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									                    PRACTICE GUIDE: HOW TO CONTRIBUTE TO A
                            (Terrorist Traps for the Unwary)

Table of Contents


The Rules………………………………………………………………………………………………………....2

Applying the Rules………………………………………………………………………………………………..4

Lessons for the New Millenium………………………………………..…………………………………………………..9

By David J. Berardo, Esq.

David Berardo has over 35 years of experience as a tax lawyer and international businessman. He
was graduated from Pomona College with a B.A. degree in International Relations. He has devoted
most of his professional career to the design and structure of international business transactions
since he was graduated from the UCLA School of Law in 1967.


The U.S. Council on Foundations estimates that since 1990 there has been a 500 percent increase in
donations by U.S. persons to charities created or organized outside the U.S. In October 2003, the
U.S. Council of Foundations and The Foundation Center released a survey report concluding:
international philanthropy is growing; more donors were involved in international grant making; and
US based programs for international grants represent a rising share of all international giving. All
agree that the number and amount of donations to foreign charities are increasing

The U.S. Internal Revenue Code (all references are to the “Code” unless otherwise indicated)
imposes rigid rules that make it difficult for U.S. donors to deduct donations to foreign charities.
The rules are justified by the Internal Revenue Service (the “IRS”) as the price for deductibility.
Professional advisors must be prepared to answer clients who ask: “After 9/11 how do I make a
foreign charitable donation without triggering an audit and being accused of supporting international
terrorist activities?” They must also be able to advise foreign charities who ask: “How do we collect
donations from U.S. donors?” The purpose of this paper is to provide practical answers to these
questions based on cases handled by the author.

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Determined Dancer.

Dancer defected from a Russian ballet company (the “Ballet”). Because of training, Dancer earned
substantial worldwide income. Dancer wanted to donate $200,000 of U.S. earnings to support the
Ballet after state subsidies were cut off. Can Dancer make a donation directly to the Ballet? Is the
donation deductible in calculation of Dancer’s U.S. taxable income? How does the Ballet collect the
donation from Dancer?

Obligated Orphan. Orphan was raised in a Vietnamese orphanage run by a church (“Orphanage”).
Biological father brought Orphan to the U.S.; Orphan became a U.S. citizen; started a corporation
and made lots of money. Orphan wants the corporation to donate funds to the Vietnamese
Orphanage. Can the corporation make a $500,000 deductible contribution directly to the Orphanage?
How does the Orphanage collect the donation without registration as a U.S. charity?

Samoa All-Stars. A Samoan All-Star Rugby Club (the “Club”) asked the Southern California Rugby
Club to finance a tour. A former U.S. Eagle (“Eagle”) was the administrator of assets of a former
teammate who died in an auto crash when the Eagles toured Samoa in 1988. Eagle agreed to pay
expenses from assets under Eagle’s administration. Can Eagle pay the travel expenses of the Club to
the U.S.? Pay for uniforms? The post-game party? How does the Club collect the donation?

Rabbi Rob. Rabbi Rob grew up in Brooklyn, N.Y. and became an Israeli citizen. Rabbi runs a
religious school in a West Bank settlement (the “School”) and asked one of his childhood friends,
David, to support the School from his U.S. family foundation (“Foundation”). David agreed to
donate $100,000 to the School. Can he do so? How does the School collect the donation from the

Herbal Hazel. Hazel was injured while visiting Mexico on a church tour. A doctor at a local clinic
saved her eyesight. Upon a return to the U.S., Hazel wanted to make a donation to the doctor. Can
Hazel donate $10,000 to the doctor? Can Hazel’s Church donate to the clinic? How does the clinic

The Rules.

Income Tax Rules

For income tax purposes, a donation by a U.S. donor to any charitable donee is eligible for a U.S.
income tax deduction under Section 170 so long as all the following requirements are satisfied:

       The donee must be “created or organized” in the U.S. or a sub-division;

       The donee must be “organized and operated” exclusively for religious, charitable, scientific,

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        literary or educational purposes or to foster national or international amateurs’ sports
        competition or for the prevention of cruelty to children or animals;

        The donee must use the donation only for charitable purposes and avoid private benefit; and

        The charity cannot support political activities.

It is not impossible for a U.S. donor to make a direct donation to a foreign charity and receive a U.S.
income tax deduction. The rules encourage the use of domestic intermediaries.

