substantial knowledge of business valuation theory, methodologies, and practices.” Applicants must attend a training program, submit references and pass an examination.
NACVA also recertifies the Certified Business Appraiser (CBA) and Master Certified Business Appraiser (MCBA) credentials for current certification-holders. These designations were originally offered by the Institute of Business Appraisers (IBA). The IBA was acquired by NACVA in 2008. In 2016, NACVA suspended the issuance of new CBA and MCBA credentials. Holders of the CBA and MCBA credentials are able to recertify by complying with NACVA’s other credential recertification requirements.
In addition to real property criteria, the AQB also publishes The Personal Property Appraiser Qualification Criteria. These criteria require applicants to have completed either 30 college-level credit hours or to have attained an associate’s degree or higher. Additionally, applicants must complete 120 classroom hours, including the 15-Hour Personal Property USPAP Course (including the final examination), a 45-hour course including a final examination and 60 credit hours related to the field of appraisal, with an emphasis on personal property.
Additionally, the AQB requires applicants to have 700 hours of experience appraising personal property. The individual must also have either “[a] minimum of 1,800 hours of market-related personal property appraisal experience . . . of which at least 900 additional hours are in the area(s) of specialization” or “[a] minimum of 4,500 hours of market-related personal property non-appraisal experience . . . in area(s) of specialization” or “[an] equivalent combination of market-related personal property appraisal experience and market-related non-appraisal experience in area(s) of the appraiser’s specialization based upon a minimum ratio of 1 year to 2.5 years,” per The Personal Property Appraiser Qualification Criteria.
The AQB also requires applicants to obtain 70 hours of continuing education every 5 years, including 20 hours of valuation theory coursework and either the 15-Hour Personal Property USPAP Course or the 7-Hour Personal Property USPAP Update Course every two years.
The American Society of Appraisers offers Personal Property (PP), Gems and Jewelry (GJ) and Machinery and Technical Specialties (MTS) designations to appraisers. Each of these designations requires specialized coursework and experience in valuation of various types of assets. For instance, the PP designation covers a number of types of personal property, including various types of art, antiques, clocks, dolls and toys, firearms, furniture, sports collectibles and memorabilia, stamps and textiles.
Applicants for a PP designation must meet a number of prerequisites, including passing a 4-hour specialty examination, meeting PP-specific education requirements, having a college degree or its equivalent and having 2 years full-time experience toward the AM designation or 5 years toward the ASA.
Difficulty with Strict Compliance
As discussed above, the personal property appraiser designation includes appraisers of artwork. However, changes in the law in the mid-2000s caused difficulty for many appraisers who had the requisite experience, but did not have the formal education or appraiser designations required. In 2006, Sotheby’s submitted comments in response to the IRS’ transitional guidance regarding the appraisal requirements published in Notice 2006-96. In its letter, Sotheby’s requested that the IRS reconsider the then-newly-created rule requiring qualified appraisers to either hold an appraisal designation or meet both the education and experience requirements. Sotheby’s contended that “[b]ecause Sotheby’s specialists are already employees of one of the leading appraisers of art and antiques in the world, they generally do not also seek recognition from a separate appraisal organization.” It also noted that “[v]ery little coursework—at any level—exists that is relevant to valuing rare art or collectibles. For many of the specialists’ areas of expertise, there is no coursework at all.” Therefore, Sotheby’s contended, the rules could cause many experienced appraisers to fail to be considered “qualified appraisers.” Despite Sotheby’s contentions, the IRS maintained the requirement of an appraisal designation or both education and experience in its final rules.
Cryptocurrency is an encrypted form of digital virtual currency. This is a relatively new type of asset that has rapidly gained popularity in recent years with the rise of Bitcoin. Given the fairly recent creation of cryptocurrency as a category of property, IRS regulations and industry standards have not yet produced appraisal standards that are common to other well-established categories of property.
While for other types of property, obtaining a professional designation satisfies the appraiser qualifications, there is no such designation yet available for appraisers of cryptocurrency. Likewise, it appears that there are very few, if any, college-level courses regarding valuation of cryptocurrency. Therefore, individuals who hold themselves out as appraisers of cryptocurrency and the donors who seek their services must exercise caution. If the IRS finds fault with the appraiser’s qualifications, the entire charitable income tax deduction from the gift of cryptocurrency may be denied.
Individuals who offer qualified appraisals of cryptocurrency should be up front about their qualifications. Appraisers of other intangible personal property type assets, such as life insurance, may be able to claim the requisite experience to be considered a qualified appraiser of cryptocurrency.
In May 2018, the AICPA submitted comments to the IRS regarding Notice 2014-21, in which the IRS provided guidance on virtual currency. The AICPA suggested that the IRS should treat valuation of cryptocurrency donations in the same manner as donations of publicly traded stock. “The rationale is that the prices for these publicly traded stocks are available on established exchanges, thus not requiring a qualified appraisal,” stated the AICPA. “The same is true for most, if not all types of virtual currencies. That is, various exchanges publish the value of the currency on any given day.” The AICPA suggested that the IRS implement a rule that allows the taxpayer to “document, and calculate the average of, the fair market value on at least two exchanges (at the date and time of the contribution) and the basis of the virtual currency contributed.” Despite the AICPA’s efforts, the IRS has not implemented such a rule.
Valuation of life insurance for charitable deduction purposes can be complex. The deduction for such a gift is generally the lesser of the donor’s cost basis (usually the premiums paid) or the value of the policy. Most often, the cost basis does not exceed the value of the policy. Nevertheless, as a noncash asset, a gift of life insurance in excess of $5,000 is required to have a qualified appraisal by a qualified appraiser. The valuation of the policy will be determined by the qualified appraiser. In many cases the value may be based either on the policy’s replacement value if it is paid in full or the policy’s interpolated terminal reserve value (ITRV) if the policy is not paid in full. While the major appraisal associations do not offer specific credentials in valuation of insurance policies, many offer certification in intangible assets, either as a specialization within another field or as a standalone credential. For example, the American Society of Appraisers offers an “Intangible Assets” specialty within the Business Valuation field.
Alternatively, some senior donors may receive a quote for life settlement of the policy. Several firms specialize in life settlement valuations. The life settlement value may exceed the cash value of the policy. In that case, the value of the policy will consist of the donor’s cost basis (premiums paid), an ordinary income element (the difference between the policy’s basis and cash value) and capital gain (the difference between the policy’s cash value and the life settlement value). Under Rev. Rul. 2009-13, the IRS ruled that charges for the cost of insurance would reduce the donor’s basis. However, that rule was abolished with the passage of the Tax Cuts and Jobs Act of 2017. Therefore, with a life settlement policy and a qualified appraisal, the donor is now able to deduct both the policy’s cost basis and capital gain.
When evaluating the qualifications of an individual who holds himself or herself out as a qualified appraiser of life insurance, consider whether the individual already holds an appraiser designation from a well-respected appraisal organization as well as substantial education and experience valuing life insurance. This may include advanced degrees in the study of insurance or years of experience in the field of insurance.
A Cautionary Tale
In Reg. 1.170A-13(c)(5)(iv), there are a number of circumstances listed in which individuals who might otherwise be qualified are excluded from being considered a “qualified appraiser.” These include when the appraiser is the donor, a “party to the transaction in which the donor acquired the property being appraised,” the donee, anyone employed by or related to one of the aforementioned parties or “an appraiser who is regularly used by” the donor, donee or a party to the transaction in which the donor acquired the property “who does not perform a majority of his or her appraisals made during his or her taxable year for other persons.”
In James Tarpey v. United States, No. 2:17-cv-00094 (2019), the U.S. District Court for the District of Montana held that an appraiser was not qualified under Reg. 1.170A-13(c)(5)(iv). James Tarpey formed a nonprofit, known as Donate for Cause (“DFC”), to facilitate the donation of timeshares. While Tarpey hired two appraisers, Ron Broyles and Curt Thor, to conduct appraisals, Tarpey and his sister, Suzanne Tarpey, also conducted appraisals for DFC.
The court noted that Tarpey relied on advice from his CPA, George Schramm, that Tarpey was qualified to be an appraiser of non-real property. However, the court also stated that “[t]he record fails to establish, however, that Schramm, or any other professional, ever advised Tarpey that he met all of the criteria to serve as a qualified appraiser for his scheme within the meaning of the Treasury Regulations.” In its ruling, the court held that “all of the appraisers lacked sufficient independence from DFC to be considered ‘qualified appraisers’ under the Treasury Regulations.”
While this is somewhat of an extreme case, it highlights the need for donors to educate themselves and seek the advice of knowledgeable and trustworthy advisors regarding the Service’s requirements for appraisals and appraisers. If a client proposes an individual as a potential qualified appraiser for a specific gift, the advisor’s inquiry should focus both on whether the appraiser meets the education and experience requirements and whether the appraiser is related to the parties involved in the transaction.
It is essential for donors seeking charitable deductions for gifts of noncash assets to understand their need to properly substantiate their gift. In many circumstances, substantiation for the charitable gift of noncash assets will require the services of a qualified appraiser. With the Service’s rigid approach to appraiser qualifications, a misstep could lead to a lost charitable income tax deduction. Given the stakes involved, it is important for the donor’s advisor to be able to assist the donor in determining where to turn when looking for an appraiser. Therefore, it is highly recommended that advisors help their clients find appraisers credentialed in the type of property transferred whenever possible. When there is no direct credential available for the type of property donated, the donor and advisor must be diligent in selecting an individual who is both highly educated and experienced in the field and sufficiently independent from the parties involved in the transaction.
New Decade Nonprofit Trends
Author: A. Charles Schultz, JD, AEP®
As we approach the new decade, what trends will emerge for successful nonprofits?
There are several reasons to be optimistic about giving in the new decade. The economy is strong and there is high employment. Public and private stock, homes and commercial real estate values are all solid. A strong economy, high employment and solid asset values generally lead to increased giving.
However, there also will be challenges. With the passage of the Tax Cuts and Jobs Act in 2017, the number of itemizers declined from around 30% in 2017 to about 10% by 2019. Because some donors are no longer itemizing, they may be less likely to make charitable gifts. Even though many loyal donors will continue to give, there is expected to be a fairly flat growth trend for the traditional annual fund.
In addition, many nonprofits are having difficulty replacing senior donors who pass away with new younger donors. While the number of nonprofits has been increasing, total donor numbers have remained generally flat over the past few years. Competition for annual fund donors will continue to increase, especially for midsized nonprofits. All nonprofits will need to expand their tents by increasing the number of new, younger donors.
Based on these giving positives and challenges, there are four major trends that will be evident during the new decade. These are growth in annual funds through IRA rollover gifts, greater fundraising success for charities that are marketing gifts of stock and land gifts, continued significant growth for donor advised fund (DAF) gifts and a blossoming of boomer generation bequests.
"New Annual Fund" with IRA Rollover Gifts
Annual fund giving is the lifeblood of all nonprofits and is essential in funding charitable programs. Loyal donors faithfully support each organization through annual fund gifts. Nonprofits should steadily build annual fund giving — both for current support and because loyal donors are candidates for future major, blended and planned gifts.
The next decade presents two big challenges and one golden opportunity for annual funds. The challenges for annual funds include the reduced number of itemizers (from about 30% in 2017 to 10% today) and the limited number of new younger donors who are replacing the seniors who pass away. The golden opportunity is to grow a "New Annual Fund" through IRA rollover gifts.
Many organizations have been building their annual funds for decades. In the early years of an annual fund, there is often modest growth between years one and three, greater growth from years three to five and increased momentum and growth from years five to 10.
It is quite probable that the pattern for a New Annual Fund from IRA rollovers will be quite similar. When individuals who are over age 70½ start making qualified charitable distributions (QCDs) from their IRAs, they are likely to continue those gifts each year. Because QCDs may fulfill their required minimum distributions (RMDs), many QCD donors increase their traditional annual fund gifts by 15% to 25%. Under federal tax rules, the RMD increases each year, thus there is an incentive for individuals to make larger IRA rollover gifts each year.
Both the traditional annual fund and the New Annual Fund must have multichannel marketing programs. A consistent marketing program will encourage senior donors to increase giving. In the book Good to Great, author James Collins emphasizes the importance of "pushing the flywheel." With consistent small pushes, the flywheel moves faster and faster until there is "almost unstoppable momentum." Success for nonprofit organizations comes from a steady growth in a favorable program. By continuing to market the "New Annual Fund," charities are continually pushing the flywheel.
This marketing will produce many IRA rollover gifts and substantial New Annual Fund revenue. How much revenue may be expected from the New Annual Fund? To some extent, it depends on the number of loyal donors who are over age 70½. Based upon surveys of Crescendo seminar classes, many nonprofits report 40% to 65% of their loyal donors are over age 70½. Because these organizations find that a significant percentage of their loyal donor base is in this category, there are likely to be many individuals who could and will make large IRA gifts.
The Investment Company Institute reported IRA balances were over $9 trillion in October 2018. With an estimated $3 trillion to $5 trillion in the loyal donor IRA pool, there should be sustained growth in your New Annual Fund revenue. While the time it takes for a marketing program to mature is often between three and 10 years for most organizations, the cumulative effect could be significant. The New Annual Fund may equal 20% to 40% of the existing annual fund.
Assume that a large university has an annual fund that is producing $2 million. This success has been built up over the past eight decades and represents a significant commitment of both staff and financial resources. The potential result for a consistent IRA gift marketing program is to generate a New Annual Fund that may produce an additional 20% to 30% of the existing fund. If the higher percentage could be reached with a New Annual Fund marketing program, the university may add $500,000 and raise $2.5 million per year. Several universities have passed the $500,000 IRA rollover level after three years of consistent marketing.
A 20% to 30% increase in annual fund amounts is possible with an effective IRA rollover marketing campaign for three to five years. Research with CPAs indicates that 70% to 85% of donors with large IRAs take a single RMD in October or November. Therefore, the majority of IRA rollover gifts are made during the fourth quarter of the year.
A persuasive IRA rollover campaign includes a multichannel marketing effort each September, with an extended postcard, eNewsletter headers, eBlasts and social media posts. These multiple contacts are designed to encourage loyal donors to make an IRA rollover gift.
Gifts of Land and Stock
Dr. Russell James is a leading researcher of philanthropy in America. In his 2018 article, "Cash is Not King for Fundraising: Gifts of Noncash Assets Predict Contributions Growth," James analyzed gifts of cash and appreciated property.
He compared the success of charities that marketed cash-only gifts in 2010 and 2015 with those who marketed gifts of cash, stock and land during both years. James discovered that the charities marketing gifts of appreciated property had greater success in raising both cash and noncash gifts.
Midsized charities are nonprofits with $3 million to $10 million in annual gift revenue. The midsized charities that were raising cash-only gifts in 2010 had essentially no growth in giving between 2010 and 2015. Midsized charities that were promoting gifts of cash, land and stock enjoyed giving growth of 7.3% per year over those five years.
There was also a clear benefit for large organizations with over $10 million in annual gift revenue. If large organizations promoted cash-only gifts, they experienced 4.8% growth per year. They grew from a median gift of $27 million in 2010 to $34 million in 2015. However, the large organizations that promoted gifts of cash, land and stock enjoyed 6.2% growth per year. Giving to these organizations increased from $51 million in 2010 to $68 million in 2015.
The more powerful statistic is that this increased growth of 2.4% (6.2% versus 4.8%) when compounded over multiple years results in much larger total giving. The median 2015 gift amount for nonprofits that promoted cash, land and stock donations was $68 million. This was double the median gift amount of $34 million for those large charities that marketed cash only gifts. Doubling the total gifts over time by marketing both cash and noncash gifts is a stunning statistic! The "cash only" nonprofits lost 50% of their potential gifts by not marketing gifts of stock or land.
During the next decade, there is likely to be limited growth in the total number of donors. As a result, there will be substantial competition for donor dollars. Thousands of midsized and large charities will discover that they must market stock and land gifts or their cash giving will stagnate at the current level. When these nonprofits become proactive in their marketing, there will be a significant growth in stock and land gifts during the new decade.
Donor Advised Funds
A donor advised fund (DAF) involves a gift of cash, stock or land to a public charity, with the donor and family members designated as grant advisors. The charity manages and invests the fund and makes distributions for charitable purposes. DAFs are frequently sponsored by community foundations, religious foundations and other nonprofits.
The DAF donor generally receives a full fair market value deduction for cash or appreciated property gifts. The donor or designated family members may advise the charity to make DAF grants. While the parent charity owns the fund assets, most charities that administer DAFs will attempt to follow the DAF advisors' recommendations. Nearly all DAF grants are made to qualified Sec. 501(c)(3) organizations.
During the next decade, DAFs will continue to experience explosive growth. In 2017, the National Philanthropic Trust reported the existence of 285,000 DAFs. Donors gave $23 billion to DAFs and made $16 billion in grants in 2017. The net increase of DAF principal was $7 billion plus investment growth.
The largest DAF nonprofit is affiliated with Fidelity. In 2018, Fidelity Charitable had 123,114 giving accounts. Grant values from Fidelity DAFs have steadily increased to $5.2 billion in 2018. Vanguard, Schwab, Morgan Stanley and many other financial institutions have similar charitable affiliates with DAFs.
Community and religious foundations also have seen dramatic growth of DAFs. Many donors appreciate the convenience of funding a DAF with cash or an appreciated property gift and then making grants at a later time. The DAF also has a very attractive benefit — children, nephews, nieces and other family members may be included as advisors. Donors view this family member involvement as beneficial for teaching good values to heirs.
A DAF is simple to create and much less expensive than a private foundation. DAFs may be funded with $10,000 or more, depending upon the minimum requirement of the DAF organization.
