Thanks for writing this up! In my opinion, it is likely that this idea would face some significant tax hurdles.
The hypothetical charity would not get to decide whether to “treat any donation to this scheme just like any other donation” for tax purposes. The treatment of any transaction would be determined by the national taxing authority (e.g., IRS) based on statutes, regulations, and caselaw.
In the US, I think it is pretty clear that the pure version of this scheme would be seen as an interest-free loan. Not only can you not deduct those, IRS is concerned enough about people manipulating the system with loans to non-profits that there are special rules imputing phantom interest to the donor if the donation exceeds a certain amount!
I think there would be considerable resistance to changing this basic rule, too—and for good reason. If you’re a taxing authority, you have to write regulations with a very cynical eye. People with money will hire people like me (only nerdy enough to actually go into tax law!) to find ways to manipulate the system to reduce their tax burden. It’s not hard for me to come up with ways a system like this could potentially be manipulated. For example, it can often be advantageous for a taxpayer to recognize net income in one tax period or another—for instance, if the tax rates between the two periods are expected to be different. One would have to tweak quite a bit to prevent people from using this scheme to do that—I haven’t thought through whether that is even practical or not. The tax code is very complex, long, and changing, and it can be difficult to prove that a certain scheme can’t be manipulated.
I doubt any taxing authority would ever approve of a pure scheme like this without requiring the donor to repay the tax advantage received from the donation (with interest). Otherwise, even if the donor does not receive a net personal financial advantage from the transaction, there is a clear loss to the public fisc. What you’ve basically done is allow the donor to pay a portion of their taxes to a nonprofit of their choice, not the government. There are few people would not not prefer to “pay” a significant portion of their “taxes” to their church, local community group, or whatever else they are interested in. If there was no clawback of the tax deduction/credit, every nonprofit in the country would be encouraging donors to donate large sums, and then ask for them back.
Admittedly, standard charitable deductions and credits do that to some extent—but they generally don’t fall into this trap because the reduction in taxes is only a relatively small portion of the amount donated. By giving $100 to Charity X under current law, I can cause what is effectively a transfer of $20 from the government’s coffers to the charity’s. But the transaction still costs me $80, which tempers willingness to make huge transfers.
Off the cuff, I think there are probably ways around much of this—but most of them are going to involve someone taking a tax hit and some limits on the solidity of the refund guarantee. Pete already mentioned Basefund, which is trying to do something similar. Apparently, they have received legal advice that this is OK for a separate non-profit to do, but only to the extent that the donor is experiencing “hardship” as defined by reference to some legal standard not controlled by the charity. (See discussion here.)
The two other ideas that come to mind—again, off the cuff—are:
Having the incoming “donation” split into two, with (say) 95% going to the donor and 5% going into an organization that holds a pot of money for potential refunds. One could think of this as a sort of self-insurance scheme by the organizations’ donors collectively. If donations to it are not tax deductible, the pot organization may be able to make refunds without causing tax problems. Assuming this would work,[1] the downsides would be a partial loss of tax deductibility and the refund guarantee being less than fully robust. If too many donors ask for refunds, the pot organization will run out of money and be unable to honor subsequent requests. For this reason, I think it would be necessary to establish some guidelines for when a refund could be issued by the pot organization rather than being solely a matter of donor discretion.
Having someone who cannot benefit from a tax deduction anyway donate directly to the pot organization described above. For example, the person may want to support an organization that isn’t tax deductible in their country anyway, or may be over the maximum allowable amount for charitable deductions. If this would work, the main challenges would be finding donors willing to give up the tax deduction and a limitation on the aggregate amount of donations to the amount raised specifically for that purpose.
Without much thinking or research, my largest uncertainty would be the tax treatment of the organization holding the pool, and payments by it. It could not be a non-profit, or it would be subject to the same limitations as Basefund. The pool organization might itself be subject to taxes, and the “refunds” might be taxable to the refunded donor as well. Usually, insurance proceeds that merely compensate the recipient for a loss (like fire insurance) aren’t taxable, and there are exclusions for certain other types of insurance under specified conditions. But I’m not sure refunds under this scheme would often be considered losses for tax purposes, or would be excluded by other provisions from the default definition of income (which is awfully broad).
Part of the reason I posted here was to get feedback exactly like this, from people more knowledgeable than I am. So I really appreciate both the feedback and your ideas as to how it can still work.
Given the complexity you describe, I am tempted to suggest a two-pronged approach:
Short-term:
Your donation is NOT initially tax-deductible, but (in return for that), if/when you decide to make part or all of a donation permanent, that would then be tax-deductible. I’m not sure, but this would seem to be fair according to the way the tax-laws are supposed to work.
Long-term:
If this becomes a common phenomenon, big enough to warrant the effort, it would be interesting to re-negotiate the way it works with the tax-authorities, so that at donation would initially be tax-deductible but the amount that would be recovered would be only the non-tax-deductible part (e.g. the $80 in the example you described) - and then (TBD) maybe the remaining $20 must be paid back to the tax-authorities, or maybe not.