Gift Tax Rules

A U.S. individual who wants to donate to a charity (domestic or foreign) must also avoid U.S. gift
taxes. In the U.S., gift taxes are generally imposed on the donor. Section 2522 permits a tax-free
gift if the donation meets the same requirements set forth in Section 170, above, except the charity
does not have to be “created or organized” in the U.S. Thus, a direct donation by a U.S. individual to
a charity organized under foreign law generally does not give rise to a U.S. gift tax so long as the
other requirements of Section 170 are met.

Estate Tax Rules

A donation by a U.S. estate to a foreign charity is permitted and is deductible for purposes of
calculation U.S. death or estate taxes. A charitable deduction is permitted under provisions of the
Code that are similar to, but different from, the income and gift tax rules. Donations may be made
directly to a foreign charity “created or organized” under foreign law so long as the foreign charity is
“organized and operated” exclusively for charitable” purposes.

Corporate Rules

A donation by a U.S corporation directly to a foreign charity that is organized as a foreign a trust or a
foreign foundation is deductible only if the donated funds are used within the U.S. or a U.S. sub-
division. A donation to a foreign charity that is organized as a foreign corporation, however, does
not have to be used in the U.S. Thus, most corporate donors ask the proposed donee for a certificate
of formation and where the money will be used; if the foreign donee is a corporation, the donor is
most comfortable. Corporate donations, however, are deductible only up to 10 per cent of adjusted
gross income (“AGI”); by contrast, donations by individuals are deductible up to 50 percent of AGI.
The limited deduction discourages most corporate donations except to donees in the U.S.

Trust Rules

Trusts are allowed to make distributions for charitable purposes and deduct such distributions for

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purposes of calculating “distributable net income”. Distributions to foreign charities are unlimited
and are permitted without regard to geographic limitations – the foreign charity does not have to be
created or organized in the U.S. or use the donated funds in the U.S. So a U.S. person wanting to
make a donation to a foreign charity often uses a U.S. trust that expressly permits such donations.

Private Foundation Rules

All U.S. exempt organizations are presumed to be “private foundations” and are subject to excise
taxes unless the IRS classifies them as “public charities.” Section 509 classifies certain exempt
organizations as “per se” public charities because of the type of work performed (e.g. a church or
school) or because the organization receives a broad base of public support. The vast majority of the
estimated 400,000 U.S. exempt organizations are private foundations, not public charities. A U.S.
private foundation is not concerned whether a donation to a foreign charity is deductible because a
private foundation is already exempt from income taxes, but it is subject to excise taxes. The private
foundation, however, must determine if the foreign charity is the U.S. equivalent a “public charity”
or a “private foundation”. If the foreign charity is a “public charity” there is no risk of the U.S.
private foundation being exposed to excise taxes; if the foreign charity is a “private foundation,” the
U.S. private foundation making the foreign donation must comply with a host of additional
regulations to avoid an excise tax on the donation. A U.S. private foundation is not prevented from
making a donation to a foreign charity that is the U.S. equivalent of a private foundation; this is true
even if the foreign charity has not applied for and received a determination letter from the IRS that it
is the equivalent of a U.S. exempt private foundation. The U.S. private foundation may make its own
good faith determination of the foreign charity’s organizational status. After years of struggle, the
IRS issued Revenue Procedure 92-94 and explained how a U.S. private foundation determined that
the foreign charity was an eligible donee. Revenue Procedure 92-94 states that if a donation is made
by a U.S. private foundation to a foreign charity which is the equivalent of a U.S. private foundation,
that does not have an IRS ruling, a “qualifying distribution” will be permitted if the requirements of
Revenue Procedure 92-94 are met. If not, the distribution will be disallowed and the U.S. private
foundation donor will be subject to an excise tax on the non-qualifying distribution.

Public Charity Rules

Public charities in the U.S. (and abroad) are exempt organizations that engage in “per se” charitable
activities (e.g., a church or school) or have a broad base of financial support. If a U.S. donor is a
“public charity” and makes a donation to a foreign charity, the U.S. public charity does not have to
determine where the foreign charity is created or organized or whether the foreign charity is publicly
or privately supported. If the foreign charity is not the equivalent of a U.S. public charity, however,
the U.S. donor risks its own tax exemption if the foreign charity uses the donation for non-charitable
purposes, for example, the donated funds inure to the benefit of a private person or are used to
finance political activities.

