Charitable Contributions Deductions*
In general. The U.S. has allowed an income tax deduction to individual and corporate donors1 to charitable organizations since 1917,2 four years after the enactment of the federal income tax. In the typical case — a donation of cash or property to a public charity — the donor may deduct the amount of cash or the fair market value of property donated. The amount of the deduction, however, generally may not exceed (1) in the case of an individual, 50 percent of the individual’s “contribution base,”3 or (2) in the case of a corporation, 10 percent of its taxable income.4
Even slight deviations from the plain vanilla situation, however, may call into play a variety of complex rules with the potential to change the amount of, or even wholly to deny, the charitable contributions deduction. These rules depend on the form of the gift, the type of property donated, and the nature of the donee organization. A succinct summary of some of these rules follows, below.5 Furthermore, certain sophisticated transactions — involving split-interest gifts (e.g., charitable remainder or charitable lead trusts), charitable gift annuities, pooled income funds, and the like — are subject to other detailed requirements that are generally beyond the scope of this chapter to explore.6 Because of the substantial aggregate size of charitable remainder trusts, however, a brief description of the basic fiscal rules affecting them is set out below.7
U.S. individuals, corporations, and foundations are generous donors to charitable causes. Total charitable gifts in the U.S. were estimated to exceed $190 billion in 1999, of which nearly $144 billion came from living individuals, a further almost $16 billion represented testamentary gifts, nearly $20 billion was given by private foundations, and approximately $11 billion came from corporations.8
Eligible donees. It is often said that gifts to charities, as defined in I.R.C. § 501(c)(3), are eligible for the income tax charitable contributions deduction.9 That statement, however, is both over- and under-inclusive. It is over-inclusive because gifts to organizations that test for public safety are not eligible for the deduction even though such organizations are listed in I.R.C. § 501(c)(3).10 It is under-inclusive because the Code section allowing the deduction — I.R.C. § 170(c) — mentions five types of eligible donee entities, only one of which is closely similar to those described in I.R.C. § 501(c)(3).11
By far the most important class of eligible donees comprises entities “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition . . ., or for the prevention of cruelty to children or animals.”12 For such entities to be eligible to receive tax-deductible gifts, three other statutory criteria must be satisfied:
The entity must be created or organized within the United States or its possessions,13
The entity must not permit proscribed inurement of benefits to insiders,14 and
The entity must not violate the restrictions on engaging in political campaign activity or excessive lobbying.15
Finally, although this is not explicitly stated in the statute, the entity must not violate fundamental public policy, per the Supreme Court’s decision in Bob Jones University.16
Because it may be difficult for potential donors to ascertain whether a prospective charitable donee satisfies all of these conditions, the Internal Revenue Service publishes a list of eligible donees and updates it regularly.17 Donors making gifts in reliance on that published list, as modified by occasional public announcements by the Service, are generally protected even if the donee organization ceases to qualify as an eligible charity.18
Eligible gifts. A “charitable contribution” is defined as “a contribution or gift to or for the use of” an eligible organization.19 There is no statutory definition of “contribution or gift.” Some early court decisions borrowed a definition from another part of the tax law,20 following a Supreme Court decision which described a “gift” for those purposes as a transfer proceeding from “detached and disinterested generosity.”21 This line of authority, however, fell into disfavor, in part because of its reliance on the subjective intent of the transferor/donor.22 More recent decisions tend to focus on objective factors. The Supreme Court articulated the test as follows: “The sine qua non of a charitable contribution is a transfer of money or property without adequate consideration.”23
Treasury regulations adopted in 1996 now state that no transfer will be treated as “a contribution or gift” unless the donor “[i]ntends to make a payment in an amount that exceeds the fair market value of the goods or services [received in exchange for the payment]” and “makes a payment in an amount that exceeds the fair market value of the goods or services.”24 The second leg of that test is purely objective; the first leg derives from a sentence in the American Bar Endowment decision in which the Supreme Court said “A payment of money generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.”25
