When Do We Cross The Line?

When Do We Cross The Line?

Article posted in Ethics on 20 November 1998| comments
audience: National Publication | last updated: 18 May 2011


In this week's edition of Gift Planner's Digest, Kansas City, Missouri attorney Scott Blakesley explores some of the legal and ethical issues that professional advisors and planned giving officers must consider when advising clients and donors in matters of charitable gift planning.

by Scott Blakesley

It is sometimes said that anything we do for the benefit of charities and donor/clients is appropriate as long as we don't violate the law. If so, where do ethics come in? It is probably safe to say that anything that is illegal is also unethical. However, the reverse may not be true. There may be times where we cross the line for ethics purposes, even though we have not violated any laws.

Of course we want to avoid things that are illegal, or maybe even things that are so close to being illegal that the distinction is hard to see. But what about the transactions where the law is unclear? Or what about those transactions which are clearly legal, but which could be considered an abuse of the system? These are difficult questions--especially when it could mean giving up a large charitable donation, or losing a significant client.

Leaving aside the legal issues for a moment, there may be times when the status of the charitable deduction (and charities in general) can be put at risk because we push just a little too much. These issues have become very controversial at times, and often create a rift between some charities who want to take a purist approach to planned giving, and some donor advisors who believe that we should be able to do anything the law allows so long as it is in the best interests of the client. This controversy is sometimes confused with a perceived distinction between the for-profit and nonprofit camps, although I'm not sure that is a correct place to draw a line.

Controversial or not, we need to think about how we are going to deal with these issues. It is clear that the IRS and Congress are looking seriously at the whole area of charities and the charitable deduction. Regardless of where you might stand on any particular issue or transaction, I think we can all agree that the closer we get to the line, the more ammunition we give to the government to put additional restrictions on charitable giving--especially planned gifts.

Accelerated Charitable Remainder Trust

In the early 90s, some clever tax planning attorneys and accountants came up with a plan for their clients to avoid large amounts of capital gain on substantially appreciated assets. The client would create a two year Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT) with a very high payout percentage (such as 80%). The NIMCRUT would be required to make a substantial distribution in the first year, but nothing would actually be distributed until the beginning of the second year. Before the first year distribution was made (in year two), the trustee would sell all the assets, so that the first year distribution could be made out of the sale proceeds.

Because of the 65-day rule of IRC § 664, the distribution for year one was treated as a distribution of principal because the NIMCRUT had no income during the first year. In the second year, the unitrust payment was substantially less because the value of the trust was all but depleted by the first year distribution. Although the second year distribution was treated as capital gain, it was only a small portion of the gain that would have been taxable if the plan had not been carried out as outlined above.

Although the Accelerated NIMCRUT satisfied all the technical requirements of the tax laws relating to charitable remainder trusts, it was also pretty clear that such a trust represented an adaptation of the rules in a way never intended.

The government issued Notice 94-78, stating that the IRS would challenge the Accelerated NIMCRUT on the basis that it was: 1) a "pre-arranged sale" taxable to the grantor rather than the trust; or 2) some kind of "self-dealing" arrangement that cannot be a CRT.

A further response by the government was the new charitable remainder trust requirements under the Taxpayer Relief Act of 1997 (TRA '97): 1) the unitrust payout percentage cannot exceed 50%; and 2) the present value of the remainder interest must be at least 10%.

This was a pretty easy call for most of us to make. We could easily see that this was an abuse of the rules, and needed to be stopped in order to preserve the integrity of the tax rules relating to charitable remainder trusts (even if all of us did not agree on the specific method of addressing this abuse).

We know there were many of these Accelerated NIMCRUTs created, and there were many charities that cooperated as the remainder beneficiaries--and who received substantial sums as a result of their participation. If charities would participate in a plan that was clearly an abuse, how would charities handle a situation that was not clear?

Marginally Charitable Private Foundations

In 1969, Congress reacted to the perceived (or real) abuse of the tax laws that then existed in connection with many family charitable foundations. It was believed that many families were using their foundations as a means of providing personal benefit to themselves through a tax exempt entity. It is clear from the old cases that some families were in fact taking advantage of the lenient or ambiguous laws on the subject.

When the "private foundation" rules were enacted in 1969, many practitioners believed that the significant restrictions would virtually kill the use of family foundations. Of course, history has proven that family foundations were not killed and are used extensively by many families as a means of setting aside assets for charitable uses while still maintaining family control. This is true in spite of the restrictions that make private foundations somewhat less attractive for tax purposes than donations to public charities.

In recent years, there seems to be a resurgence of planners who are promoting the concept of a family foundation that is designed primarily as a way for family members to get a significant financial benefit while still maintaining tax exempt status. Some of the material I have seen promotes these foundations as a means for a family to: 1) receive substantial compensation amounts; 2) provide support and maintenance for family members; and 3) provide funding for college education for family members.

