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Update on Charitable Tax Planning: Guidance on Donor-Advised Funds and Overview of New UBTI Rules

Tax Update, Volume 2018, Issue 2

Author: Lisa B. Petkun

Volume 2018, Issue 2
Update on Charitable Tax Planning: Guidance on Donor-Advised Funds and Overview of New UBTI Rules

Donor-Advised Funds
There are many areas in which guidance is lacking concerning the operation of a donor-advised fund (DAF). In Notice 2017-73, the IRS provided interim guidance on two specific issues and requested comments on several others. Two of these issues — tickets to charity events and fulfillment of donor pledges — directly impact donors.

Background of DAFs

DAFs continue to gain popularity. A DAF is a charitable giving vehicle maintained by a public charity, where the charity can be associated with the charitable affiliate of an institutional investment firm or can be a community foundation, religious organization, university or other large nonprofit institution. A DAF allows donors to make charitable contributions, receive immediate tax deductions, and then recommend grants from the fund over time. A DAF is like a charitable savings account in which donors contribute to the fund as frequently as they like and then recommend grants to their favorite charity.

A DAF functions in many ways like a private foundation that is part of a large group of private foundations, although a contribution to a DAF receives the more favorable income tax treatment afforded to a contribution to a public charity. Also, unlike a private foundation, which is required to make an annual minimum distribution of 5 percent of the value of its assets to a public charity, a DAF has no required distribution. Moreover, the self-dealing rules applicable to a private foundation are well-established, whereas restrictions imposed on a DAF are less defined. Another difference is that a foundation is typically controlled by the donor or the donor’s family, and therefore they can determine the identity of grantees. However, with a DAF, the DAF sponsoring charity is not legally obligated to grant the funds as directed by the donor. As a practical matter, if the desired grantee is an appropriate exempt organization, it is unlikely that the donor’s wishes will be disregarded.

Use of DAFs Under New Tax Law

As a result of the 2018 law changes made by the Tax Cuts and Jobs Act (the New Tax Act), many taxpayers may not have enough deductions to get above the standard deduction. This may result from the increase in the standard deduction, the restriction of popular deductions such as real estate taxes and state and local taxes, and the elimination of deductions for items that had been subject to the "2 percent rule." As a result, donors may want to "clump" their charitable deductions by using a DAF. A donor could contribute several years’ worth of charitable donations to a DAF in 2018, and have the DAF distribute those funds to the desired charities over the next few years. By front-loading the contribution, the donor may be able to claim a deduction in the year of the DAF funding that would otherwise not be available if contributions were made directly to the underlying charities over a period of years.

Tickets to Charity Events and Membership Fees

Section 4967 imposes an excise tax of 125 percent on a donor who receives more than an "incidental benefit" in connection with an advised gift made by a DAF. The Notice addresses situations in which a payment from a DAF to a charity enables the donor to attend or participate in an event. It concludes that, in these situations, the donor has received a more than an incidental benefit. For example, if a donor advises a $1,000 gift from a DAF and receives a ticket to attend an event with a fair market value of $200, has the donor received something that is more than incidental? The Notice says yes. The Notice further concludes that there would be more than an incidental benefit even if the DAF contributed $800 and the donor purchased the ticket for $200. The Notice takes the position that the same analysis would apply when a donor receives membership benefits as part of a DAF gift. The position in the Notice follows the approach used with private foundations. The IRS comments that a donor who wishes to receive tickets to an event offered by a charity in exchange for a contribution can make the contribution directly, without the involvement of a DAF.

Fulfillment of Donor Pledges

The Notice provides that the current law is uncertain about whether a grant from a DAF that fulfils the personal pledge of a donor would be treated as more than an incidental benefit that gives rise to a 125 percent excise tax. The Notice concludes that such a distribution would not give rise to an excise tax if the following requirements are satisfied: (1) The DAF sponsoring organization makes no reference to the existence of a charitable pledge when making the DAF distribution; (2) no donor receives, directly or indirectly, another benefit that is more than incidental on account of the DAF distribution; and (3) the donor does not attempt to claim a charitable contribution deduction for the DAF distribution, even if the charity receiving the distribution mistakenly sends the donor a tax contribution acknowledgement. The conclusion that there is no excise tax upon the fulfillment of a pledge is different than the treatment of a pledge fulfilled by a private foundation that satisfies the legal obligation of a disqualified person (substantial contributor or officer or director of the foundation). Such a grant constitutes an act of self-dealing, which causes the self-dealer to pay an excise tax. The Notice justifies the different treatment by noting that the relationship between a private foundation and its disqualified persons typically is much closer than the relationship between a DAF sponsoring organization and its donor. The Notice further observes that it is difficult for sponsoring organizations to determine when a donor has made a legally enforceable pledge.

Public Support Test; Treatment of DAF Grants

The Notice addresses preventing "the use of DAFs to circumvent the excise tax rules applicable to private foundations." Under the current rules, an exempt organization that receives more than one-third of its support from the general public qualifies as a public charity and not a private foundation. The perceived loophole with DAF grants is that grants from a DAF are considered to be from the DAF’s sponsoring organization and not from an individual donor. If the grant came from a donor, the grant would be subject to a more restrictive limit in computing public support than if it came from the sponsoring organization. The IRS is aware that some donors and grantee charities seek to use DAF sponsoring organizations as intermediaries. Rather than donors making contributions directly to charities, where the contributions would be subject to more restrictive limitations, these donors make contributions to DAFs and then advise the sponsoring organizations to make distributions from the DAFs to grantee charities. In light of the potential for abuse, the IRS is considering treating, solely for purposes of determining whether the grantee charity qualifies as publicly supported, a distribution from a DAF as an indirect contribution from the donor who funded the DAF rather than as a contribution from the sponsoring organization. Under a revision to the regulations, for purposes of calculating its public support percentage, an organization receiving a grant from a DAF would be required to treat (1) a DAF sponsoring organization’s distribution from a DAF as coming from the donor who funded the DAF; (2) all anonymous contributions received — including a DAF grant for which the sponsoring organization fails to identify the donor who funded the DAF — as being made by one person; and (3) a distribution from a sponsoring organization as public support without limitation only if the sponsoring organization specifies that the distribution is not from a DAF or states that no donor advised the distribution.