Nearly all DAF grants are made to public charities. Most community and religious foundations report that they make annual distributions of 10% to 14% of DAF fund balances. While critics have expressed concern that some DAFs are essentially parking charitable funds without making adequate distributions, the giving data shows that DAFs are generally making larger distributions than private foundations.
DAFs are available through charitable organizations affiliated with large financial service companies (Fidelity, Vanguard, Schwab and others), community foundations, religious foundations and other nonprofits.
During the next decade the "DAF Other Nonprofit" category is likely to grow significantly. Many larger nonprofits have been creating DAFs because their major donors request them. In order to avoid sending their major donors to the nearest community foundation, religious organization or financial services company fund, nonprofits of all sizes will consider DAFs in the future.
The Chronicle of Philanthropy surveys gifts to the Philanthropy 400 nonprofits each year. In 2018, approximately 24% of the total gifts to the Philanthropy 400 were to DAFs. The percentage of DAF gifts to mega-charities will continue to grow.
Wealth in America grew significantly in the early years of this century. In 2007, the U.S. Federal Reserve reported net household wealth to be approximately $65 trillion. While net worth declined in the 2008 downturn, over the next decade there was a significant economic recovery and unemployment moved below 4%.
As a result, the stock markets recovered and the Standard and Poor's 500 Index reached an all-time high. In addition, housing recovered and the home equity of Americans rebounded. The Federal Reserve reported that net household wealth in America had grown to over $100 trillion by 2018.
In a 2016 article on "The Future of Wealth in the United States," the Deloitte accounting firm projected the future net household worth of the Boomer generation. By 2028, the Deloitte projection shows the Boomer generation with a net household worth of $52 trillion. Boomers will be the wealthiest generation in history. The Boomer generation inherited wealth from the Silent generation (born 1930 to 1945) and had the advantage of their prime working years occurring during the time when America was the clear dominant economic power in the world.
Because the Silent generation started to turn 65 in 1995, the approximately 20 million surviving members of that generation passed age 65 between 1995 and 2010. Approximately 2,800 individuals turned age 65 every calendar day. Between 2020 and 2030, about 2600 members of the Silent generation will pass away each calendar day.
The much larger generation of Baby Boomers started to turn 65 in 2010. With larger families and an increased number of children, there were substantially more Boomers born each year between 1946 and 1964 than for the Silent generation during 1930 to 1945. Between 2010 and 2030, approximately 10,000 Boomers will turn age 65 each day. The 78 million Boomers are expected to have 8,500 "Graduation Days" each day from 2030 to 2054 (most Boomers will pass away in their mid to late 80's).
In their 2009 article "A Golden Age of Philanthropy," Dr. Paul Schervish and Jason Havens provided detailed projections for the probable transfer of Boomer wealth. Their projections cover the time period from 2007 through 2061. In 2014 dollars, with 1% growth of typical estates from 2027 to 2061, they project $2.31 trillion in charitable bequests. For the prime Boomer distribution period from 2028 to 2054, a linear extrapolation produces a Boomer bequest estimate of $1.76 trillion. A reasonable estimate for Boomer bequests during that time period is a minimum of $1.5 trillion.
Commentators have noted that 2018 bequest maturities did not reach the projected Schervish numbers. When Dr. Schervish spoke at the 2017 Practical Planned Giving Conference, your author stated, "Paul, your numbers are correct. Based upon my three decades of experience, the donor potential is real, but the nonprofit bequest marketing programs were not sufficient. If 2,000 large and midsized nonprofits create solid multichannel marketing programs, we will surpass your bequest numbers!"
New Decade Predictions
Prediction I: Annual Funds — 90% of the new decade growth in annual fund gifts will come from IRA charitable rollovers.
Prediction II: Gifts of Stock and Land — Nonprofits that market cash, land and stock gifts will grow their gift revenue at an annual rate that is 3% higher per year than those marketing cash-only gifts. The increase in gifts by 2030 with 3% greater giving growth is 34%!
Prediction III: Donor Advised Funds — DAFs will grow substantially because many nonprofits will join financial, community and religious foundations in offering donor advised funds. New decade DAF gifts will comprise 30% of total gifts to the Philanthropy 400.
Prediction IV: Boomer Bequests — Nonprofits who build a large "Boomer Bequest" pipeline during the new decade will receive 25% to 35% of their 2030-2040 budgets from bequest maturities.
Author's Note: This is the third decade your author has made predictions. In 1999 he predicted "Seven Golden Years of Planned Giving From 2000-2007." He predicted that a majority of seniors would be internet users by 2010. At the NCPP Conference in 2009, he predicted that marketing to seniors would move from 90% print and 10% electronic in 2010 to 90% electronic and 10% print by 2020. Readers are welcome to comment on any predictions in this article and may send a note to the editor.
Benefits of Bunching Charitable Gifts
With the doubling of the standard deduction in 2018, the number of taxpayers who itemized deductions declined substantially. In 2017, nearly 30% of taxpayers itemized, but with the larger standard deductions, only about 10% of taxpayers will itemize this year.
The standard deductions in 2018 doubled to $24,000 for married couples and $12,000 for individuals. The married standard deductions increased to $24,400 in 2019 and $24,800 in 2020. Individual standard deductions are one-half the married number. What tax planning strategy might benefit generous taxpayers who know there is a large standard deduction and still desire to help a favorite charity? Let's consider the options for two generous families – John and Mary Jones and Harry and Susan Green.
Both couples pay $8,000 in state and local taxes and $7,000 in home mortgage interest. They each give $8,000 to their favorite charity each year. Their total itemized deductions are $23,000 per year. Because the standard deduction is larger than their $23,000 in itemized deductions, John and Mary take the $24,400 standard deduction in 2019 and $24,800 amount in 2020. Their total deductions over two years are $49,200.
Meanwhile, Harry and Susan decide to "bunch" their charitable deductions. They give $16,000 in 2019 and nothing in 2020. Because their 2019 itemized deductions of $31,000 are more than the standard deduction, they elect to itemize their deductions. In 2020, they take the standard deduction of $28,800. Their total deductions are $55,800.
Bunching Charitable Deductions
Family Deductions for 2019 and 2020
Harry and Susan
John and Mary
By "bunching" their deductions, Harry and Susan increase their tax savings from their charitable gifts. The $6,600 increased deductions may save $1,848 in their 28% federal and state income tax brackets.
Editor's Note: If your combined state and local tax, home mortgage interest and charitable gift deductions are close to the married or individual standard deductions, you may want to visit with a tax advisor about "bunching" your charitable gifts. Making larger charitable gifts every other year could be an excellent tax-saving strategy.
Exempt Organizations 2020 Agenda
Independent Sector, The National Council of Nonprofits, The Council on Foundations and other associations are focused on their 2020 agenda. While the appropriations bill that passed in December 2019 repealed the Sec. 512(a)(7) parking tax and simplified the private foundation excise tax, there remain four main priorities for 2020.
Universal Charitable Deduction – The above-the-line charitable deduction will continue to be a priority. Because the Tax Cuts and Jobs Act of 2017 doubled the standard deductions, the number of itemizers declined over the past three years. About 30% of taxpayers itemized in 2017 and an estimated 10% will itemize in 2020. With fewer itemizers, there has been a decline in the number of annual fund donors. The universal charitable deduction is a solution for this challenge. David L. Thompson of the National Council of Nonprofits noted, “2020 will be devoted to building support for this essential solution.”
Sect. 512(a)(6) Silo Tax Repeal – Under Sec. 512(a)(6), nonprofits must maintain separate records and pay tax on each separate legal entity. The gains on one trade or business may not be offset against losses on another subsidiary. Thompson noted, “The silo tax forces nonprofits – but not for-profits -- to keep every trade or business separate for accounting and tax purposes and pay taxes on each separately.” Thompson considers this a punitive tax and seeks clarification from Treasury on how it should function.
Overreach of Executive Compensation Tax – Under Sec. 4960, there is a 21% excise tax on compensation over $1 million for officers of applicable tax-exempt organizations (ATEOs). Some ATEOs may be affiliated with private corporations. If officers of the private corporation volunteer for the ATEO, the 21% excise tax may apply.
Legacy IRA – The Legacy IRA Act expands the options for IRA gifts. It is supported by a coalition of DC organizations and associations. The Legacy IRA Act would permit IRA owners over age 65 to transfer up to $400,000 per year from an IRA to a charitable gift annuity, remainder unitrust or remainder annuity trust.
Editor’s Note: The challenge for all of these agenda items is that current legislative policy requires a “pay-for” to offset the cost. Nonprofits will need to find creative and politically acceptable offsets to move forward with this 2020 agenda.
An Interview with Michael Lynch
The Community Foundation recently sat down with Northwest Connecticut attorney Michael Lynch to discuss his work in planning for clients’ long-term goals and thoughtful giving through their estate planning.
An Interview with Michael Lynch
The Community Foundation recently sat down with Northwest Connecticut attorney Michael Lynch to discuss his work in planning for clients’ long-term goals and thoughtful giving through their estate planning.
NCCF: How do you work with your clients on their charitable goals?
ML: Every client is different. The charitable decisions they make are largely based on the experiences they have had in their lives. I always ask my clients,“what’s your overarching goal?”That really frames the whole conversation. They have very different answers. Some want to leave a gift to their children or grandchildren. Some are inclined to give to social service organizations. Some feel a strong connection to the local natural environment.
NCCF: How do you work with your clients to balance charitable goals with the wishes of their family members?
ML: Clients often want to leave some money to their children or their grandchildren, but they also have experienced the importance of work in their lives and see the importance of work in the lives of their children and grandchildren. I think most people understand that lives can be ruined by big inheritances. I can think of several people who received a large inheritance and really struggled. Ultimately, it was not a good influence on their lives. A large inheritance or an inheritance received at the wrong time, can have a negative impact. I might work with a client to set up a fund, so their grandchildren don’t receive any inheritance until they are 30 or even 50 years old, or a client may decide to calculate what a helpful amount of money might be to leave to their children or grandchildren and give the rest of their money to local charities or scholarship funds.
NCCF: What are some of the benefits your clients enjoy when they give charitably?
ML: Charitable giving is so important. It affects all of us throughout our lives— when we go to a hospital —when we are working toward our college education—the programs that are available to our children— so many of the things that add comfort and inspiration to our lives exist because of gifts people made through their estates. It’s what makes Northwest Connecticut a great place to live. People often think about charitable giving as a tax benefit, and it can be. But, giving is about so much more than a tax benefit. I encourage clients to give based on their charitable goals, not ignoring state and federal tax benefits, but not shaping their gifts solely based on them either. Creating an estate plan that meets their needs, achieves their goals for leaving gifts to their family, and makes possible the charitable giving that will become an important part of their legacy; that’s what’s really important.
NCCF: When do you recommend clients give through a Community Foundation?
ML: I don’t encourage my clients to give to any specific charity. It’s always their decision. However, I do caution clients from giving a large amount of money to one charity or naming specific charities if that client is likely to live for another 20 years. I often suggest clients consider establishing a fund with the Northwest Connecticut Community Foundation that supports their favorite charities or charitable interests. Clients can establish a named fundthrough their estate planning that supports specific charities or a named fund that supports charities working in a specific field, such as helping homeless animals, providing basic needs like food and shelter to those struggling, or supporting innovative arts projects and programs. Giving through a community foundation fund offers a level of oversight. If a specific charity becomes defunct or veers wildly from its mission, the community foundation will adjust accordingly, and ensure that your gift continues to meet your goals. I have served on the Boards of many charities. Charites can change dramatically over the decades. I tell clients, “you may have a good feeling toward one charity today, but that charity may be vastly different in 10 or 20 years. And, in fact, may not even be in existence.” By establishing a fund with the Northwest Connecticut Community Foundation, you can ensure that your gift will be used how and when it was intended. You can even specify if that gift can be used all at once or specify that it be invested as an endowment (well-invested and awarding a percentage of its value to charities, while preserving its growing balance), providing cash flow to your favorite causes, forever.
CASE STUDY: The Values-Based Charitable Remainder Trust
Stacy, age 40, has lived a very privileged life as an only daughter. When Stacy was born, it was a dream come true for her parents. They were very affluent and, during Stacy's childhood, they smothered her with love, affection, time and money. Stacy soon became very accustomed to the constant "spoiling" and financial support of her parents. As a result, Stacy possessed little drive and initiative. In fact, her idea of a productive day consisted of shopping trips and hours at the salon. Throughout her adult life, Stacy continued on this path. While she was a good person with a good heart, the her parents felt that Stacy did not mature into a financially responsible adult.
During a visit with their estate planning attorney, the they expressed their concerns about Stacy. They did not want to leave their entire estate to Stacy outright because they feared that she would simply spend it away. Instead, the they wanted an estate plan that provided retirement security, fostered financial responsibility and encouraged a love of philanthropy.
Question: What planned gift would give Stacy philanthropic involvement? How could this planned gift be structured to provide Stacy with retirement and financial security?
Solution: After consulting with their attorney, Stacy's parents decided that a customized one-life, 5% Charitable Remainder Unitrust (CRUT) might achieve their objectives. Specifically, the they would create the "Stacy Flexible Foundation." This "foundation" would actually be a FLIP CRUT. A FLIP CRUT pays the lesser of the actual net income produced by the assets in the trust or the trust's chosen payout rate until a "trigger event." Upon the occurrence of the trust's trigger event (which could be a set date in the future or the sale of an asset in the trust), the trust "flips" to a standard CRUT. Starting the next calendar year after the flip, the trust begins paying income at the trust's payout rate, regardless of the trust's net income.
The charitable beneficiary of the FLIP CRUT would be a Donor Advised Fund (DAF) created in Stacy's name. In an effort to involve Stacy in philanthropy, in addition to being the charitable remainderman, the DAF would also be named as a 1% income beneficiary. The FLIP CRUT would pay out 5%, with 4% going to Stacy and 1% going to the DAF, if the trust earned less than 5%, the ratio of the payments would remain the same. As a result, the DAF would receive distributions every year from the FLIP CRUT. (Note that there would not be additional charitable income tax deductions for the 1% income distributions to the DAF each year.)
The DAF would then make distributions each year to local charitable organizations based upon Stacy's recommendation. Note that the actual DAF distribution decisions are made solely by the charity where the DAF is funded. However, in most cases, the charity will follow the recommendations of the donor and donor's family. Stacy's parents hope this yearly, active involvement with the DAF and local charities will cultivate new personal relationships and new values for Stacy.
Stacy could also make gifts from the trust principal to the DAF during her life, by disclaiming part of her interest in the trust. By doing so, Stacy could provide greater funding to the DAF and also enjoy a charitable tax deduction for the value of the gifted income interest. See PLR 9550026. Lastly, upon Stacy's death, the FLIP CRUT would distribute its principal to the DAF. At that point, Stacy's children could be involved with the future DAF distributions.
The FLIP CRUT would also allow the Stacy's parents to meet their financial and retirement goals for Stacy. The FLIP CRUT would be invested for growth until Stacy turns 55 (the trigger event). After that point, the FLIP CRUT would turn into a standard CRUT and provide a steady stream of income for the rest of Stacy's life. With a lifetime 4% payout (plus 1% to the DAF each year for a total payout of 5%) on a very large trust, there would be significant income available for Stacy's retirement years.
While not certain of its success, the Stacy's parents feel comfort knowing that they are providing Stacy with an opportunity to grow and mature as an adult. Consequently, they are very pleased with this values-based charitable remainder trust plan.
How Charities May Collect IRA Beneficiary Designations
Traditional IRAs are funded with pretax dollars and grow tax free. Many traditional IRAs are created through rollovers of other types of qualified plans at retirement. The payouts from traditional IRAs are ordinary income because these IRAs are funded with pretax dollars. IRAs and other qualified retirement plans now equal approximately one-fourth of household net worth. In September of 2018, the Federal Reserve estimated that net household worth in America was $107 trillion. The Investment Company Institute (ICI) estimated in November 2018 that total retirement assets were $28.3 trillion. Of the total $28.3 trillion, the two largest components are IRAs and 401(k) accounts. The ICI estimate of IRA balances is $9.26 trillion. The 401(k) asset value in November 2018 was estimated to be $5.35 trillion dollars.
IRA and 401(k) Bequests to Charity
With substantial retirement plan values, there are obvious benefits for charitable individuals who transfer IRAs or 401(k) plan to charity through beneficiary designations. Because the 2019 estate exemption of $11.4 million eliminates estate or gift tax for 99.8% of estates, the typical tax on bequests to children and other beneficiaries is income tax on traditional IRAs and other qualified plans.
The taxwise inheritance plan for a parent who wants to benefit both family and charity is to make charitable transfers through an IRA, 401(k), 403(b) or other qualified retirement plan. Because charities are exempt from tax, they may receive an IRA or other qualified plan tax-free. If given their choice, children or other heirs would prefer to receive the home, stocks, land or other assets. These assets receive a step-up in basis under Sec. 1014. Children and other heirs generally will avoid payment of income, capital gains or estate tax on their inheritance.
However, if a parent transfers the home, stocks or land as a bequest to charity and leaves the IRA to children or other family members, they will pay a large (and unnecessary) income tax. If they were given the choice, the children or other heirs would always take the tax-free assets and prefer that the charitable transfer be funded through a traditional IRA or other qualified plan.
