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Caveat Charities: Disgorging Donations as Fraudulent Transfers

Posted in Bankruptcy

The Bankruptcy Code permits a trustee to avoid transfers of property that a debtor has made within two years prior to its bankruptcy filing. In 1998, Congress added a safe-harbor provision for contributions to qualified religious or charitable organizations which prevents the trustee from avoiding the transfer so long as (1) “the amount of that contribution does not exceed 15 % of the [debtor’s] gross annual income of the debtor for the year in which the transfer of the contribution is made,” or (2) even if the contribution exceeds 15% of the debtor’s gross annual income, “the transfer was consistent with the practices of the debtor in making charitable contributions.” Identical language may also be found in Florida’s fraudulent transfer statute at § 726.109(7)(b), Florida Statutes.

A recent case out of the Tenth Circuit, in a matter of first impression for all circuits, held that if a contribution is in excess of 15% of the debtor’s gross annual income, and not in keeping with the debtor’s previous contributions, the entire amount of the donation could be avoided – not just the portion exceeding the 15%. The court in In re McGough found that the plain meaning of the statute was unambiguous, reasoning that if Congress intended for only the portion of the transfer exceeding 15% of gross annual income to be subject to avoidance, it would have added limiting language to that effect.

For charities and religious institutions this result is understandably harsh. The charity in McGough argued that the result was absurd, as Congress had specifically amended the fraudulent transfer statute to protect charitable donations. What the charity ignored, however, was that the safeguard specifically protects donations even exceeding 15% of the debtor’s gross annual income so long as transfer was consistent with the practices of the debtor in making charitable contributions. Thus if the debtor had tithed 50% of its annual income for 15 years, such transfers would not be avoidable.

McGough leaves a few unanswered questions. The statute does not further define “consistent with the practices of the debtor,” and so it is unclear how long of a pattern of charity the debtor would need to establish to satisfy the court. The statute also does not define “qualified religious or charitable organizations,” but this ambiguity would likely be reconciled by reference to the Tax Code. Ultimately, McGough puts charitable organizations between a rock and a hard place. Because they run the risk of the bankruptcy trustee seizing large donations, such organizations must be now cognizant of their donors’ potentially precarious financial status.

No similar decision has been published by the Eleventh Circuit or its lower courts, but the Tenth Circuit’s statutory interpretation appears correct. Although the result is ultimately unfair for charities, one can see that the “donations” which violate the safe-harbor provision have all the trappings of any other fraudulent transfer prohibited by the Bankruptcy Code.