When a church solicited funds in 2005 for its building campaign, one member donated $5,000. Then, after the church abandoned its plans to construct a new building, the member asked the church treasurer to return her $5,000 contribution.
At another church, a member donated $1,000 to a mission project. A year later, the church decided to forego the project. Is the member entitled to a refund of the $1,000 contribution?
These are scenarios that churches may be confronted with when they solicit funds for particular ministry initiatives and later change course and drop the designated plan. But are churches obligated to return such contributions when the designated project or activity is abandoned? And, if so, what are the tax consequences to the donor?
These were the questions that Congresswoman Kay Granger asked the Internal Revenue Service in a recent letter on behalf of a constituent. In Granger's case, the constituent (the "donor") made a designated gift to a charity more than two decades ago. The charity recently informed the donor that it would no longer be using the gift for the designated purpose. The donor asked the charity to repay the designated gift plus accumulated interest to him, and indicated that he would be using these amounts to make a charitable contribution to another charity. The IRS response to Congresswoman Granger's letter is summarized below.
Returning contributions to donors
The IRS declined to address the question of whether charities can or should return designated contributions to donors when the designated purpose is abandoned. Its response to Congresswoman Granger's letter states:
This letter does not constitute a ruling, and it does not address whether federal, state, or other laws (or a charitable organization's policies) in fact require or permit the organization to repay an earlier gift or to pay interest on the repayment. We express no opinion as to the legal or tax consequences to the charity of a potential repayment.
It is odd that the IRS would address a collateral issue—the tax consequences of refunding designated contributions—and completely ignore the question of whether such refunds are legally permissible. Perhaps this was due to the complexity of the issue.
Several courts have ruled that a donor has no legal standing to enforce a designated gift to charity. The reason for this rule is simple—a charitable contribution is a gift, and a gift is an irrevocable transfer of a donor's entire interest in the donated funds or property. Since the donor's entire interest is transferred, it generally is impossible for the donor to recover the donated funds or property. Allowing a donor to enforce a designated gift, or receive a refund, is not legally or conceptually possible because the donor has no remaining interest in the gift. This is true even if the gift designated a specific project or activity.
A return of a donor's contributions would be inconsistent with the charity's previous characterization of the transactions as charitable contributions. A charitable contribution is tax-deductible because it is an irrevocable gift to a charity. If a charity complies with enough donors' requests to refund their contributions, this raises a question as to the deductibility of any contribution made to that charity. Contributions under these circumstances might be viewed as no-interest "demand loans"—that is, temporary transfers of funds that donors can recall at will.
KEY POINT. While the donor may not be able to enforce such a trust, this does not mean that a church or charity can ignore it. Some courts have ruled that the state attorney general can enforce a trust created by a designated gift, and so can any other person with a "special interest" in the trust. While this does not ordinarily include donors, their families or heirs, or even beneficiaries of the gift or trust, it may include fiduciaries (such as a trustee of a written trust).
In one of the only cases to address this issue, a Michigan court ruled that a couple could not obtain a refund of a designated contribution to their church. The couple had donated $4,000 to their church's "new building fund." The congregation planned to construct a new church the following year, but these plans were put on hold when the church received an unused school building. The couple sued their church, seeking a return of their building fund donation on the basis of the church's "breach of contract." Church leaders noted that the church had $500,000 in its new building fund and insisted that it still planned to build a new sanctuary as soon as the fund grew to $6 million.
A trial court agreed with the couple and ordered the church to refund their contributions. The church appealed. A Michigan appeals court reversed the trial court's ruling and dismissed the case. It concluded that the civil courts are barred by the First Amendment guaranty of religious freedom from intervening in such internal church disputes:
It is well settled that courts, both federal and state, are severely circumscribed by the First Amendment [and the Michigan constitution] in resolution of disputes between a church and its members. Jurisdiction is limited to property rights which can be resolved by application of civil law. Whenever the trial court must stray into questions of ecclesiastical polity or religious doctrine the court loses jurisdiction .… We hold that this dispute involves a policy of the church for which our civil courts should not interfere. Because the decision of when and where to build a new church building is exclusively within the province of the church members and its officials, the trial court erred in not dismissing the couple's lawsuit. McDonald v. Macedonia Missionary Baptist Church, 2003 WL 1689618 (Mich. App. 2003).