The ICI $9.26 trillion value suggests there is a significant potential for both IRA rollovers and for IRA beneficiary designations. Approximately 32% of IRA assets are held by individuals age 70½ and above, according to DQYDJ.com, an Exclusive Member of Mediavine Finance. With 32% of IRA balances held by persons who are age 70½ and therefore can roll over up to $100,000 per year, there is approximately $3 trillion in IRAs and $1.7 trillion in 401(k) assets that potentially may be used for qualified charitable distributions (QCDs). The 401(k) assets would need to be rolled over into an IRA, and then could be used for QCDs.
If the target market group is age 60 and above, the potential is even larger for IRA or 401(k) beneficiary designations to charity. The DQYDJ.com analysis suggests that 58% of total IRA and 401(k) assets are held by persons age 60 and above. These IRA and 401(k) owners could designate charity as the beneficiary of a portion of their $5.37 trillion in IRA assets and $3.1 trillion in 401(k) assets.
IRA and 401(k) Potential Value for Charity
The key to receiving these IRA rollover gifts is a multichannel marketing program with both electronic and print components. If charities have effective multichannel marketing programs and donors over age 60 designate 2% of their IRAs and 401(k)s to charity, then the amount of gifts may equal $166 billion. Because IRAs and 401(k)s continue to grow in value, this $166 billion amount could be substantially greater by the time the individuals age 60 and over pass away.
IRA is a Trust for an Individual
IRAs are governed by Sec. 408 and Reg. 1.408 of the Internal Revenue Code and Regulations. The IRA is a trust created for the "exclusive benefit of an individual or his beneficiaries." See Sec. 408(a). It must be a "trust created or organized in the United States (as defined in Sec. 7701(a)(9)) for the exclusive benefit of an individual or his beneficiaries." Reg. 1.408-2(b).
The IRA may be designated to charity. If the IRA owner designates a portion of the fund to children and a portion to charity, in order to permit children to use the "IRA stretch" plan, the IRA amount should be distributed to charity by September 30 of the year after the IRA owner passes away. Reg. 1.401(a)(9)-4. IRA distributions and reporting are described in IRS Pub. 590-B. When the IRA is distributed to an individual or a charity, the custodian will file IRS Form 1099-R.
With the rapid growth in the number of IRA designations to charities, many nonprofits have encountered problems with the transfer from custodians to charities upon demise of the IRA owner. Some IRA custodians may require the charity to setup an IRA account, claim that the charity is subject to provisions of the Patriot Act or decide to withhold 10% of the IRA to pay income tax. Charities and their counsel must understand the correct responses to these claims in order to expedite the receipt of IRA proceeds.
IRA Collection and 401(k) Bequests to Charity
Problem: The IRA custodian claims that the charity must set up a new account.
Response: The charity is not an individual and therefore not qualified to set up an IRA account. Under Reg. 1.408-2(b), an IRA account must be for "the exclusive benefit of an individual or his beneficiaries." A charity is a corporation and defined as a "person" under the IRC, but a nonprofit corporation is clearly not an individual. Therefore, the charity is not qualified to set up an account. The appropriate response for the custodian is to transfer the designated amount directly to the charity.
Problem: The custodian attempts to apply the Patriot Act or FINRA Rule 2090 (Know Your Customer) to the charity. Some IRA custodians ask for detailed personal and financial information of nonprofit board members.
Response: The USA Patriot Act was passed in 2001 for the purpose of protecting America and reducing the risk that funds would be transferred overseas. Sec. 326 of the Patriot Act provides that "financial institutions" shall be required to exercise efforts to reduce the risk of funds being used by suspected terrorists or terrorist organizations. Patriot Act Sec. 326 applies if an individual or corporation attempts to open a bank account. The bank must maintain records to verify the person's identity, name, address and other identifying information and ascertain whether or not the person is on the list of known or suspected terrorists.
The Patriot Act and FINRA Rule 2090 (Know Your Customer) do not apply to U.S. nonprofits if they are not creating a bank or IRA account. See Patriot Act Sec. 326. In addition, our U.S. nonprofit is not on the known or suspected terrorist list. Therefore, there is no application of the Patriot Act or FINRA Rule 2090 to the distribution of an IRA balance to a U.S. nonprofit that is not setting up a bank or IRA account.
Problem: The IRA custodian may withhold 10% of the distribution and send it to the IRS.
Response: U.S. nonprofits are tax exempt. While there is generally a requirement to withhold tax on IRA distributions to individuals, it is possible to elect no tax withholding on IRS Form W-4P. In any case, a qualified exempt charity is not subject to income tax and there is no requirement for withholding.
Letter to General Counsel to Facilitate IRA Collection
Some IRA custodians will promptly distribute the funds to a nonprofit, but others may delay or create roadblocks to that distribution. In order for a nonprofit to collect its share of an IRA, it may be necessary to send a letter to the general counsel of the bank or other financial custodian. Below is a specimen letter that nonprofits may modify and send to the general counsel of the IRA custodian. This letter may be modified to conform with the nonprofit's name, address and specific goals. The donor's name and account number also must be updated.
Specimen Letter to General Counsel of IRA Custodian
January 1, 2019
Mr. or Ms. General Counsel
1234 Michigan Avenue
Chicago, IL 00000
Dear General Counsel:
We have been informed that Favorite Charity is a beneficiary of the IRA of Jane Doe. The IRA account number is 123-45-678. We request that you liquidate the IRA funds held for our benefit and send a check to us within 30 days at our address: Favorite Charity, Bequest Administrator, 123 Oak Street, Chicago, IL 00000.
Favorite Charity is not required to open an IRA account with a custodian to receive an IRA distribution. Under Reg. 1.408-2(b), an IRA account must be created "for the exclusive benefit of an individual or his beneficiaries." A charity is a nonprofit corporation defined as a "Person" under the IRC, but a charity clearly is not an individual and therefore not permitted to set up a Sec. 408 IRA account. In addition, as custodian you are trustee of an IRA trust under Reg. 1.408-2(b). You are required by federal and state law to comply with the fiduciary responsibilities of a trustee. If you fail to make the distribution as required in your contract with the IRA owner, you are potentially in breach of your duty of fiduciary responsibility.
Favorite Charity is not subject to the USA Patriot Act (Pub. L. 107-56) or FINRA Rule 2090. Sec. 326 of the USA Patriot Act requires banks and other custodians to determine that a person opening an account is not on the suspected terrorist list. First, IRC Sec. 408 does not permit a nonprofit to open an IRA account. Because the charity cannot open an IRA account, both the Patriot Act and FINRA Rule 2090 do not apply to an IRA distribution to charity. In addition, we are a U.S. recognized exempt charity and not on a suspected terrorist list.
Finally, IRA custodians may withhold 10% of a distribution to individuals and remit that amount to the Internal Revenue Service. We are tax exempt and elect under IRS Form W-4P to not have tax withheld. Because we are tax exempt, there is no requirement for withholding on your part. Enclosed is a copy of our IRS tax exemption letter. Our IRS identification number usable on Form 1099-R is 00-1234567. There is no IRS requirement to have an IRA account for you to issue Form 1099-R
Because we are not permitted to open an IRA account, the USA Patriot Act and FINRA Rule 2090 do not apply to a U.S. charity not opening an IRA account and withholding is not required, we request that you remit within 30 days the full distribution to the above address. If you are unable to distribute our vested IRA funds within 30 days, then, in a manner similar to Sec. 6662(a), we should receive the IRA funds and a 20% penalty amount. Because after the 30-day period you are in breach of contract and breach of trustee fiduciary responsibility due to noncompliance with terms of the IRA agreement, we will be willing to settle for the IRA funds plus a 20% penalty.
If you feel you are unable to make this prompt distribution as requested, please have your Legal or Compliance Department provide a written explanation of your legal basis for not distributing these IRA funds to us. Reminder -- this is a trust. You are subject to a breach of fiduciary responsibility claim for failure to follow trust terms.
Vice President, Favorite Charity
Expected Response to General Counsel Letter
This letter has two keys that encourage IRA distributions. The 30-day limit and the 20% penalty will cause the letter to be sent to the IRA custodian general counsel. Legal counsel will recognize that he or she does not wish to create a claim for breach of fiduciary responsibility. The general counsel can negotiate with the nonprofit to drop its claim for breach of trustee fiduciary responsibility and the 20% penalty in exchange for the IRA distribution. This letter should move the IRA custodian forward and encourage a prompt distribution.
The bold words on the letter should be replaced by the nonprofit name, address and other information. The letter may be modified in the case of a Sec. 401(k), 403(b) or other type of qualified retirement account. Even with this collection letter, it may take a period of time for the custodian to respond.
IRA Transformative Gifts
With potential IRA and 401(k) bequests over $166 billion, all nonprofits should encourage lifetime and testamentary IRA gifts with a full-featured marketing program. Your Boomer and Quiet Generation donors can transform your organization through these IRA gifts. With the assistance of the IRA collection letter above, your nonprofit will quickly benefit from these excellent gifts.
Nonprofit Council Seeks Disaster Relief Tax Provisions
As parts of North and South Carolina recover from the winds, floods and tornadoes of Hurricane Dorian, the National Council of Nonprofits published a request for tax provisions to assist disaster victims.
Senate Finance Committee Chair Chuck Grassley (R-IA) appointed Sen. Richard Burr (R-NC) to lead the Senate Finance Committee Disaster Tax Relief Task Force. The task force is studying ways tax law can be used to assist victims of natural disasters.
David L. Thompson is President of the National Council of Nonprofits. He and 42 state nonprofit associations sent a letter to the task force Senators requesting four types of tax relief provisions.
- Flexible IRS Filing Deadlines - While the IRS has granted tax filing extensions after a disaster, there should be a standard extension accompanying the federal disaster zone declaration with an automatic time for that extension.
- Employer Tax Credits - After a federal disaster, many workers are temporarily unemployed due to destruction of buildings and warehouses. Congress has passed legislation with targeted tax relief for companies in disaster zones. These provisions are designed to encourage companies to resume normal employment levels. Because nonprofits do not pay income taxes but are significant employers, disaster relief tax bills should grant similar benefits to nonprofits by waiving their payroll taxes.
- Disaster Recovery - After a flood, fire, tornado or other natural disaster, nonprofits may provide food, clothing and shelter for weeks and even months. With an extended recovery period, the disaster relief tax incentives should have a longer duration to match the period of recovery.
- Targeted Universal Deduction - Disaster relief tax provisions often remove the 60% of AGI cash deduction limit for gifts to disaster recovery programs. With the number of itemizers reduced from 30% of taxpayers in 2017 to about 10% by the Tax Cuts and Jobs Act, there is a need for greater deductions for more taxpayers. A targeted "nonitemizer deduction" for gifts to disaster relief nonprofits would enable "all taxpayers to support their fellow Americans throughout the country in an immediate and responsible way." The targeted nonitemizer deduction could be limited to six months after the disaster declaration.
Senators Thune and Casey Support CHARITY Act
On May 15, Senators John Thune (R-SD) and Bob Casey (D-PA) introduced the Charities Helping Americans Regularly Throughout the Year (CHARITY) Act. The bill expands giving options for IRA charitable rollovers and addresses other charitable provisions.
The CHARITY Act includes four major provisions. If it is passed by the House and Senate and signed by the President, it would generally permit donors over age 70½ to transfer up to $100,000 per year directly from an IRA to a donor advised fund. Second, the act would simplify the excise tax paid by private foundations on investment income.
Volunteers who drive their vehicles on qualified charitable trips can currently deduct $0.14 per mile. That charitable mileage amount would be increased to the same rate as is currently permitted for medical and moving expenses. The medical and moving expense rate for 2019 is $0.20 per mile.
Finally, the CHARITY Act requires nonprofits to file their annual tax returns electronically. While nonprofits are exempt and ordinarily do not pay tax, they must file an information return each year.
Editor's Note: While the CHARITY Act has not yet passed, it is encouraging to see Congressional support for philanthropy and, especially, the existing IRA rollover. Americans over age 70½ should consider making an IRA rollover gift in 2019. The IRA charitable rollover is a great planning option for eligible IRA owners who are among the 90% of Americans who do not itemize. Because the IRA rollover qualifies for part or all of an IRA owner's required minimum distribution (RMD), IRA owners can make gifts from their IRAs, reduce their tax bill from their RMDs and still take the full standard deduction. For all donors, the IRA rollover is a convenient way to make gifts in 2019.
An Interview with Michael D. Rybak and Michael D. Rybak, Jr.
The Community Foundation recently sat down with Northwest Connecticut attorneys Michael D. Rybak and his son, and Community Foundation Apolonia Stanulis Scholarship Fund recipient, Michael D. Rybak Jr. to discuss their work advising charitably inclined clients on planning well and giving locally.
Investor or Dealer? —Gifts of Real Estate and Donor Classification
Charitable Gifts of Commercial Annuities and Savings Bonds
In the News:
TCJA and Charitable Remainder Trusts
Representative Opposes SALT Charitable Deduction Limit
An Interview with Michael D. Rybak and Michael D. Rybak, Jr.
The Community Foundation recently sat down with Northwest Connecticut attorneys Michael D. Rybak and his son, and Community Foundation Apolonia Stanulis Scholarship Fund recipient, Michael D. Rybak Jr. to discuss their work advising charitably inclined clients on planning well and giving locally.
NCCF: When does the conversation about charitable giving arise with clients?
MDR: When we do an estate plan we talk about the client’s objectives. Charitable giving often comes up with older people, those who have already provided for their family and those with no family. It’s increasingly common to have two professionals who don’t have children and would like to do some good with their money.
NCCF: How do you help clients plan for their charitable goals?
MDR: Some clients come in with a list of charities they want to support. I never influence them, but I do encourage them to do some research into where and how far their gift will go.
Some national charities are great, but if you give closer to home, you will have more information about how your gift will be used toward your charitable goals. Many clients have specific areas of interest. I have had, for example, clients set up a trust for the care of their dog or horse. After the animal passes, they want the remainder of the money to help other animals.
Others want to help people in the area, but they don’t know how. Most charitable goals can be best reached by working with a community foundation, in our area, the Northwest Connecticut Community Foundation, either by giving to an existing fund that works toward their goals, establishing a new donor-advised, discretionary, or field-of-interest fund specific to their wishes, or establishing a scholarship fund.
NCCF: How do you work with clients who want to give gifts in-kind, such as land?
MDR: Some people feel strongly about preserving their property, their land, woods or lake front. For some, I help them arrange a conservation easement. This gives them the benefit of using the property. By working with a local land trust the property is preserved forever. Alternatively, some clients choose to preserve their property through a bargain sale. They sell the property to a land trust at a low price. The land trust preserves the property, and they receive a charitable deduction on the difference between the appraised value of the land and its sale price.
There is typically a tax benefit to giving property to a nonprofit wholly through a bargain sale or through an easement rather than selling it at market value and donating the proceeds.
NCCF: What are some common misconceptions when it comes to giving through estate planning?
MDR: We all hear a lot about private foundations, often on public radio. Clients sometimes think that’s the best way to help their community.
People don’t realize how expensive and time-consuming private foundations are to establish and maintain. It’s almost never financially advantageous to establish a private foundation. It’s almost always better to create a donor-advised fund with an organization like the Northwest Connecticut Community Foundation. As donor-advisor to a fund, they can choose the nonprofits that benefit from grants and how grant money is spent. They can also leave that responsibility to a family member when they are no longer able to fulfill those duties.
Another misconception is that they can’t give until they have taken care of all of their and their family’s financial needs. Depending on their resources, clients can establish a charitable trust and receive an annuity payment for life from that trust with the remainder given to a specific charity or a fund.
Alternatively, annuity payments can be given to a charity or fund with the balance of resources given to family members or to a different charity or fund.
NCCF: You mentioned that there is a lot of value in giving locally. Please expand on that idea.
MDR JR: I think it’s worth saying that having a local charity or charitable component to estate planning is very important today in Connecticut and in Litchfield County, especially. Helping the local areas through nonprofits can help at least in some ways make up for state and local governments not being as generous as they used to be.
If clients give to a national charity because the nonprofit has a mission that they are particularly fond of, that’s great. But, it may not help in the local area. It may go to a central office somewhere.
NCCF: Why do you encourage your clients to work with the Northwest Connecticut Community Foundation as a partner in reaching their charitable goals?
MDR: The Community Foundation is local. They do a lot of good in our communities. We may not realize it, but we all know someone who has benefited from charitable giving through the Community Foundation, including a lot of young people who have received scholarships. They have benefitted, and our local communities have benefitted, because people established funds to help improve their communities.
Investor or Dealer?—Gifts of Real Estate and Donor Classification
Philanthropically motivated individuals increasingly understand the value of gifting appreciated real estate to charity. Donors are often able to claim a deduction for the property's fair market value while also bypassing capital gains tax that would otherwise be due if the donor sold the property. This is a win-win solution for the donor from a charitable and financial standpoint.
What is the result, however, when a donor is classified as a "dealer" of real estate and decides to make a gift of real property to charity? In that case, the property is considered an ordinary asset and, as such, the donor's deduction will be limited to cost basis. On the other hand, if the donor is considered an investor, he or she will be able to claim a fair market value deduction for the gift.
The distinction between dealer and investor is an important factor that advisors must take into consideration when guiding clients through the charitable giving process. While some cases may be clear-cut, other times, the line may be blurry.
Part I of this article will shed light on this important distinction between real estate investors and dealers, provide factors that advisors should take into consideration when making this determination and offer case examples to illustrate each factor. Part II will use the factors presented in this article to examine some hypothetical examples where a client makes a gift of real estate to charity. Part II will also provide charitable solutions for donors who want to make gifts of dealer-classified property. By understanding how these factors are used to determine whether a property owner is a dealer or investor, advisors can help guide their clients toward a strategy that will maximize their tax benefits while simultaneously fulfilling the client's philanthropic goals.