In addition, there seem to be several foundations that are established and maintained almost exclusively to act as the charity in connection with the more questionable planning techniques (dare I say "schemes") that have been arranged by clever planners.

Again, regardless of whether or not such foundations and their activities are technically within the boundaries of the tax laws, the question still remains as to what is really motivating the transaction. The motivation seems to be to use the tax laws for the maximum benefit of the individuals involved.

There is nothing inherently wrong with trying to apply the tax rules in a manner that provides the maximum benefit to the client and/or charity. However, when charitable intent is a distant (or perhaps entirely forgotten) variable in the transaction, we run a high risk of inviting significant, and unwanted litigation, and/or undesirable responses from the IRS and Congress.

Marginally charitable foundations threaten the typical foundation and weaken the viability of charitable organizations in general. This is especially risky in the current political atmosphere in which there is serious discussion of eliminating the charitable deduction and limiting tax exempt status to only certain types of charities.

Supporting Organization As A Target Of IRS Scrutiny

Recently, some taxpayers have determined that a supporting organization can accomplish many of the goals of a private foundation, but are treated for tax purposes as a pubic charity. As with all good ideas, there are some who might use this planning idea as a means to cross the line, and inappropriately try to bypass the private foundation rules without correctly utilizing the supporting organization rules.

The IRS seems to have focused some amount of effort on the use of supporting organizations, especially in light of articles like the one that appeared in The Wall Street Journal on May 28, 1998. The article talked about how taxpayers were avoiding taxes by using supporting organizations as a substitute for a private foundation (and avoiding all the special rules that apply to private foundations).

With this kind of publicity, we should be careful when using and promoting supporting organizations--but there is still plenty of room for the appropriate use of a supporting organization in many situations.

Potential Misuse Of Charitable Remainder Trusts

Don't get alarmed. I am not going to say that charitable remainder trusts are bad. They are clearly an important tool in the area of planned giving, and present opportunities for people to make charitable gifts while retaining certain income rights.

However, charitable remainder trusts are susceptible to abusive uses, and the IRS has stated on many occasions that it will closely scrutinize the use of CRTs when they are used in a manner that goes too far on the side of benefiting the donor.

For example, see Rev. Proc. 97-3 where the IRS states it will not issue private letter rulings for CRTs that involve the controlling of income for the benefit of the grantor (such as partnerships and deferred annuity contracts). Also consider the signal being sent in connection with the new CRT qualification rules under the Taxpayer Relief Act of 1997.

When the avoidance of capital gains is the primary (or exclusive) motivation for creating a charitable remainder trust, there is a significant risk that the line may be crossed. Sometimes the difference between crossing the line or not has to do with how we handle the discussion and implementation. For example, I recall some tax planning advisors who have marketed charitable remainder trusts (usually in combination with life insurance) as some kind of great tax-avoidance device--and the charitable aspect of the trust is only mentioned some time later, after the client has already agreed that the tax results are beneficial. With this kind of marketing, it is no wonder that the IRS is trying to find new ways to crack down on the use of charitable remainder trusts.

We all owe it to our clients and donors to carefully explain the rules and limitations on the use of charitable remainder trusts, so that such trusts continue to be used in appropriate ways to meet charitable giving goals.

It is acceptable to use the rules to provide the maximum benefit possible to the donor and family members (such as setting the payout rate at the maximum that will still satisfy the 10% benefit rule in the TRA '97). However, there should be some charitable intent involved that justifies the use of the charitable remainder trust.

Charity Involvement In Family Limited Partnerships

Family partnerships can be an effective method of providing continuity, facilitating management, and helping to reduce estate taxes. Sometimes, a charity is added as one of the limited partners in an attempt to improve the legitimacy of the partnership under applicable tax laws.

Although there is nothing inherently wrong with including one or more charities as part of the family partnership planning, the line may be crossed if there is no charitable intent, and the only reason for adding the charity is to get additional estate tax benefits for the family.

Recently, there have been plans marketed (as an alternative to charitable remainder trusts) that involve a charity as the owner of 98% of the limited partner interests in a partnership. The theory is that the income of the partnership will remain nontaxable so long as the charity is the primary owner. The agreement provides for only nominal distributions from the partnership for several years, and the value of the partnership can build up tax-free.

At some point, the charity is expected to "cash out" early at a substantial discount (in accordance with the partnership agreement), which leaves the bulk of the partnership value for the benefit of the family members who originally held only 2% of the interests. Meanwhile, one or more family members are designated as managers of the partnership, and are supposed to receive substantial amounts in compensation (sometimes proposed to be as high as 8% per year).

