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Restricting Deductions On Restricted Gifts

Tabitha Marrlett

It isn’t often that a not-for-profit organization can count on a large donation from an anonymous donor. More likely, it’ll receive restricted gifts (contributions with strings attached), such as a request to name property after the donor or use the funds for a specific purpose.

As with other donations, donor-restricted gifts may qualify for a tax deduction, but there are extensive IRS guidelines that must be followed.

For starters, taxpayers may deduct charitable gifts only if they’re made “to or for the use of” organizations authorized to accept contributions under Section 170 and accompanying regulations in the U.S. Internal Revenue Code. So, while a donor can impose restrictions on a gift, your organization must be able to use the income to further its tax-exempt purpose. This is the foundation of the tax rules on restricted gifts.

If a gift is earmarked for noncharitable purposes, or if the purpose falls outside of your organization’s mission, the gift can’t be deducted.

Two-Pronged Test

Donations mustn’t benefit specific individuals, regardless how deserving they may be. The IRS asks two questions in its test to determine if a gift has been earmarked for an individual:

  1. Does your not-for-profit maintain discretion and control over the contribution? A “yes” answer works in the donor’s favor.
  2. Does the donor intend to benefit your organization or the individual? A written agreement can provide some clarity as to how the gift will be handled. The IRS will look to the signed agreement and accompanying documentation for insight into the real intentions.

The IRS has issued extensive regulations on restricted gifts that can be deducted, such as:

  • Contributing property to a city for use as a public park,
  • Creating an endowment fund for a college or specific school department, or
  • Donating funds to construct a building used by a tax-exempt organization.

Note: Restrictions or conditions on gifts must be made at the time of the donation. In other words, a donor can’t say a gift is restricted but fail to impose the restrictions at the time of the gift. Such a gift may be treated as incomplete and, therefore, nondeductible.

Key Considerations

There are several important issues affecting deductions for restricted gifts. They include:

Condition precedents. A charitable deduction won’t be allowed if a donation is conditioned on a certain action or event happening before the gift takes effect. The deduction is disallowed unless the possibility that the action or event won’t occur meets the “so remote as to be negligible” test.

The U.S. Tax Court defined “so remote as to be negligible” as 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” and “so highly improbable and remote as to be lacking in reason and substance.” (Briggs v. Commissioner, 72 T.C. 646 1979)

For example, one donor contributed a patent to a university on the condition that a certain faculty member with expertise on the technology covered by the patent remain on the faculty for the patent’s fifteen-year remaining life. The IRS ruled that the possibility that the faculty member might not remain on the faculty wasn’t so remote as to be negligible and no charitable deduction was allowed.

Reverter clauses. Under these provisions, gifts will revert to the donors unless their conditions are met. For example, if a donor gives land to the city for a public park but the city zones the property for another use, a reverter clause may require that the land be returned. These clauses can cause the donation to be nondeductible unless the event triggering the reversion meets the “so remote as to be negligible” test.

Naming opportunities. Gifts to establish a scholarship, endowment or other project to commemorate a donor can be deducted as long as the donation furthers your not-for-profit’s charitable purpose. However, it should be noted that a scandal or crime may force or encourage your organization to rescind the name. In this case, the gift may have to be returned (you can include morals clauses in every gift agreement to protect your organization’s name).

DOs and DON’Ts

The disallowance of a deduction can affect your organization as well as the donor. It can:

  • Tie up your resources,
  • Damage its reputation, and
  • Jeopardize its tax-exempt status.

Organization leaders should be on the lookout for warning signs, such as large gifts coming out of the blue by unknown donors at the close of the tax year.

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