Haunted by the Past
(Added 12/10/2009)
We just discovered something awful. A donor established a gift annuity several years ago and it just came to our attention that the donor has not been paying taxes on what should have been reported as capital gain income. (In what was intended to be a spot check, our auditors recalculated the original remainder and payment values of a few annuity agreements.) We have been administering our own program and have not hired an outside firm to do the work. The original calculation for this donor showed an amount for capital gain income, but we've been incorrectly reporting that amount to her and the IRS as tax-free income. My executive director thinks we could easily not tell her, or tell anyone for that matter, and that from now on we should just give her the correct 1099R. Otherwise she might sue us, he said, and then where would we be? Besides, he also said, the auditors didn't care. But they were concerned only with our payment liabilities. What should I do?
The first layer of this is legal, and you should immediately - today, not tomorrow alert your organization's attorney of this problem and ask for advice.
My advice, from an ethical perspective: You must tell the donor that you screwed up. Your organization has made an egregious mistake. But as we all know, or should know, the real test of character is not in whether a mistake is made, but in how the mistake is dealt with. You must come clean with the unreported taxable amount due to your mistake.
She then must take this information to her own advisors - her accountant for certain, but also her attorney - because she then must decide how to deal with it. In a perfect world, she would say, 'No problem. I understand.' And then she'd just pay what she owes. As that probably won't happen, you must provide her with complete information.
But I get ahead of myself: Most likely she's going to be upset with you. And I wouldn't blame her. Planned giving isn't for the incompetents; as easy as it is to administer a gift annuity, the process still takes some brains and dedication. (By the way, I'd begin a full examination of all your agreements.) And your executive director needs to better deal with his fears. Putting your head in the sand is never the way to solve a problem. What was he thinking? That the donor wouldn't notice that her 1099R has a new line showing she now has capital-gain income?
Could she sue you? She can, and an attorney I have consulted with on this matter says that, although the law is not clear, she might have a good case. But the best way to avoid that is with complete honesty. Can you offer to reimburse her? Yes, I'm told, but you'd have to be clean about the transaction and provide a 1099 reporting that benefit. (I'd try to avoid that; as bad as this is, as innocent as she is, she was not paying taxes she in fact owed.)
Look, we all make mistakes. The technical and legal issues are complex, but they pale to the moral imperatives that are required when times are tough.