Tax issues raised by legal defense funds for Executive Branch officials have not been front and center since the Clinton Administration. Prospects for civil and criminal litigation and congressional investigations involving current officials, with attendant fees for private counsel, will require careful consideration, as those officials explore legal defense funds as a way to defray unexpected costs. Steptoe’s experience in recent years suggests legal defense funds create concerns under both the tax laws and the government ethics rules dealing with gifts and supplementation of income. Many of the issues raised in the 1990s remain unsettled.

Ideally, donors would like contributions to legal defense funds to be tax-deductible and government officials would prefer the payment of legal fees from the funds not to be considered taxable income. For a number of reasons, this ideal is hard to achieve. While certain legal defense funds created to litigate constitutional or human rights matters have been granted 501(c)(3) status, thus permitting a charitable deduction for donors, most defense funds to support one or several Executive Branch officials in ongoing litigation or congressional or US Department of Justice investigations would likely not qualify under current standards. Under long-standing tax principles, payment of legal fees on behalf of one person by another person could be taxable income to the former, but would potentially give rise to an offsetting deduction, subject to the two percent deduction "floor" for miscellaneous itemized deductions and to disallowance provisions under the alternative minimum tax.

Somewhat less ideal, but still helpful to both parties, would be treating contributions to such funds as a gift from the donor. Although non-deductible for donors, gifts may be exempt from gift tax if the amounts contributed remain under certain exemption levels and gifts would be nontaxable to the official. To qualify as gifts, the amounts given to the funds would have to be made out of detached and disinterested generosity, without an expectation of any benefit in return. Contributions from associations, corporations, or political action committees, for example, may have difficulty meeting this test. During the Clinton Administration, a major New York firm famously advised that contributions to one of the president’s legal defense funds would be considered gifts for tax purposes. However, the tax characterization issue is highly fact-intensive and contributions may not qualify as gifts in all situations. Even if payments qualify as gifts for tax purposes, questions remain about whether the recipient would be subject to government ethics laws restricting receipt of gifts by public officials.

In the 1990s, a number of variations on the typical fund were suggested for both Executive Branch and congressional legal defense funds. More recently, some have experimented with funds intended to qualify as political organizations under section 527 of the Tax Code. In each case, the fit between the needs of the officials and the applicable tax rules has been subject to uncertainty. Moreover, the Office of Government Ethics (OGE) weighed in on a number of the statutory and regulatory ethics requirements applicable to federal employees, including the criminal statute prohibiting "supplementation" of income while in government. In each case, OGE made reasonable accommodations and, for the most part, officials proceeded to use such vehicles in the manner prescribed by that agency.

Given the uncertainty, however, and enhanced scrutiny of both tax and government ethics issues in connection with some of the current controversies, clients would be well advised to carefully document their planning and seek guidance, either formally or informally, from government ethics officials and tax advisers to ensure compliance and avoid inadvertent liability.