Charitable gifts may be made either “to” or “for the use of” a charitable donee; this distinction affects the deduction limitation for an individual donor, and is discussed further below.26 Gifts must be complete and unconditional to qualify for a deduction: retention of control by the donor, or the existence of conditions that might defeat the gift, may postpone or prevent deductibility.27 The Treasury Regulations state the test:
If as of the date of a gift a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible.28
Designations of particular purposes for gifts, or imposition of conditions that are extremely unlikely to interfere with the charitable donee’s interests, are not fatal,29 but may affect valuation of the gift.30
Gifts of less than the donor’s entire interest in the property donated do not qualify for a charitable contributions deduction.31 There are five exceptions to this rule:
Gifts of remainder interests in charitable remainder trusts,32
Gifts of lead interests in charitable lead annuity trusts or charitable lead unitrusts,33
Gifts of an undivided interest in the entire property owned by the donor,34
Gifts of remainder interests in a personal residence or farm,35 and
Qualified conservation donations.36
Gifts of services are not eligible for a charitable contributions deduction.37
Quid pro quo. A charitable contributions deduction is allowed for payments where goods or services are received in exchange so long as the payments to the charity exceed the value of the quid pro quo received by the donor. This long-standing position of the Service38 is enshrined in 1996 regulations39 that also provide a safe harbor for the donor to rely, in good faith, on the written statement provided by the donee setting forth the value of any goods or services received by the donor in exchange for the payment.40 For these purposes, the value of certain small items provided to the donor may be ignored,41 intangible religious benefits are not taken into account,42 and recognition, praise, and even naming opportunities are disregarded.43
Perhaps the most important controversy about charitable contributions and quid pro quo amounts involved the Church of Scientology. The saga began in 1978 when the I.R.S. ruled that no deduction was available to a donor who received, in exchange for the donation, “auditing,” “training,” and “processing” courses, and other services.44 The ruling explicitly referred to and was aimed at the Church of Scientology. At that time, the Service conceded that Scientology was a bona fide religion and that the Church of Scientology was entitled to tax exemption under I.R.C. § 501(c)(3). After lengthy litigation, the Service’s position denying deductions to some donors was sustained by the Supreme Court.45
While these charitable deduction cases were wending their way to the Supreme Court, the I.R.S. changed its view about Scientology and directly attacked the tax-exempt status of Scientology organizations. It argued that they were not tax exempt because they permitted personal inurement (to the benefit of L. Ron Hubbard), conducted extensive commercial activities, and contravened fundamental public policy by violating the law. Here, again, the Service was sustained by the courts.46
Meanwhile, many — perhaps hundreds — of donors to Scientology were contesting their own deductions. The organization itself was engaged in massive ongoing litigation with the I.R.S. L. Ron Hubbard died. Finally, on October 1, 1993, the Service and the Scientologists announced a settlement under which the Scientology organizations would be recognized, once more, as tax exempt. The details were not then revealed, but attorneys involved in the matter hinted that this resulted from the cessation of private inurement (L. Ron Hubbard was, after all, deceased) and an agreement to discontinue any further violations of law.
Then, in November of 1993, the IRS issued a ruling which “obsoleted” the 1978 ruling that had started the entire process.47 This flustered and confused many observers. On the one hand, there is often no substantive meaning to the IRS’s action in declaring one of its prior precedents obsolete. On the other hand, however, it appeared that the Service might be giving up a position which it had litigated to and won in the Supreme Court. And, after all, that victory in Hernandez was based on the stipulation that Scientology was entitled to tax-exempt status, so the restoration of such status to the organizations should not have changed the result in the ruling.
The terms of the settlement between the Scientology organizations and the Service were confidential, so no details were available which might have explained the 1993 ruling’s reversal of the 1978 ruling.48 Finally, on Dec. 31, 1997, the alleged text of the Oct. 1, 1993, closing agreement between the Scientology organizations and the Internal Revenue Service was made public.49 The lengthy (over 50-page) agreement imposes very strict restraints on the governance and operations of the Scientology organizations, using many of the standards, and often the exact words, of the statutory provisions regulating the conduct of private foundations. Nothing in the closing agreement, however, explains the Service’s change of stance vis-à-vis the deductibility of gifts to Scientology in exchange for “auditing,” “training,” and “processing” courses, and other services.
