Posted November 1st, 2003

Is There Security in Planned Giving?

The Tax Reform Act of 1969 is now widely considered a cornerstone of fund-raising governance. This landmark legislation established specific guidelines for structuring charitable remainder trusts and other planned gifts in such a way as to qualify for income, capital gains, estate, and gift tax benefits. This guidance brought a welcome and necessary end to the confusion that had previously surrounded these gift plans.

During the 1960s, planned gifts had become increasingly popular, but attorneys and others who worked with donors to structure these gifts often had to guess at what payout rates and deduction formulas would ultimately be approved if a gift were examined by the IRS during a taxpayer audit.

Over the past 34 years, gift planners in both the nonprofit and for-profit arenas have become familiar with the 1969 Act, and subsequent regulations and court decisions have clarified issues to the point that few can remember when these guidelines did not exist.

Questions remained

In the years immediately following the passage of the 1969 Act, practitioners who closely examined the pooled income fund and certain other gift plans began to reflect on their similarity to mutual funds and other investments that had become subject to Securities and Exchange Commission (SEC) regulation beginning in the 1930s. In 1972, the SEC announced in a ruling that the pooled income fund was, in fact, a security under federal law. However, the SEC staff concluded that while the pooled income fund was technically a security, it was primarily a gift vehicle and thus need not be subject to full-blown securities regulation. Those who marketed this plan therefore did not have to be registered as securities dealers.

However, the SEC position was not without certain caveats. In order for a charity to be exempt from securities registration, the SEC set several requirements:

  • Only volunteers or staff of a charity could market pooled income funds.
  • They could not be paid commissions based on the amount of the contribution to a pooled income fund.
  • Each donor or prospective donor had to be given full and fair disclosure of the workings of the fund.

Beginning in 1972, therefore, charities were required to send donors disclosure statements along with proposals for pooled income fund gifts. Depending on the charity, these documents varied in content from a few paragraphs to many pages in length. The problem drafters of these statements encountered was that the SEC never issued any guidelines regarding what to include in the statements. Many chose to err on the side of providing more information than others believed was necessary and, in some cases, produced documents that donors and advisors found confusing and less than helpful in deciding whether to complete a gift.

Throughout the 1970s and 1980s, charities also began to wonder what other gift plans might be considered securities, especially gifts that involved a transfer of assets that would be managed by charities or others that returned income to a donor. Over the years, staff opinions published by the SEC made it clear that certain types of charitable remainder trusts and other gift plans may in fact be considered securities.

Many charities were confused by vaguely worded SEC statements, and others ignored them because their attorneys advised them that they were not binding since they represented only the opinion of SEC staff.

Enter the “Texas Lawsuit”

Some will remember a notorious lawsuit in Texas known variously as the “Ozee” case or simply the “Texas Lawsuit.” In this case a class action suit claimed that gift annuities, charitable remainder trusts, and other plans that were issued by a charity were, in fact, unregistered securities. The suit also claimed that charities were violating antitrust laws by acting through the American Council on Gift Annuities to set recommended gift annuity rates.

After a period of intense lobbying, Congress was persuaded to pass legislation that exempted gift annuity rates from antitrust regulation and to enact the Philanthropy Protection Act of 1995 (PPA), legislation that was designed to clarify the securities law treatment of planned gifts. Under the terms of the PPA, Congress essentially followed the guidelines set out in previous SEC staff opinions. The statute provides that gift annuities, pooled income funds, and charitable remainder trusts where funds are commingled are, in fact, securities but are not subject to registration so long as they are marketed by staff and/or volunteers and certain other persons, no commissions are paid, and each donor is given full written disclosure.

Once again, however, Congress gave no indication regarding what must be included in the disclosure statements it mandated in the PPA. Since 1995, most charities have developed disclosure statements that have been approved by counsel and the PPA has not proven to be a major impediment to the active marketing of gift annuities, pooled income funds, and charitable remainder trusts.

A material omission

In recent years, however, another aspect of securities law and regulation has begun to surface in litigation brought by donors who were not satisfied with the way gift plans had functioned in practice. In some cases, donors claimed that securities laws were violated in marketing the gifts. How was this possible if donors were given disclosure statements?

It is important to note that there are aspects of securities laws other than active disclosure requirements. The law also provides penalties for fraudulent statements or omissions from statements describing the workings of a plan. Legislative history indicates that the antifraud provisions of federal securities laws were still intended to apply to gift annuities and other planned gifts covered under the PPA.

While no reputable charity would actively seek to fraudulently mislead a donor regarding the way a gift functions, it is nevertheless possible for a charity to relay information in such a way that it is misconstrued by a donor. In addition to material misstatements, a material “omission” could be construed after the fact to have led a donor to make an unwise decision.

For example, in one case a donor called a charity in November of 2001 and asked what tax benefits he would receive if he established a $200,000 gift annuity with the charity. He was told in writing by a development officer that his deduction would be just over $100,000 but was advised to check with his advisor to verify the figure provided via a software printout. Thinking that the donor’s advisor would provide additional guidance, the development officer decided that it was not necessary to include language describing the 50% of adjusted gross income deduction limit—language that would have alerted the donor to the possibility that he might not be able to use the entire deduction.

Unfortunately for everyone involved, the donor did not seek advice and completed the gift without knowing that he was limited to a $50,000 deduction because of his $100,000 AGI. Because he was planning to deduct the entire amount and eliminate his tax liability for the year, he was very upset and threatened to sue the charity for securities fraud claiming there was a “material omission” in the marketing materials that was designed to mislead him into thinking he could take a $100,000 tax deduction. The charity refunded the gift annuity on advice of its counsel that the donor’s position was undoubtedly correct.

Keep it simple

This is just one example of why marketing materials, proposals, and other documents related to planned giving programs should be carefully prepared in light of disclosure and antifraud concerns. The best advice in preparing these documents is to keep the material simple and basic and to read it from the perspective of a donor who knows nothing about the workings of the plan. If you decide to give exact numbers when relaying specific information about tax deductions and other technical information, make sure applicable qualifications are included as well. In the case above, for example, the charity should have told the donor he would be entitled to a tax deduction of approximately 50% of the amount donated and then advised him to see his accountant for the exact number.

Here is a partial list of points to consider when communicating with donors about the tax and other benefits of planned gifts:

  • Watch the language of statements about avoidance of capital gain taxes. It is rarely true to state that a donor avoids capital gains tax when funding a planned gift. The tier structure of income reporting for charitable remainder trusts and rules regarding reporting income from gift annuities both require “recapture” of capital gain taxes received as part of the donor’s income payments. Beware of direct comparisons of payments from gift annuities and other plans to investment vehicles that pay interest or dividends. Annuity and trust payments can be partially comprised of return of the donor’s own money and thus a comparison to other investments that are purely interest or dividends may be seen as misleading.
  • Where tax deductions are emphasized, point out that limitations apply on the use of deductions for some taxpayers.
  • Be careful when illustrating future growth in income from charitable trusts or other gift vehicles. Make sure that all illustrations state that the “buildup” amounts are only estimates and may not occur.
  • Failure to disclose gift tax ramifications of certain gifts may be seen as a “material omission.”

These are just a few of the “red flags” that should be watched for in this area. They should not stop charities from communicating the benefits of planned gifts, but care should be taken that donors are, in fact, receiving accurate information on which to base their plans.

Editor’s note: This article is excerpted from the Sharpe seminar Strategic Gift Planning 2004. For dates and locations of this and other Sharpe seminars, see page 8 of this issue of Give & Take or call a Sharpe representative at 1-800-238-3253, ext. 5360.

The publisher of Give & Take is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Give & Take may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.

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