All in the Family

Planned-giving scheme lets donors and their heirs shelter huge assets and control the funds; critics call it a tax dodge

Financial advisers are promoting a controversial planned-giving tool as a boon both to wealthy people and to charities, one that rewards non-profit groups far better than do conventional giving methods like charitable trusts.

ALSO SEE:

Brazen Giving Strategies Spark New Debate Over Tax-Code Abuse

But critics worry that the plans use charities as pawns to help the wealthy pass assets to heirs largely without the sting of capital-gains and estate taxes.

Marketers claim that the plans, which are called “charitable family limited partnerships,” let donors get a tax deduction for giving a huge portion of their family business or other assets to charity, then maintain complete control over those assets for decades. Eventually, promoters claim, the donor’s heirs may be able to buy back the assets from the charity for pennies on the dollar.

Critics say the approach stretches the bounds of charitable giving and could put both donors and charities at risk of violating federal tax law. Not only that, they fear that it could lead government regulators to impose new restrictions on all types of giving, including charitable trusts.

The charitable-partnership technique is just emerging on the planned-giving scene, but it has the potential to attract millions of dollars in tax-sheltered assets. It is being promoted by scores of lawyers and financial advisers, many of whom are marketing a version called “Charitable Alliance” that is offered by Fortress Financial Group, in Dallas.

Larry Brickner, general counsel for the 10-year-old company, which also helps lawyers set up regular limited partnerships for their clients, says Fortress has licensed more than 175 lawyers and advisers to sell the plan. Although Mr. Brickner says he does not know how many of the plans have been implemented nationwide, the company has prepared documents for more than 100 people who have expressed interest in adopting the strategy, he says.

Fortress and other promoters tout the device as a winner for the wealthy and a bonanza for philanthropy. “We are opening up a whole new arena for charitable gifts,” declares Shannon W. Webb, a co-founder and vice-chairman of Fortress.

Critics say, however, that the strategy is driven more by a desire to avoid taxes and pass wealth to heirs than to promote philanthropy. James M. Floyd, an estate-planning lawyer in Oakland, Cal., says donors who set up charitable partnerships may appear to transfer assets to a charity but then may “strip away the value of the partnership” to benefit themselves or their families.

Stephan R. Leimberg, a Bryn Mawr, Pa., estate-planning lawyer, says that the approach improperly allows donors to give highly appreciated assets to charity, convert those assets to cash without paying capital-gains taxes, then shift the profits back to the donors’ families. “The whole transaction is designed to use the charity’s tax-exempt status in order to remove capital gains from appreciated property and then get the property back into the hands of the donor’s family,” he says.

Mr. Brickner acknowledges the potential for the strategy to be abused and concedes that Fortress does not police the way that partnerships are operated. But he denies that its main intent is anything but philanthropic. “We see this as primarily a charitable-giving tool,” he says. “We do not see it as any way to pass assets to the next generation using a charity as a middleman.”

Despite such denials, charities that participate in the partnership strategy must be careful not to violate federal laws that bar tax-exempt groups from being exploited for the private gain of donors.

Marc Owens, director of the Internal Revenue Service’s Exempt Organizations Division, says that a charity’s tax-exempt status could be in question if the organization is being used as a “wealth-conservation” tool and if its charitable activities are “minimal.”

Mr. Owens also says the partnership strategy “raises questions” about whether the amount of the tax deduction that a donor claims in a partnership is appropriate. Those questions, however, tend to involve the behavior of individual taxpayers, not charities, and would come under other parts of the I.R.S. than Mr. Owens’ department, he says.

It is not new for family-partnership interests to be donated to charity. What is new, however, is the debut of comprehensive tax-planned strategies like the Fortress plan, which is offered under a licensing agreement to lawyers and financial planners for a fee. Ms. Webb says Fortress spent “hundreds of thousands of dollars” on legal advice in setting up its partnership plan, including a lengthy opinion letter from Holland & Knight, one of the nation’s largest law firms.

Only lawyers can purchase the letter from Fortress, and those who do must sign an agreement that bars them from copying it and distributing it to others, making it difficult to evaluate the legal theory behind the approach.

