Honest Attorneys Go Farr

I had forgotten about the conversation.

About a couple of years ago I received a call from a nonclient concerning tax issues for his charity. I normally try to help, at least with general tax issues. I rarely, if ever, help with specific tax advice. That advice is tailored to a given person or situation and should occur in a professional – and compensated – relationship.

Some accountants will not even take the call. I get their point. Tax season, for example, is notorious for nonclient phone calls saying “I just have a quick question.” Sure. Get a Masters degree, practice for 30 years and you will have your answer, Grasshopper.

This phone-call fellow was thinking about drawing payroll from a charity he had founded. It had to do with housing, and he was thinking of contributing additional rental properties he owned personally. However, those rentals provided him some sweet cash flow, and he was looking at ways to retain some of that flow once the properties were in the charity.

Got it. A little benevolence. A little self-interest. Happens all the time.

What about drawing management fees for … you know, managing the properties for the charity.

Someone has to. A charity cannot do so itself because, well, it doesn’t have a body.

Now the hard facts: the charity did not have an independent Board or compensation committee. He was reluctant to form one, as he might not be able to control the outcome. There was no pretense of a comparative compensation or fee study. He arrived at his number because he needed X-amount of money to live on.

Cue the sounds of warning sirens going off.

This is not a likely client for me. I have no problem being aggressive – in fact, I may be more aggressive than the client - but we must agree to play within the lines. Play fudge and smudge and you can find another advisor. We are not making a mutual suicide pact here.

Let’s talk about “excess benefits” and nonprofits.

The concept is simple: the assets of a nonprofit must be used to advance the charitable mission and not for the benefit of organization insiders. If the IRS catches you doing this, there is a 25% penalty. Technically the IRS calls it an “excise tax,” but we know a penalty when we see one. Fail to correct the problem in a timely fashion and the penalty goes to 200%.

That is one of the harshest penalties in the Code.

Generally speaking, an excess benefit requires two things:

(1) Someone in a position to exercise substantial influence over the charity. The term is “disqualified,” and quickly expands to others related to, or companies owned by, such people.

(2) The charity transfers property (probably cash, of course) to a disqualified person without fair value in exchange.

The second one clearly reaches someone who is paid $250,000 for doing nothing but opening the mail, but it would also reach a below-market-interest-rate loan to a disqualified person.

And the second one can become ninja-level sneaky:

When the organization makes a payment to a disqualified for services, it must contemporaneously document its intent to treat such payment as consideration for services. The easiest way to do that is by an employment contract with the issuance of a Form W-2, but there can be other ways.

Fail to do that and it is almost certain that you have an excess benefit, even if the disqualified person is truly working there and even if the payment is reasonable. Think of it as “per se”: it just is.

Yet it happens all the time. How do people get around that “automatic” problem?

There is a safe-harbor in the Code.

(1) An independent Board approves the payment in advance.

(2) Prior to approval, the Board does comparative analysis and finds the amount reasonable, based on independent data.

(3) All the while the Board must document its decision-making process. It could hire an English or History graduate to write everything down, I suppose.

Follow the rules and you can hire a disqualified.

Don’t follow the rules and you are poking the bear. 

I thought my caller did not have a prayer.

Would I look into it, he asked.

Cheeky, I thought.

As I said, I forgot about the call, the caller and the “would I look into it.”

What made me think about this was a recent Tax Court decision. It involves someone who had previously organized the Association for Honest Attorneys (AHA). She had gotten it 501(c)(3) status and continued on as chief executive officer.

From its 990 series I can tell AHA is quite small.

Here is a blip from their website:

However, our C.E.O. has 40+ years experience, education and observation of the legal system, holds a B.S. and M.S. Degree in Administration of Justice from Wichita State University, and has helped take ten cases to the United States Supreme Court.

I do not know what a Masters in Administration of Justice is about, but it sounds like she has chops. She should be able to figure out the ins-and-outs of penalties and excess benefits.

She used the charity’s money for the following from 2010 through 2012:

1. Dillards
2. Walmart
3. A&A Auto Salvage
4. Derby Quick Lube
5. Westar Energy
6. Lowes
7. T&S Tree Service
8. Gene’s Stump Grinding Service
9. an animal clinic
10. St John’s Military School (her son’s tuition)
11. The exhumation and DNA testing of her father’s remains

Alrighty then. 