A taxpayer who is a "dealer" of certain assets recognizes ordinary income rather than capital gain on the sale of those assets. Thus, the starting point for understanding the distinction between a dealer and investor is IRC Sec. 1221, which, in part, explains that property will not be considered a capital asset in the hands of a taxpayer if the property is "stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."
Therefore, if an individual holds property for sale or as part of a trade or business, then he or she may be classified as a dealer. Alternatively, an individual who holds property for investment only is not a dealer, but is an investor. However, the line becomes blurred when determining at what point selling property changes from an "investment activity" to a "recurring business activity."
Again, this distinction is important because property held for investment purposes may be subject to more favorable capital gains tax treatment, while dealer property will be subject to less favorable ordinary income rates. While these categories are important for those buying and selling real estate, they also must be considered when an individual is planning to make a gift of real property to charity.
For example, if a donor is contributing real estate that has been held as investment property for many years, then the property is considered a capital asset in the hands of that donor and he or she will be entitled to a charitable income tax deduction equal to the property's fair market value. Capital assets include real estate that has been operated as a rental property or has been held as a management-free investment. If, on the other hand, the donor is in the business of flipping houses or developing real estate, then the real estate could potentially be classified as ordinary income in the hands of the donor. If the donor contributes this "dealer-type" property to charity, then the deduction will be limited to the donor's cost basis in the real estate. It is important to note that this status determination is made on a property-by-property basis, meaning that an individual could be classified as a dealer in the context of one property and an investor in the context of another.
The tax code and regulations do not provide clear guidance in making the dealer-investor determination. In fact, the Tax Court noted that there is an "indistinct line of demarcation between investment and dealership." Buono v. Commissioner, 74 T.C. 187 (1980). However, this classification issue has been litigated many times over the years and as such, advisors typically turn to case law when making this determination. There are five main factors that courts consider when classifying an individual as an investor or a dealer. The remainder of this article will examine each factor and provide case examples for further guidance. Advisors should consider all facts and circumstances in light of these five factors to ensure that they are providing their clients with accurate information and steering them toward a charitable gift that will maximize their tax savings.
The Dealer-Investor Factors
1. Frequency, Number and Continuity of Sales
The first factor, and perhaps one of the most important to consider, is whether the property owner has been frequently and continuously selling real property (see Biedenharn Realty Co., Inc. v Comr., 526 F.2d 409 (5th Cir. 1976) noting that the "the frequency and substantiality of taxpayer's sales" is the most important factor that must be considered). In Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court explained, "Frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment."
The more regular and continuous the sales, the more likely it is that the donor will be considered a dealer. Thus, when analyzing this factor, advisors should consider the following questions: How many properties has the donor sold? What was the time frame of these sales? Were the donor's sale activities regular and sustained or intermittent and occasional?
For example, in Hancock v. Commissioner, T.C. Memo 1999-336 (1999), the Tax Court held that the property owner's sale of 47 unimproved lots over a nine-year period demonstrated "frequent, regular and substantial" sales. In contrast, in Buono v. Commissioner, 74 T.C. Memo 187 (1980), the Tax Court found that, despite the property owner's intent to zone and subdivide a particular piece of property, the property was not deemed "dealer property" when it was sold. The Tax Court emphasized the "isolated nature of the transaction" and noted that it considered the "lack of frequent sales to be the most important objective factor for purposes of characterizing the gain petitioners received." The fact that it was a single sale precluded a finding that the property owner "was engaged in substantial and frequent real estate sales over an extended period of time."
While, in many circumstances, the courts have found that a single sale will not result in dealer status, there have been cases where a property owner was classified as a dealer on the first transaction (see Allen v. US, 113 AFTR 2d 2014-2262, (DC CA) below). As such, all factors must be considered even if the donor has not engaged in frequent and continuous sales in the past.
Trouble often arises where the donor has engaged in more than a single sale but fewer than what would clearly be considered a substantial number. When the status of the property owner falls into this "gray area," the courts will dive deeper into the other factors to make an ultimate determination. If a client who is considering making a gift of real estate to charity falls into this area, the advisor should look to case law and carefully analyze the remaining four factors to determine whether the scales tip more toward classification as an investor or a donor.
2. Nature and Purpose of Holding or Purchasing the Property
The second factor focuses on the intent of the property owner. Here, the questions are: What was the donor's original purpose when acquiring the property and what was his or her intent at the time the property was transferred? Was the property purchased with the intent to hold it as an investment or was it purchased for the purpose of development and sale?
In Allen v. US, 113 AFTR 2d 2014-2262 (DC CA), a district court in California shocked many advisors who had long believed that a single transaction would not result in dealer status. In Allen, the court held that the one-time sale of land would be subject to ordinary income tax treatment. While the first factor — the frequency, number and continuity of sales — weighed in favor of the property owner, the court noted that the evidence clearly demonstrated that the property owner purchased the land with the intent to develop and sell it. This intent was further demonstrated by the property owner's efforts to sell the property. Ultimately, the court found that the property owner purchased and held the property with the intent to develop and sell it in the ordinary course of his trade or business.
It is important to note that the courts have recognized that intent can change over time. The most important intent to consider is that of the property owner at the time of transfer. For example, in Maddux Construction Co. v. Commissioner, 54 T.C. 1278 (1970), the property owner originally acquired a tract of land with the intent to subdivide it and construct homes. However, the Tax Court found that at the time the property was sold, the property owner had abandoned the "intention to subdivide the property for residential purposes and decided to hold the property for investment purposes, either as rental property or for eventual sale at a profit." The court noted that "intent is subject to change, and the determining factor is the purpose for which the property is held at the time of sale." Ultimately, the Tax Court found that while the property owner originally purchased the property to sell to customers in the ordinary course of business, this intent was abandoned and, at the time of sale, the property was held as an investment. As such, the property owner was entitled to report the gain as long-term capital gain.
Advisors should take intent into consideration when a donor is considering making a gift of appreciated real estate to a charitable organization. In order to ensure the donor receives a fair market value deduction, advisors should assist by analyzing the facts and circumstances to determine the intent of the donor with regard to the property in question at the time of the charitable transfer.
3. Nature and Extent of Taxpayer's Business
The third factor looks to the property owner's undertakings. Was the property owner actively engaged in managing, improving or developing the property? Activities like subdividing, grading, zoning and installing roads and utilities tend to favor dealer status rather than investor when analyzing this factor.
For example, in Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court found that the property owner's act of developing a water and wastewater system was "more akin to a real estate developer's involvement in a development project than to an investor's increasing the value of his holdings." As such, this factor supported the Tax Court's ultimate holding that the property was not held for investment but was held primarily for sale in the ordinary course of the property owner's trade or business.
Again, it is important to note that this factor is analyzed in relation to the particular property involved. Thus, a property owner could be developing a residential neighborhood and be classified as a dealer for that particular tract of land and, at the same time, be holding a separate parcel of land for investment purposes. For example, in Pritchett v. Commissioner, 63 T.C. 149 (1974) the Tax Court granted investor status to a property owner who had historically held land for development and reported gain on properties he sold as ordinary income. The Tax Court found that the property owner had not made any effort to improve, subdivide or sell the property. Rather, he held it passively until he received an unsolicited offer to purchase the property. As such, the Tax Court held that the property owner was an investor in respect to this particular parcel. Therefore, the gain from the sale of the land would receive capital gain treatment.
Given the property-specific nature of this analysis, it is important that advisors analyze their clients' actions toward the property they intend to donate. If, prior to making a gift to charity, the client had been developing the particular property, a court may find that this factor supports classifying the client as a dealer, in which case the donor would have to limit the deduction to the property's basis. Advisors should consider all facts and circumstances involved and keep in mind that this factor is weighed in relation to the other factors involved. The greater the amount of development activity, the more likely that this factor will support a dealer-status finding.
4. Advertising, Solicitation and Sales Activities
The fourth factor considers the property owner's sales and marketing involvement with regard to the property. Here, questions to consider include: At the time of the transfer (either sale or charitable donation), was the property owner spending a great deal of time and effort attempting to sell the property? Was he or she personally trying to find buyers? Was he or she involved in negotiating sales? How engaged has the property owner been in marketing, advertising and solicitation?
The more time the property owner has spent either personally advertising the property or working with sales agents, brokers or marketing professionals, the more likely it is that the court will find an underlying business, rather than investment, motivation. In Biedenharn Realty Co., 526 F.2d 409 (5th Cir., 1976), the court pointed to a property owner's sales efforts as evidence of dealer-like real estate activities. The court explained that the property owner "hired brokers who, using media and on site advertising, worked vigorously on taxpayer's behalf." The court made clear that hiring real estate professionals does not protect a property owner from dealer treatment, noting, "We do not believe that the employment of brokers should shield plaintiff from ordinary income treatment."
The less time and effort the property owner has spent on attracting buyers, the more likely he or she is to receive more favorable investor treatment. For example, in Byram v. United States, 705 F.2d 1418 (5th Cir. 1983), the court found that a property owner who sold 22 parcels of real estate over the course of three years should be classified as an investor, despite the large number of sales in a short period of time. The court noted that the property owner "made no personal effort to initiate the sales; buyers came to him. He did not advertise, he did not have a sales office, nor did he enlist the aid of brokers." As such, despite the number of sales, the court found that the fourth factor, among others, weighed in the property owner's favor and that the properties were held for investment and not for sale in the ordinary course of his trade or business.
Advisors should consider the amount of time that a client has devoted to sale activities and actively participated in the sales process prior to making a charitable transfer in order to avoid dealer status and claim a full fair market value deduction. As the Biedenharn case explains, the use of brokers and third party sales agents does not shield a property owner from dealer status. Advisors should look at all the facts and circumstances involved when weighing this factor and understand that owning a sales office, working with brokers to find a buyer and using media and signage to advertise are activities that may add weight to the dealer side of the scale.
5. Extent and Substantiality of Transactions
The fifth factor looks at the overall level of the property owner's real estate activities. Questions to analyze here include: Is the property owner in the business of buying, selling, developing and improving real estate? If so, is it the property owner's full-time occupation? If the property owner is involved in multiple income-producing activities, what percentage of his or her income is derived from real estate activities?
While a property owner can be in the real estate business and still hold property for investment purposes (see Pritchett v. Commissioner, 63 T.C. 149 (1974) above), courts do consider the property owner's history with respect to his or her real estate transactions. In Galena Oaks Corp. v. Scofield, 218 F.2d 217, 220 (5th Cir. 1954) the court explained, "Congress intended to alleviate the burden on a taxpayer whose property has increased in value over a long period of time. When, however, such a taxpayer endeavors still further to increase his profits by engaging in a business separable from his investment, it is not unfair that his gain should be taxed as ordinary income."
When considering this factor, courts also look at the amount of income the property owner derives from his or her personal real estate activities in comparison to other income-producing activities. In Evans v. Commissioner, T.C. Memo 2016-7 (2016), the Tax Court found that even though the property owner, Jeffrey Evans, was employed by a real estate development firm, his personal real estate activities did not rise to the level of a trade or business. When classifying Evans as an investor, the court noted that Evans' "primary source of income was his full-time job" and that "any income he may have earned from developing properties accounted for an insubstantial portion of his income."
In contrast, in Gamble v. Commissioner, 242 F.2d 586 (5th Cir. 1957), the property owner, Harry Gamble, sold 70 parcels of land in a two-year period. During that time, Gamble was actively practicing law and earning money as an attorney and a notary. Gamble argued that since he did not have a license to sell real estate and because his legal practice was his only place of business, he was not in the real estate business. The court rejected his argument and classified him as a dealer with respect to the properties in question. The court explained that "a person may be engaged in more than one business" and that it was "significant that the petitioner's profits from his real estate ventures exceeded, during each of the two years in question, his earnings as a lawyer and notary."
Advisors who assist clients with charitable gifts of real estate should consider each client's current property dealings and past real estate transactions in addition to occupation, keeping in mind that even if a client's primary occupation is unrelated to real estate, it will not automatically prevent the client from being classified as a dealer. While a client can be in the business of buying, selling, developing and improving real estate and still hold property separately as an investor, the advisor will need to be prepared to present evidence that supports classifying the client as an investor with regard to the gifted property.
The classification of a donor as a dealer or an investor is an important, yet difficult, distinction that must be made in order to accurately report a charitable deduction where the property is gifted to charity. The process of making this determination, however, is not black and white. In Byram v. United States, 705 F.2d 1418, 1419 (5th Cir. 1983), the Fifth Circuit noted the difficulty and uncertainty that exists when it comes to this classification process, stating "[I]n that field of the law—real property tenure—where the stability of rule and precedent has been exalted above all others, it seems ironic that one of its attributes, the tax incident upon disposition of such property, should be one of the most uncertain in the entire field of litigation. But so it is..."
And so it is that advisors are faced with the task of guiding their clients through the somewhat murky waters that exist in the dealer-investor determination process. While there is no bright line, advisors can turn to the factors the courts have presented and the cases in which they are discussed. By understanding these factors and considering how courts have ruled in past cases, advisors can help guide their clients and determine the best charitable giving strategy, given the client's likely status as a dealer or investor.
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Charitable Gifts of Commercial Annuities and Savings Bonds
Savings bonds and commercial annuities are considered by many to be very safe investments for individuals. Investors enjoy the guaranteed return these assets offer. Many individuals are concerned that they might outlive their nest eggs. Savings bonds and commercial annuities have been marketed as low-risk investments that can ease that fear.
Over the years, many individuals have invested in U.S. savings bonds or commercial annuities. Individuals who are charitably-minded may be interested in gifting savings bonds or commercial annuities to charity.
U.S. savings bonds are issued by the Department of Treasury and backed by the full faith and credit of the U.S. government. Because of this guarantee, savings bonds are generally considered a stable investment. The trade-off for the safety that these investment vehicles provide is a smaller investment return. The guaranteed return for a Series EE savings bond hovers at approximately 3.5%, while the rate for the Series I savings bond starts at 2.52% for bonds issued in mid-2018. Those returns are much lower in comparison to stocks, which have averaged a return of approximately 7% over the past decade.
The two most common savings bonds are Series EE and Series I bonds. Series EE and Series I savings bonds are subject to the same rules and tax treatment, despite their differences in structure. When savings bonds reach final maturity, all accumulated interest income must be recognized in the year the savings bond matures.
Series EE bonds are purchased at a discounted value. A Series EE bond is sold for half its face value and will accrue interest at a fixed rate. Series EE bonds will mature to face value after 20 years. After the maturity date, Series EE bonds continue to accrue interest for an additional 10 year period until reaching the final maturity date. The accumulated interest will be taxed on the final maturity date 30 years after its purchase, if not cashed in prior to that date.
Series I bonds, on the other hand, accrue interest at a variable rate. A Series I bond accrues interest at a guaranteed fixed interest rate plus the variable inflation rate as calculated in semiannual intervals. The potential benefit of the variable rate is that it allows Series I bonds to potentially appreciate at a higher rate than Series EE bonds.
The variable rate also means that Series I bonds carry more risk than Series EE bonds. Series I bonds accrue interest for 30 years, but the savings bond is not guaranteed to double in value by the 30-year maturity date. Because the fixed interest rate is added to the inflation rate, Series I bonds bear a risk that there will be little or no appreciation if the inflation rate is negative. Series I bonds will never be worth less than their purchase price because the combined variable rate cannot fall below zero.
A commercial annuity is an agreement between a financial institution, such as an insurance company or a bank, and an annuitant. Commercial annuity contracts promise fixed or variable income payments from the financial institution for the duration of the annuitant's life or a term of years. Most annuity contracts also offer a death benefit. The annuity contract is backed by the assets of the insurance company or bank. Thus, it is important that the annuity is purchased from a strong and reliable company.
Annuities are often purchased by individuals as a means of insuring adequate retirement income and may be acquired as part of a retirement account or with after-tax income. Lifetime transfers of annuities purchased on or before April 22, 1987 require recognition of ordinary income when the annuitant receives proceeds from the contract in excess of the cost basis. For the purposes of this article, after-tax funds are assumed to have been used to purchase a deferred commercial annuity after April 22, 1987 that has not been annuitized.
Commercial annuities can be structured in a variety of ways. The annuity can provide a minimum guaranteed payout or minimum guaranteed duration. An annuity can begin making payments immediately or can defer payments for a number of years. A flexible payout option is also available.
Commercial annuities grow on a tax-deferred basis and there is no limit to the amount of money that can be used to fund the contract. If the annuitant is younger than 59½, there is a 10% penalty for withdrawing funds from the annuity. When the annuity starts making payments, the distributions are taxed as ordinary income with a portion designated as tax-free return of principal. Commercial annuities typically offer a reasonably high payout.
Commercial annuities should be distinguished from charitable gift annuities. A charitable gift annuity is a contract between a donor and a charitable organization that makes payments for one or two lives. When the charitable gift annuity ends, the charitable organization receives the use of the remaining contract value. With a commercial annuity, the entire funds, minus fees, will be invested and are expected to be returned to the annuitant through the annuity payments. In most cases, a death benefit to a designated beneficiary is an additional option.
Lifetime Transfers of Savings Bonds
Many individuals may have held savings bonds for quite some time and desire an increase in their investment return. Investors may wish to make lifetime gifts of those savings bonds to charity. The owner of the savings bonds hopes to receive a charitable income tax deduction and bypass the interest income held in the bond.
Savings bonds can only be registered in the name of an individual. See 31 C.F.R. 315.6. Charities cannot be listed as owners, co-owners or beneficiaries on savings bonds. Due to these restrictions on re-issuing savings bonds, lifetime gifts of savings bonds to charity can only be accomplished by redeeming the savings bond and making a cash donation of the proceeds.
