ELITE ADVISOR BEST PRACTICES
The Supporting Organization
A flexible vehicle for investing charitable dollars in private equity, real estate and other nontraditional assets. Here’s what advisors need to know about philanthropic “alternatives”.
By Michael King
- Affluent philanthropists often desire to invest charitable dollars in assets beyond cash, bonds and publicly traded stock.
- A supporting organization is generally the most effective charitable vehicle for investing in nontraditional asset classes, such as private businesses and real estate.
- Expanding the breadth of permissible investments for your clients’ charitable dollars provides enhanced investment flexibility and the potential for greater investment returns.
From a stewardship perspective, and in an effort to maximize investment return, some philanthropists prefer to invest charitable dollars in assets other than cash and marketable securities. This can be challenging because historically, the vast majority of charitable assets are simply invested in the more traditional asset classes—stocks, bonds and cash.
Affluent philanthropists who give generously, and who have charitable dollars that are not currently being deployed for charitable purposes, often prefer to invest charitable dollars in a broader spectrum of investment classes. This is particularly true for philanthropists who built their personal wealth through alternative asset classes. Perhaps the two most common alternative investment classes in this regard are (1) family or private businesses and (2) real estate, although other assets such as intellectual property and interests in oil, gas and minerals might also be relevant.
Sometimes the assets that initially funded the philanthropists’ charitable giving consisted of these “alternatives.” Despite the fact that relatively few philanthropists ever consider making charitable gifts of alternative assets or investing charitable dollars in such assets, “alternatives” represent some of the most attractive assets they can give because these assets provide donors with multiple tax benefits and higher potential investment returns. Also, for many donors, alternative assets represent the majority of their total wealth so they are able to give far more of it away than if they were limited exclusively to giving cash.
Three alternative vehicles for family philanthropy
Unfortunately, investing in alternative assets in a charitable context can be very challenging due to various issues and obstacles that arise under current tax laws. For family philanthropists, the most common charitable vehicles used to facilitate their giving include the following three alternatives:
- A private foundation
- A donor-advised fund
- A supporting organization
Although the supporting organization is the least known and least used of the three aforementioned charitable vehicles, it is generally the most effective and the most flexible charitable entity for investing in private equity, real estate and other alternative investments.
The effectiveness and flexibility of alternative assets are partially attributed to the fact that supporting organizations:
1. Provide a fair market value charitable deduction for gifts of such assets. Private foundations, by contrast, provide a deduction limited only to the assets’ income tax basis.
2. Are not subject to the self-dealing rules that apply to private foundations. These rules can dramatically restrict various transactions between the philanthropist and the private foundation and its assets.
3. Are not subject to the excess business holdings rules. These rules apply to both private foundations and donor-advised funds that could restrict the philanthropist’s desire for the charitable entity to hold and invest in such assets long-term.
Of course, even in the context of supporting organizations, investing charitable dollars in private businesses, real estate, and other alternatives investments must be done with great care and consideration of the various tax rules and issues.
Two key issues for your philanthropic clients
There are two issues in particular that you must help your philanthropic clients navigate:
1. Excess benefit rules. It is important to consider the “excess benefit rules”under the tax code that effectively prohibit certain transactions between the giver (and other “disqualified persons”) and the supporting organization, including its underlying assets. These prohibited transactions include any “grant, loan, compensation or other similar payment” provided by the supporting organization to the giver or other disqualified person. All economic transactions that may occur between the supporting organization and disqualified persons should be examined to ensure compliance with these rules.
2. Control. In order to qualify as a supporting organization under the tax code, the giver and other disqualified persons can’t “control” the supporting organization. This prohibition precludes the disqualified persons from having majority appointments on the board of the supporting organization. The IRS has taken the position that this rule also prohibits disqualified persons from controlling the underlying assets of a supporting organization, even when they do not control the board of directors of the supporting organization.
Furthermore, the IRS takes the position that a business entity that is controlled by disqualified persons, but is partially owned by the supporting organization, may violate this rule and cause the supporting organization to fail to qualify as such. In this case, the supporting organization would terminate and default to private foundation status. The extent of this position is illustrated by the following examples.
Assume a privately owned business entity is capitalized with both voting and nonvoting interests. The voting interests represent one percent of the equity of the business, and the nonvoting interests represent 99 percent of the equity of the business. Assume that some portion of the nonvoting interests is gifted to a supporting organization, but that the giver retains the one percent voting interest. If the supporting organization’s sole asset is the nonvoting interests in the business, then the IRS takes the position that the giver essentially controls the nonvoting interests and, therefore, the supporting organization itself. Thus, the IRS takes the position that the supporting organization would not qualify as such, and instead would be treated as a private foundation.
This control issue is generally the primary issue that needs to be appropriately addressed and navigated to ensure that investments in privately owned businesses, real estate and certain other assets are permissible.
In most cases, these issues can in fact be effectively navigated. The following examples illustrate permissible structures that will generally satisfy or avoid any control issues. These examples are in the context of investments in private businesses. However, these examples would apply similarly to real estate in which the giver continues to own a controlling interest—whether directly or through a business entity such as a partnership or a limited liability company.
Example 1. The control issue, in the context of a business entity, arises when the giver owns a voting interest in the entity that exceeds 50 percent of the total voting interests, even if the voting interests represent only one percent of the equity of the business. If there are multiple owners of the entity, and the giver’s (and any other disqualified persons’) interest in the voting interests is 50 percent or less, then no adverse control issues arise.
Example 2. If a giver gifts interests in a business entity to a supporting organization and retains a majority interest in the voting interests of the entity so that the control issue would otherwise be violated—but the supporting organization owns other assets that are not controlled by the giver and that are equal in value to or exceed the value of the business entity—then no adverse control issues arise. This result occurs because the giver’s deemed control over the entire assets of the supporting organization is 50 percent or less. Of course, a situation like this would require careful monitoring to ensure that the values of the various assets don’t change over time to a point in which the giver’s control shifts and exceeds the 50 percent threshold.
In both of the above examples, the specific facts and circumstances of givers might allow some to satisfy the control requirements easily, while for others it may be more difficult or even impossible. Therefore, a careful examination of the facts, circumstances, goals and objectives of each giver is required.
The ability to invest charitable dollars in nontraditional investments such as private businesses and real estate may be very appealing to affluent philanthropists who give generously. This desire can be extremely difficult, if not impossible, to achieve through a private foundation or a donor-advised fund. However, a supporting organization may provide such investment flexibility and, as a result, may expand and enhance the investment options, alternatives and performance with respect to charitable dollars that are not immediately deployed for charitable purposes.
Charitable giving has become increasingly important to many of your clients and also more complex. Contact me anytime if you would like more information about the topics discussed in this article.