Charitable Gift Annuities: Due Diligence for Advisors

Charitable gift annuities (CGAs) are a type of planned gift that, by contract, are supposed to pay fixed income for life. Two recent cases provide cautionary tales (though at the outset, it should be clearly said: calling the groups that issued these annuities "charities" may be like calling Bernie Madoff and Allen Stanford "investment managers").

The National Heritage Foundation (NHF) has been in existence since the 1960's - and on the wrong side of the IRS for much of that time. NHF aggressively promoted so-called "charitable split-dollar life insurance", and its recent troubles began some years ago when the IRS cracked down on these abusive transactions. Last year, it lost a $6+ Million lawsuit after it substituted itself for a couple's children as beneficiaries of three life insurance policies. Shortly thereafter, NHF declared bankruptcy and suspended payments to its annuitants. In mid-November 2009, a bankruptcy court in Virginia authorized liquidating the bulk of NHF's assets - including donor-advised funds originally intended to benefit other charities - to compensate the annuitants.

Also in the headlines is Mid-America Foundation (MAF). MAF posed as a charity and sold CGAs through commissioned investment advisors. In reality, MAF was a Ponzi scheme that bilked participants of $50+ Million. As with all Ponzi schemes, incoming assets paid earlier participants (and, in this case, the gambling debts of the Foundation's President). When MAF imploded in 2001, it left a trail of litigation and enforcement actions in its wake. Of particular interest is a recent 9th Circuit case, Warfield v. Alaniz (569 F3d 1015), in which a Receiver sought to recover the advisors' commissions on behalf of the annuitants. The Court applied the venerable Howey test (328 U.S. 293) and concluded that these CGAs were investment contracts, placing particular emphasis on marketing materials that stressed the income that participants would receive, with philanthropic considerations a distant second. (Charities, take note!) The Court also ruled that, because of the commissions, these CGAs were not exempt from securities registration under the Philanthropy Protection Act of 1995.

Defaults by charities are extremely rare; nevertheless, if clients are considering a CGA, you can assist them in several ways. First, make sure the charity supplies a Disclosure Statement as required by federal law. Second, many states (including California) require charities to register with the Insurance or Securities Commissioner before offering CGAs; in those states, verify that the charity is in fact registered. In addition, since CGAs are backed by the charity's assets, examine its most recent IRS Form 990 to see how much it spends to carry out its mission and for clues to its financial strength. Most of all, ascertain that only volunteers or salaried employees of the charity are facilitating the gift. The involvement of outside salespersons - and any incentive or perceived incentive they may receive - is a recipe for trouble.