In general, transfers of savings bonds prior to the final maturity date will accelerate the accumulated interest in the year of the transfer. Reg. 1.454-1(c)(1). Rev. Rul. 55-278. No exception exists for charitable donations of savings bonds during life. PLR 8010082. The owner will be required to recognize the interest income on the difference between the amount paid for the savings bond and the redemption value of the bond.
The tax consequences of recognizing interest income on the savings bond will be offset by the charitable income tax deduction generated from the cash donation of the proceeds. Since this is a cash gift, the donor will be able to use the deduction to offset up to 60% of his or her adjusted gross income. The donor can carry forward any remaining deduction for up to five additional years.
Judy purchased Series EE bonds approximately 25 years ago. Her bonds were five years from the final maturity date. Judy went to her bank to have her bonds transferred to the name of her favorite charity. The bank informed her that she cannot have the bonds re-issued to the charity. Instead, Judy decided to cash in her savings bonds. She was required to report the accumulated interest from the savings bonds on her income tax return. Judy received a charitable deduction for the cash proceeds she donated to her favorite charity. She may use her deduction to offset up to 60% of her adjusted gross income.
Lifetime Transfers of Commercial Annuities
Some individuals may find they have retirement security and do not need any additional income from a commercial annuity. Others may find that the return from the annuity is not as substantial as they hoped and decide to terminate the contract. Typically, individuals will want to avoid surrender charges for early terminations of an annuity contract. Many hope that making a gift of an annuity contract to charity will meet that goal and provide a charitable income tax deduction.
Generally, deferred commercial annuities may be transferred to charity. If the commercial annuity has been annuitized, the transfer options may be limited or not permitted. A commercial annuity is deemed annuitized if the annuity contract has been converted to a specified payment schedule. If the contract is transferrable, a charitable transfer will require the recognition of any untaxed gain in the year of the transfer. The tax consequences of the transfer may be offset at least in part by a charitable income tax deduction.
A commercial annuity is part investment, which is the amount the annuitant paid for the annuity, and part ordinary income, which is the amount of the tax-deferred earnings. A portion of the distribution will be recognized as ordinary income if the annuity is worth more than the original cost. The original cost of the annuity will be distributed tax free, but any amount in excess will be taxed as ordinary income. Therefore, a donor will recognize and be required to report any untaxed gain as ordinary income in the year that the transfer is made. The ordinary income would be equal to the difference between the surrender value of the commercial annuity and the donor's basis in the annuity. The donation of the annuity contract to charity may avoid surrender charges if the annuity is outside the surrender period.
The donor will receive a charitable deduction for the value of the annuity contract. If the annuity contract is over $5,000 in value, the donor will be required to obtain a qualified appraisal. Although the annuity contract may have a value assigned to it through the issuing organization, the IRS requires a qualified appraisal for all non-cash charitable gifts valued at more than $5,000. The donation of an annuity contract would be subject to a deduction limit of 50% of the donor's adjusted gross income, as it is a cost basis deduction. Donors rarely, if ever, structure their gift in this way.
In almost all circumstances, a donor will surrender the annuity contract and donate the cash received. If the donor makes the gift using the cash proceeds from the contract surrender, he or she would be entitled to a deduction of up to 60% of adjusted gross income. Although the tax consequences remain the same, the difference between the surrender value and the purchase price will be taxed as ordinary income in the year of the transfer, the charitable deduction may be more attractive because the deduction limit increases to 60% for cash gifts. An annuitant may be more inclined to donate the cash proceeds from the surrender of the annuity contract.
Xavier wanted to make a gift using his commercial annuity contract to his favorite charity. Xavier's insurance company confirmed that he was outside his surrender period. Xavier decided to surrender his commercial annuity to the insurance company in order to make a cash gift to his favorite charity. His annuity was valued at $100,000, with a cash value of $75,000. Xavier's original cost for the annuity was $50,000. He recognizes $25,000 as ordinary income. Xavier's adjusted gross income for the year was $125,000. His charitable deduction was limited to 60% of his adjusted gross income, since this was a cash gift. He was able to use all $75,000 of his charitable deduction in the year of the gift.
Generally, charitably-minded owners of commercial annuities hope to avoid generating additional taxable income and want to benefit from charitable income tax deductions. The taxability of lifetime transfers of savings bonds and commercial annuities may dissuade some of these donors from making lifetime charitable transfers. The tax treatment of lifetime transfers to charity is not dependent on whether the gift is made outright or through a life income gift, such as a charitable remainder trust or a charitable gift annuity. The charitable income tax deduction resulting from the gift can be used to offset the ordinary income recognized from the transfer. There may be additional options to explore when using savings bonds or commercial annuities to meet a donor's philanthropic goals.
Testamentary Transfers of Income in Respect of a Decedent Assets
Commercial annuities and savings bonds are assets categorized as income in respect of a decedent ("IRD"). IRD refers to the amounts that a decedent was entitled to as gross income, but was not received nor taxed as the decedent's income prior to the decedent's death. IRD assets represent untaxed ordinary income and are governed by Sec. 691. IRD assets are included in the estate of the decedent and may be subject to estate tax. Under Sec. 691(c), there is an offsetting deduction for estate tax paid on IRD assets.
Some common examples of IRD assets include IRAs, U.S. savings bonds and commercial annuities. Generally, IRD assets are known as "bad assets" to pass on to heirs due to their tax consequences. IRD assets are subject to tax at ordinary income rates on all distributions. Other appreciated assets, such as stocks and real estate, receive a stepped-up basis upon the original owner's death and are considered "good assets," because they can be sold by the beneficiary without paying a large capital gain tax.
Many financial planners suggest transferring "bad assets" to qualified charities and "good assets" to heirs. This transfer at death provides a two-fold benefit. The charity can sell IRD assets tax free and heirs will avoid the negative IRD tax consequences, while receiving a generous inheritance from other assets in the estate.
Transfers at death, known as testamentary transfers, of savings bonds and commercial annuities to heirs may result in the assets being subject to two tiers of taxation. Typically, IRD assets are included in the decedent's estate for estate tax purposes and distributions to heirs will be subject to income tax. Testamentary charitable gifts of savings bonds and commercial annuities may provide a more favorable outcome. Most estates will not be subject to the estate tax because the lifetime exemption shields estates up to $11.18 million per decedent in 2018, with indexed increases thereafter and a sunset provision in 2025. Charitable solutions can alleviate some of the tax burdens associated with IRD assets and advisors can better serve their clients by understanding the challenges associated with these assets.
Testamentary Transfers of Savings Bonds
The regulations restricting the re-issue of savings bonds will prohibit a charity from being named as a co-owner of the savings bonds. If an individual wants to use a savings bond to benefit his or her favorite charity at death, the best option is to leave a specific bequest of the savings bonds to charity in a will or trust. If a specific bequest of the savings bonds is not included in the estate plan, there are two possible outcomes. If there is no will or trust directive to use IRD assets to fulfill charitable bequests, the estate may be required to recognize the interest income held within the bonds. As a result, the estate would be required to realize ordinary income before the proceeds are passed on to charity. The reduced after tax amount would pass to charity.
Alternatively, if the executor or trustee has the authority under local law to make non-pro rata or in-kind allocations, the estate may be able to avoid tax on the savings bonds. PLR 9537011. If local law is silent on the matter, the estate document may specifically provide that the savings bonds can be used to satisfy charitable gifts from the estate and the estate will avoid income taxation on the interest accumulated in the bond. If savings bonds are used to satisfy pecuniary bequests or bequests of specific dollar amounts, savings bonds may be subject to income tax within the estate. PLR 9507008.
If a qualified charity receives savings bonds, it may be able to redeem the bonds tax free. If the savings bonds were not subject to income tax at the estate level, they will escape taxation completely because the charity will not be taxed on the redemption. Savings bonds will avoid income tax at the estate level if the testamentary transfer was either a specific bequest of the savings bonds or there is authorization under local law that permits the executor to satisfy charitable bequests with IRD assets. The estate will avoid the estate tax on the savings bonds and the charity is exempt from taxation. This is a great result for the estate and the charity.
Linda was the executor of her mother's estate. Her mother left the residue of her estate to charity in her will. The will provided that IRD assets were to be used to satisfy charitable gifts. Linda used the savings bonds to satisfy the charitable bequest. The estate avoided paying estate tax and the heirs avoided income tax on the savings bonds. The charity did not owe income tax on the savings bond received and was able to use the entire value for its charitable purpose.
Testamentary Transfers of Commercial Annuities
In some instances, a commercial annuity may offer a death benefit to a beneficiary of the annuitant's choice. If an annuity has already been annuitized, a testamentary transfer may be the only option for a gift to charity. A commercial annuity is generally not controlled by an estate planning document. The annuity administrator will distribute the death benefit according to the beneficiary designation form.
A beneficiary designation form is the controlling document that dictates how the account is distributed after the accountholder's death. The beneficiary designation form can be obtained from the account administrator or custodian. It is a fairly simple and easy way to change the beneficiary on an account.
The owner may designate a primary beneficiary, a contingent beneficiary or split percentage beneficiaries. Generally, distributions from the annuity contract will be subject to income taxation. The heir may choose a lump sum, a five-year payout or to annuitize the payout. Heirs will be subject to income tax on the annuity proceeds regardless of the payout chosen.
A charity may be listed as a designated beneficiary of a commercial annuity. If a qualified charity is the beneficiary on the beneficiary designation form, any distribution received from the commercial annuity will be estate and income tax free. The charity will be free to use the entire proceeds for its charitable purposes.
Edward listed his favorite charity as the designated beneficiary of his commercial annuity. His annuity contract offered substantial death benefits for his beneficiary. Later in life, Edward created a will. The will stated that his entire estate was to be given to his niece Elizabeth. When Edward passed away, the commercial annuity was distributed according to the beneficiary designation form he completed, not according to his will. Edward's favorite charity received the proceeds from his commercial annuity and Elizabeth received the other assets from her uncle's estate.
Transfers of savings bonds and commercial annuities generally have similar tax treatment. Outright gifts to charity have the same tax deduction limits as gifts to fund charitable gift annuities or charitable remainder trusts. The unrealized ordinary income will be recognized at the time of transfer. Lifetime transfers of cash proceeds from savings bonds or commercial annuities may generate large charitable deductions, which can be used to offset the tax consequences of the transfer.
Testamentary transfers may be more attractive to donors. If the gift is structured correctly, the asset will avoid estate and income tax. The charity is able to cash in the asset tax free, as well. The estate will receive an estate tax deduction, however, most estates will not reach the threshold for taxation. A testamentary transfer to charity will allow heirs to avoid recognizing taxable income from the IRD asset and allow the entire proceeds to be gifted to charity.
Individuals may have commercial annuities or savings bonds that have been held for many years and may be interested in using those low-yield assets to make gifts to charity. By understanding the options and strategies that are available for transferring these low-yield investments, advisors can better serve their clients and provide creative solutions that will benefit the client and achieve their personal and financial objectives.
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TCJA and Charitable Remainder Trusts
The Tax Cuts and Jobs Act (TCJA) was the most comprehensive change in tax law since 1986. While there have been voluminous comments and articles on the business and personal tax effects of TCJA, the bill also has potential impact on charitable remainder trust accounting.
In an article titled "Impact of the TCJA on Trust and Estate Income Taxation," American University Professor Donald T. Williamson discussed the potential impact of Sec. 199A and the repeal of miscellaneous tax deductions on charitable remainder trusts (CRTs).
A CRT is generally exempt from income tax. If it has unrelated business income (UBI), 100% of that UBI is forfeited as an excise tax. Sec. 664(c)(2). Therefore, the CRT does not need or qualify for a Sec. 199A deduction. Prop. Reg. 1.199A-6(d)(3)(5).
The accountant for the CRT must track the four-tier amounts for ordinary income, capital gain (with sub-tiers for short term gain, tangible personal property gain, straight line depreciation gain and long term gain), other income (tax-free payments) and return of principal.
However, a CRT beneficiary may qualify for a Sec. 199A deduction. The "taxable recipient of a unitrust or annuity amount from a CRT may take into account the CRT's qualified business income (QBI), real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income to determine the recipient's Section 199A deduction."
Assume a CRT has investment income of $500 and qualified REIT dividends of $1,000. The CRT distributes $1,000 as a unitrust amount to a beneficiary. The $1,000/$1,500 ratio is 66.67%. The beneficiary receives that percentage of income taxed at the same rates, or $333 of investment income and $667 of REIT dividends.
The CRT also distributes a proportionate amount of the Form W-2 wages and unadjusted basis immediately after acquisition (UBIA). If the QBI, REIT dividends or PTP income are unrelated business taxable income (UBTI), they are subject to the 100% excise tax.
TCJA also repealed the miscellaneous deductions for trusts. However, "Sec. 67(e) provides that estate and nongrantor trusts may continue deducting costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate."
Examples of the deductible fees are fiduciary attorney or accounting fees. Therefore, "all ordinary and necessary expenses attributable to the production of income from real property remain deductible."
Editor's Note: CRTs generally invest in securities with a goal of avoiding UBTI. The combination of the Sec. 664 four-tier and the Sec. 1411 Medicare tax accounting rules create substantial complexity. If the CRT also has QBI that is not UBTI, the process is even more complex. CRT accounting in the future will continue to be a very specialized field.
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Representative Opposes SALT Charitable Deduction Limit
On April 1, 2019, Rep. Josh Gottheimer (D-NJ) sent an open letter to IRS Commissioner Chuck Rettig. Gottheimer opposed the IRS limits on state tax credits for charitable gifts.
In REG-112176-18 (effective August 27, 2018), the Service published Proposed Regulations to limit the benefits of state tax credits for charitable gifts. The Tax Cuts and Jobs Act limited state and local tax (SALT) deductions to $10,000. Sec. 164(b)(6). Because several states with higher tax rates had many affected taxpayers, a number of states passed new tax credit plans in an attempt to replace the lost SALT deductions.
Under the proposed regulations, a state tax credit is "quid pro quo" and reduces the federal charitable deduction by the amount of any state or local tax credit received for the donation. Thus, if a state resident gives $20,000 to a state charity and receives a $20,000 state tax credit, the federal charitable deduction is zero. Prop. Reg. 1.170A-1(h)(3)(i).
The "reduce the federal deduction" rule also applies to a state deduction that exceeds the charitable gift amount. An exception applies for a state tax credit that is not more than 15% of the gifted amount. Prop. Reg. 1.170A-1(h)(3)(vi). Gifts with a state credit at or below 15% qualify for a full federal charitable contribution deduction.
Gottheimer noted that the Tax Cuts and Jobs Act "includes no reference to new limitations on the charitable deduction that you have proposed in this regulation. There are over 100 programs that permit a state tax credit for charitable gifts. Under the proposed regulation, the state tax credits over 15% are considered 'quid pro quo' gifts and reduce the federal deduction. The 'quid pro quo' rule effectively eliminates the benefit for state programs that were designed to bypass the federal $10,000 SALT deduction limit."
The state credits support many social programs, rural hospitals and schools. These charitable programs need support because they are "crucial funding mechanisms for families, entities, and communities. Such a significant change requires explicit congressional action, particularly as this represents a significant tax increase on many Americans in at least thirty-three states."
In the view of Gottheimer, the proposed "quid pro quo" rules are arbitrary and capricious. The IRS "suddenly wants to reverse decades of precedent and court cases."
Editor's Note: Many tax professionals had hoped the IRS would publish final regulations on the charitable deduction limits connected with state credits prior to the April 15 filing deadline. Most tax software companies calculated the charitable deduction using the "quid pro quo" principal specified in the proposed regulations. The tax preparation community awaits the final regulations.
An Interview with Donna Vincenti
The Community Foundation recently sat down with Northwest Connecticut estate planning attorney Donna D. Vincenti to discuss her work advising charitably inclined clients on gift options, tax advantages, and common concerns related to charitable gift planning.
An Interview with Donna Vincenti
The Community Foundation recently sat down with Northwest Connecticut estate planning attorney Donna D. Vincenti to discuss her work advising charitably inclined clients on gift options, tax advantages, and common concerns related to charitable gift planning.
NCCF: When does the topic of charitable giving arise when working with clients?
DV: My estate planning questionnaire that clients complete before we begin the planning process asks if the client has any charitable goals or objectives. About 10-15 percent of clients do. It’s most often a childless couple or a single or widowed client who doesn’t have dependents. Sometimes it’s folks who have a lot of wealth to spare and have been thinking in terms of charitable giving. Often, those who have not given much thought to charitable giving decide to leave a charitable gift as a contingency in the event that all of their loved ones predecease them.
NCCF: Tell us about some of the options for clients who want to give back to their community.
DV: There are a lot of options. If a client wants to make a substantial charitable gift, but wants to retain income for a spouse or child, they might consider a Charitable Remainder Trust (CRT), which would guarantee a fixed income with the charitable goal met at the end of the spouse’s or child’s life. Some clients want to make an outright charitable gift to a charity, but have concerns about how that charity will manage the money and/or what that charity’s mission might be in the future. In that case, I might recommend a designated, field-of-interest or donor-advised fund* with NCCF.
NCCF: Tell us about the tax considerations that affect charitable giving.
DV: Tax considerations come into play when we discuss how to achieve charitable goals. If a client’s required IRA distribution is more than he or she needs or wants added to taxable income, I might suggest a charitable rollover into a field-of-interest fund. With CRTs, clients get a deduction based on an actuarial calculation of the amount passing to charity after the recipient has passed away. A Charitable Lead Trust, where a charity receives a percentage of the fund for a number of years and the client’s children or grandchildren receive the remaining balance, offers a substantial deduction when interest rates are low. There are many tax advantages to giving, but people are not typically motivated by the tax savings. When clients have a charitable goal, I might look at their estates and say, ”here’s one way to accomplish what you want to accomplish and also get a tax deduction.” It‘s just an extra benefit.
