My Hypothetical Family Foundation

I deeply doubt that I will ever fund a private foundation. However, all things are possible until they are not, so it may yet happen.

And private foundations have been in the news recently, as you know.

What are these things, and how are they used?

Let us start with what a private foundation is.

First, the terms “private foundation” and “family foundation” are often interchanged.  If it is private enough, the only donors to the foundation are one family.

Second, it is a type of tax-exempt. It can accept tax-deductible donations, but the overall limit on the deduction is lower than for donations to a 501(c)(3).  It is not completely tax-exempt, however, as it does have to pay a 2% tax annually. I suspect however most of us would leap at an opportunity to pay a 2% tax.  Depending on what the foundation does, it may be possible to reduce that tax further to just 1%.

Third, what is the word “private” doing in there?

That “private” is the big difference from a (c)(3).

Generally speaking, a private foundation does not even pretend that it is broadly supported. To contrast, a (c)(3) has to show on its Form 990 that it is publicly-supported, meaning that it receives donations from a large number of people. Calling it a private – or family - foundation clues you that it is disproportionately funded by one family. When I hit the lottery there will be a Hamilton Family Foundation, funded by one family – mine.

There are two key reasons that someone would establish a private foundation:

(1)  one has accumulated wealth and wants to give back through philanthropy; and

(2)  to provide income for someone.

The first reason is quite common, and the private foundation has a lot to commend it. Let’s say that I sign an NFL contract and receive a $25 million signing bonus. That is an excellent year to fund the Hamilton Family Foundation, as (i) I have the cash and (ii) I could use the tax deduction. An additional attractive feature is that I could fund the foundation in one year but spread the charitable distributions over many years. The tax Code requires a foundation to distribute a minimum amount annually, generally defined as 5% of assets. Assuming no rate of return on investments, I could keep the Hamilton Family Foundation functioning for 20 years off that one-time infusion.

I have had clients that use a foundation as a focal point for family giving. It allows multiple generations to come together and decide on causes and charities, and it helps to instill a spirit of giving among the younger family members.

The second reason is to provide an income stream to someone, such as an unemployable family member or friends and associates that one wants to reward.  An easy enough way to do so is to put them on the Board – and then pay trustee fees. This is more the province of the larger foundations, as it is unlikely that a foundation with $2 million or $3 million in investments could sustain such payouts. I myself would not be interested in providing an income stream, but I might be interested in a foundation that provided college grants to students who are residents of Kentucky, attend the University of Tennessee and have the last name "Hamilton."

The ongoing issue with private foundations is the outsized influence of one family on a tax-favored entity. Congress has tried over the years to tighten the rules, resulting in a bewildering thicket of rules:

(1) There is a tax if the foundation owns 20% or more of a business. Congress does not want foundations running a business.

(2) The foundation managers have to exercise common sense and business prudence when selecting investments.  Stray too far and there is a penalty on investments which “jeopardize” the charitable purpose.

Note the reference to the charitable purpose. Let’s say the Romanov Foundation’s purpose is to promote small business in economically disadvantaged areas. Let’s say it made a high-risk loan to business-people interested in opening a shopping center in such an area. Most likely, that loan would not jeopardize its exempt purpose, whereas the same loan by the Hamilton Family Foundation would. 

(3) Generally speaking, foundations that make grants to individuals must seek advance approval from the IRS and agree to maintain detailed records including recipient names, addresses, manner of selection, relationship with foundation insiders and so forth. As a consequence, it is common for foundations to not make contributions to a payee who is not itself a 501(c)(3). Apparently Congress realized that - if it did not impose this restriction - someone would claim a charitable deduction for sending his/her kids through college. 

(4) Certain transactions between the foundation and disqualified persons are prohibited. Prohibited transactions include the sale or leasing of property, the loaning of money, the use of foundation property (if unrelated to carrying out the exempt purpose of the foundation), paying excessive compensation or reimbursing unreasonable or unnecessary expenses.

Who are disqualified persons? The group would include officers, directors, foundation managers (a term of art in this area), substantial contributors and their families. I would be a disqualified person to the Hamilton Family Foundation, for example, as I would be a substantial contributor. 

Would prohibited transactions include the travel and entourage expenses of an ex-President and politico spouse receiving speaking and appearance fees not otherwise payable to their foundation?  Tax law is ... elastic on this point. I am thinking of including a tax education purpose for the Hamilton Family Foundation so I can, you know, travel the world researching blog topics and have my expenses paid directly or otherwise reimbursed to me.

For many years the IRS enforced compliance by wielding the threat of terminating the tax-favored status. It did not work well, frankly, as the IRS was hesitant to sign a death sentence unless the foundation had pushed the matter beyond all recognizable limits.

Congress then expanded the panoply of tax penalties applicable to tax-exempts, including both (c)(3)’s and private foundations. These penalties have come to be known as the “intermediate” sanctions, as they stop short of the death sentence. Penalties can be assessed against both the foundation and its officers or managers. There can even be a second round of penalties if the foundation does not correct the error within a reasonable period of time. Some of these penalties can reach 200% and are not to be taken lightly.