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Applying the Rules

Determined Dancer

Dancer cannot contribute directly to the Ballet and claim a U.S. income tax deduction. The Ballet is
not “created or organized” in the U.S. Moreover, Dancer was not a U.S. taxpayer -- Dancer lost
Russian citizenship upon defection and was only given permission to reside in the county of
defection. Thus Dancer for U.S. tax purposes was stateless. Therefore, donations by Dancer to a
foreign charity must be allocated between Dancer’s U.S. and foreign source income.

Dancer offered to make a donation to a U.S. public charity called a “community foundation” which
would act as a grant administrator. The community foundation agreed to “earmark” the donation for
foreign use -– the Ballet. The community foundation accepted the donation with the understanding
that it would be re-granted to the Ballet recommended by Dancer. The community foundation agreed
to accept a single donation but would not do so on a regular basis. The community foundation
properly determined that international donations are beyond its regional purpose.

Dancer looked for a different U.S. exempt organization to act as grant administrator. The IRS has
ruled that organizations that serve as conduits, merely funneling “earmarked” donations to foreign
charities without any independent oversight control, are not eligible to receive deductible charitable
donations from U.S. taxpayers. The IRS has also ruled that a “Friends of Organization” formed to
benefit a foreign charity can qualify for a tax deduction if the Friends of Organization demonstrates
that it was organized under U.S. law and has full control of donated funds and full discretion as to
use. Therefore to receive the donation from Dancer, the Ballet formed a “Friends of Organization”
in the U.S. and had to prove to the IRS that:

        It would have complete control and discretion over how to use Dancer’s donation.

        The Friends of Organization and the Ballet could not have identical or substantial
        overlapping managers.

        The Friends of Organization had to have some independent purpose other than just remitting
        funds to the Ballet.

        The Friends of Organization had to use some portion of its funds in the U.S. or for purposes
        that may be of mutual benefit to the Friends of Organization and the Ballet.

        The fund-raising material must tell potential donors that the funds are subject to the
        independent control of the Friends of Organization.

The Ballet formed a Friends of Organization, a California non-profit corporation and Dancer was the

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main donor as well as an officer and director. The IRS classified it as a private foundation, which
means all grants to the Ballet, had to be “qualifying distributions”. After the Ballet failed to provide
regular accountings on the use of donated funds, Dancer restricted donations to pay for U.S.
expenses of the Ballet when it toured the U.S. In this manner the donor reduced the risk of excise

Obligated Orphan

For the Orphanage to receive a donation from the corporation owned by Orphan, the first task was to
determine how the Orphanage would be classified in the U.S., for example was it a public or private
exempt organization; where was it organized; and where would it use the funds. Investigation
revealed that the Orphanage was the equivalent of a U.S. public charitable trust because it was run by
a church that was organized in Vietnam as the equivalent of the U.S. trust. Because the funds will be
used in Vietnam, however, the corporation gets no tax deduction. If the Orphanage converted its
legal status to the equivalent of a U.S. corporation, any donation becomes fully deductible. If the
donation is more than 10 percent of the corporation’s AGI – the excess has to be claimed as a
deduction next year.

In the face of this obstacle, Orphan set up a “Support Organization” for the Orphanage. A Support
Organization is different from a Friends of Organization. A Friends of Organization is usually a
private foundation. A Support Organization is a public charity under Section 509(a)(3).

Once the Support Organization was set up, Orphan’s corporation made a donation directly to the
Support Organization and the donation was fully deductible (subject to the 10% of AGI rule) on the
corporation’s U.S. income tax return because the donation was to a person created and organized in
the U.S. Transfers from the Support Organization to the Orphanage (the Vietnamese supported
Orphanage) were made without “expenditure responsibility”, because the Orphanage was the
equivalent of a U.S. public charity.

In order to obtain IRS approval that the Support Organization met the requirements of Section 509, it
was necessary to demonstrate that the Vietnamese supported Orphanage was run as part of a church
and had a broad base of financial support from a wide cross-section of the general public, rather than
from one person, one company or one family. Orphan now regularly organizes fund-raising activities
for the Orphanage by soliciting donations to the U.S. Support Organization.