NCCF: What are some missteps that can occur when clients make major gifts without the assistance of a knowledgeable advisor?
DV: Most people are concerned about the management of a large gift, especially if it’s given to a small organization–and for good reason. A small organization may not be able to afford an investment manager, leaving financial decisions to its Board. I have seen organizations make less than advantageous investment decisions. One charity put all of its money into an annuity and couldn’t touch it for seven years without a penalty; another received hundreds of thousands of unrestricted dollars through a donor’s will and spent all of it on one project instead of creating an endowment. I’ve also seen many private foundations created from estate plans in situations where they were not appropriate.
If an advisor has a client who expresses the desire to make a charitable gift and that advisor isn’t familiar with the various giving options, he or she should seek advice from someone who is—NCCF staff, the client’s accountant, or an attorney who practices tax law. I always recommend my clients work with a team of experts.
NCCF: What do you want other professional advisors to know about working with NCCF?
DV: NCCF is a facilitator for charitable giving within Northwest CT. I think people might assume that if you contact the Community Foundation there might be some pressure to make a gift. NCCF staff are happy to guide people in the appropriate direction for their giving. Community Foundations are great vehicles for accomplishing and facilitating clients’ charitable goals. People almost never initially say,“I’m going to make a gift to the Community Foundation,” but they have a certain area in mind, whether it’s specific organizations they’d like to support, a scholarship fund, or a cause, like the environment, a gift in memory of someone they love. They soon realize that NCCF is a great place to explore different options for achieving charitable goals.
In the wake of natural disasters, national tragedies and medical misfortunes, donation-based crowdfunding campaigns seek to raise funds to help those in need. Online crowdfunding platforms make it possible for individuals to create campaigns within minutes of a disaster striking. By utilizing social media and other web-based platforms, campaign organizers are able to publicize their campaigns and collect thousands of dollars in donations for their causes.
Crowdfunding as a fundraising method has sky rocketed in popularity in recent years. A 2016 study from the Pew Research Center found that 22% of American adults surveyed had contributed to a crowdfunding campaign. Yet, despite this rise in popularity, there is little to no guidance for donors and advisors regarding the tax consequences of making donations to non-qualified charitable crowdfunding campaigns. The IRS has not released guidelines for these types of donations, leaving advisors to rely on traditional tax concepts to interpret how transfers to crowdfunding campaigns should be treated for tax purposes.
This article will examine donation-based crowdfunding and shed light on several issues for advisors to consider. Along with income and gift tax implications, there are also practical considerations that must be taken into account. These considerations include accountability for funds raised and whether donations will help—or hinder—the ultimate beneficiary of the campaign funds. By understanding the potential issues that exist in the murky waters of donation-based crowdfunding, advisors will be better prepared to work alongside their clients in order to guard against unwelcome and unexpected tax consequences in the future.
Crowdfunding is the practice of funding a project, charitable campaign, personal campaign or commercial venture by raising money from large numbers of individuals through a variety of online platforms. There are various types of crowdfunding, including donation-based, reward-based, equity-based and debt-based crowdfunding. This article will focus on donation-based crowdfunding, where individuals give money for a cause, project or person without receiving anything in return.
There are numerous crowdfunding platforms that serve as webhosts for individuals to launch their crowdfunding campaigns. GoFundMe is one of the leading donation-based crowdfunding platforms, with over $5 billion raised since its launch in 2010. Crowdfunding platforms, like GoFundMe, serve as the web host for the campaign, manage donations and track the campaign's progress.
Individuals who are not affiliated with qualified charities can set up crowdfunding websites to raise money for a variety of needs, including funeral costs, hospital bills, housing costs and adoption fees. Crowdfunding campaigns are also often sparked by the occurrence of national tragedies. Numerous campaigns were launched to help victims of the Las Vegas shootings, California wildfires and Hurricane Harvey. These campaigns gain attention by being shared across social media platforms and are often set up to benefit a friend or relative in need. One of the largest crowdfunding campaigns was set up to help victims of the Las Vegas shooting in October 2017. The campaign raised more than $10.8 million in its first 15 days.
Qualified Sec. 501(c)(3) charities are also entering into the crowdfunding arena. By creating crowdfunding pages, charitable organizations are able to appeal to a diverse field of donors and promote their charitable causes. In other instances, qualified public charities have partnered with existing crowdfunding campaigns. It is important to note, however, that some crowdfunding platforms charge a "platform fee" to public charities that use their websites. Thus, if an individual is considering giving to a qualified public charity's crowdfunding campaign, he or she may want to research the crowdfunding platform to see if it assesses a fee on public charities. If so, it may be preferable to give directly to the public charity itself in order to avoid reducing the total amount transferred to the charitable cause.
Is the Donation Tax Deductible?
The IRS permits taxpayers who contribute to qualified charitable organizations, as defined in Sec. 170, to deduct their contributions. Therefore, donors who give directly to public charities are accustomed to receiving charitable income tax deductions for their gifts.
What happens, however, when an individual makes a donation to a crowdfunding campaign? Is that contribution deductible? The answer is — it depends. If the crowdfunding campaign is run by a qualified, 501(c)(3) organization, then the contribution may be deductible. If the campaign is organized and run by an individual or a group that has not received tax-exempt status from the IRS and is not a qualified charitable organization, then the donation will not be deductible.
How can individuals tell whether or not their contributions to a crowdfunding campaign are going directly to a charitable organization? Some crowdfunding platforms will clearly label the campaign as one that is benefiting a qualified, or "certified," public charity. Alternatively, the organization itself will typically make it clear if it has tax-exempt status. In addition, advisors can urge their clients to look up the name of the organization on the IRS's "Tax Exempt Organization Search" tool on irs.gov.
In general, as a rule of thumb, if a crowdfunding campaign's website does not clearly indicate that donations are being made to a qualified charity, then it is unlikely that contributions will be tax deductible. In addition, if the campaign is raising funds for a specific individual, rather than the general public, then donations are not likely to be deductible. See PLR 201701021. This is because gifts to public charities must be made either "to" or "for the use of" the charitable organization in order to be deductible. A donation made to a qualified charity to benefit a specific individual is not deductible, regardless of how deserving that person may be. As such, if a crowdfunding campaign is requesting donations to pay for a specific individual's medical costs, rebuild a particular family's home or cover an individual's funerals costs, then those donations will not be deductible charitable contributions.
Becca was heartbroken after seeing television coverage of the most recent wildfires spreading across California. She wanted to make a contribution to the cause and discussed her options during her monthly meeting with her advisor, Garrett. Becca mentioned that she saw a Facebook post for a crowdfunding campaign that was established to help rebuild a family's home that had been destroyed by a wildfire. Garrett sat down with Becca to take a look at the campaign's website. After reviewing the campaign's information, it was clear that the campaign was not being organized by an exempt, qualified charitable organization because the funds raised would be going to only one family in particular. Upon closer examination, it was evident that the campaign was organized by a family member rather than a qualified charity. As such, Garrett suggested that they conduct more research to identify an exempt charitable organization providing similar support to affected families in the area. A simple internet search provided plenty of options and qualified organizations for Becca to choose from. Becca decided to make a contribution to a tax-exempt organization that will help to rebuild homes in the aftermath of the wildfires. As an added bonus, Becca will be entitled a charitable income tax deduction for her donation.
Is the Donation a Taxable Gift?
For donations to crowdfunding campaigns that are not organized by qualified charities, there is uncertainty regarding whether the donor may be required to report a taxable gift when he or she transfers funds to a crowdfunding campaign. In general, when an individual transfers funds or property to another individual, he or she may be required to file a Form 709 gift tax return. The annual gift tax exclusion allows individuals to transfer up to $15,000 per person, in 2018, without filing a gift tax return. For the annual exclusion to apply, the transfer must be considered a completed, present interest gift. Sec. 2503(b). This means that the gift recipient must have immediate use, possession or enjoyment of the property or income. Reg. 25.2503-3(b).
Gift tax issues arise in the crowdfunding arena where a campaign is organized not by a public charity but by an individual or group on behalf of an individual or group of individuals. This is because transfers to public charities qualify for an unlimited charitable gift tax deduction. Alternatively, if a donor transfers funds to a campaign that is raising money to cover costs of a child's medical bills, the donor has technically has made a taxable gift and may have to file Form 709. If the donation is less than $15,000, the donor may be able to argue that the transfer qualifies for the annual exclusion. However, under certain circumstances, that argument may fail to persuade the IRS.
Is the Donation a Completed Gift?
As stated above, the gift tax exclusion applies if the gift has been completed. Regulation 25.2511-2(b) explains that a gift is not complete if the donor reserves the power to revest the beneficial title to the property in himself. For crowdfunding sites, if the donor is able to claim a refund for his or her donation, is the transfer an incomplete gift for gift tax purposes? Alternatively, is the gift incomplete until the funds are distributed from the campaign to the beneficiary or cause?
The IRS has not provided a definitive answer to questions regarding the gift tax implications for contributions to donation-based crowdfunding campaigns. The only guidance that the IRS has provided in the area of crowdfunding was in Information Letter 2016-0036. This letter, however, focused not on donation-based crowdfunding but on reward and equity-based crowdfunding. As such, advisors must look to established gift tax principles to guide clients who plan to make contributions to an independent crowdfunding campaign. Advisors counseling clients through the donation process should review the crowdfunding site's terms of service, along with the terms of the payment processor for the site. In addition, the terms may be subject to state-specific laws and, as such, the controlling state's laws should also be considered.
Is the Donation a Present Interest Gift?
If the donation is determined to be a completed gift, then the next inquiry for the donor and advisor is whether the gift qualifies for the annual exclusion as a present interest gift. If the donation is going to benefit a large number of potential recipients, who cannot be presently determined, then the donation may not qualify as a present interest gift. Reg. 25.2503-3. In addition, if the campaign organizer is holding the donations in trust for the ultimate recipient, then the gift may not qualify as a present interest gift until the recipient has the right to the immediate use, possession or enjoyment of the funds. Reg. 25.2503-3(b).
In these situations, advisors should talk to the campaign organizer. If the recipient has the ability to withdraw the funds immediately, then the donation may qualify as a present interest gift under Sec. 2503. This could be accomplished by attaching a Crummey power to the trust, which would provide the recipient the right to withdraw the donor's gift from the trust for a limited period of time. See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). Do note, however, that if the trust is set up as a special needs trust, giving the beneficiary the right to withdraw the transferred funds could jeopardize the purpose of the special needs trust and put the beneficiary's needs-based government assistance at risk.
Because of the uncertainty in this area, guidance from the IRS is needed to clarify the gift tax implications for donors giving to crowdfunding campaigns. In the meantime, advisors should educate their donors on these issues and help steer them in the right direction. If the donor is worried about exceeding his or her lifetime exemption amount, it may be preferable to give directly to a public charity to avoid any gift tax questions or unforeseen consequences. By giving directly to a public charity, not only will the donor not have to file a Form 709 gift tax return, the donor will be entitled to a charitable income tax deduction for the amount of the gift.
Will the Donation Jeopardize the Recipient's Needs-Based Benefits?
For those receiving needs-based government assistance, like Medicaid, Supplemental Security Income or other income-based support, receiving a large sum of money through a crowdfunding campaign could jeopardize important benefits. Even though the funds received through a crowdfunding campaign are considered gifts rather than taxable income to the beneficiary, for purposes of qualifying for certain government assistance, the beneficiary's resources as a whole—not just the beneficiary's taxable income—are taken into account.
For example, to be eligible to receive Supplemental Security Income (SSI), an individual's countable resources cannot exceed $2,000 (or $3,000 for a couple). For purposes of SSI, countable resources include, cash, stocks, bonds, real estate (other than the individual's residence), life insurance and other deemed resources. Thus, if the beneficiary of a crowdfunding campaign receives a large sum of cash or property, then he or she could be at risk of losing needs-based government assistance.
Because of these concerns, advisors should encourage clients who are considering giving to a crowdfunding campaign to contact the campaign organizer to ensure that the donation will not do more harm than good by putting the campaign recipient's government benefits at risk. One way to safeguard the donations is to ensure that the funds raised are not deemed the property of the campaign recipient. This may be accomplished by channeling the donations to a carefully drafted special needs trust. By sending the funds directly to a special needs trust, the recipient's benefits may be protected and the donations used to pay for costs that Medicaid and other needs-based benefit programs will not cover. (Note, however, that if a donor makes a contribution to a special needs trust, this may require the filing of a Form 709 gift tax return, since the contribution will not be a present interest gift for purposes of the gift tax annual exclusion amount. See the above present interest gift tax discussion for more information).
Will the Funds be used for the Campaign's Stated Purpose?
In addition to the tax implications and uncertainties surrounding crowdfunding donations, there are other potential issues to consider. When donors make gifts to crowdfunding campaigns that are not created by qualified charities, they run the risk that their donations will not be used as intended. Unlike qualified public charities, which must submit annual filings to the IRS and are subject to oversight by regulators and boards of directors, independent crowdfunding campaigns are not subject to government regulation. The terms of GoFundMe's website warn donors that "All Donations are at [their] own risk" and that it assumes "no responsibility to verify whether the Donations are used in accordance with any applicable laws."
While many crowdfunding platforms have procedures in place to guard against misuse and fraud, with the number of crowdfunding campaigns increasing each year, there have been numerous reported instances of scammers using crowdfunding pages to tug on the public's heart strings in order to unlawfully acquire large sums of cash. For example, in 2015 a thief set up a crowdfunding campaign to pay for the funeral of a Fayetteville, NC family killed in a house fire, when, in reality, the fire and the family did not exist. In another instance, a Brighton, MI resident falsely claimed to be suffering from stage-four breast cancer and raised more than $31,000 from nearly 400 people using a crowdfunding website. In other instances, criminals have claimed to be raising funds for real events and individuals but never transferred the funds to the specified person or cause. While sometimes the scammers are caught, in other instances they are able to take off with thousands of dollars.
It is important to note, however, that the majority of crowdfunding campaigns are organized for legitimate purposes. GoFundMe estimates that fraudulent campaigns make up less than one tenth of one percent of its campaigns. Still, advisors should counsel their clients to do their research and exercise caution before handing over a donation to a crowdfunding campaign in order to ensure that the funds will be used exactly as intended. Clients should be encouraged to thoroughly research the campaign and cause or, alternatively, only give to a campaign if they know the organizer or organization. Alternatively, donors could choose to donate directly to a qualified public charity instead. This may offer clients peace of mind in knowing that appropriate safeguards and regulations are in place to protect their donations.
With the number of donation-based crowdfunding campaigns increasing each day, it is important that advisors educate their clients on the possible implications of their contributions. Without firm guidance from the IRS or federal legislation stating otherwise, it can be assumed that contributions to crowdfunding campaigns that are not organized by public charities may be considered reportable gifts for gift tax purposes. For clients with taxable estates, this is an important consideration and topic of discussion.
Additionally, clients may incorrectly assume that every donation to a crowdfunding campaign qualifies for a charitable income tax deduction. By explaining that a charitable income tax deduction only applies if the campaign is organized by a qualified tax-exempt charity, advisors can ensure that their clients are giving in a way that meets both their financial and philanthropic goals. Often times, it may be preferable to give directly to a charitable organization in order to ensure that the client's donation qualifies for a charitable deduction and that it will be used for the organization's stated purpose. Because public charities are subject to government oversight and regulation, not only does the donor receive comfort in knowing that the funds are safeguarded but he or she can also be assured that the beneficiary's needs-based government assistance will not be jeopardized.
While a donation to a crowdfunding campaign may be motivated by noble and altruistic intentions, it is important that donors know to exercise caution before handing over a large sum to a crowdfunding campaign. Not only is the campaign's legitimacy something that should be considered, but the tax treatment of the donation should also be on the forefront of the donor's mind. Until further guidance is provided by Congress or the IRS, advisors should discuss the issues raised in this article with their clients in order to prevent unintended tax and legal consequences. With an understanding of the issues involved with donation-based crowd funding, advisors can arm their clients with knowledge that will protect their best interests and fulfill their charitable and financial objectives.
IRS Tax Treatment of Cryptocurrency
Cryptocurrency is an encrypted form of digital virtual currency which has grown in prominence, as its most popular variant, Bitcoin, has exploded in value in recent years. With increased popularity comes increased curiosity as to the tax treatment of cryptocurrency. Many cryptocurrency owners have held onto this unique asset for a number of years, amassing enormous growth. Programming changes have left many cryptocurrency owners holding several forms of digital assets. These owners now wonder how their digital currency will be taxed if they transfer it and whether charitable solutions exist similar to those for gifts of cash or appreciated property.
The IRS addressed several questions related to the taxability of virtual currency when it issued Notice 2014-21. However, certain questions remain unaddressed by the Service. This article will explore the basic function of cryptocurrency and the tax treatment surrounding transfers of cryptocurrency.
What is Cryptocurrency?
While Bitcoin may, at times, seem to be virtually synonymous with "cryptocurrency," it is merely the most prominent member of its class. Other cryptocurrencies, such as Litecoin, Ethereum and Ripple have become major players in the world of virtual currency. The rise in popularity of cryptocurrency has led to questions about what it is and how (or even whether) it is taxed.
