Monday October 2, 2023
Lucky Lucy Lindstrom's "Cousins' Scholarship" Plan
Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor and began advising clients. Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucy was so successful in these markets that she now only manages her own large personal portfolio.
Somewhat late in life, Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and has learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market.
Lucy had invested $1,000,000 in a "penny stock" company. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy thinks that this stock should be sold as soon as possible, but she would like to receive a charitable deduction this year. In addition, she thought that the $5,000,000 could be placed in a supporting organization with a community foundation to provide scholarships for students.
Lucy comes from a large family. She has 30 cousins, and many of their children are now entering college. Since her supporting organization will distribute $250,000 in scholarships each year, Lucy asked the community foundation's CEO if she could give scholarships to the children of her 30 cousins. She likes the concept of a "Cousins' Scholarship" program.
Would this plan work? Can the supporting organization fund scholarships for her cousins' children?
There are several potential issues with Lucy's plan. First, the supporting organization is a public charity that must be operated for the benefit of the public. The operational test examines the way an organization actually conducts its activities (as opposed to what its documents say about how it will operate). An organization only qualifies as a charity if it engages primarily in activities that accomplish its charitable purposes. Reg. 1.501(c)(3)-1(c). There are three different ways to measure whether or not a charity's activity accomplishes its charitable purposes. These three methods of measuring charitable activity include (1) the ban on private inurement; (2) the public benefit requirement; and (3) the prohibition on lobbying and candidate electioneering.
While the ban on private inurement prevents charities from giving benefits to people that have a close relationship to the charity, the purpose of the "public benefit" requirement is to ensure that the charity's activities actually help a broad group of people – namely, the "public." If an organization's activities benefit only a single person or small group of people, it does not provide sufficient public benefits to qualify as a charity.
A scholarship program for only Lucy's cousins' children would not qualify, because the group is too small to reasonably be considered the "public." However, if the potential group is larger, the plan could be permissible. For example, if most of the 30 cousins lived in the state of Kansas, then her scholarship fund could include all students within that state. While the cousins' children would need to compete with other students in Kansas for scholarships, they would be permissible recipients.
Another potential issue is the restriction on excess benefits under Sec. 4958. If the scholarships were given to Lucy's siblings or Lucy's lineal descendants, there could be an excess benefit tax for a prohibited benefit to a disqualified person. If a supporting organization (Type I, Type II, or Type III) makes a grant, loan, payment of compensation or other similar payment to a substantial contributor or related person, there is an automatic Sec. 4958 excess benefit for the entire payment. The recipient is subject to an initial tax of 25% of the amount of the payment under Sec. 4958(a)(1) and an organization manager that participated in the making of the payment, knowing that the payment was to a substantial contributor, is subject to a tax of 10%. Sec. 4958(a)(2). Second, the taxes of Sec. 4958 may also apply to the entire payments, not just the excess value. However, Lucy's cousins are not disqualified persons for this purpose under Sec. 4958(f)(4). Therefore, scholarships are permitted if the class is sufficiently large.
Since most of her cousins' children live in Kansas, Lucy decided to fund the supporting organization and offer scholarships to students from Kansas. Most of the scholarships were awarded to other students, but several of her cousins' children did qualify and receive scholarships.
Published January 20, 2023
Lead to Remainder Double Charitable Trust
Lucky Lucy Lindstrom's Long Shot Unitrust
Lucky Lucy Lindstrom's Unitrust
Stock Unitrust Payouts to Donors
The Values-Based Charitable Remainder Trust