How many charities have accepted charitable-partnership donations is unclear. Ms. Webb identified the University of Georgia, in Athens, and Abilene Christian University, in Texas, as recipients of gifts under the Fortress plan.

Mac Corry, executive director of development at the University of Georgia, says its partnership gift was “not anything we pursued.” He adds: “We had a law firm on behalf of the donor contact us to see if we would be willing to accept it, and we looked into it far enough to determine that it was legal and appropriate for us to accept it. At this point we really don’t know exactly what the extent of the benefit to the university will be.”

That uncertainty is not unusual, given the way the partnership approach works.

In a typical plan, a wealthy donor sets up a family limited partnership, a form of ownership resembling limited partnerships in the business world. The partnership has a corporation as general partner. The donor is named the general partner’s managing director for life. The donor and his or her spouse transfer highly appreciated assets into the partnership in return for limited-partnership interests. The partnership is set up to last 40 years or more, and the assets might include a family business, real-estate holdings, an individual retirement account, or a stock portfolio.

The donor gives 98 per cent of the partnership interests to one or more charities, getting an independent appraisal of the value of those interests. The charity or charities serve as limited partners, as do the donor’s children or other heirs, who get a 1-per-cent limited-partnership interest.

The general partner — effectively the donor — holds only 1 per cent of the partnership interests but has full management control of all assets in the partnership, including the charity’s portion. The general partner may collect an annual fee for managing the assets.

If a special mechanism is included in the partnership agreement, the charity can force the donor or donor’s heirs to buy back its interest in the partnership after, say, five years. The purchase price for the appreciated assets may be at a predetermined discount that reflects the fact that the partnership has not yet matured. If a charity gets out of the partnership in the early years, the discount can be deep.

The donor gets an income-tax deduction based on the appraised value of the donated partnership interests, adjusted downward to reflect the fact that the charity has no management control over its portion of the assets and no ability to sell them easily, except back to the family. While that adjustment lowers the donor’s income-tax deduction, the family benefits in a different way: The adjustment technically reduces the value of the donated partnership interests so that if they wind up back in the hands of heirs, estate taxes will be lowered commensurately.

Other benefits also flow to the donor and donor’s family. For example, if the donor decides to convert highly appreciated assets in the partnership to cash, 98 per cent of any profit is sheltered from capital-gains taxes because charities — which own that proportion of partnership interests — are not subject to those taxes.

And if the assets earn income, the donor and family members can elect to get a proportional share — a total of 2 per cent in the typical plan. Meanwhile, 98 per cent of the earnings — or all the earnings, for that matter — could be left to build up in the partnership tax-free. However, any management fees paid to the donor would come from partnership earnings.

In the end, if the charity has the option of selling its partnership interests back to the donor or his or her heirs, the family could be sitting on a windfall. It could get assets on which an initial tax deduction was taken, then perhaps allowed to grow tax-free. The assets also may have been converted to cash, free of capital-gains taxes. And best of all, the family may be repurchasing those assets at a price far lower than their market value.

If a charity has the option to bail out of a 50-year partnership after five years — only one-tenth of the full term — heirs could be able to buy $1-million in assets for just $100,000, depending on the terms of the partnership agreement.

Proponents of the strategy argue that even though donors and heirs can benefit, charities get the best part of the deal. Some charities don’t like to accept gifts of real estate or businesses, they note, and the partnership structure allows them to do so without incurring the management headaches that typically go along with such assets. And, they say, some giving mechanisms such as charitable remainder trusts do not always accept assets such as real property.

Charities also can get current income from a partnership, and they may be able to convert their interests to ready cash if the partnership arrangement includes the buy-out option. And for charities that do wait the full term of the partnership, proponents say, 98 per cent of the assets — including appreciation — wind up in the charity’s pocket.

But critics see plenty of opportunity for abuse. Among the big questions that can arise:

* Has the donor valued the assets properly at the outset and taken an income-tax deduction that reflects the assets’ true worth to the charity?

* Is the management fee reasonable so that the donor does not bleed the partnership of income and perhaps induce the charity to sell out prematurely?

