Special Report: 15 Years of Taxes
April 1, 2002 Harvey Berger
When I was first asked to write about the most significant tax developments for nonprofit organizations in the past 15 years, a lot of things came to mind. I pondered over intermediate sanctions, quid-pro-quo contributions, travel tours, corporate sponsorships and other even more arcane subjects.
As I did so, I concluded that most of these subjects involved issues that had arisen from action by the Internal Revenue Service (IRS) or Congress. Nonprofit organizations then had to deal with them, which made understanding the issues important.
However, I felt that the most significant developments should be those that arose from the industry itself, and which caused the IRS to react to what was going on.
The two most significant developments of that ilk are the dependency of nonprofits on revenue other than contributions or dues, and the rise of the donor advised fund. Both of these items have resulted in reactions from the IRS, some of which have been fascinating to watch.
Of course, things are still happening in these areas and will continue to happen for the foreseeable future.
Outside revenue streams
At one time, most organizations relied almost exclusively on contributions and gifts, if you were a Section 501(c)(3) organization, and on dues if you were some other category of exempt entity. This is probably still true today for some of you.
However, as your financial lives have gotten more complicated, and as the demands on your organizations have continued to increase, these revenue sources are often not enough. In addition, you have discovered that your organization may own intangible assets that are valuable to third parties.
We have therefore witnessed an explosion of additional sources of revenue to your organizations (some of you may feel this more powerfully than others). In recent years, we have seen revenue streams develop from mailing list transactions, licensing of other intangible assets, Internet transactions, exclusive provider agreements, joint ventures and many other sources.
The impetus for much of this activity comes from for-profit businesses that want to access your members, donors, or others within your sphere of influence, and are willing to pay for the privilege. Many of the proposed arrangements moved into areas of the tax law that were uncharted. Therefore, your organizations and tax advisors made decisions as to taxability and moved on with the deal in order to take advantage of the new revenue source.
The IRS has tried to deal with these transactions, and has had a lot of difficulty in doing so. The area of mailing lists is a classic example. The IRS had won a case in 1981 in which the Court of Claims taxed an organization on income from renting its donor list. In a subsequent year, the organization again took the position that the income was not taxable. The IRS again challenged this treatment. The organization went to Tax Court this time, which held that the income from the donor lists was exempt as royalty income. The IRS appealed and won when the Appeals Court decided the organization couldn’t make the same argument it had lost before.
The IRS began challenging royalty treatment for any arrangement in which an organization provided a member or donor list as part of its consideration for the revenue. In fact, the IRS adopted a “tainting” rule — if you provide a mailing list, every dollar you receive is taxable, regardless of other considerations.
Needless to say, organizations challenged this intransigent position, and took their cases to Tax Court. As they had in the Tax Court previously, the IRS lost all of these new cases, and the appeals as well. It took several years, but the IRS finally gave up on the broad position that mailing list transactions were taxable and tainted other aspects of a transaction. Its current position is that your organization will owe tax if it provides services in connection with the use of an intangible, but only the profits from those services is taxable.
We are currently seeing the IRS struggle in other areas. Joint ventures between nonprofit organizations and for-profit companies are currently before the IRS. They are wrestling with whether such deals could cause your organization to lose its tax exemption, whether they are taxable as unrelated trade or business income, or whether they are merely another way to conduct your exempt purpose activities. As arrangements proliferate, the IRS will have to come to some conclusions and provide guidance to you and to others who are establishing these ventures with for-profit companies.
The search for outside revenue streams to provide additional funds to your organization will continue. Our changing economic situation makes it difficult for you to rely on a few sources of revenue. Diversification, as it does in investments, is also a helpful concept in raising funds to keep your organization financially healthy. Therefore, we will see new concepts develop, and the IRS will have to keep pace. This will be a continuing challenge to them and to you as you search for certainty in your tax position.
Donor advised funds
The other choice for a significant tax development during the past 15 years is the rise of the donor advised fund (DAF). While the concept is not totally tax-driven, it wasn’t until the IRS accepted it that DAFs began to proliferate.
To understand DAFs, we have to look back more than 30 years to pre-1969. Then, a donor could set up a “private charity.” The organization would meet the definitions of a Section 501(c)(3) organization, and would receive deductible donations from a few people, generally one family. There were few restrictions or requirements for the operation of these organizations, so they often just held non-liquid assets, such as artwork or stock in a closely held business, for which their donors had claimed charitable deductions for contributing.
In 1969, Congress closed the “private charity” loophole by creating “private foundations” (PF). The new provisions imposed numerous requirements on these organizations – they had to make annual distributions for charitable purposes, they generally couldn’t own interests in closely held businesses, and they couldn’t engage in transactions with board members, substantial contributors, or their families. The PF provisions generally have worked to eliminate most of the abuses that existed prior to 1969, but the burdensome restrictions make them unattractive to some donors.
A DAF is an account within the confines of a public charity. Community foundations have had them for many years, and the tax regulations provide a structure for a community foundation that wants to establish one. However, in the 1980s and 1990s, new charitable organizations were formed, primarily by financial services companies, which carried the concept to a higher level.
Here is how a DAF works. A donor transfers assets (cash, appreciated securities, real estate, etc.) to the charity. The donor is generally entitled to deduct the full fair market value of the transferred assets under the annual limitations that apply to public charities, which are higher than those that apply to donations to a PF. At some future time, the donor, or someone designated by the donor, can “advise” the charity to transfer funds from the account to a recognized public charity.
In most cases, the charity will follow the advice, as long as there are no benefits to the donor or other problematic aspects to the transaction. If the charity itself has limited purposes, such as only supporting organizations within a geographic area or those that work for a specific cause, the acceptable advisory donees may have to come within those purposes. The charities established by financial services firms generally will follow advice for donations to any recognized Section 501(c)(3) organization. Thus, the donor receives the full charitable deduction in one year, and has some measure of control over making the actual donations in future years.
Many donors view the DAF as a great improvement over the private foundation. The deduction limitations are higher, and there are none of the restrictions that apply to a PF. The fund will last as long as it has some assets left to transfer.
The drawback to a DAF is that the donor and his family do not have absolute control over the operations, they can only “advise” the charity. Also, the subsequent donations come from the sponsoring charity not the donor directly. The donor can’t accept some of the perks, such as dinners or other recognition, which would come from a direct donation. Especially in the charities controlled by a financial institution, the investments available for the funds may be limited to a few mutual funds or other designated accounts. A PF offers more flexibility in investing assets held for charitable purposes and in allowing the donor to manage the organization.
The IRS has grudgingly accepted these new DAF sponsors. They have required the sponsoring charity to distribute 5 percent of assets each year, but not from each DAF. Thus if one donor requests donations of 10 percent of his or her fund, some other donor can advise for less than 5 percent. A PF must distribute each year in order to avoid a penalty tax. The IRS has also required the sponsoring charity to make sure the advisor does not receive personal benefits from the subsequent donations. These and other requirements have been acceptable to the sponsors, and DAFs have become much more common.
We will continue to see the development and expansion of the DAF concept. Many public charities have established DAFs within their operations. Of course, they expect to receive much of the assets that donor advisors contribute to the fund, but they often will have to accept donations to other charities.
However, the DAF concept is very attractive to a donor who has an unexpected windfall that increases his tax liability beyond the acceptable level. It is easier to establish a DAF, transfer the assets, and decide on the ultimate charitable recipients later.
Harvey Berger is a partner and national director of not-for-profit tax services in Alexandria, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: email@example.com.
NPT staff writer Jeff Berger also contributed to this story