There are two basic (though not necessarily equal) reasons why people donate to a charity: one, the charity can accomplish good works with the gift; and two, the donor earns a tax deduction. If a client wants to take advantage of a deduction for a charitable contribution, an advisor must take care to explain the rules governing the allowance for such deductions.

There are two basic (though not necessarily equal) reasons why people donate to a charity: one, the charity can accomplish good works with the gift; and two, the donor earns a tax deduction. If a client wants to take advantage of a deduction for a charitable contribution, an advisor must take care to explain the rules governing the allowance for such deductions. An important consideration concerning the deductibility of a charitable donation is the extent of donor control over that gift. Any gift can be made if both donor and charity are willing, but, not every gift will entitle the donor to a deduction under the Internal Revenue Code or Treasury Regulations. The task for advisors is explaining how strings attached to a gift made to a charitable organization may compromise its deductibility.

Issue One: Acceptable and Unacceptable Restrictions on a Gift

A donor generally may earmark gifts for a particular use or purpose by a qualified charity and still deduct that gift [Reg. Sec. 1.507-2(a)(8)(i)].

However, any restrictions placed on the gift cannot conflict with the tax-exempt purpose of the charity. Nor can such restrictions create a conduit for the gift to be channeled to a particular person [Estate of Hubert v. Comm’r, TC Memo. 1993-482]. The tax-exempt purpose of an organization must fit a category under IRC Sec. 501(c)(3), and must be maintained so as to avoid the suspicion that the tax-exempt organization is used as a conduit for private benefits. It does not matter that the private party is needy or otherwise deserving of charity if the tax-exempt purpose is not served.

Compare four examples of a gift made to benefit a tax-exempt religious organization’s missionary program:

• In 1990, the Supreme Court ruled that a deduction could not be claimed for payments made to church-designated travel agents to pay the travel expenses for their children while serving as missionaries for their church. Though the church did not control the funds, the church did exercise control over the activities and defined the amount of their support needs. The Court rejected the taxpayers’ contention that the payments were directed towards church sponsored activity because the church itself never had actual control of the funds [Davis v. United States, 495 US 472, 110 S. Ct. 2014, 65 AFTR 2d 90-1051 (1990)].
• In 1994, the IRS issued a technical advice memorandum that proscribed a donor from taking a deduction for monthly gifts to a church made with the stipulation that such payments be used to support a ministry created by their son: “The test in each case is whether the organization has full control of the donated funds, and discretion as to their use so as to ensure that they will be used to carry out its functions and purposes” [PLR 9405003].
• In 1962, the IRS issued a ruling that permitted a deduction for a donation made to a church for the benefit of its missionary activity even though the donor’s son was a missionary on behalf of the church and would indirectly benefit from the donation [Rev. Rul. 62-113, 1962-2 CB 10].
• In 2010, the Tax Court issued a ruling that permitted a deduction for donations made directly to missionaries of local churches because the missionaries worked within an agency relationship with the local churches [Wilkes v. Comm’r, T.C. Summ. Op. (April 22, 2010)].

The critical factor seems to be the degree of autonomy the charity had over each gift versus the probability that the donation would go primarily benefit a particular individual: “the charity begins where certainty in the beneficiaries ends” [S.E. Thomason v. Commissioner, 2 T.C. 441 (1943)].

Factors used to identify an independent governing body include: the selection of the governing body, the terms of service for governing board members, and terms of renewal of service time for governing board members.

Issue Two: Gifts Subject to Conditions Subsequent

A gift made conditional on a preceding act or event cannot qualify for a charitable deduction unless the condition that would preclude the gift is so remote as to be negligible [Reg. Sec. 1.170A-1(e); see also, Reg. Sec. 20.2055-2(b), Reg. Sec. 25.2522(a)-2(b)]. To answer the question of what condition could possibly be important enough to include in a gift contract, yet remain so remote as to be negligible, we look to the example included in the regulation itself [Reg. Sec. 1.170A-1(e)]:

“For example, a donor transfers land to a city government for as long as the land is used by the city for a public park. 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, X is entitled to deduction . . . for his charitable contribution.”

And, here is another example – this time for a conditional gift that could not be deducted: A donor transferred a patent to a university but the gift was made contingent on the university’s continued employment of a particular faculty member for another 15 years. The IRS ruled that this condition was not so remote as to be negligible since the university might very well not employ the individual for 15 more years [Rev. Rul. 2003-28, 2003-11 I.R.B. 594].

