For philanthropic clients, year-end tax planning often involves charitable contributions. Many donors have specific purposes in mind and, understandably, want to ensure that the contributions they make achieve their charitable goals. To this end, they may want to restrict the gift or earmark it for a specific purpose; however, an impermissible restriction could risk their charitable deduction. Attorneys should take special care in drafting gift agreements that ensure the client’s wishes will be respected while protecting their tax deduction.
Let’s take a closer look at three common restrictive pitfalls – use restrictions, reversionary interests and deferred gifts – and review some considerations when drafting such agreements.
IRC stipulates that donors may only deduct contributions made "to or for the use of" a charity. If a donor restricts a contribution for a specific use, the restriction must not prevent the charity "from freely and effectively employing the transferred assets, or the income derived therefrom, in furtherance of its exempt purposes." Any condition that restricts the charity’s use of the assets for its exempt purposes will cause the gift to be nondeductible. Whether a restricted gift will be deductible depends on the nature of the restriction in light of the charity’s mission. Consider this Treasury Regulations example: a gift of land to a city government for use as a public park. Regulations provide that the restricted gift is deductible if two conditions are satisfied. First, the donee must intend to use the land as a park on the date of the gift. Second, the possibility that the donee will not use the land for a public park must be “so remote as to be negligible.” If these conditions are satisfied, the donor may deduct the value of the gift notwithstanding the use restriction.
Some donors may want to include reverter clauses that transfer the property back to the donor if its use violates the gift agreement. In this situation, the reverter clause will cause the gift to be nondeductible unless the possibility of reversion is “so remote as to be negligible.” The phrase “so remote as to be negligible” has been defined by the Tax Court to mean “so highly improbable and remote as to be lacking in reason and substance” and a “chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.”
A deferred gift can occur if the transfer of the contribution depends on a future act. Unless the likelihood that the future condition will not occur is so remote as to be negligible, the charitable deduction may be deferred until the condition occurs.
Considerations When Drafting Gift Agreements
When drafting gift agreements for your clients, keep in mind the rules governing use restrictions, reversions and gift deferral. Donor and charity must both have a clear understanding of the terms of the gift agreement before signing. To avoid future disputes, any restrictions or conditions should be clearly described. The gift agreement should also clearly specify the consequences of any use of the donated property that violates a use restriction or the failure of any condition to occur.
When possible, gift agreements should include provisions that allow for future modification. Future modification could be based on negotiation with the donor, a condition specified in the agreement, or changes approved by a court that would enable the charity to fulfill its exempt purpose.
When the gift involves a use restriction, the gift agreement should specifically identify the charity’s exempt purpose and explain how the restricted gift furthers the charity’s exempt purpose. The agreement should also require the charity to monitor the use of the donation to ensure that it accords with the donor’s intent.
Because of the ambiguity in the phrase “so remote as to be negligible,” almost any gift with a reverter clause leaves the door open to an IRS challenge. Reverter clauses should be used as a last resort and only in situations where there is a very strong likelihood that there will be no reversion. A better strategy may be to provide an alternative charitable donation of the property instead of returning it to the donor. Depending on the circumstances, the gift agreement could provide that, if the condition occurs, the property could be used by the charity for a different use or transferred to another exempt organization.
Are you currently involved in the drafting of gift agreements for your clients? Please share your experiences, concerns and best practices in our comments section.