Samoan All-Stars

Section 501(c)(3) defines charitable purpose to include activities which foster international amateur
sports (but not the provision of athletic facilities or equipment). Section 501(c)(3) also limits sport
activities to those carried out by a corporation, community chest, fund, or foundation organized and
operated exclusively for athletic purposes. Therefore, in order for Eagle to support the Samoan all-

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star Club, the team itself must be a separate corporation, community chest, fund, or foundation.

Eagle determined that the Club was not a separate legal entity, but with Eagle's encouragement, the
Club incorporated. Next, Eagle had to make sure that financial support to the Club would be used
only for proper activities; donated funds could not be used for new uniforms. Finally, Eagle had to
determine whether the Club was from the independent country of Samoa (formerly Western Samoa
administered by New Zealand) or the U.S. possession, American Samoa (“AS”).

After Eagle sorted out these facts, Eagle examined the documents that created the estate he
administered. Fortunately, Eagle drafted those documents and they permitted eligible charitable
donations for purposes of both U.S. income and estate tax purposes. Unfortunately, Eagle drafted the
documents to permit gifts to the U.S. Rugby Federation, the Support Organization for the U.S.
Eagles, the official U.S. team. The documents permitted gifts for U.S. charitable purposes but not
foreign charitable purposes.

Eagle then formed an exempt organization in American Samoa (“AS”), under AS law, which mirrors
the Code. In other words, it has the identical provisions as the Code, but is administered by AS tax
officials. Once the AS charity was formed, it was an exempt organization “created and organized”
in a U.S. possession, an eligible donee. However, since the AS charity was not a “per se” public
charity, and since it did not have a broad base of public support, it was classified by the IRS as a
private foundation. Therefore, donations from the estate were fully deductible, but the AS charity
had to make sure its donations to the Club were “qualifying expenditures” and the AS charity had to
exercise “expenditure responsibility” on all grants to the Club. The basic requirements for the AS
charity to exercise "expenditure responsibility" are:

       Pre-grant Inquiry: the AS charity must make a reasonable investigation of the Club to
       make sure that it is carrying out charitable activities.

       Written Agreement: the Club must sign a written agreement with the AS charity which set
       out what is to be accomplished with the donation and prohibiting the use of the donation for
       lobbying or personal benefit.

       Separate Account: The Club must establish a separate account for deposit of the donation
       and promise not to commingle charitable donations with other funds.

       Regular Reports: The Club must provide the AS charity regular status reports on the use of
       the donation.

       Report to the IRS: The AS charity must indicate on its annual IRS Form 990-PF that it
       made an "expenditure responsibility" grant and must add a schedule to the tax return
       describing the name of the foreign charity, the amount of the donation, the charitable purpose

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        of the donation, and the when the funds were used up.

The AS charity determined, with the help of Eagle, that it could make travel grants to individual
players, but not to the Club. Grants for travel expenses did not create taxable income under the
Code; therefore, no U.S. source taxable income to the All-stars. So Eagle was able to finance travel
and beer, but no balls.

Rabbi Rob

To fund Rabbi Rob's School, David’s Foundation had to determine, first, whether the School was the
equivalent of a U.S. public charity or private foundation. Schools generally are “per se” public
charities under Section 170, but only if they have a regular faculty and curriculum and had a
regularly enrolled body of pupils in attendance at the place where educational activities were
regularly carried on. Rabbi Rob asked his friends for help because the School had been damaged by
Israeli tanks and needed repair. Therefore, the School was conducting classes in public places and
attendance was sporadic.

Fortunately, the U.S. and Israel have a tax treaty that allowed the Foundation to rely on the U.S.
definition of exempt purpose under U.S. law, not Israeli law. Unfortunately, however, the IRS has
ruled that an educational institution requires that there be no discrimination. The School only
provided religious training to selected Israeli youth from West Bank settlements. Therefore, the
Foundation could not make a donation directly to the School.

The Foundation then consulted various international Jewish organizations and asked them to
administer a "friends of" grant. Unfortunately, the School did not teach orthodox theology;
moreover, the administrative fee to accept the donation and transfer it to the School would be 45% of
the total sum contributed by the Foundation.