There are risks to the family members and the charity if the amount of compensation is higher than can be justified based on the services performed. The charity should review the agreements carefully to determine what it will actually receive.

The bottom line is that the transaction should be scrutinized carefully (because you know the IRS will) to determine if the involvement of the charity is really for the benefit of the charity, or simply to provide a tax benefit to the family member (which is how they are usually marketed to the potential "donors").

Valuation And Substantiation Quagmire

Valuation discounts have long been a viable tool for estate planners who are trying to reduce the value of undivided or minority interests owned by their clients. If these same interests pass to charity, during lifetime or at death, it is likely that the same valuation discounts will apply in determining the amount of the charitable deduction.

When clients or charities are involved in donations of undivided or minority interests, it is important to point out to the donor that the value of the gift may be less than expected because of the appropriate discounts. Be careful to provide a description of what is received by your charity, but it would be wise not to get into the valuation game--the charity is not required to provide a valuation to the donor.

Quid Pro Quo

If a donation is over $75, and the charity provides goods or services to the donor, it must provide a receipt that provides the value of goods or services received. [IRC § 6115] If the donation is over $250 with no return of goods or services, the donor will still need to obtain a receipt from the charity, and the receipt must indicate if any goods or services were received. [IRC § 170(f)(8)] Charities must be honest about direct and indirect benefits to individuals. If making a donation permits a donor to receive preferential tickets to an event, it is important to determine the market value of the tickets. If a donation entitles a donor to attend a recognition dinner, make sure to inform the donor of the market value of the dinner (and entertainment if applicable).

Certain goods or services are considered insubstantial. In 1998, they include goods and services, the value of which do not exceed the lesser of 2% of the contribution, or $71; contributions of $35.50 or less; or if the only benefits received have an aggregate annual value of not more than $6.70. [Treas. Reg. § 1.170A-1(h)(3) and Rev. Proc. 97-57]

A receipt is not required for donations in the form of an annual payment of $75 or less, if the membership benefits are limited to free or discounted admission to member-only events, and the cost to the charity is not more than $6.70 per person. Also included are membership benefits that are limited to free or discounted access to the charity's facilities, and/or discounts on the purchase of goods or services (such as discounts at the gift shop).

Watch out for the less obvious items such as: 1) payment to a church for a family wedding or other ceremony; 2) donation to a school that is intended to be used to provide education for a family member; and 3) a donation to a retirement home to allow admission of a family member.

New Intermediate Sanctions For Private Inurement

Section 501(c)(3) has always required a charity to use funds exclusively for charitable purposes, and not for the benefit of private individuals. Prior to the Taxpayer Bill of Rights, which was signed into law on July 30, 1996, the only real alternative was revocation of the entity's tax exempt status (a step that was only taken in the most extreme cases).

As part of the Taxpayer Bill of Rights, intermediate sanctions have been added that apply to actions providing a benefit to "disqualified individuals"--such as excess compensation, sales, or exchanges of assets, leases, loans, etc.

The "penalty" is in the form of a tax equal to 25% of the amount of the excess benefit, payable by the disqualified person, and 10% payable by organization managers involved in the transaction. If not corrected before the next tax period, there is a second tier tax on the disqualified person equal to 200%.

Who Is The Client And Who Is The Lawyer?

Providing Documents And Giving Legal Advice. It is common (and sometimes appropriate) for charities and other nonlawyers to provide documents to donors and inexperienced attorneys in order to facilitate the planned charitable gift. Because some donors will do almost anything to avoid dealing with a lawyer, they may expect employees of the charity (and other nonlawyers) to provide the legal advice so that lawyers don't have to get involved.

There are also situations where the charity attempts to take care of all the legal issues for the donor, so that a lawyer doesn't get involved and mess up everything. Whether you agree or not, every state has rather strict rules regarding the unauthorized practice of law.

There is nothing inherently wrong with providing prototype or sample documents--if it is made clear from where the document comes, and that it should not be relied upon without independent determination of appropriateness for a particular donor and situation.

Regarding legal advice, the line is very fuzzy. However, charities and their employees need to be careful about any advice given to donors and potential donors. If the advice is legal, it may be considered the unauthorized practice of law.

As an example of what can happen, the Texas State Bar Committee on Unauthorized Practice of Law is investigating Arthur Andersen and Deloitte & Touche for alleged violations in connection with the drafting of legal documents, implementing estate plans, and representing clients in tax court--all without the involvement of legal counsel. See Charitable Gift Planning News, Vol.16 No.5, May 1998, page 1.

Dealing With Lawyers Who Are Out Of Their Element. It is very tempting for a charity's employee who is well-educated in planned giving to cross the line in providing documents and/or advice to a client and his/her attorney, when the attorney appears not to know what he/she is doing in this area. Frustration with the lack of progress being made by such an attorney may encourage the charity's employees to push just a little too hard to close the deal.