I really appreciate your perspective of looking at this from the tax-authorities point-of-view, which indeed would probably have to be very cynical. And let’s face it, in most cases, I agree with them. It already bothers me that very rich people can give millions to a very rich church rather than pay taxes that would be used to help provide better services for the poor—even when nobody breaks any laws.
But that’s my top-of-mind reaction—I will give this some more thought!
Short term plan should work in the US, as long as the donor doesn’t have more than $250K in revocable donations (which the tax system will treat as loans) to any organization. The downside is that there is no tax benefit until the year in which the donation becomes irrevocable, and donors tend to value the immediate deduction. E.g., this is one of the main motivations for donor advised funds in which the donor gets the deduction now but decides the ultimate recipient of the funds later.
Long term plan could be tough—Congress is relatively unlikely to accept any plan unless it leaves the government coffers in as good a shape after the gift is reversed than they would have been in had the gift never occurred. Trying to unwind a transaction that happened, say twenty years ago is just painful.
One possible way to ameliorate that would be to impose a limit of ~five years on any refund, and to require taxpayers to keep full records for the tax year of deduction until the refund window closed. I guess it would then be possible to require the taxpayer to file an amended return for the tax year of donation without the deduction, then pay any increase in tax plus interest.
Another option would be a rule like we use for most premature withdrawals from certain tax-advantaged retirement & medical accounts: you have to declare the withdrawal as income in the year of withdrawal and pay a 10 percent penalty on top of that. I’m not sure what the theoretical justification for that penalty is, but it should at least dampen enthusiasm for manipulating the tax system with income-timing games.
Some really good ideas there. The last paragraph is particularly interesting. Because, indeed, my idea is that this should be absolutely a last-resort scenario, and so, while I too would struggle to find a justification for this, it is the kind of scheme that would fit well.
Your second paragraph is the key challenge. All i can say is that I haven’t investigated this in depth, especially since I’m not only not a tax-expert, but also not US-based, and this point would be different in every country. But I believe that it’s not an impossibly difficult calculation to figure out a way to ensure this, the challenge might be just in convincing anyone to add even more complexity to the tax-laws.
Really appreciate your thoughtful input and ideas!
One note of encouragement: for EA at present, the bulk of donations come from a few countries, so you could get the bulk of expected impact by making the scheme work in only those few countries.
Thanks for writing this up! In my opinion, it is likely that this idea would face some significant tax hurdles.
The hypothetical charity would not get to decide whether to “treat any donation to this scheme just like any other donation” for tax purposes. The treatment of any transaction would be determined by the national taxing authority (e.g., IRS) based on statutes, regulations, and caselaw.
In the US, I think it is pretty clear that the pure version of this scheme would be seen as an interest-free loan. Not only can you not deduct those, IRS is concerned enough about people manipulating the system with loans to non-profits that there are special rules imputing phantom interest to the donor if the donation exceeds a certain amount!
I think there would be considerable resistance to changing this basic rule, too—and for good reason. If you’re a taxing authority, you have to write regulations with a very cynical eye. People with money will hire people like me (only nerdy enough to actually go into tax law!) to find ways to manipulate the system to reduce their tax burden. It’s not hard for me to come up with ways a system like this could potentially be manipulated. For example, it can often be advantageous for a taxpayer to recognize net income in one tax period or another—for instance, if the tax rates between the two periods are expected to be different. One would have to tweak quite a bit to prevent people from using this scheme to do that—I haven’t thought through whether that is even practical or not. The tax code is very complex, long, and changing, and it can be difficult to prove that a certain scheme can’t be manipulated.
I doubt any taxing authority would ever approve of a pure scheme like this without requiring the donor to repay the tax advantage received from the donation (with interest). Otherwise, even if the donor does not receive a net personal financial advantage from the transaction, there is a clear loss to the public fisc. What you’ve basically done is allow the donor to pay a portion of their taxes to a nonprofit of their choice, not the government. There are few people would not not prefer to “pay” a significant portion of their “taxes” to their church, local community group, or whatever else they are interested in. If there was no clawback of the tax deduction/credit, every nonprofit in the country would be encouraging donors to donate large sums, and then ask for them back.
Admittedly, standard charitable deductions and credits do that to some extent—but they generally don’t fall into this trap because the reduction in taxes is only a relatively small portion of the amount donated. By giving $100 to Charity X under current law, I can cause what is effectively a transfer of $20 from the government’s coffers to the charity’s. But the transaction still costs me $80, which tempers willingness to make huge transfers.
Off the cuff, I think there are probably ways around much of this—but most of them are going to involve someone taking a tax hit and some limits on the solidity of the refund guarantee. Pete already mentioned Basefund, which is trying to do something similar. Apparently, they have received legal advice that this is OK for a separate non-profit to do, but only to the extent that the donor is experiencing “hardship” as defined by reference to some legal standard not controlled by the charity. (See discussion here.)