In 2014, the IRS took a first step toward addressing the taxation issues surrounding virtual currencies. In Notice 2014-21, the IRS defines virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value." Virtual currency has been touted in recent years as a potential replacement for standard currency. Whereas standard currency is issued and regulated by a governmental entity, virtual currency is usually decentralized and is not issued by any government.
Cryptocurrency is a subset of virtual currency. It is distinguished by its use of cryptography for security. Cryptocurrency transactions are recorded on a digital ledger known as a blockchain. As its name suggests, each transaction for the cryptocurrency creates a new block in a chain of transactions. The ledger is stored in various places and contains cryptographic identifiers, known as hashes. Each block in the chain contains its own hash and that of the previous block. The presence of these identifiers and the wide distribution of the ledger greatly reduce the blockchain's susceptibility to tampering.
How is Cryptocurrency Treated by the IRS?
According to Notice 2014-21, cryptocurrency is treated as property. A taxpayer who acquires virtual currency as a payment for goods or services has a cost basis equal to the fair market value of that virtual currency on the date of transfer. Any gain or loss related to the sale of cryptocurrency is treated the same as a sale of other appreciated or depreciated property.
The type of gain or loss the taxpayer must recognize upon disposition of virtual currency "depends on whether the virtual currency is a capital asset in the hands of the taxpayer." Notice 2014-21 notes the difference in the tax treatment of capital assets, such as stocks and bonds, from non-capital assets, such as inventory. Therefore, if the taxpayer holds the virtual currency in a manner consistent with the capital asset rules, it will be taxed in the same manner as a capital asset upon disposition.
Bitcoin, for example, was created in 2009 using an algorithm that limits the total number of possible Bitcoins in existence to 21 million. New Bitcoins are discovered through a process called mining. The mining process involves the use of particular software to solve a complex equation. As more Bitcoins are discovered, the difficulty of the equations increases. In Notice 2014-21, the IRS explained that a taxpayer who has mined Bitcoins or other virtual currency has generated ordinary income through the mining activity.
If an individual holds Bitcoins or other virtual currency as a dealer-one who holds it as inventory-any increase in the value of the virtual currency will be treated as ordinary income. In contrast, a non-dealer individual investor will hold the virtual currency as a capital asset. The taxpayer will realize capital gains upon sale of the property.
Amy operated a successful Manhattan restaurant. One day, in the summer of 2010, she received an odd request from a potential customer. He called in a takeout order and was interested in paying with Bitcoin. Having heard of Bitcoin, and willing to take a risk on a small order, Amy accepted the order and received payment of 5,000 Bitcoins in exchange for the entrée. On the date the purchase was made, the fair market value of 5,000 Bitcoins was $20.
Although amused by the transaction, Amy filed away her receipt and forgot about her modest Bitcoin holding until a news article discussing the rising value of cryptocurrencies caught her eye three years later. After digging up her information, Amy was elated to find that her 5,000 Bitcoins were now worth $3,000,000. Amy decided that she did not want to risk a tremendous loss in value by holding onto the Bitcoins for any longer. She quickly decided to sell the Bitcoins, putting some of the cash toward paying off loans and using the rest to expand and improve her restaurant.
Having sold the Bitcoins for $3,000,000, with a cost basis of $20, Amy incurred a capital gain of $2,999,980. At the top capital gains rate of 23.8%, Amy had a tax bill of $713,995 from the sale. She therefore received $2,286,005 from the sale of her once $20 asset.
Using Cryptocurrency to Fund a Charitable Gift
Because holders of virtual currency face the same capital gains tax ramifications as owners of other appreciated assets, many will find similar charitable solutions to be attractive. Outright gifts, charitable gift annuities and charitable remainder trusts are all potential solutions to the capital gains tax problem. As with other gifts of appreciated property, it is important to keep in mind that the donor will need a qualified appraisal in order to substantiate the value of a donation of virtual currency in excess of $5,000 in value.
Advisors and donors should be mindful that the relative novelty of cryptocurrency could be an obstacle in circumstances where owners wish to transfer ownership of these digital assets to charitable organizations. While there are many organizations that have begun accepting cryptocurrency donations, there are many others that have not yet tested the waters. For these organizations, charitable gifts that require a transfer of legal ownership directly to the charity may not be an option.
One alternative solution is for the owner to establish a charitable remainder trust, naming the charity as the beneficiary of the trust. The owner then transfers units of cryptocurrency to the trust, which may then sell the cryptocurrency and reinvest. This generates both a payout stream and a charitable deduction for the donor and a residual benefit for the charity, without the charity having to take ownership and possession of the cryptocurrency.
Instead of selling her 5,000 Bitcoin, Amy's tax advisor recommends that she consider creating a charitable remainder unitrust with a portion of her cryptocurrency and sell a portion. This strategy will allow her to offset a portion of her capital gains tax from the sale of her Bitcoin holding with a charitable deduction. She would receive an immediate lump sum of cash from the sale and lifetime payouts from the unitrust. Working with her advisor, Amy determines that she can zero out the taxation on the sale of $1,120,500 worth of Bitcoin if she uses $1,879,500 to fund a one-life charitable remainder unitrust. She will bypass a portion of her capital gains by funding the unitrust and will receive an initial annual payout of $93,975, which could increase over time, depending on the performance of the trust's investments. Given her age at the time the trust is created, she may have 30 years of payouts, potentially totaling $3,263,000.
Determining the capital gains allocated to a cryptocurrency can be relatively straightforward. For cryptocurrency acquired by purchase, the owner's cost basis is equal to the amount paid for the property. The cost basis of a cryptocurrency received as a payment for goods and services is the fair market value of the cryptocurrency on the date of receipt. However, there are other ways a taxpayer may acquire cryptocurrency, which can make the valuation process more difficult.
When a software coding change is proposed to a cryptocurrency, the change will bring about what is called a fork. The fork creates an alternate path in the blockchain. A fork may either be a soft fork or a hard fork. A soft fork will result in a change to the makeup of all future blocks in the blockchain. This might occur if there is agreement as to how the blockchain should be modified. While there is a change to all future blocks in the chain, no new asset is created in the hands of the owner of the virtual currency.
A hard fork, on the other hand, creates two divergent paths for the blockchain, resulting in completely separate cryptocurrencies. Anyone who owns units of a particular cryptocurrency prior to a hard fork will continue to own the same number of units of that cryptocurrency, along with an identical number of units of the new cryptocurrency.
Bitcoin, for example, has experienced multiple hard forks. On August 1, 2017, Bitcoin owners received the newly created Bitcoin Cash in an amount equal to the number of Bitcoins that the owner originally held. Similar hard forks occurred on October 24, 2017 and February 28, 2018, creating Bitcoin Gold and Bitcoin Private. Anyone who held units of Bitcoin prior to August 1, 2017 and did not dispose of them prior to March of 2018, subsequently held an equal number of units of Bitcoin, Bitcoin Cash, Bitcoin Gold and Bitcoin Private. Hard forks have the potential to generate extra value for the owner of cryptocurrency, since the holder of one unit of a particular cryptocurrency can eventually become the holder of units of multiple distinct and separate cryptocurrencies following a series of hard forks. However, this increase in value to the owner depends on the ability of the new cryptocurrency to gain traction in the market. If the new cryptocurrency is not well-received, the owner may end up with little or no increased value.
The pressing question for the owner of cryptocurrency acquired through a hard fork is whether the new property is treated as taxable income. Under IRC Sec. 61, gross income is defined as "all income from whatever source derived." Absent specific guidance from the IRS to the contrary, the most conservative approach is to treat the new cryptocurrency as ordinary income on the date it is created. Under this theory, the cryptocurrency owner will realize ordinary income for the year in which the hard fork occurred, equal to the new cryptocurrency's fair market value on the date of the fork.
Tim purchased three units of the latest and greatest cryptocurrency, OldCoin, a few years back for a total of $300 as a long-term investment. The value of Tim's three units of OldCoin has reached $8,200. Tim is aware that OldCoin experienced a hard fork on the first day of December and decided to meet with his advisor to determine the effect of the hard fork on his small cryptocurrency investment. Tim's advisor explains that, due to the hard fork, Tim now owns three units of OldCoin and three units of NewCoin. The advisor then tells Tim that he may need to report the value of the new cryptocurrency as ordinary income on his tax return. Tim and his advisor determine that each unit has a fair market value of $250 on the date of the hard fork. Because Tim holds three units of an entirely new asset at $250 per unit, he will recognize an additional $750 in income for the year. Tim accordingly reports the small bump in income for his 2017 taxes.
Tim decides to hold onto the three OldCoins and three NewCoins for five years, at which point his original three units have appreciated to a total value of $20,000. His newer cryptocurrency has reached a fair market value of $10,000. Eager to cash in on his modest $300 investment, Tim decides to sell all six of his cryptocurrency units for a total of $30,000. He returns to his advisor and asks what the tax consequences of the sale will be. Because Tim has held the cryptocurrency for more than one year, his advisor explains that Tim will be taxed at long-term capital gains rates for the sale. Tim's basis in his OldCoin units will be the $300 that he originally invested. Therefore, he will have $19,700 in taxable capital gains upon the sale. His NewCoin units have a cost basis of $750, with capital gains of $9,250.
In a letter dated March 19, 2018, the American Bar Association (ABA) Section of Taxation submitted comments to IRS Acting Commissioner David Kautter, seeking updated IRS guidance on cryptocurrencies and offering recommendations, specifically related to the tax treatment of cryptocurrency hard forks. Among its suggestions, the ABA recommended that the IRS create a temporary safe harbor for cryptocurrency holders who experienced a hard fork in 2017. The ABA Section of Taxation cited "difficult timing and valuation issues" as the impetus for the suggested safe harbor rule. The date on which an owner takes possession of a unit of cryptocurrency has been the subject of debate and may depend on whether the owner holds the unit directly or through an intermediary. A similar difficulty arises as to the valuation of the new cryptocurrency, as there are various online exchanges, each of which may provide a different estimated value on the starting date.
The ABA's proposed temporary rule would treat a hard fork as a taxable event whereby the owner of the original unit of cryptocurrency would realize taxable income with a zero basis in the newly created unit of cryptocurrency. The taxpayer would then have a capital asset that will have capital gain treatment after the owner has held it for more than one year.
Instead of treating the NewCoin as an accession to an additional $750 of wealth in the tax year, Tim and his advisor decide to take a more aggressive approach and claim that Tim's three units of NewCoin had a zero basis on the date of the hard fork. Therefore, his adjusted gross income for the year is not affected by the hard fork. When Tim sells his NewCoin holdings five years later for $10,000, however, he will recognize $10,000 in capital gains.
The ABA's request for updated IRS guidance is just one of many attempts to clarify the tax treatment of cryptocurrency. The IRS has not responded to the ABA's request, or other similar requests for guidance, choosing instead to remain silent in the years following the release of Notice 2014-21. Professional advisors, therefore, are left to determine the proper treatment of their clients' cryptocurrencies by applying general principles of law, despite the fact that those general principles may not be directly on point for this relatively new type of asset.
Cryptocurrency is a new and constantly developing facet of the 21st century economy. While the IRS has provided certain guidelines as to its tax treatment, and general principles of law can be used to fill in certain gaps, the ever-evolving nature of this new type of property means that additional guidance will be required in the years to come. Nevertheless, appreciated cryptocurrency may be a good asset to use to fund a charitable gift, as the owner may receive a tax deduction and be able to bypass capital gains on the cryptocurrency.
The current limited nature of the IRS's guidance regarding the tax treatment of cryptocurrencies affects owners, tax professionals and charitable gift planners, causing uncertainty over the value of potential donors' cost basis and capital gains in their cryptocurrency holdings. Cryptocurrency owners should seek guidance from their professional advisors prior to acquiring, selling or donating units of cryptocurrency. Owners should also beware that they may be deemed to have acquired new cryptocurrency during a given year, thus increasing their adjusted gross incomes, due to a hard fork.
In the News: Charitable Gifts of Intellectual Property Assets
Intellectual property assets are intangible products or creations of the mind that may receive protection under the law. The most common types of intellectual property (IP) that a client might consider gifting to charity include copyrights, trademarks and patents. While making a charitable gift an IP asset can provide a client with tax benefits, the legal complexities that surround these types of gifts necessitate a deeper understanding of these assets prior to making a charitable transfer. As such, it is crucial that advisors have a firm grasp on how these gifts operate in order to best serve their clients' needs and objectives.
This article will explain the basic rules surrounding charitable gifts of IP assets and the opportunities that exist for IP asset owners. It will shed light on the tax benefits associated with charitable gifts of IP and identify practical issues for clients who are considering charitable transfers of IP assets. By understanding the rules and nuances that apply to charitable gifts of IP assets, advisors will be better equipped to guide clients in the right direction and accomplish their goals in a tax-efficient manner.
Common Types of Intellectual Property Gifts
A copyright is an intangible property right that protects original works, including literary, artistic, dramatic, pictorial, graphic, audio, sculptural, audio-visual and architectural works. The owner of a copyright has the exclusive right to reproduce the copyrighted work, to prepare derivative works, to distribute copies of the copyrighted work for sale or lease, to perform the copyrighted work publicly or to publicly display the copyrighted work. A copyright is a property right that is separate from the copyrighted work. For example, an individual might own the copyright to a manuscript and a different person may own the manuscript itself.
A trademark is a word, phrase, symbol or design that is used to identify a maker of a commodity offered for sale. Common examples include company names, logos, taglines and product names. However, a trademark could also be a particular shape, sound, color or scent that is used to identify or distinguish a particular commodity. A trademark can be registered with the United States Patent and Trademark Office (USPTO). Both registered and unregistered trademarks reflect the right to legitimate use of the mark, but only a registered trademark gives the owner the exclusive right to use the mark nationwide on, or in connection with, the goods and/or services listed in the registration.
A patent is an intangible property right that protects an invention. The owner of a patent has the right to exclude others from making, using or selling the patented invention for a number of years. In the United States, the USPTO grants patents to inventors after the inventor publicly discloses the invention by filing a patent application. The most common type of patent is a utility patent, which is granted to an individual who discovers or invents "any new and useful process, machine, article of manufacture or composition of matter, or any new and useful improvement thereof." 35 U.S.C. Sec. 101.
General Rule for Charitable Gifts of Intellectual Property
A donor who makes a charitable gift of an IP asset is entitled to a deduction that is equal to the lesser of the property's basis or fair market value. IP assets are considered capital assets if the taxpayer purchased or inherited the asset. As such, the deduction for charitable gifts of IP assets will be limited to 30% of the donor's adjusted gross income (AGI) in the year of the gift with the excess carried forward up to five additional years.
After the gift is made, the donor may be able to claim additional deductions based on the income produced by the IP asset. Under Sec. 170(m) of the Internal Revenue Code, the donor may be entitled to additional deductions for the percentage of qualified donee income (QDI) derived by the charity from the IP asset. QDI includes any net income received by or accrued to the charity allocable to the IP itself, including royalties or other net income. I.R.C. Sec. 170(m)(3). The deductions may be taken for up to 10 years. Sec. 170(m)(5).
In order to take advantage of these additional deductions, the donor must provide written notice to the charity at the time of the contribution that the gift is to be treated as a qualified intellectual property contribution for purposes of Sec.170(m)(5) and Sec. 6050L. Sec. 170(m)(8)(b). Each year, the charity will be required to report the amount of qualified donee income (QDI) on Form 8899, Notice of Income from Donated Intellectual Property.
The amount of the QDI deductions is determined on a sliding percentage scale basis and is limited to 10 years beginning on the date of the contribution. The deduction is only available for QDI in excess of the donor's original deduction. The deduction amount starts at 100% of the QDI in excess of the donor's original deduction in year 1 and declines to 20% by year 10. Sec. 170(m)(7)
|Tax Year||Deductible Percentage|
Rose invented and obtained a patent for a state-of-the-art inflatable life raft that, despite its compact size, is able to carry twice the number of people as current inflatable models. Her $100,000 cost basis consists of development costs, including material and labor. Experts predict there will be high demand for Rose's patented device and assign a fair market value of $1,000,000 to the patent and device. Rose would like to make a gift of the patent and her rights to the life raft to her favorite charity. Her advisor informs her that, pursuant to Sec. 170(m), the patent is qualified intellectual property and, therefore, eligible for additional deductions after the gift. In order to receive these benefits, Rose's advisor assists her in putting together written notice to her favorite charity of her intention to treat the gift as a qualified intellectual property contribution.
In the year of her gift, Rose will claim a basis deduction of $100,000. The charity, in return, licenses the patent to a manufacturer. Two years later, her favorite charity is beginning to receive substantial royalties. Because the income is derived from the patent, Rose can claim additional charitable deductions. The patent earns $500,000 in year two, which exceeds her original deduction by $400,000. As such, the patent has produced $400,000 of QDI. Assuming that, following year two, the patent produces $100,000 of QDI each year, her deductions will be as follows:
|Year||Deductible %||QDI||Deduction Amount|
The charity will be required to file Form 8899 each year to report the amount of QDI to the IRS and provide a copy to Rose to substantiate her deduction.
Creators of Copyrighted Works and Carry-over Basis Copyright Holders
Copyrights are not considered capital assets if they are owned by the individual who created the copyrighted property or received by an individual as a gift from the creator of the copyrighted property during life (i.e., someone who has received a "carry-over basis" from the creator). Sec. 1221(a)(3); Reg. 1.1221-1(c)(1). As such, these copyright gifts will be subject to the 50% (rather than 30%) AGI deduction limitation. Charitable deductions for gifts of copyrights held by a donor whose personal efforts created the property, or who has received a carry-over basis, will be limited to cost basis.