Taxation of refunded contributions
What if a church solicits contributions for a designated project, which is later abandoned, and it elects to refund some or all of the designated contributions to donors? What are the tax consequences for the donors? Must the donors report the refunds as taxable income? Does it matter how long ago the contributions were made? And, what if some donors contribute their refund to the same or another church or charity? The IRS responded to these questions in its response to Congresswoman Granger's letter as follows:
We are pleased to provide you with the following general information about the federal income consequences to a donor who receives a repayment of a charitable gift plus interest on the repayment ….
If a taxpayer receives the full tax benefit of a charitable contribution deduction when making a contribution to a qualified charity, and the charity repays the contribution to the taxpayer in a subsequent year, the "tax benefit rule" requires the taxpayer to include in gross income in that subsequent year the amount of the previously deducted contribution.
A taxpayer who receives interest on a repaid contribution must also include that amount in income. An individual taxpayer generally includes interest in income when it is available to the taxpayer free of substantial limitations and restrictions.
If the taxpayer uses a repaid contribution to make a new charitable contribution to a different charitable organization, he or she may claim a charitable contribution deduction for the new contribution, subject to the usual restrictions and limitations on charitable contribution deductions.
The tax benefit rule is codified in section 111 of the tax code, which states: "Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter."
In several cases, the IRS and the courts have ruled that section 111 requires donors who have received a refund of a charitable contribution made in a prior year should report the refund as taxable income in the year of the refund rather than file an amended return for the year of the contribution deleting that contribution. See, e.g., Revenue Ruling 75-150.
KEY POINT. Note that Congresswoman Granger's constituent made his designated contribution to charity "more than two decades ago." According to the IRS, this did not affect his obligation to report the refunded contribution as taxable income.
Note the following:
1. So long as a church has not abandoned the project for which designated contributions are solicited, it generally has no legal obligation to return a donor's designated contribution. Quite to the contrary, returning a donor's designated contribution under these circumstances would create the same problems addressed previously in this article.
2. If a church abandons a project for which it solicited designated funds from donors, one option would be for the church to ask donors if they want their contributions to be returned or retained by the church and used for some other purpose. Ideally, donors should communicate their decision in writing to avoid any misunderstandings.
3. Donors should be advised that if they want a refund of their designated contributions they will need to report any refund as taxable income, according to the tax benefit rule. IRC §111. The same is true for any accrued interest that is refunded. Some churches have issued donors a Form 1099-MISC under these circumstances to reduce the church's risk of liability for aiding and abetting in the substantial understatement of tax. IRC 6701(b). But this approach presents two problems:
- It assumes that the donor claimed a charitable contribution deduction for the designated gift. In fact, some donors did not get a tax deduction for their gifts because they could not itemize their deductions on Schedule A. Others received a "discounted" deduction because of the amount of their income (high-income taxpayers only get a partial deduction for their charitable contributions). A church treasurer would have to inspect the actual tax return of each donor who requests a return of his or her contribution. Most church leaders consider such precautions excessive and unnecessary, especially for smaller contributions.
- Form 1099-MISC is not designed to report this kind of income. It is designed for nonemployee compensation. In what sense have these donors performed services for the church for which they are being compensated?
4. The fact that donors who receive refunds of their designated contributions plan on redirecting their refunds to the same or another charity does not avoid recognition of the refunds (and accrued interest) as taxable income.
5. What if a church cannot identify all of the donors who contributed to the abandoned project? One option is to address the matter in a membership meeting. Another is to ask a court for authorization to transfer the special project fund to another church fund, pursuant to the Uniform Management of Institutionalized Funds Act (UMIFA). UMIFA has not been enacted in all states, and even where it is enacted, it applies only to "institutional funds" (such as endowment funds) that are regarded as permanent. Other options are available.
6. Churches should consult with an attorney when deciding how to dispose of designated funds if the specified purpose has been abandoned or is no longer feasible.
Tip. Churches that solicit funds for designated projects face difficult choices when they abandon the project and are left with the task of disposing of funds donated for that project. Some of these problems may be avoided if the church simply includes a statement similar to the following when soliciting funds for a specific project: "By contributing to this project, donors acknowledge that the church has full authority to apply contributions designated for this project to other purposes in the event the project is canceled." Such a statement should be printed on special offering envelopes used for the project, or on any other materials so long as they provide adequate notice to donors of the policy and reflect donors' consent to it.
This article first appeared in Church Finance Today, March 2010.