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George F. Bearup, J.D. Senior Legal Trust Advisor

2-Sep-20

Donor Advised Funds: Closer Scrutiny Ahead

Take-Away: There is pending a federal court case that addresses how much ‘control’ a donor can exercise over the donor’s contribution to a donor advised fund, and by inference, if the donor advised fund is reclassified as a private foundation. This case may shed light on just how many conditions a donor can impose on a gift to a donor advised fund and still claim a charitable income tax deduction.

Court Case:  Fairbain v. Fidelity Investments Charitable Gift Fund, Case No. 18-CV-4881-JSC (N.D. Cal March 2, 2020)

Facts: The Fairbains considered a gift of about $100 million in cash on marketable securities [1.98 million shares of Energous, a publically traded company.] As they were investment advisors they were acutely aware of the impact of the liquidation of their publically traded securities in a short period of time on the value/price of those securities. Accordingly, the Fairbains claimed to have imposed several liquidation restrictions on Fidelity Investments Charitable Gift Fund (Fidelity) Fidelity’s donor advised fund. Those restrictions included Fidelity’s claimed agreement that upon its receipt of the Energous stock it would: (i) employ sophisticated state-of-the-art methods to liquidate the large bloc of Energous stock; (ii) it would not trade more than 10% of the daily trading volume of Energous at one time; (iii) it would not liquidate any of the Energous stock until 2018; and (iv) it would allow the Fairbains to advise on the price limits for the Energous stock. The 1.93 million shares of Energous were gifted to Fidelity on December 28 and December 29, 2017. To be expected, none of the liquidation restrictions or ‘promises’ were in writing, and only orally made by Fidelity. Fidelity liquidated the entire 1.93 million shares of Energous in a 3-hour trading window on December 29, 2017 which caused more than a 30% run-down in the value of the Energous stock which, in turn, resulted in more than $10 million less in charitable income tax deductions the Fairbains were able to claim.

  • More Background: Apparently the Fairbains already had a $20 million donor advised fund with JP Morgan where they claimed that JP Morgan allowed donors to advise on the timing and rate at which donated securities are liquidated. In contrast, Fidelity had no such policy, and Fidelity’s guidelines only stated that it would liquidate donated stock at the earliest possible date. It is unclear why the Fairbains opted to use Fidelity’s donor advised fund when they already had a donor advised fund at JP Morgan.

Contested Issues: Donor advised funds permit only advisory privileges to the donor. Yet the Fairbains claim that Fidelity agreed to several binding contractual restrictions on the liquidation of the donated Energous stock transferred to the Fidelity donor advised fund. There are far-reaching implications if more than just advisory privileges were given to the Fairbains, including: (i) no charitable income tax deduction to the Fairbains, if Fidelity did not have exclusive legal control over the gifted securities [IRC 170(f)(18)(B).]; and (ii) reclassification of Fidelity’s donor advised fund as a private foundation, which reclassification would cascade into other legal requirements, like providing an acknowledgement of the gift and the need for a qualified appraisal of the stock. [IRC 4966(d)(2).]

Lawsuit: The Fairbains sued Fidelity claiming: (i) misrepresentation; (ii) breach of contract; (iii) estoppel; (iv) negligence; and (v) violation of California’s Unfair Competition law, all leading to a claim that Fidelity restore to the Fairbains the amount of money that a ‘reasonably competent liquidation’ would have yielded, leading to a larger charitable income tax deduction. Fidelity responded that as the sponsoring organization of the donor advised fund, it was required to have exclusive legal control over the donated shares of stock of Energous; in other words, Fidelity could not be bound to any promises is may have made to the Fairbains because it, as sponsor of a donor advised fund, was required by law to have exclusive legal control over the donated shares.