In addition, gifts of copyrights held by the creator (or a donor who received a carry-over basis from the creator) are not considered qualified intellectual property for purposes of additional QDI deductions under Sec. 170(m). As such, any royalties or net income received by the charity derived from the copyright cannot be deducted by the donor in future years.
Jack is an author of a copyrighted novel. He wants to gift his copyright and his novel to his favorite charity. Jack spent approximately $1,000 on legal fees and costs associated with registering and maintaining his copyright. Because he is the creator of the copyrighted work, his charitable income tax deduction for his gift will be limited to his basis, which in this instance is $1,000. Jack will not be able to claim deductions in future years for royalties that the charity derives from the novel. This is because the copyright is not qualified intellectual property since it was created through the personal efforts of Jack. As such, the total deduction that Jack will be able to claim is $1,000.
Recall that, whether the owner of a copyright can deduct QDI will depend on if the copyright is considered qualified intellectual property under Sec. 170(m). If the donor receives the copyright interest as a gift from the creator of the copyrighted work during life, then the donor will have a carry-over basis from the creator and, therefore, will not be able to deduct QDI. If, on the other hand, the donor inherited the copyright after the death of the creator, then the donor will not have a carry-over basis and will be able to deduct QDI.
Many years later — after authoring numerous best-sellers — Jack gifted one of his manuscripts (manuscript A) and its copyright to his cousin Molly. He also executed his will and provided that his brother, Fabrizo, would receive a manuscript (manuscript B) and its copyright upon Jack's death. Five years after Jack's death, Molly and Fabrizo decide to make charitable gifts of their manuscripts to Jack's favorite charity in his honor. Jack's original cost basis for both manuscripts was $1,000. Upon his death, the fair market value of each manuscript was $250,000.
Because Molly received the gift during Jack's life, her basis is Jack's original basis of $1,000. Therefore, she would receive a $1,000 deduction for her charitable gift. Because she has a carry-over basis from the manuscript's original creator, she will not be able to claim QDI deductions for future royalties received by the charity.
Because Fabrizo inherited the copyright and copyrighted work after Jack's death, his basis is equal to the fair market value of the copyright at Jack's death. Therefore, he will receive a $250,000 basis deduction for his charitable gift. In addition, because he does not have a carry-over basis, the copyright is qualified intellectual property. Therefore, Fabrizo will be able to deduct future royalties received by the charity as QDI.
Partial Interest Rule
Under Sec. 170(f)(3), a charitable deduction will not be allowed where a donor transfers less than his or her entire interest in the property. The partial interest rule may arise in a variety of circumstances related to gifts of IP assets. For example, a donor who owns both a copyright and the underlying copyrighted material cannot claim a charitable deduction if the donor gifts the copyright only and retains the copyrighted asset. The donor who owns both the copyright and copyrighted material must make gifts of both interests to claim a charitable deduction. If, however, the donor only owns the copyright and not the copyrighted work, then he or she could make a charitable gift of the copyright alone and receive a charitable deduction, since the copyright in that instance is the donor's entire interest in the property.
The partial interest rules also dictate that a donor cannot hold onto certain rights related to the IP asset. For example, a donor cannot make a charitable gift of a patent while retaining the right to manufacture the patented product. Nor could a donor make a gift of a trademark to charity but retain the right to prescribe the standard of quality of products or services sold under that trademark. In both instances, the donor would be giving a nondeductible partial interest in the IP asset.
Generally, a charitable gift of property over $5,000 in value will require a qualified appraisal. Reg.1.170A-13(c). However, donations of intellectual property are excluded from this requirement. See IRS Pub. 561 and IRS Form 8283 Instructions. The value of the IP gift will still need to be determined and recorded on Form 8283. As such, the question becomes: how is the value of the IP asset determined?
Typically, the charity will consult an intellectual property valuation professional. Most often, the valuator will determine the IP's fair market value by using an income-based approach. This method forecasts future financial earnings results based on historical financial data, market trends and comparable income for similar assets. Taking these, and other data, into consideration, the valuator will forecast the present value of the IP asset's future income in determining the fair market value of the IP asset.
Unrelated Business Income Tax
Under Sec. 511, the unrelated business income of an exempt organization is subject to tax. Unrelated business taxable income is defined as the gross income derived by any organization from any "unrelated trade or business" regularly carried on by the organization, less the allowable deductions directly connected with the conduct of that trade or business. Sec. 512(a)(1). In the context of IP assets, the question arises whether income produced by a donated IP asset is classified as unrelated business income.
Luckily, under Sec. 512(b)(2) royalties are classified as passive income and therefore not subject to unrelated business income tax (UBIT), except to the extent that the asset is debt financed. The definition of a royalty is exceedingly broad and extends to virtually all payments for the right to use intellectual property. Sec. 1.512(b)-1(b).
Charitable organizations should be cautious, however, before involving themselves in the IP's underlying trade or business. While receipt of passive royalty income is excluded from UBIT, actively participating in, and performing services for, an unrelated trade or business is not. Thus, if income can be traced to services performed, rather than the royalty income, the charity could be opening itself up to risk and potential UBIT consequences. Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996). As such, organizations should exercise caution when executing royalty agreements in connection to donated IP assets.
While a charitable gift of an IP asset can be an effective way to secure tax benefits and accomplish a client's charitable goals, IP owners and their advisors should work together to ensure that the charitable transfer is accomplished in a tax-efficient manner in order to avoid potential issues that can arise. IP owners and their advisors should consider the value of the owners' cost basis relative to the IP asset's fair market value, as well as the estimated value and timing of the asset's revenue stream in future years. These considerations will help the client to arrive at a charitable strategy that will meet personal and financial objectives. While there are many complexities in this area, charitable gifts of IP assets should not be overlooked, as the benefits and opportunities associated with these gifts can often outweigh potential hurdles in the planning process.
Developments with Donor-Advised Funds
Individuals concerned with tax planning often include charitable giving as an important element of their planning strategies. In addition to the satisfaction of knowing that they have contributed to important causes, these taxpayers may also enjoy the charitable income tax deduction that comes with a gift to charity. For many individuals, regular annual outright gifts have satisfied their goals. Under certain circumstances, taxpayers may find that their giving strategies over recent years will no longer produce their desired results. These clients may benefit from a giving strategy that allows them to make a large donation up front and the flexibility to direct the payouts over a number of years.
This article will explore the basic rules related to donor advised funds (DAFs), specifically those regarding charitable deductions and benefits to donors and their family members. It will also discuss recent developments in tax law and policy directly affecting DAFs. Finally, the article will cover scenarios in which the recent changes may encourage taxpayers to consider DAF donations.
Under Sec. 4966(d)(2)(A), a donor advised fund must be (i) "separately identified by reference to contributions of a donor or donors" and (ii) "owned and controlled by a sponsoring charity." In addition, "the donor must have or reasonably expect to have advisory privileges with respect to the distribution or investment of the amounts in the account." Funds or accounts that make distributions to only a single organization are not considered donor advised funds. Sec. 4966(d)(2)(B).
For the fund to be separately identified, it is usually created in the name of a specific donor. The donor can then add to his or her own fund at any time. If a separate account is not created for each donor, then the organization should have a mechanism in place to track the contributions of each donor to the fund.
A charitable organization must have complete ownership of and control over the fund. Sec. 4966(d)(1). The owner of the fund, known as the "sponsoring organization," must be a 501(c)(3) public charity and may not be a private foundation. However, the donor must also reasonably expect to have advisory privileges regarding both investments and distributions. Therefore, a DAF must be clearly owned by a charitable organization and also allow the donor to provide input as to when and where distributions are made.
Normally, the sponsoring organization will abide by the wishes of the donor. However, the donor does relinquish title and control over the funding asset(s) on the date the DAF is funded. Therefore, the sponsoring organization is not bound to follow the donor's advice. If, for instance, the donor advises a gift that is impermissible, either under IRS rules or the sponsoring charity's mission or standards, the sponsoring charity may refuse to make the distribution. Normally, sponsoring organizations will make their best efforts to follow their donors' wishes.
Because DAFs are owned and controlled by Sec. 501(c)(3) public charities, taxpayers may deduct donations in the same way that they would for other gifts to public charities. Donors' deductions are limited to 60% of adjusted gross income (AGI) per year on gifts of cash and 30% of AGI for gifts of appreciated property held for more than one year.
The deduction is taken in the year that the DAF is funded. The donor does not have the option to delay taking a deduction until the DAF makes a distribution to charity. However, if the donor meets the deduction limits in the year the DAF is funded, he or she may carry the deduction forward for up to five additional years.
TCJA Changes and DAF Solutions
In December 2017, Congress passed the Tax Cuts and Jobs Act (TCJA). Among its many changes to U.S. tax law, the TCJA nearly doubled the standard deduction amount. For 2018, the standard deduction is $12,000 for individual taxpayers and $24,000 for married couples filing jointly. This has the likely effect of greatly curtailing the number of taxpayers who itemize their deductions. A vast number of taxpayers who previously itemized their deductions may instead be left with one option: take the standard deduction.
Over the last five years, Darryl has given $10,000 annually to his local homeless shelter and $5,000 to his alma mater. He has a passion for helping care for the homeless and also wishes to do what he can to give back to the university he attended. He has also enjoyed the $15,000 charitable income tax deduction he has received each year. While meeting with his tax advisor regarding this year's tax situation, however, Darryl is dismayed to discover that even with his generous charitable giving, he and his wife Sue will be below the threshold for itemizing their taxes and will instead take the standard deduction for a married couple.
One potential solution to this problem is a gift to a donor advised fund. A taxpayer who might otherwise be disincentivized from making a charitable gift by the newly-doubled standard deduction may be attracted to the flexibility of donor advised fund giving. The taxpayer may find that he or she can continue to itemize by bundling several years' worth of charitable gifts into one year, exceeding the standard deduction threshold.
In an attempt to maximize his tax deduction this year, Darryl asks his advisor if there are any alternative giving methods available. Darryl is pleased to hear his advisor offer a potential solution. Instead of giving $15,000 each year to charity, Darryl can bundle five years' worth of charitable gifts into one year. He decides to use $75,000 of stock to set up a donor advised fund. Darryl takes a deduction up to 30% of his adjusted gross income for the year. Darryl deducts $45,000 this year and then carries forward the remaining $30,000 deduction to next year. During each of the next five years, Darryl directs annual distributions of $10,000 to the homeless shelter and $5,000 to the university.
Donor advised funds are subject to the excess benefit transactions rules of Sec. 4958. An excess benefit transaction occurs when a charity engages in any transaction with a disqualified person whereby the disqualified person receives a direct or indirect benefit from the charity for which he or she did not pay and the value of the benefit exceeds the value of the consideration received. Any grant, loan or payment of compensation to a donor, donor advisor or a relative of the donor (hereinafter referred to as a "disqualified person") is an excess benefit transaction. Sec. 4958(c)(2). The disqualified person who receives the excess benefit will be assessed a tax equal to 25% of the excess benefit. If an organization manager knowingly assists in an excess benefit transaction, the manager will be taxed at 10% of the value of the excess benefit.
Donor advised funds are prohibited from making distributions that benefit donors, their family members or an entity of which 35% or more is controlled by these individuals. Sec. 4967. These rules are similar to the private foundation "disqualified person" rules and are designed to minimize the potential for donors to abuse the DAF structure and receive inappropriate benefits. Any disqualified person with respect to the DAF who advises a distribution resulting in more than an incidental benefit to a disqualified person will be subject to an excise tax equal to 125% of the distribution. If the fund manager makes the distribution knowing that it would confer more than an incidental benefit on a disqualified person, the manager will be subject to a tax equal to 10% of the benefit.
For many years, the consensus among practitioners has been that the "incidental benefit" rules preclude distributions from DAFs to satisfy legally-binding pledges. A pledge is an agreement between an individual and a charity whereby the individual promises to donate a specific amount of money by a specific time. If there is consideration for the promise to pay, then the pledge may be legally-binding, depending on the governing state law. Once the donor satisfies his or her obligation to make the donation, the pledge has been fulfilled, releasing the donor from a legal obligation. The common understanding among tax professionals has been that this release of a legal obligation is more than a mere incidental benefit. Under this framework, a donor's request that the sponsoring organization make a distribution to a charity with which the donor has an outstanding legally-binding pledge would be taxable at 125% to the donor. If the fund manager is aware of the obligation, he or she would be subject to a 10% tax.
Five years ago, Erin signed a binding pledge agreement with her local hospital foundation, promising to donate $5,000 each year for 10 years. Two years ago, while looking for an additional charitable deduction during a particularly successful year for her law practice, Erin donated $10,000 to a DAF. She liked that she could take an immediate deduction now and decide which charities will receive the money at a later date. Over the past several months, Erin's law practice has recently fallen on hard times, considerably tightening up her budget for the year. She would prefer to hold onto her hard-earned cash and advise the DAF to make this year's $5,000 distribution to the hospital foundation to satisfy her pledge. When Erin met with her tax professional, however, he advised her that she would face a substantial excise tax if she advised the sponsoring organization to fulfill this year's pledge amount. Rather than saving her some cash, the distribution could cost her an additional $6,250.
In Notice 2017-73, released in December 2017, the IRS announced its intention to develop proposed regulations and requested comments on several issues pertaining to donor advised funds. The Service provided a brief history of its approach toward DAFs, including Notice 2006-109, which provided temporary guidance on certain DAF questions and Notice 2007-21, which requested comments on IRS rules related to DAFs. The Service noted that several commenters requested IRS guidance on two specific issues. First, many commenters asked whether a distribution from a DAF to pay for tickets to a charity-sponsored event, such as a fundraiser, would result in more than an insubstantial benefit to the donor under Sec. 4967.Second, commenters inquired whether a DAF distribution that satisfies a donor's pledge would violate Sec. 4967.
Regarding the first question, the Service noted that commenters suggested that if a DAF distribution paid for only the deductible portion of the ticket, then an excess benefit has not occurred. Under this theory, if a DAF pays for only the fair market value portion of the ticket and the donor covers the excess cost, the donor's benefit is insubstantial.
Nevertheless, the Service disagreed with this theory and determined that a DAF's payment of part of the ticket price would relieve the donor of the obligation to pay the full ticket price. Thus, the IRS stated that the proposed regulations would conclude that a DAF distribution to pay for fundraiser tickets would result in more than an insubstantial benefit to the donor. The Service further noted that the distribution may violate both the Sec. 4967 "incidental benefit" rule and the Sec. 4958 "excess benefit transaction" rule.
The Service next addressed the question of whether DAF contributions can be used to satisfy donors' pledges. The Service began by pointing out that several commenters likened the Service's approach to DAF distributions to the Sec. 4941 prohibition against private foundations making grants to fulfill the legal obligations of disqualified persons. The Service then noted that with regard to pledges, the distinctions between legally-binding pledges and non-binding pledges (which it labeled "merely an indication of charitable intent") are often difficult for sponsoring organizations to determine. Therefore, the Service suggested a framework under which DAF distributions may be allowable to charitable organizations with which the donor has an outstanding pledge.
If the following three-prong test is satisfied, the donor will not be treated as having received more than an incidental benefit. First, the distribution from the sponsoring organization must make no reference to the existence of a pledge. Second, the donor may not receive any other benefit that is more than incidental. Third, the donor must not attempt to claim a charitable deduction for the distribution. If all three of the above requirements are met, a contribution made in fulfillment of the pledge will not be treated as more than an insubstantial benefit to the donor and will not subject the donor to a 125% excise tax.
After doing some research, Erin's tax professional informs her that the IRS has proposed new guidance which may enable her to advise a distribution from the DAF to the hospital foundation in satisfaction of her pledge. He informs her that she can safely advise the distribution so long as the distribution is done without any reference to the existence of a pledge, she receives no additional benefits from the distribution and she does not try to claim a charitable deduction. Erin decides to move forward and contacts the sponsoring organization to initiate the process. The hospital foundation gladly receives the distribution from the DAF and credits it toward Erin's $5,000 pledge for this year. Erin has been able to accomplish her goal of fulfilling her pledge obligation and holding onto her $5,000 of savings.
It is important to note the Service's rationale with regard to legally-binding pledges. On the one hand, the Service appears to tacitly acknowledge that the contribution from a DAF to satisfy a legally-binding pledge may, in fact, be more than an insubstantial benefit to the donor, when it states, "The Treasury Department and the IRS currently agree with those commenters who suggest that it is difficult for sponsoring organizations to differentiate between a legally enforceable pledge by an individual to a third-party charity and a mere expression of charitable intent." On the other hand, the notice specifically permits such distributions "regardless of whether the charity treats the distribution as satisfying the pledge."
A prudent tax professional should bear in mind that in Notice 2017-73, the Service merely announced its intention to develop proposed regulations. While the Service has announced its position regarding DAF distributions to satisfy legally-binding pledges, there has been no actual change in the law. At best, this notice merely represents a change in posture by the IRS. While a distribution to satisfy a legally-binding pledge may currently carry low risk, a number of circumstances could cause the Service to revert to its former position on the subject. Should the Service fail to propose and enact the announced regulations, legally-binding pledges could once again be off-limits for DAFs. Therefore, ample caution is warranted for practitioners considering this route for their clients.
Donor advised funds can be an excellent way for individuals to effectuate their tax planning goals. Savvy advisors can counsel their clients to use DAFs to continue to make their charitable gifts without sacrificing their deductions. Nevertheless, individuals should exercise caution and understand the rules surrounding permissible DAF distributions in order to avoid the traps that can cause the donor to pay hefty excise taxes. With proper guidance and planning, however, many taxpayers will find DAF gifts to be a tax-efficient and philanthropic solution.