The safest route is to encourage the client and/or the attorney to seek the assistance of a lawyer who specializes in planned giving. (I like to make an analogy to the medical practice where it is common for general practitioners to refer patients to particular specialists.)

The Need For Separate Representation. Be careful if the charity's lawyer is also representing the donor regarding advice, or in the preparation of documents. Even if the potential conflict has been discussed and waived, there is the appearance of impropriety if a lawyer with strong ties to the charity is the only one advising the donor on the available options.

The biggest risk is often the surviving family members who claim the charity crossed the line and is guilty of undue influence in pursuing the charitable gift or bequest. Remember that even if the charity wins the fight, the negative publicity may be worse than the cost of an early (and private) settlement.

Payment Of Fees And Expenses. In most cases, the charity should not pay the legal or accounting fees for work that is done for the benefit of the donor, or for the benefit of a trust, or entity other than the charity. The line gets rather fuzzy in the case of a charitable remainder trust (or other split interest gift) where both the donor and the charity will benefit from the transaction. The risk is that the payment of attorney fees by the charity will be treated as a quid pro quo that will reduce, or eliminate, the value of the charitable deduction.

An additional concern is the risk of private benefit if funds from the charity are used to satisfy a donor's financial obligations (i.e., legal or accounting fees). Sometimes it is a tough choice between obtaining and paying for a lawyer, and the donor simply deciding to go it alone. There is a constant question as to which is the bigger risk: 1) being accused of undue influence because the charity's lawyer advises the donor; or 2) being accused of undue influence because the donor does not consult with a lawyer.

It might be possible to argue that the involvement of the lawyer was to protect the charity from future claims from family members (making it appropriate for the charity to pay part, or all, of the fees). On the other hand, it would be best to avoid any situation that requires having to make this argument.

Dealing With An Insistent/Aggressive Board Of Directors

A board member (or the entire board) suggests a transaction that you believe is not appropriate (or perhaps illegal) for the charity. You know you should tell the board you won't carry out the transaction, but you know they are responsible for paying your salary.

Try to avoid the situation in advance by providing appropriate education to your board so they will know where the line is that should not be crossed. Hopefully, a board that is familiar with the rules and limitations will not put you in a tight spot.

Don't give in to the temptation to achieve short-term goals if it means losing the long-term benefits. Encourage your board that the short-term benefit of the proposed transaction may not be worth the long-term disadvantage of: 1) potential litigation and/or liability; and/or 2) reduced donations in the future if the charity's reputation is called into question.

Examples. Be on the lookout for potential conflicts of interest among board members (and their families) when?

  • The board member is proposing a life insurance program, and you know that the board member's child is the one who will be selling all the policies (and receiving nice commissions).
  • The board is proposing the acceptance of some appreciated real property for a charitable remainder trust (or outright gift), and you are aware that one of the board members will be involved in the sale of the property and will receive a sizable commission.

Possible solutions could be?

  • Let the IRS and/or the lawyers play the roll of the heavy. You can tell the donor and/or the board that you have talked with the lawyers and they say it cannot be done (people already tend to dislike lawyers, and this will just give them another reason to pass along the next lawyer joke). You can also tell your board that because the lawyers say we can't do it, the board member will just have to take it up with the lawyer. Most people really don't want to talk with lawyers, so this should get you off the hook.
  • Tell the board that they have a good idea, but someone has already thought of it a few years ago and the tax laws were changed to prevent such a transaction.
  • Tell the board you will be happy to carry out the proposed transaction provided they will increase the amount of your litigation defense fund budget (maybe you are not this brave, but you get the idea).

Parting Thoughts

While there may be differences of opinion on where the line is, it does not mean we should avoid looking for it--and when we find it, we should know what to do next.

Remember what you learned in school--for every action there is an opposite and equal reaction. While we are certainly allowed to push the envelope in the charitable field, we shouldn't be surprised when the IRS pushes back. Also remember the old Aesop fable about the dog crossing the river who lost his bone in the water while trying to grab the bone of the other dog in its reflection: "Don't be greedy."

Be aware of how charitable planning ideas are being sold to the donor. There are few, if any, situations where the donor and family members are ahead financially by including charity as part of the planning. Therefore, be very cautious of planning ideas that are being sold on this basis.

Finally, consider whether you have, or should arrange for liability coverage for the charitable organization's board and officers to cover the liability risks for the kinds of things discussed in these materials. Above all, make sure you are honest with your donors and clients, even if telling them the truth, or giving them an accurate assessment of the risks, might result in losing a big gift or bequest, or the ability to assist with the legal work.

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