There is wide variation in the size of private foundations, by the way. Our hypothetical Hamilton Family Foundation would be funded with a few million dollars. Contrast that with the Bill and Melinda Gates Foundation, with net assets over $40 billion. It is an aircraft carrier in the marina of foundations, yet it is considered "private" because of its disproportionate funding by one or a limited number of families.

Bill Yung and Columbia Sussex Sue Grant Thorton

I am reading Yung v Grant Thornton. This is a mammoth decision – it runs over 200 pages.

William Yung (Yung) owns a hotel and casino company (Columbia Sussex) based in northern Kentucky. I remember meeting with some of his tax people several years ago.  I have watched fireworks from his Kentucky office location.

Then there is Grant Thornton (Grant), a national accounting firm, and its former partner, Jon Michel (Michel). Jon and I worked for the same accounting firm, although not at the same time. I remember having lunch with Jon a few years later and discussing joining Grant Thornton’s tax team. I also remember the unacceptable sales pressure that went with joining Grant. I passed on that, and I am glad I did.

Jon is in the tax literature, and not in a good way. It has a lot to do with that sales pressure.

Today we are talking about tax shelters.

CPA firms - especially the nationals - in the 1990s and aughts became almost pathologically obsessed with profitability. Accounting practice was changing, and the tradition of accountants being business advisors and confidantes was being replaced with a new, profit-driven model. We saw metrics like “write-ups” and “write-downs” by individual accountants. There were “individual” marketing plans for accountants two or three years into the profession and having another five or seven job changes ahead of them. I remember a CPA whose promotion to manager was delayed because she missed her “chargeable” budget by approximately 40 hours – over the course of an entire year.

And tax departments were leaned upon to come up with new “products” to market to clients.

COMMENT: Referring to tax advice as a “product” tells one a lot about the underlying motivation of whoever is promoting it. I for example do not sell a “product.” I provide business and tax advice. If you want a product, go to Amazon.

So what flavor of tax shelter are we talking about?

Yung and family and family entities (such as Columbia Sussex) own casinos and hotels. Some of them are in the Cayman Islands, which would make them controlled foreign corporations (CFCs). You may recall that the U.S. wants to tax all U.S. businesses on their worldwide income. Since doing so would almost guarantee that there would be no U.S. - based international businesses, the tax Code allows for tax deferrals, then exceptions to those deferrals, and then exceptions to the exceptions, and so on. It borders on lunacy, frankly, but this is what Yung and entities were caught in. Yung and entities had monies overseas, but it would have cost a fortune in taxes to bring the monies back to the U.S. Yung’s son Joe traveled regularly to the Caribbean, Central and South America seeking acquisition opportunities as a means to reinvest the Cayman monies. Grant was their accounting firm. Jon Michel even assisted in the acquisition of a Canadian hotel.

There was opportunity there for a sharp tax advisor.

Here is opportunity knocking:

·        A partnership contributes cash to a foreign corporation (FC). It receives the common stock.

·        Another party also contributes cash. In return it receives preferred stock.

·        The FC borrows money from a bank.

·        With the money, the FC buys marketable securities.

·        FC then distributes the securities, with its attendant debt (sort of), to the partnership, liquidating the partnership’s investment in FC.

·        There is a technical tax rule concerning a distribution with debt attached. The debt reduces the fair market value of the securities. If the debt were equal to the value of the securities, for example, the net distribution would be zero (-0- ).

·        The partnership received a liquidating distribution worth zero (or near zero) but had an investment equal to the cash it put in FC. This leads to a big tax loss.

So far, so good. The partnership received marketable securities, but it also has to pay back the bank. Where is the tax shelter, then?

·        The FC later pays off the debt.

Whoa!

The partnership is out no money but has a big tax loss.

The key to this was being able to reduce the liquidating distribution by the bank debt, even though the partnership never intended to pay the debt. Some tax CPAs and tax attorneys argued that this was fine, as tax Code Section 301(b)(2)(B) reduced the distribution…

“… by the amount of any liability to which the property received by the shareholder is subject immediately before, and immediately after, the distribution.”

We are talking the Bond and Optional Sales Strategy tax shelter sold by Price Waterhouse in the 1990s. The nickname was BOSS, and the IRS was determined to come down hard on the BOSS transactions and enablers. Frankly, I don’t blame them.

In 1999 the IRS published Notice 99-59, which warned that tax losses claimed in a BOSS transaction were not allowable for federal income tax purposes. The Service also warned of substantial and numerous penalties.

Congress followed this up with new tax Regulations to Section 301 in 2000.

So what did Grant Thornton do? It developed a new “product” which it called “Leveraged 301 Distributions” or Lev301.  How did it work? Here is an internal Grant document:

           

The objective of the Leveraged 301 Distributions tax product is to structure distributions in order to permanently avoid taxability to shareholders. Either closely-held C corporations or S corporations can distribute assets subject to liabilities … and provide this benefit to shareholders.”

           

How similar is this thing to BOSS, which provoked Notice 99-59 and new tax Regulations? Back to that Grant internal document:

Further the IRS may assert arguments it used against the BOSS transaction in Notice 99-59 and against the subject-to language of former IRS Section 357”

This has to be a finalist for the “Worst Timing Ever” award.

