JULY 2004 (back to index)

Planning For Donor Control And Other Strings Attached To Charitable Contributions

By: Richard L. Fox, Esq.

Editor’s note: A good many of us in the State Bar of Nevada are called upon to serve on, or advise the boards of, various charitable organizations. This article gives such excellent direction to the questions which so often arise, that Nevada Lawyer sought permission to use it in a digested form. The original article with its 51 footnotes may be found in the Estate Planning Journal (30 Est. Plan. 441 Sept. 2003)). Brad Anderson — issue editor.

Donors often seek to impose conditions and restrictions on contributions to charity or want to retain an interest in contributed property. Advisors should review whether doing so will reduce or eliminate the anticipated income tax benefits.

Increasingly, charitable donors are not making unconditional gifts of money or property, but instead are earmarking them for a specified purpose and imposing other terms and conditions on the contribution. For example, rather than giving an unrestricted gift, a donor may wish to fund the construction of a building to be named after him or his family; name a scholarship or professorship; create an endowment fund to support a particular college within a university; support the work of a particular individual; or earmark contributed funds for a variety of other specified purposes. A donor may also choose to limit gifts of property for a particular use or prohibit the charity from selling the property. In some instances, a donor may even try to retain some interest in that property.
 

Conditions and restrictions imposed by a donor are generally embodied in gift agreements or other contractual arrangements between the donor and the charity. Such restrictions may include allowing the donor involvement in a project; requiring the charity to provide financial reports to the donor; and requiring the return or change of the contribution if the charity dissolves are changes its purpose.
 

Practitioners must consider whether a donor's imposition of conditions or the retention of an interest in the gift will disqualify or reduce the donor's charitable income tax deduction.
 

This article explores the income tax issues raised in connection with donor control and other strings attached to gifts to charity, including those addressed in the recent IRS rulings, and provides relevant planning strategies.

Transferring less than the donor's entire interest
Section 170(f)(3)(A) denies a charitable income tax deduction for a contribution of less than the donor's entire interest in property, even though the contribution is effective under local law and otherwise constitutes a valuable right. Thus, for example, the contribution of the rent-free use of a building, a life estate, or a remainder interest is not deductible, because these interests represent less than the entire interest in the property. Similarly, if a donor contributes an interest in motion picture films, but retains the right to make reproductions of such films and exploit the reproductions commercially, no deduction is available, because the donor has not contributed his entire interest.
 

In Rev. Rul. 2003-28, the IRS determined that the license granted to the university to use a patent, under which the taxpayer retained the right to license the patent to others, is similar to a rent-free lease and a partial interest in motion picture films, so that the contribution constitutes only a partial interest in the patent. Accordingly, the IRS disallowed the charitable deduction under Section 170(f)(3)(A). The Ruling indicates that the result would be the same if the donor had retained any other substantial right in the patent, such as if the donor had contributed the patent (or a license to use the patent) solely for use in a particular geographic area while retaining the right to use the patent (or license) in other geographic areas.
 

Nondeductibility for income tax purposes also results if a donor who owns both a painting and its copyright contributes only the painting to a museum, retaining the copyright interest. While a tangible work of art and its copyright are treated as separate property interests for purposes of the estate and gift tax charitable deductions, no such rule applies for purposes of the income tax charitable deduction. Therefore, although a charitable gift tax deduction would be available, no charitable income tax deduction is available under Section 170(a), if the owner of both a painting and its copyright contributes the tangible work of art to a museum but retains the copyright.
 

Even where the entire interest is contributed to charity, if the donor is also the creator of artwork, the available income tax deduction has limited value, because the deduction may not exceed the tax basis of the contributed property. Under Section 170(e)(1)(A), the deduction based on fair market value (FMV) that is otherwise available for a contribution of appreciated property must be reduced by the amount of the appreciation, if the property is not long-term capital gain property, such as artwork created by a donor.
 

Despite the disallowance rule of Section 170(f)(3)(A), the contribution of a partial interest in property by a donor is deductible for income tax purposes in the following situations:

1. Retention of an insubstantial interest. If the donor retains only an insubstantial interest in the property contributed, an income tax deduction will be available. A number of IRS rulings have considered this issue. In Rev. Rul. 75-66, the IRS approved a charitable deduction when the donor contributed a parcel of land to the U.S. but retained the right to use the land to train his hunting dog. In Ltr. Rul. 8152072, the IRS ruled that a donor's retention of investment control over contributed funds, subject to certain limitations and restrictions, was "not substantial enough to affect the deductibility of the property contributed."
 

