Welcome to the LACGP Newsletter. This e-newsletter is sent out on a monthly basis. The newsletter provides links to this page. Please see below for the items that appeared in the February 2023 issue.

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All Those Red Flags Are NOT a Parade: Declining a Gift of a Complex Asset

By Carí Jackson Lewis, J.D., LL.M. (tax), TEP, CSPG, AEP, CAP

Etymonline, the online dictionary of etymology explains that, in the 18th century, red flags were used as signs of danger or warning.  Today, the Merriam-Webster dictionary defines the idiom “red flag” as an item that signals or “draws attention to a problem, danger, or irregularity.” 

Savvy donors understand that when they donate long-term appreciated property directly to a charity (instead of selling it and gifting the net sales proceeds), they can deduct from their income the fair market value of the donated asset, all while avoiding the capital gains taxes on the unrealized gain that would have been generated upon the sale.  The charitable income tax deduction is taken against ordinary income.  

In this case, a donor (Ms. Moneybags) generously offered to donate to the charity her LLC interest in an income-producing commercial asset that, unfortunately, threw up multiple “red flags.” After robust analysis, outreach to professional colleagues, and a carefully crafted declination strategy, we were able to decline the gift without damaging the nonprofit’s relationship with the donor.

FlagRed Flag #1 - Indebtedness

Here, the property manager indicated that the property had a partnership debt of $4MM. Mrs. Moneybags is a 10% owner and, pursuant to the Partnership Agreement, the debt is allocated pursuant to the partnership interest. Accordingly, Mrs. Moneybags is responsible for $400,000 of the partnership debt, which was being paid down through withdrawals from each partner’s annual income distribution. The last two years’ K-1’s indicated that Mrs. Moneybags’ interest is worth $227,000.

When a charity accepts a gift of real property subject to an underlying mortgage or loan, this gives rise to “acquisition indebtedness.”  Even if the charity does not formally assume the underlying mortgage or loan, the amount of the mortgage or loan is called "indebtedness."   Because there is debt on the underlying real estate, there is debt on the partnership interest. Debt at the partnership level is attributable to the donor, Mrs. Moneybags. Therefore, the value of the charitable gift would be reduced by the amount of debt allocable to Mrs. Moneybags.

Red Flag #2 - Bargain Sale Treatment

Charitable gifts of LLC interests (taxed as a partnership) with partnership debt also result in “bargain sale” treatment on the transfer of the interest. Bargain sale treatment means that if Mrs. Moneybags donated the interest to the charity, Mrs. Moneybags would receive the charitable income tax deduction for the value of the equity in the asset. Unfortunately, the release of indebtedness on the asset would be a taxable event to Mrs. Moneybags. If she had any equity in the asset, she would recognize gain and be liable for capital gain or ordinary income tax attributable to the transfer. Most donors do not like to pay taxes on charitable contributions, so this would be problematic.

Red Flag # 3 - Unrelated Business Income Tax

If the charity accepted the partnership interest and sold it, unless the interest qualified for a special exception, the charity would be liable for the unrelated business income tax (UBIT) on the transfer. In addition, if a charity owns indebted real estate that produces income (as was the case), the income may subject the charity to UBIT (unrelated business income tax), unless the charity's use of the property is “substantially related” to its exempt purpose. In our case, since the income earned by the indebted property would be unrelated related to the charity’s exempt purpose, for the period of time in which the charity held the property prior to sale, the income would be subject to UBIT.

Red Flag #4 - Marketability

Finally, as part of the charity’s analysis of the potential gift, we interviewed the property manager about the potential market for the interest.  She confirmed that she was unaware of any market for the gift and that over the last 30 years, no LLC member had ever sold their interest. The lack of marketability was a clear barrier to acceptance of the gift. 

Based upon the above, the charity’s Gift Acceptance Committee firmly declined the gift. The charity Informed Mrs. Moneybags of its decision by briefly explaining the disadvantageous tax consequences while carefully emphasizing how important she and her family was to our organization and how much we appreciated her longstanding kindness and generosity.  Accordingly, despite the refusal of the indebted property, the charity was able to maintain its good relationship with the donor, resulting in a lovely bequest gift.  

It is essential to recognize the potential “red flags” that may arise when accepting a charitable donation of complex assets.  Nonprofits should have a comprehensive gift acceptance policy, robust internal procedures, and a Gift Acceptance Committee in place to help fundraisers and charities recognize the potential “problems, dangers, or irregularities” associated with gifts of complex assets.  Otherwise, the charity’s reputation, relationship with the donor, and financial status could end up in danger.

Becoming an Empowered Philanthropist: It’s About Knowing Your Options

By Andy Ragone

Periodically, I am given the opportunity to present the value of gift planning in front of an organization’s leadership. I love the “Aha!” moments that invariably happen when the room begins to internalize the implications of giving from wealth and not disposable income. Not only do board members see a new horizon for the organization itself, many also begin to wonder about the potential impact gift planning might have on their own financial and legacy planning.

I find that many charitably minded board members experience the unintended burden of becoming the primary targets for various giving needs identified by an organization. Are there budgetary concerns? Is a capital campaign in the works? Have we held our board accountable for our minimum giving requirements? Do we have a “Give or Get” policy for our board members? The resounding answer to all of these questions may be to ask the board to give more than what they normally give.

In each of the above cases, we are asking a volunteer board member to do more —without demonstrating much empathy for personal situations or perhaps appreciating what has already been done or donated. Sometimes, we assume board members have unlimited resources and will carry the load in a pinch. Yes, board members are serving because our mission compels them. They truly believe in our cause, enough to invest of their time, their wisdom and their money.

Certainly, gratitude goes a long way, as does the fruit of a compelling vision. People stick around when an organization is able to effectively carry out its vision and mission. Even more so, when they see how they played an instrumental role in carrying out said vision and mission. What happens, then, when a nonprofit’s compelling vision is tied to an effective tax savings strategy? What happens when a board member learns about tax advantaged ways to give?

After learning how real estate funded charitable remainder trusts can bypass significant capital gains and increase income, board members may be interested in moving forward with creative ways to give. Charitable remainder trusts create an income for the donor for life, lives or a term up to 20 years, while creating a future gift to charity. The trust is a tax free trust and can sell highly appreciated assets without realizing capital gains. The donor will receive a charitable deduction for the present value of the remainder to charity. The donor will benefit from the bypass in gain, increased income and a charitable income tax deduction. Before, a board member may dismiss an “ask” for another outright gift of cash, but revealing other funding assets can help motivate donors.

Helping the board discover new ways of being charitable, while greatly reducing tax burdens and increasing income can motivate them to become champions of the gift vehicle with other donors.

It can be transformative to learn that support does not need to be given from the limited resources of disposable income. Instead, giving from wealth AND receiving income from these assets is a new opportunity.

I love seeing the look on the faces of those who have these type of “Aha!” moments—those realizations when leaders learn how to give from asset wealth and not just disposable income. Many board members out there faithfully serve and want to do more but are unaware of their options.

I share this blog to encourage and challenge you, as development officers, to educate your boards on the virtues of gift planning. Your board members will welcome new ways to help them as donors and influencers within your organizations’ communities.