IRS Approves Donor-Managed Investment Account Technique

In Letter Ruling 200445023, the IRS approved the donor-managed investment account (DMIA), a new charitable giving technique that generates an immediate income tax deduction in the year of contribution and allows donors to manage contributed assets actively, without the administrative cost and complications of operating a private foundation.

Types of Charitable Giving

Charitable giving has long been an attractive component of financial planning for high-net-worth individuals with philanthropic objectives. Under the income and gift tax charitable deductions of Secs. 170 and 2522, taxpayers can benefit their favorite charities and also reduce taxable income. Until recently, aside from using charitable remainder trusts and other split-interest techniques, there have generally been three ways to make charitable contributions:

1. Making direct gifts to the charitable organization;

2. Contributing to a donor-advised fund; and

3. Establishing a private foundation.

For the first two alternatives, the donor retains little or no control over the management of contributed assets. Donor-advised funds (e.g., commercial products offered at various brokerage firms and funds within a community foundation) are hybrids between outright gifts and private foundations. Although immensely popular, they limit a donor’s investment options to publicly traded stocks and bonds and, in the case of commercial products, to a small selection of mutual funds. Also, a donor has only advisory, nonbinding control over the ultimate disposition of his or her contributions.

In donating to a private foundation, the donor has maximum control over contributed assets, but is subject to certain start-up costs and reduced percentage limits on deductions (i.e., 30% of adjusted gross income for cash contributions, rather than the 50% limit applicable to gifts to public charities and donor-advised funds), as well as the administrative burdens of tax compliance and grantmaking.

How DMIAs Work

A DMIA caters to charitably inclined individuals who want to make a substantial charitable gift of at least $200,000, but have more confidence in their own (or their financial adviser’s) money management skills than in the skills of foundation managers. Just as donor-advised funds provide a middle ground between outright gifts to a public charity and use of private foundations, DMIAs provide an alternative to donor-advised funds and private foundations.

So-called “venture philanthropists,” who have ambitions of making a much larger charitable gift than their current financial resources allow, are the intended consumers of this planned giving product. Of course, individuals can manage their assets on their own without using a DMIA and simply grow their wealth, paying income taxes on an accumulation from year to year until they are ready to contribute to charity. However, the most significant advantage of a DMIA is that the assets contributed are income tax free, which substantially enhances their growth potential.

In a DMIA transaction, the donor and the donee charitable organization (qualified under Secs. 170 and 2522) agree to an irrevocable transfer of assets to an investment account titled in the charity’s name, for the charity’s sole benefit. In surrendering all ownership and beneficial interest in the transferred property, the donor (or the donor’s financial adviser) is permitted to manage the account’s investments, subject to a limited power of attorney allowing the donor to act as the investment manager for a fixed term.

The agreement specifies the types of assets the account can hold (e.g., equities, mutual funds, fixed-income securities, on- and offshore hedge funds and real estate investment trusts). Also, it can set investment performance benchmarks, as well as consequences for not meeting them (e.g., triggering an automatic termination of the agreement). The agreement gives the charity the right to withdraw any or all of the assets and the power to terminate the agreement at any time, for any reason.

The donor is prohibited from engaging in any acts of self-dealing that involve the account assets. Additionally, the donor cannot borrow against the account assets or commingle them with other assets.

Letter Ruling 200445023

The ruling request, which was based on the arrangement described above, asked whether such contributions would qualify for an income tax deduction under Sec. 170 and a gift tax deduction under Sec. 2522.

In general, to qualify under Sec. 170, the donor must make a voluntary gift of his or her entire interest in the donated property to a qualifying organization. For the gift tax deduction under Sec. 2522, the donor must part with all dominion and control over the donated property, relinquishing any power to direct the gift’s disposition or manner of enjoyment. Given the law described above, the IRS concluded that the donor’s contribution would qualify for both charitable deductions, because the transfer was voluntary, gratuitous and complete.

Income tax: The donor’s retained investment management right was not deemed to be a substantial right in the contributed property; thus, it did not constitute a retained partial interest under Sec. 170(f)(3)(A), which would foil the income tax deduction. The Service cited Rev. Rul. 75-66, in which a taxpayer transferred 800 acres of real estate to the Federal government, retaining lifetime rights to use and maintain paths on the property to train his hunting dog. The retained right was deemed insubstantial and did not trump the deductibility of the gift for income tax purposes under Regs. Sec. 1.170A-7(b)(1)(i).

Gift tax: For gift tax purposes, the Service reiterated its finding that the right to manage the investments is not a retained interest in the donated property that would deny the gift tax deduction under Sec. 2522(c)(2). It then considered whether the gift depended on some act or triggering event. If so, no deduction would be allowable, unless the possibility that the gift will not occur is “so remote as to be negligible”; see Regs. Sec. 25.2522(c)-3(b).

In a DMIA arrangement, although the donor has the right to direct the account’s investment policy for a fixed term, the charity has the ultimate power to terminate the agreement. Consequently, the Service ruled that the gift would not be contingent on a condition precedent under Regs. Sec. 25.2522(c)-3(b)(1), allowing the gift tax charitable deduction.

Planned Giving

Charitably inclined individuals ought to consider their giving alternatives carefully before signing up for a DMIA. They should question the importance of retaining investment management control over the assets contributed and growing them tax free for the charity’s benefit. After all, if the donor waits to contribute until the assets grow to a certain level, the deduction will be greater (which may reduce the donor’s income tax) and, if he or she contributes the long-term appreciated assets directly to the charitable organization, there will be no capital gain.

The commonality that hybrid charitable giving techniques—such as donor-advised funds and DMIAs—seem to share is their profitability to the money management industry. Donor-advised funds have been created at most major brokerage firms across the U.S.; DMIAs may become just as popular among independent money managers and financial advisers, who would then have one more way to keep assets under management.

Also, in the case of the letter ruling, the DMIA fee (reportedly a sliding scale of less than 1% of assets under management for the charity’s benefit) of the Connecticut-based consulting firm is payable by the charitable beneficiaries, not by the donors. Because the charities will be paying the fee, they need to consider the consequences of accepting a DMIA as a gift, particularly from a donor-relations point of view.

From Elizabeth E. Nam, J.D., New York, NY