Grant goes live with the product in June 2000. Jon Michel begins to promote the thing, including to Yung and Columbia Sussex.

You already know this thing went to trial, so let’s fast-forward to some language from the Court:

           

No one associated with Grant Thornton, even those intimately involved in the process who testified to the court, has stepped forward and taken credit for the idea and creation of Lev301.”

Hey, but Lev301 is substantially different from BOSS, right?

Here is the Court:

Grant Thornton believed that there was a 90% chance that the IRS would disallow the tax benefits on the Lev301 on audit.”

Good grief! Why would a self-respecting tax advisor be associated with this?

Yung and Columbia Sussex were not told about the 90% chance.

The court finds that Yung and associates brought income into the United States from his CFC’s on a routine basis. Yung and his associates looked for ways to accelerate this process but vetted possible means of doing so with a close concern for the risks involved, as evidenced by the decision not to participate in other tax strategies presented to them. Yung and his associates maintained a very conservative risk level about income tax reporting as evidenced by the IRS complimenting the consistent approach to paying taxes. The court finds the Yung’s testimony to be consistent with this approach to tax reporting and, therefore, to be credible.”

What did the Court say about Grant?

The evidence indicates everyone who participated was on high alert regarding this product. As a result, while this court certainly understands the fading of memory, the failure of some of Grant Thornton’s witnesses to recall anything about their participation in the research and development of this product is disingenuous and not credible.”

Let’s continue. Would Jon Michel have been permitted to meet and pitch Lev301 to Yung had Yung’s tax department been informed of the risk?

The likelihood that the IRS would view the Lev301 as an unlawful abusive tax shelter was a present risk that would have impacted … (Columbia Sussex’ CFO) decision to allow …. J(on) Michel to present Lev301 to Yung. Had the risk been disclosed … (Columbia Sussex’ CFO), (as he had done with the prior proposals) would have terminated discussions about Lev301 at that point.”

So Jon Michel and Yung meet. Yung wanted to know if other Grant clients had used this scheme.

J(on) Michel told Yung that, while he could not divulge the names of other Grant Thornton clients, he could disclose that a local jet-engine manufacturer and a local consumer products manufacturer had successfully used the Lev301 strategy to transfer foreign wealth to the U.S.”

For those of us who live in Cincinnati, the reference to GE and Proctor & Gamble is unmistakable. Still, if GE and P&G did use the strategy…

When Michel made this representation to Joe Yung, he had no knowledge as to whether GE and P&G had utilized a Lev301-like strategy.”

All right then.

In 2002 the IRS initiated an examination of Grant Thornton. The IRS issued a summons asking for documents relating to Grant’s promotion of Lev301 and the names of clients who participated in the product.

Grant Thornton did not notify the Yungs … about the summons, which further increased the likelihood that the Yungs … would be audited by the IRS on account of their participation in the Lev301.”

In November of 2002 the IRS audited Columbia Sussex for reasons unrelated to Lev301.

NOTE: This is fairly common for larger, higher-profile corporations. It does not necessarily mean anything.     

Grant was hired to represent during the tax audit.

In 2003 Yung and Columbia Sussex received an Information Document Request from the IRS. The IRS wanted to know whether they had directly or indirectly participated in any transactions that were the same or substantially similar to a “listed” transaction.

            NOTE: Like a BOSS or a BOSS-like transaction.

Jon Michel answered the question “No.”

The tax director at Columbia Sussex later read in a trade journal that the government was summoning Grant Thornton. He called Jon Michel. Jon informed Yung and associates that Grant was likely to comply with the summons and that client names would be turned over to the IRS.

And they were.

The IRS expanded its audit of Columbia Sussex to include more years, the Yung family, family entities and any unfortunate soul driving past corporate headquarters on I-275 in northern Kentucky. On the other hand, in 2004 Jon Michel wrote a nice letter to Yung and entities offering limited tax representation before the IRS.

Do we need to continue this story?

The Yung family and entities owed over $18 million in tax, interest and penalties to the IRS.

If this were you, what would you do next?

You would sue Grant Thornton.

           

COMMENT: Be honest: this is a Mr. Obvious moment.

A Kentucky circuit court has just ordered Grant Thornton to pay Yung and family and entities approximately $100 million, including $80 million in punitive damages. The judge described Grant’s actions as “reprehensible.”

Grant intends to appeal, saying:

We are disappointed in the Court’s ruling and believe we have strong grounds for an appeal, which we will pursue.”

Grant has to appeal the decision, of course.

My thoughts?

Remember that Yung is in the hotel and casino business, an industry subject to higher financial and personal scrutiny. What is the collateral and reputational damage to him and his entities from an abusive tax shelter? Yung has said the ordeal has already cost him a casino license in Missouri.

I have little patience for this type of practice. What was motivating Grant with the Lev301 “product”- solving a client’s tax problem or generating a million dollar fee? Could it be both? Sure, but the smart money would bet the other way. This type of behavior is not “practice.” It is greed, it is an abuse of a professional relationship and it is disreputable to those of us who try to practice between the lines.