Transfer of Funds by a Private Foundation to a DAF as a ‘Qualifying Distribution’

The Notice requests comments on whether a contribution to a DAF by a private foundation should be considered a distribution that counts for purposes of a private foundation’s annual 5 percent distribution requirement only if the DAF sponsoring organization agrees to distribute the funds for charitable purposes within a certain time frame. Although not stated in the Notice, the concern is that, by making a distribution to a DAF, a private foundation could avoid the intent of the private foundation distribution rules. The purpose of these rules is to ensure that at least a portion of the assets of a private foundation are expended for actual charitable use. If a private foundation makes a distribution to a DAF sponsoring organization, and the DAF sponsoring organization does not distribute the funds, the purposes of the private foundation distribution rules could be thwarted.

New UBTI Rules for Trade or Business Income and Loss
The New Tax Act made a change to the tax law regarding the computation of unrelated business taxable income (UBTI) that could have wide-ranging ramifications. Generally, income from an exempt organization’s trade or business that is not substantially related to the performance of its tax-exempt function is subject to tax as UBTI. Before the New Tax Act, all UBTI was aggregated, with the result that losses from one trade or business would offset income from another. Under the New Tax Act, exempt entities must compute income and loss separately with respect to each trade or business, so that losses from one trade or business cannot offset income from another, effective for taxable years beginning after January 1, 2018.

There is no guidance on how to determine what is a separate trade or business. If an exempt organization has invested in one partnership that conducts multiple businesses, must each trade or business conducted by the partnership be separately traced? Are all oil and gas businesses one business? If an exempt organization invests its endowment in 100 funds of funds, each of which has invested in multiple pass-through entities, must there be a tracing to each investment? Or could all K-1s be aggregated as one business, perhaps by separating income generated by passive investment as a single trade or business? Some have suggested that businesses could be "siloed" based on separate activities, such as consulting versus retail. There is the added complication of how to characterize income that is generated from activities for which the exempt organization borrows money to invest in the activity, thereby generating debt-financed income. Until guidance is provided, taxpayers will remain in the dark on how the new rule will operate.

The new rules arose from a concern raised by the IRS in its college and university study. There, the IRS found that a number of those surveyed had businesses that generated perpetual operating losses. The study found that the net operating losses (NOLs) generated from these activities were used to offset income from profitable businesses. The IRS believed that these losses should have been disallowed because the money-losing businesses were not legitimate businesses. However, rather than implementing a solution, such as precluding the use of losses from an unrelated business that continues to generate losses after a period of years, the new rule instead siloed the losses.

Recently, IRS representatives stated that they are working on providing guidance on this issue. In addition, the IRS is updating Form 990-T, "exempt organization business income tax return," to account for the law changes.

A further change in the New Tax Act is that, effective for NOLs arising in 2018 and thereafter, an NOL can no longer be carried back to any prior tax year and can only be carried forward. Further, the NOL can offset only up to 80 percent of a corporation’s taxable income. In addition, the prior 20-year carryforward period is eliminated, such that NOLs arising after the effective date of the New Tax Act can be carried forward indefinitely. NOLs that arose in years prior to the effective date of the New Tax Act remain subject to the 20-year carryforward period.

As a result of this rule, exempt organizations that incur NOLs in 2018 and thereafter from the operation of unrelated trades or businesses are no longer able to eliminate all UBTI through the use of NOL carryforwards because new NOLs can only be used to offset a maximum of 80 percent of taxable income. As a result, tax-exempt organizations would now be subject to the unrelated business income tax on a minimum of 20 percent of their UBTI. However, the New Tax Act does not change the ability of taxpayers to offset income with NOLs that were incurred in a tax year that began before January 1, 2018. Thus, in general, existing NOL carryforwards can still be used to offset more than 80 percent of an exempt organization’s UBTI. The interaction of the NOL limitation, the issues around the ordering rules and use of NOLs incurred in years before and after the effective date of the New Tax Act, and the "siloing" of separate trades or businesses will create even more complications for which guidance is needed.

Pepper Perspective
The IRS’s position that a DAF that makes a charitable grant that enables the donor to attend an event has provided more than an incidental benefit, subjecting the donor to an excise tax, is not welcome news. However, this position is consistent with the rules governing private foundations and was not unexpected. Donors should be pleased with the IRS’s position that a DAF grant that satisfies a donor’s pledge is not more than an incidental benefit.

Concerning UBTI, exempt organizations and pass-through entities that produce UBTI for their exempt organizations need to know how to apply the new rule that income and loss must be computed separately with respect to each trade or business. However, until the IRS issues guidance on how to determine what constitutes a trade or business, exempt organizations are left speculating on this topic. It is possible that, once guidance is provided, these investments will be restructured to ensure maximum use of losses. Understanding how this determination is made takes on even more significance in applying the rule that an NOL generated after the effective date of the New Tax Act can offset only 80 percent of taxable income.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.