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Donor-Advised Funds Under Attack;
IRS Business Plan Unveiled

April 2000
By Harry J. Friedman and Robert J. Robes, Greenberg Traurig, Miami Office

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A donor-advised fund is a fund typically held by a public charity consisting of money contributed by an individual or entity. The donor or its designee retains the privilege of making non-binding recommendations to the governing body of the public charity as to the recipients of grants from the fund. The public charity is the owner of the principal amount of the gift along with any income generated by the gift. It can decline to follow or only partially follow the donor’s suggestions without any obligation to the donor. The donor sacrifices control of the contributions because the donor’s recommendations are advisory only; further the right to advise is often limited by the life span of the donor. A donor-advised fund program is attractive to many donors who want advice and administrative services. They are willing to sacrifice ultimate control over their funds in exchange for these services.

Because the donor is making a gift to a public charity, the donor is entitled to the most favorable rules on deductibility with respect to a gift to a donor-advised fund. This is true so long as the gift is a complete gift and is not subject to material restriction. Moreover, depending on the public charity, the donor may be permitted to let the fund build tax-free over a period of years before making any recommendations. In contrast, if a donor formed a private foundation, the foundation would be required to distribute annually an amount equal to 5% of its assets.

Donor-advised funds formed by some mutual fund organizations have been heavily advertised. For the donor, it permits a current charitable deduction for contributions, not withstanding that the final recipient of the contribution has not been chosen. For the mutual fund operator, it provides additional funds under management.

The increasing use of donor-advised funds has resulted in the 2001 Budget Proposal including proposed legislation to provide rules for donor-advised funds that address the potential for misuse of donor advised funds to benefit donors and advisors. The proposed legislation would provide that a charitable organization which maintains more than 50% percent of its assets in the operation of one or more donor-advised funds may qualify as a public charity only if: (1) there is no "material restriction" or condition that prevents the organization from freely and effectively employing the assets in such donor advised funds, or the income therefrom, in furtherance of its exempt purposes; (2) distributions are made from such donor-advised funds only as contributions to public charities (or private operating foundations) or governmental entities; and (3) annual distributions from donor advised funds equal at least five percent of the net fair market value of the organization’s aggregate assets held in donor advised funds (with a carry forward of excess distributions for up to five years). Failure to comply with these requirements with respect to any donor advised fund would result in the organization being classified as a private foundation.

The proposed legislation also provides that a charitable organization that does not maintain more than 50% of its assets in the operation of donor advised funds, but does in fact operate one or more donor-advised funds, must comply with the above three requirements with respect to the donor-advised funds. If the organization’s donor-advised funds do not comply, the organization’s public charity status is unaffected; however, all assets maintained by the organization in donor advised funds would be subject to the private foundation rules and excise taxes.

The proposed legislation also changes the application of Intermediate Sanctions and the prohibition on self-dealing. In the case of a donor-advised fund, this definition of "disqualified person" is applied on a fund basis rather than looking to the person’s relationship to the organization.

Exempt Organization Items on IRS Business Plan

On March 21, 2000 the IRS and Treasury released this year’s business plan for tax-exempt organizations. Annually, the IRS publishes a business plan outlining the regulation projects and guidance it is intending to release during the year. The list puts taxpayers and their advisors on notice of what to expect for the year from the Treasury and IRS. More importantly, the list offers some guidance as to what issues are high on the IRS’s radar screen.

Most of the exempt organization items reflect matters on the previous year’s business plans that were not released in 1999. An important item on the list is the promulgation of Final Regulations under Section 4958 of the Internal Revenue Code, commonly referred to as Intermediate Sanctions. Proposed Regulations were issued in July, 1998. (See, GT Alert, August, 1998, for a discussion of the Proposed Regulations.) Final Regulations were anticipated last year, but were not issued. In a recently published interview, Marcus Owens, IRS Exempt Organizations outgoing Division Director, stated that the chances of the regulations being finalized in 2000 are less than 50/50. Current IRS officials have been less pessimistic.

Reportedly, there are several key issues that IRS and Treasury Officials are trying to work out. Presumably, an important one is the impact of the decision of the 7th Circuit Court of Appeals in the United Cancer Council case. (See below for an update on that case.) Proposed Regulations did not contain a "first bite rule", i.e., a rule that would presume that an initial contract with the organization would not support a conclusion that the party was a disqualified person under the Intermediate Sanction rules. The UCC case used a first bite rule to find that a party was not an "insider".