The Tax Court went through the exercise: she used charity money for personal purposes; she never reported the money as income; there was no pretense of the safe harbor.

She was on the hook for both the 25% and 200% excise tax.

How did she expect to get away with this?

I suspect she was playing the audit lottery. If she was not caught then there was no foul, or so she reasoned. That is more latitude than I have. As a tax professional, I am not permitted to consider the audit lottery when deciding whether to take or not take a tax position.

The case is Farr v Commissioner, T.C. Memo 2018-2 for the home gamers.

Can A Coffee Shop Be Tax-Exempt?

I have been spending quite a bit of time over the last few days working on or reviewing not-for-profit returns.

It may surprise you, but – with a few exceptions – not-for-profit organizations are required to file paperwork annually with the IRS.

There is a reason for this: the tax Code recognizes some organizations as “per se” not-for-profit – churches are the classic example. Churches do not need to be told by the IRS that they are tax-exempt; they simply are. A large part of this is church:state separation, although church programs that begin to look uncannily similar to for-profit businesses are supposed to file an income tax return (known as Form 990-T) and pay tax.

Then we have the next tier: the education, charitable, scientific, etc. entities that also comprise not-for-profits. These are not “per se” and have to apply with the IRS to have their exempt status recognized. The application is done via either Form 1023 or Form 1024, depending upon the type of exempt status desired.

We talking about the March of Dimes, Doctors Without Borders or your local high school boosters club.

One thing this tier has in common is that they have to explain to the IRS what their exempt purpose is.

And there are tax subtleties at play. For example, can your exempt purpose be less than 50% of what you do? What if it is more than 50% but you have a significant (but less than 50%) non-exempt purpose? What if you start out at a more-than-50% exempt purpose but – over time – your non-exempt purpose goes over 50%?

This becomes its own field of specialization. I have met practitioners over the years whose only practice is tax exempts.

I am looking at the IRS response to a recent exempt application. I will give you a few facts and flavor, and let’s see if you can anticipate the IRS decision on the matter.

(1)  A minister had an idea for a coffee shop. The shop would be separate from the church (hence the exempt application). Being separate however would allow (and maybe encourage) other churches and religious groups to participate.

(2)  The coffee shop would allow believers and non-believers to interact. There would be religious activities, but the activities would not be organized by the shop. They would instead be organized by the patrons. By the way, the shop could also be used for non-religious activities. One could leave a donation for the use of the space.

(3)  There are no similar businesses where the shop is located, hence it is not taking commercial opportunity from a profit-seeking business.

(4)  The shop affords a gathering space that is open late, as well as provide safe space for residents to gather.

(5)  The shop takes part in a job-skills training program to help underserved youth by placing them in an actual job for a six-week internship.

(6)  The shop participates in a project for the children of incarcerated parents. Patrons can share gifts with the kids, such as for their birthdays and Christmas.

(7)  The shop does not want to turn away anyone for inability to pay. There is a program where a customer can pay for a certain amount of coffee in advance. When a not-able-to-pay patron enters, he/she is served from those advance payments.

(8)  The shop sells coffee, teas, smoothies and so forth. There are also baked goods, as well as salads and desserts.

(9)  The shop roasts its own coffee, which is sourced directly from coffee farmers. This allows the farmers to earn more than other conventional means of distribution. The coffee is also available for sale, and there are plans to sell the coffee online in the future

(10)        The shop uses some volunteers, but its largest expense is (understandably) wages and related payroll costs.

(11)        The shop intends to give away its profits - that is, when it finally becomes profitable.

What do you think? Would you give this shop exempt status?

Here goes the IRS:

(1)  To be exempt, an organization must be both organized and operated exclusively for an exempt purpose. The test has two parts: the paperwork and what is actually going on.

(2)  The IRS has defined the word “exclusively” to mean “primarily.”

(3)  Hot on the heels of that definition, the IRS has also said that non-exempt activities must not be “more than an insubstantial part” of activities.

OBSERVATION: You can see the evolution of law here. A non-tax specialist would anticipate that an activity is exempt if the exempt activity is 51% or more of all activities. The flip side is that a non-exempt activity should be as much as 49%.

The IRS however states that a non-exempt activity cannot be “more than an insubstantial part” of all activities.

Does “insubstantial” mean as much as 49%?

If not, then the IRS is changing definitions all over the place.

(4)  The IRS has previously decided that the operation of a grocery store to provide on-the-job training to hardcore unemployed represented two purposes, not one. Each purpose has to be reviewed to determine whether it is exempt or not.

