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

2-Dec-20

Donor Advised Funds: Too Much Retained Control?

Take-Away: If the donor’s gift to a donor advised fund (DAF) is subject to too much control over the contribution to that DAF, it may cease to be tax exempt under the Tax Code, and the donor’s gift to the DAF may be treated as a gift to a private foundation. That ‘worst-case-scenario’ would limit the donor’s charitable deduction to 20% of the donor’s adjusted gross income  with the charitable gift’s tax basis used as the amount of the charitable income tax deduction.

Background: There is a interesting case now grinding its way through the federal courts in California that was previously reported in an earlier missive, Fairbairn v. Fidelity Charitable.

  • Facts: The donors, Mr. and Mrs. Fairbain, made a gift of close to $100 million of publically traded securities to Fidelity Charitable which sponsors a DAF’s: 1.93 million shares of Energous stock traded on the NASDAQ exchange. The dispute arose because the Fairbains claim that as an inducement to them to make their large gift of stock to Fidelity Charitable (Fidelity’s) donor advised fund (DAF) several promises were made to them by Fidelity. Those promises included: (i) Fidelity would employ sophisticated state-of-the-art methods to liquidate large blocks of stock; (ii) Fidelity would not trade more than 10% of the daily trading volume of Energous shares; (iii) Fidelity would not liquidate any of the Energous shares until 2018; and (iv) Fidelity would follow the Fairbains advice on price limits, a point below which Fidelity allegedly agreed not to sell the Energous stock without first consulting the Fairbains. The Fairbains were sophisticated investment advisors who were fully aware of the impact of disposing of a large number of publically traded shares in a short period of time. Moreover, even after their substantial gift of stock to the DAF, the Fairbains continued to retain a substantial interest in Energous, the value of which they wanted to protect through the conditions that they imposed on Fidelity. In short, the Fairbains’ wanted to control when and how the gift of their publically traded Energous stock would be disposed by Fidelity.
  • Gift to DAF: The 700,000 shares of Energous stock was given to the DAF on December 28, 2017. The remaining Energous shares were gifted on December 29, 2017.The gifts were made immediately after a favorable ruling from the FCC with regard to Energous which increased its value by more than 39%. Fidelity, following its stated policy that it will liquidate donated stock “at the earliest possible date” promptly liquidated the entire block of Energous stock over a three hour period on December 29, 2017 which caused a drop in the stock’s average daily trading price per share by 30%.
  • Lawsuit: The Fairbains sued Fidelity for not abiding by its promises. The Fairbains claim that the sale of all of their donated Energous stock in the short three hours caused, contrary to Fidelity’s promises, caused a significant reduction in the amount of the charitable income tax deduction the Fairbains were able to claim on their 2017 income tax returns, not to mention there was much less held in the DAF from which they planned to make, i.e. advise,  future charitable gifts. The Fairbains seek damages and the addition of funds to their DAF to bring its balance back to the level it would have been had Fidelity followed their conditions on the stock’s liquidation. Fidelity’s defense is that in order for the Fairbains to claim an income tax charitable deduction they had to fully divest themselves of all control over the donated stock, such that the Fairbains could exercise no further act control over the Energous stock, nor over its liquidation. Thus, Fidelity claims that by the Fairbains taking an income tax charitable deduction with regard to their gift of the Energous stock to their DAF, the Fairbains attested that they only retained the privilege to advise, not to control, the liquidation of the Energous stock. In short, the Fairbains were taking an inconsistent position in the litigation with the position that they took on their 1040 income tax return.
  • Federal Court: The federal judge, at this preliminary stage of this litigation, refused to grant Fidelity’s motion for summary judgment. The judge distinguished when the Fairbains placed conditions on the liquidation of the stock: before the charitable gift versus any attempt to control the stock after it had been given to Fidelity. In addition, the judge found that the doctrine of tax estoppel, e. taking  an inconsistent position on an income tax return contrary to that taken in subsequent litigation, could not be applied to the Fairbains’ claims against Fidelity with regard to its unfilled promises. In permitting the litigation to proceed to trial, the judge however did observe: “ If the Fairbains prove that Fidelity made legally enforceable promises, and Fidelity is correct that such legally enforceable promises disqualify the donation from a charitable tax deduction, the IRS may take action against the Fairbains to recover any improper deduction. No ‘taxpayer estoppel’ is needed to prevent unfairness: Fidelity would be held to its promises, and the Fairbains would suffer the consequences, if any, of enforcing those promises.”

DAF Basics: We often take the income tax deduction associated with a contribution to a DAF for granted. It is helpful to review some of the principles behind establishing a DAF. As such, some thoughts on restrictions or conditions placed on gifts to a DAF follow.

