Another new wrinkle: DAFs, Endowments, Charitable Asset Protection and Bankruptcy

Every time I stumble on a really important legal ruling or fact or principal, I always get a “been there, done that” email from a reader.   I don’t mind – maybe I was sleeping when that ruling popped up in my email.

This one though – I really doubt my readers out there will have picked up on it because I learned something very important about endowments and asset protection from the ongoing National Heritage Foundation (NHF) disaster stories.

In Dec., I reported on how the NY Times had botched up a story about NHF, and their CGAs and DAFs (Donor Advised Funds).  Here is a link to that story:

Based on that post, someone directly involved and affected by NHF’s nefarious activities got in contact with me and among the things he shared with me, was attorney Richard L. Fox’s December 2009 update to his book:  Charitable Giving: Taxation, Planning and Strategies.  Based on what I read, I whole-heartedly recommend the book.

I would actual post the full update (48 pages worth) but I can’t risk getting in trouble over my blog again.

In this update, Attorney Fox had an extensive discussion about NHF’s attempts to INCLUDE their DAF in their bankruptcy estate (so far successful but under appeal).

By the way, normally a charity facing bankruptcy wants to keep out as much as they can from the bankruptcy estate because that is the money that gets lost to creditors (and obviously see the charitable contributions go to good causes, if not their own).  Not NHF.  It would take about a 600 page book to cover all of the slimy stuff they have engaged in and all of the problems as a result to their donors.

What struck me was the fact that there is extensive legal precedent that restricted gifts, particularly for permanent endowments (spend income, save principal), are typically EXCLUDED from a failing charity’s bankruptcy estate!  He quoted a case where a hospital had already closed, but the bankruptcy court determined that the restricted endowment gifts were to be transferred to other charities for similar purposes rather than be used  to pay creditors.

Amazing.  For so many years, I have seen so much written and discussed about asset protection, and use of separate incorporation for endowments, etc.. and never once did I actually see any hint that bankruptcy courts generally do not include restricted endowments in the bankruptcy estate.

What is crazy about this issue is in states still dealing with “underwater” endowments under UMIFA (New York and 6 others), the advice many of the best of the best attorneys offer is to draft endowments to be outside of the “permanent – income only” type to avoid potentially being frozen.  Sounded like great advice but from an asset protection approach, it appears (just appears) that those permanently restricted endowments funds are the most protected, safest from bankruptcy of the organization.

Note, any restriction on a gift helps potentially protect it from a bankruptcy – it is just that the greater the restriction (“permanent – income only” being the highest level of restriction), the more weight it will have in front of a bankruptcy court judge.

This takes us to the issue Fox was addressing in regard to Donor Advised Funds and NHF.  Are they restricted or not?

For sure, the lawyer in me says UNRESTRICTED.  Why?  Well, if not, then you don’t deserve a charitable deduction.  DAFs are a legal sham.  IRS doesn’t necessarily mind legal shams; what do you think GRATs, Lead Trusts, CRTs, etc.. all are?  But, when they know it’s a sham but not really a criminal one, they impose higher levels of scrutiny and protections to prevent crimes.  For DAFs, that protection has always been the fact that the DAF is supposed to be considered for “legal” purposes unrestricted, no strings, period.

But, what Mr. Fox opened my eyes to was an idea I talk about quite a bit.  To understand the whole legal thing, you have understand that there can exist with one legal system, contradictions between various courts and agencies.  For example, in a criminal court, you might be found not guilty, but a civil court can find you liable for the damages of the crime you committed (one is not necessarily dependent on the other).

Here, DAFs, under general legal principals, are unrestricted assets (albeit with an asterisk).  But, bankruptcy courts have a totally different approach.  They need to decide how much should be made available for creditors and if courts over time have developed an approach to restricted gifts, who is to say that those same principles wouldn’t apply to DAFs.  That is the analysis Mr. Fox did and he made a strong case for saying that everyone knows that charities are not free to spend their DAFs freely, even though the agreements explicitly say so.  The argument is the old “duck” argument:  walks like a duck and swims like a duck and quacks like a duck, it’s a duck!  DAFs funds are unitized, never touched except for donor recommendations, intended to be held, etc..

It will be interesting to see if an appeals courts eventually agrees with that logic.  And, if bankruptcy courts decide that DAFs are really restricted gifts from a legal point of view, does that mean the IRS should go ahead and start denying deductions for excessive donor control?  Like I said, courts have no problems with contradictions.  For donor deduction purposes and the IRS, DAFs are unrestricted assets.  For bankruptcy estate purposes, DAFs are restricted.  One is not dependent on the other

In the meantime, maybe we need to get up to speed on how permanently endowments are actually a protected asset class under a bankruptcy!

Have a great weekend!

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