(a)  And now it gets tricky. If the store is staffed principally by a target group (or volunteers) AND the store is no larger than reasonably necessary for achieving the exempt purpose, the IRS has said that the store is exempt.

(b)  Conversely, if the store is not staffed by the target group (or volunteers) or larger than necessary, the IRS has said that the store is non-exempt.

(5)  While the coffee shop intends to donate its profits, its main activity is the operation of a coffee shop in a commercial manner.

(6)  And that activity is “more than insubstantial.”

The IRS rejected the application. The coffee shop will have to pay taxes.

Doesn’t it matter that they are giving away all profits? Isn’t there a vow-of-poverty-thing that one can point to?

And there is a key point about tax law in the world of exempts. Giving away money will not transform a for-profit activity into a not-for-profit activity. Granted, you may get a charitable deduction, but you will be taxable. The IRS has been steadfast on this point for many years. The activity itself has to be exempt, not just the monies derived from said activity. To phrase it differently, gigantic donations will not make Microsoft a tax-exempt entity.

The IRS decided the shop was too similar to a Starbucks or Caribou.    

And giving away any profits wasn’t enough to change the answer.

Does the shop do great work?

Yes.

Is it tax exempt?

Nope.

The NFL Is Giving Up Its (c)(6) Tax Status

So the NFL is going to relinquish its 501(c)(6) status, meaning that it will start filing as a regular, tax-paying corporation.

And I doubt it means much, unless someone simply has simply lost the plot when it comes to the NFL.

Let’s talk about it.

The gold-plate among tax-exempts is a 501(c)(3), which would include the March of Dimes, Doctors Without Borders and organizations of that type. The (c)(3) offers two key benefits:

(1)  Donations made are deductible, which is especially important to individuals.

(2)  Donations received are not taxable.

Point (1) is important because individuals are allowed only a limited plate of deductions, unless the individual is conducting a business activity. Point (1) is probably less important to a business, as the business could consider the donation to also be advertising, marketing, promotion or some other category of allowable deduction. An individual unfortunately does not have that liberty.

Point (2) represents the promised land. We would all like our income to be nontaxable.

The NFL is a (c)(6), which means that it does not receive benefit (1). It does not need benefit (1), however, as no one is trying to claim a donation.

Here is how the tax Code describes a (c)(6):

Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.

By the way, are you curious how the words “professional football leagues” got in there?

The NFL had been a nonprofit going back into the 1940s. During the 1960s it faced a challenge from the Al Davis and American Football League. An easy way to defuse an enemy is to recruit the enemy, and the NFL was talking to the AFL about merging. There was an issue, however, and that issue was antitrust. There were two leagues playing professional football, and there was a proposal on the table to combine them.

This made the proposed merger political.

It also meant that one had to go through Senator Russell Long, an extremely powerful senator from Louisiana.

Pete Rozelle, the then NFL commissioner, had an idea. What if the NFL “expanded” the league to include a team in Louisiana? Senator Long was quite interested in that turn of events.

And that is how we got the New Orleans Saints.

And, around that time, Congress amended the Code to include the words “professional football leagues.”

Back to our story.

So the NFL does not care about benefit (1). The reason is that the NFL does not receive monies from individuals like you and me. It receives money from its business members, which are the 32 NFL teams. Each team is a corporation, and payments by them to the NFL may be deducted a hundred ways, but none of those ways can be called a “donation.”

Notice that the “NFL” that is giving up its tax exempt status is NOT the individual teams. The “NFL” under discussion is the league office, the same office that organizes the draft, reviews and revises game rules, hires referees, and negotiates labor agreements with the players union. Each individual team in turn is a separate corporation and pays tax on its separate profits.

So is the league office a money-making machine, committing banditry by being tax-exempt?

Here I believe is the real reason for the NFL’s decision to relinquish its (c)(6): the NFL is tired of explaining itself. The NFL is an easy target, and the issue brings bad press when the NFL is trying to create good press, especially after recent issues with domestic violence and player concussions.  

But to give up the promised land of taxation…?!

Why would they do that?

What if there was no profit left once the league paid everything? You have to have a profit before there can be a tax.

That is, by the way, (c)(6)’s are supposed to work. They are not a piggybank. They are intended to promote the interests of their members, whatever that means in context. Years ago, for example, I worked on the tax filings for the Cincinnati Board of Realtors, a classic (c)(6). You can readily presume that its interests are to promote the recognition, status and earning power of realtors in the Cincinnati real estate market.

