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HR1104 would unintentionally eliminate private foundation safeguards

HR 1104, the Fair Treatment of All Gifts Act, was one of several bills passed by the House of Representatives to commemorate tax day on April 15. The legislation is intended to exempt contributions to organizations that participate in lobbying and political activity from the federal gift tax. But in an effort to bring clarity to donors to political organizations this change would remove one of the fundamental pillars of the regulation of charities.

The tax code creates a distinction between charities funded largely by a single donor or family, known as private foundations, and those whose funding and activities subject them to public oversight, known as public charities. Establishing a private foundation is a common technique for individuals who have philanthropic goals and wish to avoid the federal gift and estate taxes. Since 1969, private foundations have been subject to restrictions on their activities designed to safeguard the abuse of a charitable entity for the personal benefit of wealthy individuals and their families. These restrictions include, among others, a prohibition on transactions with related family members, limitations on the ownership of closely held businesses, prohibitions on lobbying and political activity, a tax on investment income, and a minimum annual payout for the benefit of active charitable activities.

{mosads}If HR 1104 is enacted as currently drafted, it will provide wealthy individuals a straight path to avoid the safeguards placed on private foundations. HR 1104 provides all individuals a charitable contribution under the gift tax for transfers to all organizations that are exempt from income tax under sections 501(c)(4), 501(c)(5), or 501(c)(6) of the tax code. Since the Supreme Court’s 2010 decision in Citizens United v. FEC, there has been increased interest in these types of organizations, more commonly known as social welfare organizations, labor unions, and trade associations, and their ability to participate in lobbying and political campaigns. But HR 1104 does not limit its impact to politically motivated contributions. And these types of organizations are not required to be operated for political purposes. Social welfare organizations, in particular, can be organized to carry out any of the same charitable missions that a private foundation or public charity could support. Therefore if HR 1104 becomes law, wealthy individuals looking to avoid gift and estate taxes would have two options: 1) transfer their funds to a private foundation subject to a range of safeguards that limit their activities, or 2) transfer their funds to a new social welfare organization with the same charitable mission and without the private foundation limitations.

The choice for any well advised, high-net worth individual will be obvious. Although contributions to a private foundation can give rise to an income tax deduction that would not be available to transfers to a social welfare organization, for most individuals contemplating leaving a substantial portion of their assets to a private foundation to avoid the gift or estate tax the income tax benefits of the transaction are typically not substantial. This is in part because the income tax deduction for contributions to a private foundation are limited to an individual’s basis for contributions of appreciated assets and subject to lower percentage limitations, but also because contributions made in contemplation of death to avoid the estate tax are generally not structured to save an individual income taxes. The ability to obtain a gift tax deduction for a contribution to a social welfare organization would have essentially the same tax benefits as leaving the assets to a private foundation at death as long as the donor completes the transaction while he or she is still alive. And establishing a new social welfare organization without the safeguards that limit private foundation activity will give the donors and their family members greater flexibility with a lower compliance cost. This freedom will come, however, at the cost of nullifying the safeguards that have protected the public’s interest in these philanthropic ventures for over 45 years.

It appears that HR 1104’s end run around the private foundation regime and its associated safeguards may have been inadvertent. These potential consequences are not mentioned in the legislative history. And the Joint Committee on Taxation description of the bill does not explain this possibility or its potential impact on federal revenues through the loss of the tax on the net investment income of future private foundations.

It is possible for Congress to bring clarity to the gift tax treatment of contributions to social welfare organizations without undermining the private foundation safeguards. To fix HR 1104, Congress should consider subjecting social welfare organizations that fail to pass a public support test, similar to the one used for distinguishing public charities from private foundations, to the same safeguards applicable to private foundations. Including this additional change would be one way to close the loophole HR 1104 creates. Contributions to social welfare organizations supported by multiple donors would still escape the threat of the gift tax, but the bill would then not allow individuals or families to subvert the private foundation safeguards.

Fournier is a senior associate at Caplin & Drysdale.


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