Any right retained by a donor must be carefully scrutinized to assure that it will not be considered substantial enough to cause the contribution to be treated as a nondeductible contribution of a partial interest. If a proposed contribution is significant, a private letter ruling should be obtained before the contribution is made, because the deduction otherwise available under Section 170(a) will be disallowed if the retained right is ultimately determined to be substantial.

2. Partial interest representing entire interest held. Section 170(f)(3)(A) does not apply to, and therefore does not disallow a deduction for, a contribution of an interest that-even though partial-represents the donor's entire interest in the property. If, however, the property in which such partial interest exists was divided in order to create such a partial interest, and thus avoid Section 170(f)(3)(A), a deduction is not allowed. For instance, if a donor owns only a life estate or a remainder interest in a parcel of real estate, a contribution of that interest would be deductible, as long as that interest was not created in order to make the contribution.
 

An income tax deduction would also be available if the sole surviving noncharitable beneficiary of a charitable remainder trust contributes his entire unitrust or annuity interest to charity. An income tax deduction will be available if a donor simultaneously contributes a life estate to one charity and a remainder interest to another charity, or contributes partial interests to several charities, which in the aggregate comprise the donor's entire interest.

3. Fractional or percentage interest. Section 170(f)(3)(B)(ii) and Reg. 1.170A-7(b)(1) allow a deduction for a contribution of a partial interest that is less than the donor's entire interest in property, if the partial interest is an undivided portion of the donor's entire interest, consisting of a fraction or percentage of each and every substantial interest or right owned by the donor in such property and extending over the entire term of the donor's interest in such property. A deduction is allowable under this exception if the charity is given the right, as a tenant in common with the donor, to possession, dominion, and control of the property for the portion of each year appropriate to its interest in the property. Under this authority, a donor may transfer, for example, an undivided interest in artwork to a museum, thereby giving possession of the art to the museum for a predetermined period of time each year. As a practical matter, contributing an undivided interest in artwork to a charity is generally limited to situations where the donor ultimately intends to contribute the remaining interest to the same charity.
 

To the extent that the charity fails to take possession for any particular year in accordance with the underlying agreement, there should be some bona fide justification for that failure, the reasons for which should be contemporaneously memorialized.

Earmarking contributions for a particular purpose or use
A donor may earmark a contribution to a qualified charity for a particular purpose or use without jeopardizing the charitable deduction, provided that such restrictions do not prevent the charity from freely and effectively employing the transferred assets, or the income therefrom, in furtherance of its exempt purposes. Consequently, so long as the contribution is earmarked for a permissible charitable purpose (such as a contribution of land to a city for use as a park, the creation of an endowment fund for a particular college within a university, or the building of a new hospital facility), a deduction will be available.
 

On the other hand, if the earmarked use of the contribution could somehow be construed as being contrary to, or inconsistent with, Section 501(c)(3) tax-exempt purposes, or if it relates to a particular project never before conducted by the charity, the tax deduction could be in jeopardy. To bolster the donor's position regarding deductibility, the underlying gift agreement should specifically acknowledge that the enumerated conditions set forth therein are in furtherance of, and consistent with, the charity's Section 501(c)(3) tax-exempt purposes. Further, for substantial gifts, a board resolution by the charity, under which the charity officially accepts the gift, should contain a similar acknowledgement with respect to the Section 501(c)(3) tax-exempt purposes of the gift.
 

In the context of earmarking gifts to charities, the following planning points should be considered:

1. Earmarking a contribution for a particular purpose is generally permissible, but if there is a possibility that the contribution could revert to the donor because it may never, in fact, be used for that purpose or if the purpose is no longer being fulfilled, the charitable contribution deduction could be disallowed, depending on the particular facts and circumstances existing as of the date of the gift. To ensure deductibility in such situations, an alternative charitable use — within the same or a different charity — should be considered so as to avoid the possibility of a reversion to the donor.
 

2. The earmarking of a contribution for a particular use or purpose, as well as any other conditions attached to a contribution, should be imposed at the time the gift is made, and the donor must not have continuing authority to change the use or purpose of the contribution. If, however, the donor merely retains the right to make non-binding recommendations on an ongoing basis with respect to contributed funds, a deduction generally will be available as the charity retains the ultimate control and power to direct the funds.

3. Plan for contingencies in the event that the charity (1) no longer exists, (2) does not continue to do the same charitable activities as when the gift was made, or (3) takes certain subsequent actions that may have an adverse effect on carrying out the donor's intentions.

4. Typically, only the state attorney general has standing to enforce charitable restrictions imposed on charitable contributions. Nevertheless, in a New York case, Smithers v. St. Luke's-Roosevelt Hospital Center (225 NYLJ No. 68 (4/5/01); 281 A.D.2d 127, 723 N.Y.S.2d 426 (2001)), the court held that the estate of a donor of a charitable gift had standing, under the common law of New York, to sue the donee charity to enforce the terms of the gift, because the donor was in a better position than the attorney general to be vigilant and to enforce his intent. Therefore, consideration should be given to specifically conferring standing and a contractual right to sue upon the donor within the gift agreement; these rights would be held by some third party individual or foundation after the donor's death.