The same way the NFL promotes its teams in a sports universe including Major League Baseball, the NHL, NBA, NCAA sports, MMA and so on.

How about the $44 million salary to Commissioner Roger Goodell? Is it outrageous for a tax-exempt to pay a salary of this amount?

Outrage is a tricky thing. Someone might be outraged that a tag-a-long politician has become rich by having her ex-President husband steer – and then drain – donations to a family foundation while she was serving as secretary of state.

Let’s replace “outrage” with something less explosive: is it reasonable for the NFL to pay Goodell $44 million?

Well, let’s consider an alternative: each team pays Goodell 1/32nd of his salary directly.

The financial and tax effect is the same, although this structure may be more acceptable to some people.

So the NFL league office is going to be taxable.

And I am looking at the NFL’s Form 990 for its tax year ended March 31, 2013. For that year, the excess of its revenues over expenses was almost $9 million.

How I wish that were me. I would be blogging as the Travelling-Around-The-World Tax Guy.

Nine million dollars would trigger some serious tax, right?

Wait.

I also see on the Form 990 that the year before there was a loss of more than $77 million.

Ouch. That, in the lingo of a tax-paying corporation, is a net operating loss (NOL). It can be carried forward and deducted against profits for the next 20 years.

Let’s assume that $9 million or so profit for the NFL is a reasonably repetitive number.

Have we eliminated any tax payable by the NFL for the next eight or more years?

No, it will not work that way. The NOL incurred while the NFL was tax-exempt will not be allowed as a deduction when it becomes tax-paying. However, if it happened once, it can happen again – especially if the tax planners REALLY want it to happen.

Even if it doesn’t happen, the federal tax would be around $3 million, which is inconsequential money to billionaire team owners who are trying to maximize their good press and minimize their bad.

And remember: tax returns filed by a tax-paying corporation are confidential. There will be no more public disclosure of Goodell’s salary.

Although if I made $44 million, I would post my W-2 on Facebook.

An easy way to reinstate nonprofit status will expire at the end of 2012.

You may recall that the IRS recently required nonprofits to file annually. This was a sea change from prior practice, where the smallest nonprofits were not required to file at all. Under the new rules, everyone has to file. To make it less burdensome, the smallest can file Form 990-N, also called the “postcard.” Nonprofits were alerted that three successive years of nonfiling would now result in revocation of nonprofit status. The IRS held true to its word and revoked the status of numerous nonprofits.

To recover tax-exempt status, the nonprofit must (again) file an application (Form 1023). A key issue here is that the nonprofit also has to present “reasonable cause” why it did not previously comply with IRS requirements.  The IRS can be harsh on what it considers to be “reasonable cause.” For example, let’s say that your CPA takes ill and, as a consequence, your tax returns are filed late. Many if not most people would consider that to constitute “reasonable cause” for late filing. The IRS disagrees. They argue that you could have hired another tax professional to prepare the return on time.

If you are small nonprofit (defined as gross receipts of $50,000 or less) the IRS will automatically deem you to have “reasonable cause.” You still have to file Form 1023, be careful to include certain prescribed language and attach a $100 check.

What is very, very important is that you do this by December 31, 2012. Starting in 2013 all nonprofits, whether large or small, must present reasonable cause when resubmitting for tax-exempt status.

275,000 Charities Have Lost Tax Exempt Status

You may remember that charities, even small ones which previously had been exempt from IRS reporting, were required last year to file with the IRS. There was a “postcard’ filing (990N) for the smallest, but nonetheless everyone had to report.

What prompted this was a change in the tax law in 2006. The Pension Protection Act made it mandatory for most tax-exempts to file, irrespective of their gross receipts. This was a seismic change from prior law. If an organization failed to file for three consecutive years, then the PPA required it to lose its exempt status.

Counting off three years, many of these organizations had to file for the first time last year (2010). The IRS yesterday announced that approximately 275,000 organizations did not comply and have therefore automatically lost their exempt status. In addition, procedures have been announced for these organizations to regain their exempt status, in some cases by paying as little as a $100 fee.

Note that the revocation of status does not affect charitable deductions for amounts donated to these charities before 2011. However, deductions going forward will be disallowed because the organization names have been published - unless the charity reinstates its exempt status.