By Professor Ellen P. Aprill, John E. Anderson Chair in Tax Law, Loyola Law School
President Trump and a number of his associates have established legal defense funds (LDFs) in connection with various Congressional investigations, the investigation by Special Counsel Mueller, and in anticipation of possible legal action. Legal defense funds for government officials have a long history. The U.S. Senate and the House have detailed rules regarding LDFs for their members. The most famous LDFs were the two Clinton LDFs. Over the years, the Office of Government Ethics (OGE) has given some guidance on LDFs for members of the executive branch, particularly with regard to the solicitation and receipt of gifts. For example, it informed President Clinton that, although he was not subject as president to rules limiting the acceptance of gifts, because he and his wife established his first LDF, he and his agents were subject to laws forbidding executive branch official from soliciting gifts for that LDF. OGE guidance regarding LDFs is far less complete than the Senate and House rules. Recently, OGE issued an advisory that an LDF must prohibit contributions from anonymous sources.
By far, the most common structure for LDFs of prominent officeholders is a trust. The House and Senate rules require that an LDF be a trust. These LDF trusts are generally established in one of two ways. In the first way, the beleaguered officeholder creates the LDF trust, transfers a small amount to the LDF trust as its initial funds, solicits contributions to it, and receives its benefits by having the trustee of the trust pay legal bills in connection with the investigation or proceeding. In the second way, friends or family of the person establish the LDF trust on behalf of the official (or former official). President Clinton had one of each type. In both models, the government official (or former government official) is the beneficiary of the trust. There is an option to treat the LDF trust as a political organization that offers a number of tax advantages, but appears not to have been adopted widely. It is also important to know that there is no tax guidance, directly or by analogy, regarding LDF trusts for former government officials.
Overview of Tax Issues
LDF trusts raise questions as to tax treatment of the trust, whether the trust can take advantage of special rules applicable to political organizations, whether contributions to the LFD trusts can be deemed gifts excluded from the official’s income, whether donors to LDF trusts are subject to gift tax liability, whether the government official must report amounts distributed from the fund for legal expenses as income, and the extent to which deductions are available to the government officials for amounts expended from the trust on his or her behalf.
Tax Treatment of the Trust
An LDF trust may or may not be treated as an entity separate from the official or former official it benefits, depending on the wording of the document and the rights given the official/beneficiary. It is more likely to be treated as a separate taxable entity. If so, the LDF trust could be subject to tax on certain amounts of income, such as any investment income not distributed for legal defense in a particular year. Details regarding trust taxation, however, is beyond the scope of this explainer.
Could LDF Trusts Be Treated As Political Organizations?
Section 527 governs political organizations. These political organizations do not pay tax on contributions and expenditures connected with political activity as defined in the provision. Amounts exempt from tax under this provision include contributions and expenditures of amounts, which, if incurred by an individual holding a public office, would be allowable as a business deduction. Such would be the case for public officials defending themselves for actions taken while in office. (This aspect of section 527 also permits political parties, which are subject to section 527, to establish legal defense funds.) Importantly, section 527 applies to appointed officials who have a policy-making role as well as those elected to office.
Thus, if a LDF trust registers as a section 527 organization, the public official will not have any tax liability from contributions to or expenditures from the fund. Section 527 organizations are also exempt from gift tax. (These organizations, however, are subject to tax on investment income.) A section 527 organization of this type must register with and make regular reports to the IRS; all of these documents are available on a public searchable data base on the IRS website.
To date, few officials appear to have taken advantage of this option. Senators Ensign and Menedez and a handful of state officeholders have registered LDF trusts as section 527 organizations. Government officials and former government officials incurring legal fees for their actions in office could consider doing the same.
Could Contributions to an LDF Trusts Be Excluded from Officials’ Income as Gifts under the Income Tax?
Gifts are excluded from income for purposes of the income tax. If the contributions to an LDF trust are deemed to be gifts, the official would not have income subject to tax. Under the leading Supreme Court case, Commissioner v. Duberstein, whether or not a contribution is a gift for income tax purposes and thus excluded from income, depends on whether the contribution is made out of “detached and disinterested generosity.”