* Is the charity being paid fairly if it does decide to sell its interests back to the donor or donor’s family?

* Is the charity a legitimate non-profit organization, or is it one — perhaps created by the donor — that was set up simply to facilitate a partnership deal?

* Is a charitable deduction being claimed for a transaction that benefits the donor more than the charity?

“You must have donative intent when you make a charitable gift,” says Mr. Leimberg, the Pennsylvania lawyer.

In a similar vein, Mr. Leimberg questions whether the donor’s contribution of assets is really being given unconditionally to the charity. If it has strings attached, it would probably fail to qualify for a tax deduction under federal tax law, he says.

Even if the partnership idea passes muster with the courts, critics say, Congress could still move to block the approach on the ground that donors may try to give assets to a charity, convert those assets to cash without paying capital-gains taxes, then shift those profits back to heirs. “How long is Congress going to allow the use of a charity’s tax-exempt status to wash away those capital gains?” Mr. Leimberg asks.

Critics also take issue with the way the partnership strategy is being marketed by individual financial advisers. Mr. Floyd, the California estate lawyer, points to one promotion that promises donors “tax-free loans” from the partnership that are secured by other assets of the donor. Mr. Floyd believes that donors could try to use the partnership to “finance their life-style needs by taking a series of loans” that are not intended to be repaid until the donor dies. When the donor is gone, he says, “the charity is going to be sitting there holding a bunch of paper” that it can only hope to redeem from the sale of the assets that the donor put up as collateral.

Some estate-planning experts say that charitable family limited partnerships can be used in ways that don’t raise concerns. “It comes down to how it’s implemented,” says Houston lawyer S. Stacy Eastland. “If the managing partner does his fiduciary duty toward the charity, it could be a very good thing for the charity.”

Mr. Brickner and Ms. Webb maintain that much of the opposition to the partnership idea is not rooted in legitimate legal concerns, but in fears of competition. Charities and lawyers who have for years successfully promoted charitable remainder trusts fear aggressive competition for donor dollars, they contend.

Such trusts, which were authorized in their current form in 1969 under the federal tax code, allow donors or their beneficiaries to get regular payments in exchange for a gift of assets. When the donor or beneficiary dies, the remainder of the assets go to charity.

Ms. Webb argues that charitable limited partnerships are far more attractive to wealthy donors than are charitable trusts. “You can line them up side by side and use exact numbers, the exact assumptions, and the benefit to the charity and the benefit to the donor and the benefit to the heir is so many more multiples on a charitable limited partnership,” she says.

Charities also come out on top with charitable partnerships, she argues, because charitable trusts must make regular payments to donors. In a charitable partnership, she says, there can be a “compounding of growth” so that “you can easily have more” money in the charitable partnership than in the charitable trust after an equal number of years.

Fortress officials also say that if implemented properly, charitable partnerships need not raise concerns that donors or heirs are reaping unfair advantage.

Using independent appraisals of donated assets insures that a donor’s charitable deduction and buy-back price on donated assets will be fair, they argue. And because federal law prohibits excessive management fees or “sweetheart” deals between clients and charities, donors or their family members would be discouraged from taking undue advantage of the partnership arrangement.

“For those willing to do the research and abide by the critical rules of establishing these things,” Mr. Brickner says, “they work very well.”

“Besides,” he says, “there’s just as much potential for abuse of a charitable-remainder trust as for charitable partnerships.”

Further, Mr. Brickner says, charities that are in collusion with donors to get ready cash while helping the donor get tax breaks are wide open to suffering the consequences.

”If you’re talking to a fly-by-night charity who promises you, under the table, to sell back at a bargain discount, then that’s a sham transaction, and everybody stands to be penalized and potentially taxed out of existence,” Mr. Brickner says.

Fortress officials say they are confident that charitable partnerships, when implemented properly, will have no trouble with government regulators. In fact, Mr. Brickner suggests that the charitable-partnership approach soon will be on the tip of every fund raiser’s tongue and primed to surpass rival methods for luring donations.

“I have no doubts,” he says, “that 10 years from now it will be probably as common as charitable remainder trusts.”