IRS and Treasury also indicate in the business plan that they will continue to work on a notice requesting comments on applying the rules of unrelated business taxable income, lobbying expenditures and political intervention to exempt organizations’ internet activities. In the August, 1999 GT Alert we described some of the issues presented by the internet activities of tax-exempt organizations. Websites have commonly become the method for organizations to communicate with their members. In order to take advantage of this, businesses who make payments for endorsements and sponsorships frequently request that the website contain a link to the business’ web site. Members of the organization who visit the organization’s website then have the opportunity to quickly move to the websites of businesses which are supporting the organization. IRS officials have suggested that these links may constitute advertisements for the business. Some commentators have suggested that the link should be treated as merely an acknowledgment of the sponsor and not advertising. Recent legislation provides that acknowledgments of sponsorship activities does not constitute advertising for an exempt organization.

Many commentators have indicated that the need for guidance in this area is critical. So far, most of the IRS statements in connection with internet activities do not offer any firm direction as to how the rules are to be applied.

Another item on this year’s agenda is charitable split-dollar insurance reporting requirements. As has been widely publicized in the media, IRS officials are concerned about these arrangements. Typically, they involve a wealthy taxpayer who makes a donation to a charity. The understanding between the taxpayer and the charity is that the charity will buy a split-dollar life insurance policy on the donor’s life. The donor then claims a charitable deduction for the contribution, notwithstanding the fact that a substantial portion of the proceeds of the split-dollar policy will be paid to the donor’s family. The charity gets a cut of the life insurance proceeds. IRS notices have indicated that such arrangement may constitute private inurement or more than incidental private benefit.

In the benefits area, guidance on reporting and withholding for Section 457(b) plans is on the project list.

UCC Closing Agreement Released

The United Cancer Council has released the closing agreement it reached with the IRS that has been the subject of substantial litigation. UCC was a national organization whose members were local cancer agencies. UCC was in poor financial condition when it hired Watson and Hughey Company ("W&H") to act as a fundraiser. Under the contract with W&H, a contributor list developed for the fundraising campaign on behalf of UCC became the joint property of UCC and W&H. W&H was able to use list for marketing itself to other charities. W&H provided UCC with the initial capital to conduct a fundraising campaign and also provided operating funds to UCC. Contributions received were placed in an escrow account controlled by W&H. Of $29 million received in contributions, only approximately $2 million actually made its way to UCC.

The IRS revoked UCC’s exemption arguing that UCC was operated for the private benefit of W&H and that UCC’s net earnings had inured to the benefit of a private person, W&H. In 1997 the Tax Court upheld the private inurement argument and the IRS revocation of UCC’s exempt status. As noted in the Court of Appeals decision, the IRS did not contend that any member of UCC’s board of directors received any of UCC’s earnings nor that any member of the board was related to any of W&H’s owners or employees. It was conceded that the contract was negotiated on an arms-length basis. The Tax Court found that W&H was an "insider" and had improperly received a portion of UCC’s net earnings, thereby supporting revocation of exemption. The terms of the contract, according to the Tax Court, provided W&H with influence over UCC to the extent that it became an insider.

The 7th Circuit disagreed with the Tax Court’s conclusions on private inurement. Private inurement, according to the 7th Circuit, is designed to prevent "the siphoning of charitable receipts to insiders of the charity, not to empower the IRS to monitor the terms of arms-length contracts made by charitable organizations. . . ." The Court observed that "insiders" were persons who are the equivalent of owners or managers. An "insider" could be a nominal outsider such as a physician with hospital privileges.

The Court concluded that a service provider was not an insider simply because it entered into an arms length contract. The private inurement prohibition was, according to the Court, not intended to provide the IRS with power to monitor service contracts of charities. An arms-length contract even if badly negotiated and one-side in the IRS’ eyes, does not constitute a violation of law that would lead to revocation of exemption.

Although the UCC was successful on the private inurement issue at the 7th Circuit, the case was remanded to the Tax Court to address private benefit. Instead of returning to the Tax Court on the private benefit issues, the parties agreed to settle. The settlement agreement provides that the UCC’s exempt status is revoked effective January 1, 1986. The IRS agreed to accept a fixed settlement amount and did not require UCC to file an income tax return for the period January 1, 1986 through December 31, 1989. At the conclusion of the bankruptcy proceeding, UCC agrees to distribute its assets solely for the payment of expenses of direct care of cancer patients. Its noteworthy that amounts are only permitted to be distributed to exempt organizations that have never been associated with W&H, the cause of the proceedings. The IRS agreed not to disallow the deductibility of any charitable contributions made to UCC prior to 1989. This will benefit its contributors who will not need to be concerned about disallowance of charitable contribution deductions, although as a practical matter, it will remain unlikely that any year remain open with respect to that period.

In addition, the IRS approved a new application for exempt status effective January 1, 1990. In the application, UCC states that it will limit its activities to accepting charitable bequests and will transmit the bequest to local cancer councils for use solely to provide direct care. It will not engage in other fundraising from the general public.


© 2000 Greenberg Traurig

This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.