Limitations and carryovers. The 50 percent limitation is generally available for gifts made by individuals “to” a public charity.50 Gifts “for the use of” public charities are deductible only up to 30 percent of the individual donor’s contribution base.51 The Supreme Court has said that “a gift or contribution is ‘for the use of’ a qualified organization when it is held in a legally enforceable trust for the qualified organization or in a similar legal arrangement.”52 Gifts of an income interest in property, whether or not in trust, are treated as made “for the use of” the charitable recipient,53 but gifts of a remainder interest are generally treated as made “to” the charitable recipient.54 Unreimbursed expenses incurred in connection with rendering services to a charity are deductible and are treated as made “to” the charity,55 even though no deduction is permitted for a donation of services themselves.
Gifts of “capital gain property” made by an individual to a public charity qualify only for a 30 percent, rather than the usual 50 percent, limitation.56 Capital gain property is any capital asset the sale of which by the donor at fair market value would give rise to long-term capital gain;57 thus, gifts of appreciated stock or securities often fall under the 30 percent limitation. Donors may elect to reduce the amount of such gifts by the amount of any long-term capital gain, in which case the balance is deductible under the larger, 50 percent limitation.58
An individual’s gifts to private foundations generally may only be deducted up to 30 percent of the individual’s contribution base.59 Furthermore, gifts of appreciated capital gain property to private foundations generally are subject to two additional adverse rules: (1) a special reduction rule discussed below60 and (2) a still smaller, 20 percent limitation.61
There appears to be some, albeit opaque, fiscal purpose behind the creation of three separate limitations — 50 percent, 30 percent, and 20 percent — for individual charitable contributions. It may be doubted whether that purpose outweighs the resulting complexity.
Gifts by corporations are subject to a more straightforward, single 10-percent-of-taxable-income limitation.62 Corporations on the accrual basis of accounting may elect to treat certain charitable gifts made after the close of a given taxable year, but before the 15th day of the third month thereafter, as having been made during the taxable year;63 the election is not available to S corporations.64
Amounts disallowed by any of the limitations may be carried forward for five years and may be deducted in the future years to the extent to which the donor’s gifts made in such years are less than the relevant limitations.65 The computations may be complex, particularly if more than one of the relevant limitation percentages is involved.66
Special reduction rules. Three special rules may apply to reduce the amount of a charitable contributions deduction:
Charitable donations of property must be reduced by the amount of any ordinary income that would have been recognized if the donor had sold the property for its fair market value.67 For example, if an artist donates one of her own paintings, her deduction is limited to her basis in the painting, i.e., the cost of the canvas, frame, paints, etc.68
Charitable donations of tangible personal property, if the donee puts the property to an unrelated use, must be reduced by the amount of any long-term capital gain that would have been recognized if the donor had sold the property for its fair market value.69 It is clear that a sale by the donee is an unrelated use, thus triggering the reduction.70 When the donated property is retained by the donee, the I.R.S. has opined that:
“a direct and functional use test must be applied [for determining what is unrelated use]. Where a donee does not intend actually to use contributed appreciated personalty in carrying out its specific exempt purposes, we believe the Code requires the amount of the charitable contribution otherwise allowable to be reduced.”71
Applying that standard, the Service held that display of donated art by a medical school does not constitute “related use,” and thus the donor must reduce the amount of its gift under this rule. By contrast, “if a painting contributed to an educational institution is used by that organization for educational purposes by being placed in its library for display and study by art students, the use is not an unrelated use . . . .”72 Because a donor may not always know the actual use to which donated property is put by the donee, some safe-harbor rules are provided in regulations.73
Charitable donations of property to a private foundation must be reduced by the amount of any long-term capital gain that would have been recognized if the donor had sold the property for its fair market value.74 An important exception permits gifts of certain “qualified appreciated stock” without any such reduction. The stock must be quoted on an established securities market, and not more than 10 percent of the corporation’s outstanding stock may be so contributed.75
Any reduction under these three rules is forever lost, i.e., no carryover is provided in such cases.