Contributions subject to a condition precedent or condition subsequent
A charitable income tax deduction under Section 170(a) is not allowable if a transfer for charitable purposes is, as of the date of the gift, dependent on the performance of some act or the happening of a precedent event in order for the transfer to become effective unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. Similarly, if, as of the date of the gift, a transfer for charitable purposes may be defeated by the performance of some act or the happening of some event, no deduction is allowable unless the possibility that such act or event will occur is so remote as to be negligible.
 

Examples of the effect of imposing a condition precedent or subsequent are as follows:

1. A gift of land to a city "for as long as the land is used by the city for a public park" is deductible if, on the date of the gift, the city does plan to use the land for a park and the possibility that the city will not use the land for a public park is so remote as to be negligible.

2. A Board of Education solicited gifts to build a new public high school, advising donors that if sufficient funds were not received, the contributions would be returned. The IRS ruled that until it was known whether the contributions would be returned or retained, the possibility that the contributions would be returned was not so remote as to be negligible. Thus, the deductions were disallowed until it was clear that the school would retain the contributions.

To avoid the risk of disallowance under Section 170(a) in those situations where the possibility of reversion may not be so remote as to be negligible, consider providing for an alternative charitable use within the same charity or an alternative charitable donee so that there is no possibility that the property will be used for other than charitable purposes.

How restrictions affect the value of the deduction
Reg. 1.170A-1(c)(1) provides that if a charitable contribution is made in property other than money, the amount of the contribution is the FMV of the property at the time of the contribution, reduced as otherwise provided in Section 170(e). If a donor places a restriction on the marketability or use of the property, the charitable deduction equals the FMV at the time of the contribution, determined in light of the restriction. In Rev. Rul. 2003-28, although the three-year prohibition on sales could never cause the patent to revert to the donor and would not otherwise provide the donor with a benefit, the IRS ruled that such prohibition reduces what would otherwise be the FMV of the patent at the time of the contribution and, therefore, reduces the charitable contribution deduction under Section 170.
 

There are a multitude of rulings as well as case law where the imposition of restrictions and other limitations imposed on charitable contributions of property caused the deduction to be less than the unrestricted FMV of the property contributed; this authority should be analyzed prior to placing restrictions.
 

As a general rule, though, as long as the restrictions do not affect the marketability of the donated property, a full FMV income tax deduction should be available. The failure to impose deaccessioning restrictions, however, may ultimately thwart the donor's intentions because the donee charity would then be free to dispose of the contributed property. As an alternative to mandatory language, precatory language may be used whereby the donor expresses his desire that the contributed property not be disposed of or sold, but should be retained by the charity for its perpetual use.

Earmarking contribution for a particular person
In Thomason (2 T.C. 441 (1943)), the court held that "charity begins where certainty in beneficiaries ends, for it is the uncertainty of the objects and not the mode of relieving them which forms the essential element of charity." A charitable contribution deduction is not allowed, therefore, if a charity is used as a conduit for a payment designated for the benefit of a particular individual, even if the individual is a member of the class the charity is intended benefit. Each case requires a factual inquiry as to whether the contributed funds were earmarked for a designated individual pursuant to a commitment or understanding between the donor and the charity, so that the charity lacked control and discretion over the funds.
 

Although it is virtually certain that donor recommendations will be followed by a charitable organization, the IRS has determined that the donor-advised funds are a part of a public charity (i.e., the "independent" charity associated with the mutual fund, brokerage firm, or other investment company), not separate and distinct private foundations, provided that the charity retains the ultimate control and discretion over the funds. However, existence of any written or oral agreement or understanding between the donor and the charity, whereby contributed funds are, in fact, ultimately destined for a particular individual, would undermine the deduction.

Conclusion
Before imposing conditions, restrictions, or other strings with respect to charitable contributions, consider whether doing so will jeopardize the anticipated income tax benefits. With proper planning and an understanding of the issues involved, the donor can likely effectuate his charitable intentions while still realizing the anticipated tax benefits. NL

RICHARD L. FOX is an attorney and a partner in the law firm of Dilworth Paxson LLP, in Philadelphia (www.dilworth law.com). Mr. Fox's practice areas include income taxation, charitable giving, private foundations, family planning, and trusts and estates. He may be contacted at foxrl@dilworthlaw.com. This article is based on an article by the author in WG&L's "Charitable Giving and Solicitation," Bulletin No. 63 (3/18/03).