Court: The federal District Court judge denied Fidelity’s Motion for Summary Judgment. Interestingly, with regard to the ‘exclusive legal control’ defense asserted by Fidelity, the judge observed that while the tax law requires the sponsor of a donor advised fund to have exclusive legal control over the donated assets, the parties were still free, albeit at their own peril, to enter into a legally binding agreement that ultimately could cause a purported donor advised fund not to provide the otherwise available tax benefits to the donor. Restating this judicial observation, if Fidelity made legally enforceable promises to the Fairbains with regard to the liquidation of the donated stock, then that would disqualify the Fairbains’ donation from any charitable income tax deduction. In fact, the judge noted that if the Fairbains are successful in their lawsuit against Fidelity, the IRS may take action against the Fairbains to recover any improper charitable deduction claimed by them, i.e. invoking the old adage be careful of what you ask for- you will suffer the consequences if you successfully enforce the promises you claim were made to induce you to contribute to Fidelity’s donor advise fund.

So this case now heads to trial.

Other Defenses: A couple of other defenses were addressed by the trial judge in rejecting Fidelity’s arguments.

  • Tax Estoppel: The Fairbains claimed an income tax charitable deduction on their tax return as a result of their gift to the Fidelity donor advised fund. In order to claim that deduction, Fidelity had to have exclusive legal control over the gift. Therefore, the Fairbains are estopped to claim that they retained legally enforceable rights with regard to the liquidation of the Energous stock and that Fidelity was bound by the liquidation restrictions to which it allegedly agreed. The judge found that at this early stage of the litigation it was not established that Fidelity did not acquire exclusive legal control of the donation as required by the Tax Code.
  • Timing of Restrictions: Fidelity also relied upon an earlier court decision, Fund for Anonymous Gifts v. Internal Revenue Service, No. CIV 95-1629 RCL, 1997 WL 198108 (D.D.C. April 15, 1997) vacated in part, 194 F.3d 173 (D. C. Cir. 1999) which Fidelity claimed provided that any enforceable conditions or restrictions on gifts to the donor advised fund must be agreed to after, or subsequent, to the gift, not before, which is the Fairbains’ claim. The trial judge found that the legislative history of donor advised funds made no distinction between restrictions prior to or at the time of the donation or subsequent to the transfer of the assets to the donor advised fund. Consequently, the judge found that the timing of the restrictions will not impact the availability of the charitable deduction, but it may impact the amount of the deduction (i.e. reducing the value of the donated property.)

Possible Outcomes: It will be interesting to see how this litigation shakes out after a trial. Some possible results include:

  • Disqualified as a Donor Advised Fund: If the liquidation agreement between Fidelity, the donor advised fund sponsor, and the donor, the Fairbains,  goes beyond advisory privileges then the fund will be disqualified. The legislative history to donor advised funds notes: “Advisory privileges are distinct from a legal right or obligation. For example, if a donor executes a gift agreement with a sponsoring organization that specifies certain enforceable rights of the donor with respect to a gift, the donor will not be treated as having ‘advisory privileges’ due to such enforceable rights for purposes of the donor advised fund definition.” A donor advised fund is not separate from its sponsoring organization, it is a component part of the sponsor, i.e. a public charity. If it is not a component part of the sponsor, then the fund will be classified as a private foundation, not a public charity.
  • Excise Tax: If Fidelity’s fund is treated as a private foundation, a 1.39% excise tax on net investment income, which includes capital gain, will be imposed. Therefore, Fidelity’s sale of the Energous stock would be exposed to a 1.39% excise tax. [IRC 4940.]
  • Charitable Tax Deduction Limitations: If the Fidelity fund is later to be determined to be a private foundation and not a donor advised fund, then that will change the charitable deduction available to the Fairbains. The amount of their income tax charitable deduction will be limited to their income tax basis in the Energous stock because their contributed stock does not constitute qualified appreciated stock, due to the restrictions imposed on its liquidation. [IRC 170(e)(5)(B).] Therefore, the Fairbains could deduct only up to 20% of their contribution base (as opposed to the 30% limitation applied for contributions to a public charity.)

Conclusion: This litigation will provide some interesting insights into the implications of liquidation restrictions imposed on assets contributed to a donor advised fund. The question that I have is if the Fidelity fund is determined to be a private foundation, will that classification be limited solely to the Fairbains, or will all gifts to the Fidelity donor advised fund be implicated, which will limit the amount of tax deductions other donors may claim with their charitable gifts to that donor advised fund. Only time will tell.