Characterization of a contribution as a gift for income tax purposes is a question of fact. Relevant tax authorities make it difficult to characterize as gifts under the income tax amounts that benefit taxpayers. In general, if the official continues in office or can control distributions from the trust, contributions will not qualify as gifts on the belief that contributors are not acting out of disinterested generosity but to aid the government official in carrying out official duties. Contributions to former officials, out of concern for that individual’s well-being, have a better chance of being characterized as gift. Nonetheless, the behavior at issue arose out of official duties when the former office holder in office, and that fact may militate against characterization of the contributions as gifts. Whether contributions can be deemed gifts will depend on the particular facts of each case. If President Trump is found to make contributions to the LDF trusts of others, the funds will be considered gifts not subject to the income tax if the president acts solely out of personal concern for the beleaguered person. If the President acts instead out of his own interest, to protect his reputation, the contributions would be income to the beneficiary.
If contributions to an LDF trust are not deemed to be gifts, then as detailed below distributions from the LDF trust would likely be considered income subject to tax for the benefitting official or former official.
Could Contributions to LDF Trusts Subject Contributors to the Gift Tax?
If the contributions are gifts, the contributors could have gift tax liability. The definition of gift for purposes of gift tax is not the same as the definition for income tax. A gift for gift tax purposes takes place when property is transferred “for less than full and adequate consideration in money or money’s worth.” Except for the president and vice president, current executive branch employees have strict limits on the dollar amount of gifts they can accept from certain prohibited sources. (Former executive branch employees would not be subject to these limits of course.) The House and Senate also have general rules regarding gifts to members officers, or employees.
The Internal Revenue Code provides an annual exclusion from gift tax liability for each gift a donor makes to an individual donee. The amount of the annual exclusion is adjusted from time to time for inflation. It is $14,000 per each donor-donee pair this year and will be $15,000 next year. However, amounts are eligible for the annual exclusion only if the transfer is of a so-called transfer of a present interest, a current right to funds. In the case of an LDF trust, if the trust terms gave the official or former official who is the beneficiary of the trust the right to demand funds as needed to cover legal expenses, the present interest requirement is likely to be satisfied. That is, the precise provisions of a particular trust instrument matter in connection with the annual exclusion.
Amounts not eligible for or in excess of the annual exclusion are subject to gift tax. The Internal Revenue Code, however, includes a credit for taxpayers such that gift tax liability is subject to payment out of pocket only to the extent that all taxable gifts for all years exceed a specified amount, which is adjusted for inflation. For 2017, the exclusion amount is $5,490,000. To the extent that a taxpayer makes a taxable gift, he or she is required to file a gift tax return, whether or not gift tax out of pocket is owed.
Income for Officials in Connection with Amounts Distributed from an LDF Trust
If the LDF trust does not register as a section 527 organization and the contributions do not qualify as gifts for income tax purposes, the official is likely to have to include in income amounts from the LDF that are used to discharge or satisfy the beneficiary’s obligations. That is, if the official is the beneficiary of the trust, he or she would need to report as income the amount spent on legal fees.
Deductions for Officials in Connection with Amounts Distributed from an LDF Trust
While the official may have to report these amounts as income, he or she has only a limited ability to take as deductions the amount spent on legal fees. Under the Internal Revenue Code, deductions can be taken for “trade or business” expenses. Under relevant authority, performance of the functions of a public office is a trade or business. Even for a former officeholder, these legal expenses have their origin in the performance of the functions of a public office, and under tax law, the origin of the claim determines tax consequences.
Although these expenses are likely to be considered business expenses, unreimbursed employee expenses are deductible under the Internal Revenue Code for regular tax purposes only to the extent they and certain other expenses exceed 2% of adjusted gross income (the number found at the bottom of the first page of an individual’s tax return). If the official is subject to the alternative minimum tax, then these expenses are not deductible at all. Thus, deductions for expenditures from LDF trust will be severely limited, if allowed at all.
As discussed above, the tax consequences of an LDF trust for the trust itself, whether the beneficiary, and contributors to it will turn on the particular language of the trust document and particular facts regarding the trust beneficiary’s situation, such as status as current or former government official, the motivation for donors to contribute to it and whether it has registered as a political organization under section 527.