The two other ideas that come to mind—again, off the cuff—are:
Having the incoming “donation” split into two, with (say) 95% going to the donor and 5% going into an organization that holds a pot of money for potential refunds. One could think of this as a sort of self-insurance scheme by the organizations’ donors collectively. If donations to it are not tax deductible, the pot organization may be able to make refunds without causing tax problems. Assuming this would work,[1] the downsides would be a partial loss of tax deductibility and the refund guarantee being less than fully robust. If too many donors ask for refunds, the pot organization will run out of money and be unable to honor subsequent requests. For this reason, I think it would be necessary to establish some guidelines for when a refund could be issued by the pot organization rather than being solely a matter of donor discretion.
Having someone who cannot benefit from a tax deduction anyway donate directly to the pot organization described above. For example, the person may want to support an organization that isn’t tax deductible in their country anyway, or may be over the maximum allowable amount for charitable deductions. If this would work, the main challenges would be finding donors willing to give up the tax deduction and a limitation on the aggregate amount of donations to the amount raised specifically for that purpose.
Without much thinking or research, my largest uncertainty would be the tax treatment of the organization holding the pool, and payments by it. It could not be a non-profit, or it would be subject to the same limitations as Basefund. The pool organization might itself be subject to taxes, and the “refunds” might be taxable to the refunded donor as well. Usually, insurance proceeds that merely compensate the recipient for a loss (like fire insurance) aren’t taxable, and there are exclusions for certain other types of insurance under specified conditions. But I’m not sure refunds under this scheme would often be considered losses for tax purposes, or would be excluded by other provisions from the default definition of income (which is awfully broad).
Thank you Jason for this really helpful comment!
Part of the reason I posted here was to get feedback exactly like this, from people more knowledgeable than I am. So I really appreciate both the feedback and your ideas as to how it can still work.
Given the complexity you describe, I am tempted to suggest a two-pronged approach:
Short-term:
Your donation is NOT initially tax-deductible, but (in return for that), if/when you decide to make part or all of a donation permanent, that would then be tax-deductible. I’m not sure, but this would seem to be fair according to the way the tax-laws are supposed to work.
Long-term:
If this becomes a common phenomenon, big enough to warrant the effort, it would be interesting to re-negotiate the way it works with the tax-authorities, so that at donation would initially be tax-deductible but the amount that would be recovered would be only the non-tax-deductible part (e.g. the $80 in the example you described) - and then (TBD) maybe the remaining $20 must be paid back to the tax-authorities, or maybe not.
I really appreciate your perspective of looking at this from the tax-authorities point-of-view, which indeed would probably have to be very cynical. And let’s face it, in most cases, I agree with them. It already bothers me that very rich people can give millions to a very rich church rather than pay taxes that would be used to help provide better services for the poor—even when nobody breaks any laws.
But that’s my top-of-mind reaction—I will give this some more thought!
Cheers!
Short term plan should work in the US, as long as the donor doesn’t have more than $250K in revocable donations (which the tax system will treat as loans) to any organization. The downside is that there is no tax benefit until the year in which the donation becomes irrevocable, and donors tend to value the immediate deduction. E.g., this is one of the main motivations for donor advised funds in which the donor gets the deduction now but decides the ultimate recipient of the funds later.
Long term plan could be tough—Congress is relatively unlikely to accept any plan unless it leaves the government coffers in as good a shape after the gift is reversed than they would have been in had the gift never occurred. Trying to unwind a transaction that happened, say twenty years ago is just painful.
One possible way to ameliorate that would be to impose a limit of ~five years on any refund, and to require taxpayers to keep full records for the tax year of deduction until the refund window closed. I guess it would then be possible to require the taxpayer to file an amended return for the tax year of donation without the deduction, then pay any increase in tax plus interest.
Another option would be a rule like we use for most premature withdrawals from certain tax-advantaged retirement & medical accounts: you have to declare the withdrawal as income in the year of withdrawal and pay a 10 percent penalty on top of that. I’m not sure what the theoretical justification for that penalty is, but it should at least dampen enthusiasm for manipulating the tax system with income-timing games.
Thanks Jason,
Some really good ideas there. The last paragraph is particularly interesting. Because, indeed, my idea is that this should be absolutely a last-resort scenario, and so, while I too would struggle to find a justification for this, it is the kind of scheme that would fit well.
Your second paragraph is the key challenge. All i can say is that I haven’t investigated this in depth, especially since I’m not only not a tax-expert, but also not US-based, and this point would be different in every country. But I believe that it’s not an impossibly difficult calculation to figure out a way to ensure this, the challenge might be just in convincing anyone to add even more complexity to the tax-laws.
Really appreciate your thoughtful input and ideas!
Cheers
Denis
One note of encouragement: for EA at present, the bulk of donations come from a few countries, so you could get the bulk of expected impact by making the scheme work in only those few countries.