  • DAF and its Sponsoring Organization: A DAF is treated as a component of the sponsoring organization, which is a public charity. Consequently, a contribution to the DAF is treated as a contribution directly to a public charity, the sponsoring organization. A DAF not a separate taxable entity.
  • Ultimate Control: The governing body of the DAF’s sponsoring organization must have the ultimate authority and control over the contributed assets and income from those contributed assets to meet the definition of a public [Treasury Regulation 1.507-2(a)(7)(i)(C).]
  • Private Foundation: If a DAF is not classified as a component part of its sponsoring organization, i.e. a public charity, the fund will be treated as a private foundation, not a public charity. [Treasury Regulation 1.170A-9(f)(11.]
  • Owned and Controlled: The Tax Code and implementing Regulations make it clear that all DAFs must be owned and controlled by its sponsoring organization. [IRC 4966(d)(2)(A)(ii).]
  • Acknowledgement of Exclusive Control: A donor to a DAF cannot claim a charitable income tax deduction unless the donor obtains a contemporaneous written acknowledgement from the DAF’s sponsoring organization that “such organization has exclusive control over the assets contributed.” [IRC 170(f)(18.]
  • Advisory Privileges: While the exclusive control must rest with the sponsoring organization, the donor may “have, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor.” [IRC 4966(d)(2)(A)(iii).] However, these advisory privileges are not legally binding control over the subject of the gift to the DAF.
  • Legally Enforceable Restrictions: An agreement between the DAF’s sponsoring organization and a donor that provides enforceable legal rights to the donor with respect to assets contributed to the DAF, legal rights that go beyond advisory privileges, will disqualify the fund from being treated as a DAF.
  • Private Foundation: If the gift to the sponsoring organization is not a DAF due to too much control retained by the donor over the contributed assets, that will cause the fund to be treated as a private foundation.

Possible  Tax Consequences to the ‘Controlling’ Donor: As the federal judge noted in his decision to deny Fidelity’s motion for summary judgment, the Fairbains by their litigation may ulitmately invoke the old phrase, “be careful what you as for, because you might get it.” The Fairbains may win their case against Fidelity and their claim that Fidelity did not abide by its promises to them, but in the process they might lose their entire charitable income tax deduction. Another, albeit less drastic consequence to the Fairbains v Fidelity litigation might be if the Fairbains gift of their Energous stock is treated as being a gift to a private foundation. The tax consequences arising from the gift to a private foundation would include the following:

  • AGI Charitable Deduction Limit: If the Fairbains are found to have enforceable legal rights over their contributed Energous stock to their Fidelity DAF, then the gross income percentage limitation for contributions to a private foundation is 20% of their contribution base, i.e. their adjusted gross income (AGI) for the year, as opposed to the 30% AGI limitation that is applied for contributions of property to a public charity (that sponsors a DAF.) [IRC 170(b)(1)(C).]
  • Deduction Limited to Basis: In the case of a contribution of appreciated stock to a private foundation, unless the stock meets the definition of qualified appreciated stock, the charitable income tax deduction will be limited to the income tax basis of the stock, not the stock’s fair market value which in in the Fairbains case is much, much higher. [IRC 170(b)(B)(ii).]
  • Qualified Appreciated Stock Defined: While the Fairbains’ Energous stock was publically traded on the NASDAQ, it will not meet the definition of qualified appreciated stock. That qualified appreciated stock classification is defined in the Regulations. Securities are not considered publically traded securities if “the securities are subject to any restrictions that materially affect the value of the securities to the donor or prevent the securities from being freely traded.” [Treasury Regulation 1.170A-13(c)(7)(xi)(C).] Because the Energous stock could not be freely traded by Fidelity due to the restrictions that the Fairbains imposed on the stock’s liquidation, if those restrictions are legally enforceable, the stock, even though it is in a public company, would not meet the definition of qualified appreciated stock. Accordingly, the result would be that the Fairbains’s income tax charitable deduction would be limited to the stock’s income tax basis, and not its fair market value.
  • Excise Tax: There is a 1.39% excise tax imposed on the net investment income, including capital gains, of a private foundation. Thus, any capital gain realized on the sale of the Energous stock by the fund/private foundation would trigger the 1.39% excise tax.
  • Qualified Appraisal: Normally the a qualified appraisal by a qualified appraiser is not required for the gift of publically traded stock. [IRC 170(F)(11)(A)(ii).] The conditions imposed by the Fairbains on the Energous stock’s liquidation would take it out of the exception; the exception to the qualified appraisal requirements for publically traded securities would not apply to the Fairbains gift of the Energous stock to the DAF.
  • Valuation Discounts: While publically traded marketable securities are normally valued taking the average (high and low) prices for which the stock was traded on the day of the gift, the presence of the claimed legally enforceable rights to control the timing and price of the liquidation of the Energous stock would require the application of valuation discounts for lack of control and lack of marketability, further reducing the Fairbains’ income tax charitable deduction.

Conclusion: It will be interesting to see how the Fairbains v Fidelity litigation is played out in the courts. [I am guessing a settlement will be reached if a gigantic federal income tax charitable deduction hangs in the balance.] Fairbains v Fidelity does raise important issues with regard to the effect of promises made by a DAF’s sponsoring organization to donors beyond those that relate solely to the donor’s advisory privileges. Obviously prospective donors who consider imposing some restrictions or conditions on the assets that they intend to transfer to a DAF need to seriously consider all of the negative tax consequences that will probably follow if the donor is found to have retained “legally enforceable rights” over the donated asset. Or, as the federal judged observed in his summary judgment decision, the donor may not be able to even claim any federal income tax charitable deduction. This litigation is something to keep in mind as we enter the gift-giving period as 2020 comes to a close, and individuals consider making, or bunching, large gifts into a single calendar year using a DAF.