Brazen Giving Strategies Spark New Debate Over Tax-Code Abuse

In fund raising, a little chutzpah is often what it takes to produce big gifts for good causes.

But in April, a prominent organization of fund raisers voted to take a stand against what it said was too much chutzpah.

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The National Committee on Planned Giving passed a resolution condemning a technique that has been nicknamed a “chutzpah” or “full Monty” trust for its brazen approach to setting up charitable trusts.

The trusts are being marketed mainly by for-profit financial planners and accounting firms, the committee says. According to the resolution, the approach provides little financial benefit to charities, and abuses federal laws on charitable deductions.

The decision to condemn the trusts comes at a time when many in the non-profit world are debating just how far tax laws can be bent to benefit donors and charities. Spurred by the good economy and a trillion-dollar intergenerational transfer of wealth that is expected over the next few decades, many financial-services companies have been scouring the federal tax code to figure out how tax breaks intended to encourage charitable giving can be used to the maximum financial gain of their wealthy clients.

Proponents of such plans say they could channel billions of dollars to charities in the 21st century. But detractors fear that charities will end up receiving relatively little money from the new approaches — and that if too many of the new financial products skirt the law and do little for charity, Congress and the Internal Revenue Service would be likely to impose sweeping restrictions on many forms of giving.

“Every time we stretch the envelope and play games with the tax code, it’s just going to bring harsher rules down on charity,” says J. J. MacNab, a planned-giving and insurance analyst in San Francisco.

Federal officials have already moved to shut down several of the new approaches. Most recently, the Internal Revenue Service threatened penalties and other “adverse tax consequences” for participants in deals that involve charitable split-dollar insurance, in which charities and wealthy donors divide the proceeds of life-insurance policies purchased with tax-deductible dollars (The Chronicle, August 13, 1998, and February 11, 1999). The announcement (I.R.S. Notice 99-36), issued in June, came several months after the introduction of bills in Congress that would, in effect, abolish the split-dollar scheme.

Among the next items to be scrutinized by federal regulators could be the chutzpah trust, which is sometimes labeled “son of accelerated charitable remainder trust” because it resembles a technique that Congress effectively stopped several years ago.

Promoters of the original accelerated trust promised donors that they could quickly recoup most of their trust principal largely tax-free by manipulating the timing of the payout.

The new version uses complicated borrowing and “forward-sales-contract” techniques in an effort to help wealthy donors reduce capital-gains taxes on highly appreciated assets. Donors contribute the assets to a charitable trust, which in turn converts the assets to cash. Donors then take a payout. Promoters of the accelerated plan say the payout can be largely tax-free because the trust has had little or no taxable income. The reason for that, they say, is that the trust has borrowed the money being paid to the donor or obtained it through a forward contract.

“You’re basically avoiding — or perhaps arguably evading — taxation that should be paid at some point,” says Reynolds T. Cafferata, a Los Angeles tax lawyer.

Mr. Cafferata says the strategy could violate several aspects of federal tax law, including a section that bars people from using a charitable trust for private benefit.

Observers cite several reasons that a growing number of aggressive for-profit financial planners are interested in using the charitable deduction for tax planning. After the overhaul of the federal tax code in 1986 shut down a number of non-charity tax shelters, observers say, the financial-services industry began to see the non-profit arena as a promising new marketing frontier for sales of tax-shelter plans to wealthy clients.

And charities, locked in heated competition for donor dollars, sometimes are willing to participate in controversial giving schemes, lest they lose out on big gifts.

Moreover, observers say, some financial planners believe that Congress and the I.R.S. are so burdened with more pressing — or, perhaps, more politically visible — issues than charitable giving that they may not challenge tax practices until the plans have gained a foothold in the marketplace.

Part of the appeal of unorthodox strategies, observers say, also stems from a mistrust of government spending priorities among many wealthy Americans.

One emerging strategy that seeks to exploit that sentiment is the “charitable family limited partnership,” a controversial technique that promises wealthy donors significant savings on estate and other taxes. “Our government redistributes your tax dollars based on its agenda,” declares a marketing tape distributed by a promoter for one charitable-partnership product. “While you may or may not agree with that agenda, if you could direct the distribution of your tax dollars, it’s unlikely you would spend your money the same way the government does.”

That is precisely the sentiment of many conservative lawmakers, who, some observers say, have an incentive to look the other way when devices come along that cut or eliminate the estate tax, which can claim up to 55 per cent of the assets that a person leaves at death.

Whether federal regulators can adequately monitor the onslaught of new techniques is unclear.

Marc Owens, director of I.R.S.’s Exempt Organizations Division, said the agency is trying to improve its ability to respond. Yet even when regulators want to root out abusive schemes, the process often requires time-consuming reviews of individual tax returns, followed by lengthy fact-finding and administrative procedures.

“We’re constantly looking for ways to be more timely, to be more efficient, and to be more effective,” Mr. Owens says.

One way the I.R.S. is doing that, he says, is to issue warning notices like the one it put out last month on split-dollar insurance instead of using its customary approach of auditing individual tax returns.

Still, some controversial strategies, such as the chutzpah trust, seem to move faster than the I.R.S.’s ability to keep up.

When asked about that emerging device, which already had been roundly criticized in planned-giving circles in recent weeks, Mr. Owens replied, “That’s something new to me.”

Charities that seek to raise money through the controversial approaches can live to regret it.

In a case pending in the U.S. District Court for the Northern District of California, Mercy Retirement and Care Center, a Catholic charity in San Francisco, is alleging fraud, conspiracy, racketeering, and other misdeeds in connection with charitable reverse split-dollar transactions arranged by independent fund-raising consultants.

While regulators and courts have an important role to play in policing the activities of financial advisers, non-profit organizations also must learn to do a better job of protecting the image of charitable giving, observers say.

“Charities are going to have to learn to reward those advisers who act responsibly and weed out those that don’t,” says Ms. MacNab.

As aggressive financial advisers market more and more strategies that “capitalize on the good feelings that people have of charity,” she says, charities could get caught in a backlash. “If the general public has negative connotations about financial services and products, that may transfer over to how they deal with charity.”