The Foundation then approached an Israeli hospital that had recently hired another of Rob’s
childhood friends, Jacob, as a development officer. Aware of current fund raising practices in the
U.S., the hospital agreed to accept the Foundation’s donation and act as a “Friends of Organization”
for the School, extracting a lesser fee. The hospital’s philosophy was that a small fee was better than
no fee. However, the hospital was not a public charity; so David’s Foundation was making a
donation to the U.S. equivalent of a foreign private foundation. To avoid loss of its tax exemption,
the Foundation had to exercise “expenditure responsibility” and require Rabbi Rob to report to Jacob
so Jacob could report to David’s Foundation on how funds were used. Lots of reporting, but in
compliance with the rules and no excise tax.

Herbal Hazel

Hazel learned that she could not make a U.S. tax-deductible donation to the doctor-- he was not

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organized or created in the U.S. and he would receive personal benefit. Therefore, she asked that her
Church, which sponsored the tour, to make the donation. Since several members of the Church were
injured on the same tour, the elders agreed to accept a donation from Hazel and use it as requested by
Hazel. The elders, however, consulted counsel and learned that even though the Church was a “per
se” public charity, the Church would risk its exempt status if it made a donation that was not used for
charitable purposes in Mexico.

The elders also learned that charitable purpose under Sec. 501(c) (3) prohibited private benefit.
Therefore, the Church could not make a grant directly to the doctor. The elders asked Hazel to
inquire whether the clinic was a “medical research organization.” Hazel confirmed that the clinic did
indeed do research in connection with a local hospital. Then the elders learned that the medical
research was on indigenous herbs that reduced eye pain for diseases like glaucoma. Afraid that the
Church would be sponsoring drug research, the elders declined to fund Hazel’s request and kept the
money for church repairs.

Hazel was determined to make good on her promise to help the Doctor. Therefore Hazel discovered
that the U.S. had a tax treaty with Mexico that, unlike the Israeli and Canadian tax treaties, allowed
Mexican law to determine charitable purpose. Hazel also discovered that the clinic was designated
by The Hacienda (the equivalent of the IRS) had classified the clinic as a hospital under Mexican
law. Therefore, Hazel was confidant that under the Mexican tax treaty, she could make a donation
directly to the clinic, which would use the donation to support the research of Doctor. What Hazel
failed to discover was that she was unable to deduct the Mexican donation against her U.S. taxable
income. Hazel was able to deduct the donation only against her Mexican source income.

Therefore, Hazel set about the task of buying and reselling herbs supplied by the Doctor. In order to
get approval from the appropriate regulatory authorities, Hazel formed a Mexican company and got
an export license. Therefore, Hazel’s company had Mexican source income against which a
donation to the Clinic could be offset.

Lessons for the New Millennium

After finally mastering the inconsistent rules that govern U.S. donations to foreign charities, along
came the events of 9/11. After 9/11, new and more confusing rules are in play.

First, the Office of Asset Control of the U.S. Department of Treasury proposed “voluntary best
practices” for foreign charitable donations, without consultation with the IRS. Second, the IRS
issued Notice 2002-92 asking for comments on how the IRS approves and obtains reports from non-
profit organizations generally. Third the IRS issued Notice 2003-29 inviting comments on
improving international grant making and activities by U.S. charities. Fourth, the Sarbanes-Oxley
Act requires full disclosures of corporate gifts to affiliated persons, e.g. wives of executives who
serve on board of U.S. exempt organizations. As of the date of this writing, there have been no

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major revisions to Revenue Procedure 92-94, the “Expenditure Responsibility” guidelines or the
procedures for applying for and for reporting on the activities of exempt organizations. .But, changes
will come and professional advisors must remain diligent in this area. For ease of monitoring this
fast changing area of the law, see: www.obmwatch.org/npadv and its monitoring of non profit issues.

In summary, U.S. donors who want a U.S. income tax deduction for donations to foreign charitable
activities must investigate the donee and for donations to foreign charities that are not the equivalent
of U.S. public charities, donations should be channeled through U.S. exempt organization in
compliance with existing and proposed federal rules. U.S. domestic trusts, “Friends of
Organization” and “Support Organizations” are the recommended conduits.

Finally, the foregoing has focused on the U.S. federal rules. Various states and foreign countries are
also active in the field, largely due to pressure from the U.S. These must also be examined for
conformity. There is increased emphasis on international charitable activities at a time when
international need is great. There are truly terrorist traps for the unwary. Proceed with caution!

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