Split Interest Trusts. There are two broad categories of split-interest charitable trusts: charitable lead trusts (in which the charitable beneficiary’s interest precedes the interest of non-charitable beneficiaries) and charitable remainder trusts (in which the reverse is true). Because the aggregate assets that have been donated to charitable remainder trusts (“CRTs”) are much greater than those in charitable lead trusts,76 this brief discussion focuses only on CRTs. Pooled income funds, a special form of CRT, are not described.77 As of 1998, the aggregate assets of CRTs exceeded $64 billion.78
CRTs come in two flavors: charitable remainder annuity trusts (“CRATs”) and charitable remainder unitrusts (“CRUTs”).79 Both have a charitable beneficiary that becomes entitled to the trust assets after the termination of a predecessor non-charitable beneficiary’s interest.80 The lead, non-charitable interest may either be for a fixed term (not to exceed 20 years) or for the life or lives of the non-charitable beneficiary(ies).81 The value of the charitable remainder interest — determined on a present-value basis after subtracting the value of the lead, non-charitable interest — cannot be less than 10 percent of the net fair market value of the donation to the trust.82 In a CRAT, the lead interest is an annuity, i.e., a fixed annual amount specified or calculable at the inception of the trust; the annuity amount cannot be less than 5 percent nor greater than 50 percent of the initial value of the trust.83 In a CRUT, the lead interest is a fixed annual percentage (specified at the inception of the trust) of the trust assets valued at least once a year; the percentage cannot be less than 5 percent nor greater than 50 percent.84 Thus, the non-charitable beneficiary of a CRAT is entitled to receive the same amount every year regardless of the value of the trust, whereas the non-charitable beneficiary of a CRUT is entitled to receive an amount that varies from year to year depending on the value of the trust.
A donor to a CRT is entitled to a charitable contributions deduction for a portion of the fair market value of the money and property donated to the trust.85 No deduction is permitted unless the trust is either a CRAT or a CRUT;86 thus, no deduction is permitted for a donation to a trust in which the interest of the lead non-charitable beneficiary is defined solely by reference to the trust’s “income.”87 The amount of the deduction is calculated by apportioning the value of the donation to the CRT between the non-charitable lead interest and the charitable remainder interest88 using an interest rate (or discount factor) that is fixed by the I.R.S. every month. The interest rate varies according to market interest rates on U.S. government mid-term bonds.89 The present value of the remainder interest is usually treated as paid “to,” rather than merely “for the use of” the charitable remainderman;90 therefore, it may qualify for the higher, 50 percent limitation if the remainder beneficiary is a public charity.91
The CRT itself is exempt from income taxes so long as it does not generate unrelated business income.92 Thus, gifts to CRTs of appreciated property may be advantageous, as the donor is not taxed, at the time of contribution, on the unrealized gain and the CRT is not taxed on the gain even when it is realized upon actual sale of the property by the CRT. A CRT is subject to some, but not all, of the private foundation excise tax rules (discussed elsewhere in this chapter): in all cases, the self-dealing prohibitions and the rules against expenditures for prohibited purposes apply;93 in certain unusual situations, the excess-business-holdings and jeopardy-investment rules may also apply.94
A lead, non-charitable beneficiary is taxable on annuity or unitrust amounts paid by the CRT under a four-tier system of tracing income from the CRT to the beneficiary.95 The details are beyond the scope of this chapter.96 CRTs are subject to other highly complex and technical rules that the Service tends to enforce with rigorous and remorseless rigidity.97
Deduction floor. An individual’s itemized income tax deductions, including those for charitable donations, must be reduced by the lesser of (i) three percent of the excess of adjusted gross income over the “applicable amount” or (ii) 80 percent of itemized deductions.98 The “applicable amount” was $100,000 when the statutory provision was adopted in 1990,99 but it is subject to inflation adjustments100 and is $137,300 for calendar year 2002.101 Legislation adopted in 2001 schedules the phase-out of this floor beginning in 2006, with total repeal slated for 2010;102 the repeal itself, however, is scheduled to be repealed (thus fully restoring the floor) in 2011.103
This provision is not even handed: taxpayers in different states or with different housing arrangements may be affected differently. That is because the affected itemized deductions are, in addition to the charitable contributions deduction, those for mortgage interest and for state and local taxes. Homeowners making payments on mortgages and persons living in states with income taxes often will incur such expenses in excess of the deduction floor. Because such payments are not discretionary, the deduction floor, from one point of view, will not adversely affect their charitable donations deduction. In contrast, people living in rented housing or in states with low or no income taxes may experience this deduction floor primarily against their charitable gifts.104