Several Court decisions have set out to define what it means to be “so remote as to be negligible”. One court explained the phrase as a chance so highly improbable that a person would generally ignore it with reasonable safety in undertaking a serious business transaction [United States v. Dean, 224 F. 2d 26, 29 (1st Cir. 1955)]. Another court found defined the phrase as a chance that every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance [Estate of Woodward v. Commissioner, 47 T.C. 193, 196 (1966)].

Planning Point

Despite the cost, it might be a prudent choice to seek a Private Letter Ruling on the issue of whether a proposed restriction to a charitable gift is “so remote as to be negligible”.

Issue Three: The Partial Interest Rule

Generally, in order to take a deduction, the donor must transfer the entire interest in a gift to a qualified charity. A donor cannot continue to enjoy control over donated funds or property contributed; the gift must be irrevocable to qualify for the charitable deduction. Thus, a gift of a partial interest generally does not qualify for a deduction [see IRC Sec. 170(f)(3)].

However, there are exceptions to the partial interest rule – gifts of property that do qualify for a deduction even though the donor retains certain rights.

• Remainder Interest in a Personal Residence or Farm: The donor makes a charitable gift of the remainder interest in a personal residence or farm under IRC Sec. 170(f)(3)(B)(i). The donor (and spouse, if desired) will retain a life estate in the property with full enjoyment of the property for life or a term of years.
• Undivided Interest: A deduction is allowed under IRC Sec. 170(f)(3)(B)(ii) for the value of a charitable contribution not in trust of an undivided portion of a donor’s entire interest in property. An undivided portion of a donor’s entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property. It must also extend over the entire term of the donor’s interest in such property and in other property into which such property is converted.
• Qualified Conservation Contributions: A deduction is allowed under IRC Sec. 170(f)(3)(B)(iii) if the donor agrees to provide a perpetual conservation restriction over the real property that is enforceable by a qualified organization to meet conservation purposes [IRC Sec. 170(h); Reg. Sec. 1.170A-14(a)].
• Retaining Insubstantial Rights: The retention of insubstantial rights does not cause the gift to be termed a non-deductible partial interest. This is true if the rights the donor retains do not interfere with the charity’s interest in the property.Here are some examples of permissible donor retention of an insubstantial right:
  • The donor who makes a gift of land with the proviso that he be allowed to train his hunting dogs on the land is an insubstantial right [Rev. Rul. 75-66, 1975-1 CB 85].
  • The donor retains approval rights for the gallery design and the installation design for artwork donated to the charity [PLRs 9303007 and 200223013].

  Here are some examples of rights retained by the donor which are not insubstantial (and, thus, impermissible):

  • The donor retains right to vote shares of donated stock [Rev. Rul. 81-282, 1981-2 CB 78].
  • The donor retains mineral rights believed to be viable in underlying contributed land [Rev. Rul. 76-331, 1976-2 CB 52].
  • The donor the right to cut timber on the contributed land [Rev. Rul. 76-253, 1976-2 CB 51].

Important Note: A donor may be denied a charitable deduction if he or she divided the gifted property (creating a partial interest) with the sole intention of avoiding the partial interest rule.

Valuation

When the donor does place restrictions on the gifted property, the corresponding charitable deduction for the gift may not be its fair market value under normal circumstances. Of course a charitable gift – except publicly traded and some restricted stock – valued at more than $5,000 requires a qualified appraisal [Reg. Sec. 1.170A-13(c)]. So, for practical reasons, a professional appraiser will be necessary to value the property with the donor’s restrictions in place.

For instance, a donor agrees to create a restrictive easement over 100 acres of land near a state park for her local conservation group. She agrees that the restrictive easement will be made in perpetuity and exclusively for conservation purposes. A qualified appraiser will first look to see if there are any comparable sales of similar easements. If no such sales exist, the value of the restrictive easement can be found by subtracting the value of the property before and after the easement [Reg. Sec. 1.170A-14(h)(3); Hughes v. Comm’r, TC Memo 2009-94].

Issue Four: Permissible Control over Investment of the Gift

A donor may not retain any immediate control over a gift. This prohibition extends to the charity’s investment of the gifted assets. A donor may not invest his or her own gift to a charity. However, some donors believe that the charity could benefit from their own financial savvy.

A Donor Advised Fund (DAF) allows a donor to make an irrevocable charitable gift to the fund (which creates a tax deduction). A donor may suggest that payments be directed to a particular qualified charitable organization [IRC Sec. 4966(d)(2)]. The donor may make suggestions on grants to qualified charities. However, the donor may not place any material restrictions on the fund’s distribution – that is a gift of a partial interest and the donor could not claim a charitable deduction for the contribution. What constitutes a material restriction is a question of fact that must be determined by looking at all of the facts and the circumstances.

It is important to note that for the DAF, the donor can only request that the charity act or invest a certain way – the charity itself has the ultimate decision as to what causes to benefit and what investments to choose.

Issue Five: Can the Donor Have Final Say Over Use of the Gift?

The donor must not have continuing authority to change the use or purpose of the contribution. A donor should not retain dominion and control over funds or property contributed or the power to direct the disposition or manner of enjoyment of the property, which can otherwise render a gift incomplete.

Many donors would like to include a reverter clause within the contract to provide for the return of the gift if and when the charity does not meet certain criteria. As noted above, such a clause might compromise the deductibility of the charitable gift because a revocable gift is not deductible.

A better option would be to create an ‘alternative charity’ clause. The donor can set forth his or her criteria for the gift. If the original charity cannot or will not meet the reasonable (and permissible) expectations set forth by the donor, the donated funds or assets will be transferred to a different charity. This preserves the charitable deduction because a different 501(c)(3) charity receives the funds.

Another way that a donor could structure a gift so to retain some indirect control over the use of the gift would be to make a gift on an installment plan. When donor and charity agree to the gift, the parties could also agree to stages for completion of the gift. Generally, once the donor is satisfied that progress has been made, the donor makes the next installment on the gift.

Written Donor Agreements

Any gift contract between the donor and charity should clearly stipulate the conditions and restrictions associated with the gift and clearly state that such conditions and restrictions are consistent with the charity’s mission. Furthermore, there are certain precepts to keep in mind when crafting a gift agreement meant to last:

• A clear statement of the donor’s intentions.
• Specific restrictions on the use of the contribution.
• Realistic benchmarks for measuring the success of the restricted gift.
• Flexibility for use of the contributed funds over time in order to preserve the donor’s intentions.
• Provisions for dispute resolution.

Issue Six: Gifts under Scrutiny

The issue of donor control can be difficult to discuss with clients. A gift is by definition an act of generosity, but attaching strings to a gift can create problems. It might be useful to discuss the recent legislative trends towards greater scrutiny over charitable gifts and more rigorous administrative enforcement of the rules. A good point of reference would be the Pension Protection Act of 2006 (PPA).

The passage of the PPA is a watershed event for the effort by Congress to create more strict rules regarding charitable gifts and permitted deductions for those gifts. These changes were not necessarily unexpected: the U.S. Senate Committee on Finance held a series of hearings concerning tax deductions for suspect charitable gifts in the years preceding the PPA. And Congress enacted the American Jobs Creation Act of 2004 which included a provision to generally limit the charitable deduction for motor vehicles to the actual resale value rather than an estimated fair market value at the time of sale, plus a provision to limit the charitable deduction for patents and other intellectual property to the lesser of the fair market value or the taxpayer’s cost basis.

The stricter rules included in the PPA include:

• More rigorous recordkeeping requirements for substantiating charitable gifts.
• More exacting recapture of the tax benefit for gifts made with property not used for the charity’s exempt purpose.
• Special rules regarding the valuation of contributions of fractional interests in tangible personal property and a timetable to make subsequent gifts of the remaining interest in the property in order to avoid recapture of those tax benefits.
• Stronger penalties for overvaluing charitable gifts.
• A statutory definition for a DAF.

The Joint Committee on Taxation published a thorough explanation of the charitable provisions of the PPA [see Technical Explanation of H.R. 4 prepared by the Joint Committee on Taxation (JCX-38-060)].

In response to the PPA, many commentators have observed that the new rules and requirements are a welcome step. Others worry that additional regulations could burden non-profits, especially smaller charities that do not have deep pockets (for instance, the number of charities required to file Form 990 has significantly increased). Certainly, charities and foundations are aware of the need to promote greater understanding the rules regarding charitable giving.