Marijuana And Tax-Exempt Status

I am not surprised.

I am looking at a Private Letter Ruling on a tax -exempt application for an entity involved with marijuana and CBD.

I doubt the CBD plays any role here. It is all about marijuana.

I have become sensitive to the issue as I have two friends who are dealing with chronic pain. The pain has risen to the level that it is injuring both their careers. The two have chosen different ways to manage: one does so through prescriptions and the other through marijuana.

Through one I have seen the debilitating effect of prescription painkillers.

The other friend wants me to establish a marijuana specialization here at Command Center.

I am not. I am looking to reduce, not expand, my work load.

What sets up the tax issue?

Federal tax law. More specifically, this Code section:

        § 280E Expenditures in connection with the illegal sale of drugs.

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Marijuana is a Schedule I substance, so it runs full-face into Section 280E. There is “no deduction or credit” allowed on that tax return.

There is one exception, and that has to do with the cost of the marijuana itself. Accountants refer to this as “cost of sales,” and it would include more than just the cost of the product. It would include costs associated with buying the product or storing it, for example. Still, the big bucks would be with the cost of the product itself.

There is a Court decision which defines taxable revenues as revenues after deduction for cost of goods sold. The decision applies to all businesses, not just marijuana.

What it leaves out is everything other than cost of sales, such as rent, utilities or the wages required to staff and run the business.

That gets expensive. One is paying taxes on business profit, without being allowed to deduct all the costs and expenses normally allowed in calculating business profit. That is not really “profit” in the common usage of the word.

I am reading that someone applied for tax exempt status. They argued that their exempt purpose was:

·      To aid financially disadvantaged patients and families affected by the cost of THC and CBD medical treatment

·      To educate health providers about THC and CBD medical treatments

·      To support research into said THC and CBD medical treatments

The entity anticipated the usual stuff:

·      It will be supported by contributions and gifts

·      It will develop a website, which will give it another venue to educate about its mission as well as fundraise

·      It will develop relevant medical and treatment literature

·      It will conduct relevant seminars and classes

·      It will organize support groups for patients and their families

·      It will track and publish relevant medical data

The IRS led with:

You were formed to aid financially disadvantaged patients and patient’s families who are affected by the costs of THC and CBD medical treatment by providing financial support to cover costs of living and other expenses that the patients may incur.”

It continued:

… you are providing funding to the users of these substances who may be struggling to pay living and/or travel expenses because of their use of these illegal substances. Furthermore, your financial assistance is only available to users of these substances.”

In response the entity argued that it did not directly provide THC or CBD to individuals nor did it provide direct funding for the same.

The IRS was unmoved:

You were formed for the purpose of providing financial assistance to individuals who are engaged [in] an illegal activity which is contrary to public policy.”

The IRS rejected the tax-exempt application.

There are numerous tax-exempts throughout the nation that counsel, research, educate and proselytize concerning their mission. A substance abuse clinic can provide methadone, for example. What it cannot do is provide the heroin.

The entity could, I suppose, withdraw the financial support platform from its mission statement, greatly increasing the likelihood for tax-exempt status.

If its core mission was to provide such financial support, however, this alternative might be unacceptable.

If I were advising, I might consider qualifying the entity as a supporting organization for a pain clinic. The clinic would likely address more than marijuana therapy (it would have to, otherwise we are just circling the block), which represents a dilution of the original mission. In addition, a supporting organization transfers some of its governance and authority to the supported organization. It may be that either or both of these factors could be deal-breakers.

It has been interesting to see the continuing push on this area of tax law.

Spotting A Contribution

Do you think you could spot a tax-deductible donation?

Let’s begin by acknowledging that the qualifier “tax-deductible” kicks it up a notch. Give $300 to the church on Christmas Eve service and you have made a donation. Fail to get a letter from the church acknowledging that you donated $300, receiving in return only intangible benefits, and you probably forfeited the tax deductibility.

Let’s set it up:

(1)  There was a related group of companies developing a master-planned community in Lehi, Utah.

(2)  There were issues with density. The company had rights to develop if it could receive approval from the city council.

(3)  The city council said sure – but you have to reduce the density.

a.     Rather than reduce the number of units, the developer decided to donate land to the city – 746.789 acres, to be exact.

I see couple of ways to account for this additional land. One way is to add its cost to the other costs of the development. With this accounting you have to wait until you sell the units to get a deduction, as a slice of the land cost is allocated to each unit.

That wasn’t good enough for our taxpayer, who decided to account for the additional land by …

(4) … taking a charitable donation of $11,040,000.

What do you think? Does this transaction rise to the level of a deductible contribution and why or why not?

In general, a contribution implies at least a minimal amount of altruism. If one receives value equivalent to the “donation,” it is hard to argue that there is any altruism or benevolence involved. That sounds more like a sale than a donation. Then there is the gray zone: you donate $250 and in turn receive concert tickets worth $60. In that case, one is supposed to show the contribution as $190 ($250 - $60).

Sure enough, the IRS fired back with the following:

(1)  The transfer was part of a quid pro quo arrangement to receive development approvals.

That seems a formidable argument, but this is the IRS. We still have to bayonet the mortally wounded and the dead.

(2)  The transfer was not valid because [taxpayer] did own the development credits (i.e., someone else in the related-party group did).

(3)  The contemporaneous written acknowledgement was not valid.

(4)  The appraisal was not a qualified appraisal.

(5)  The value was overstated.

Yep, that is the IRS we know. Moderation is for amateurs.

A quid pro quo reduces a charitable deduction. Quid too far and you can doom a charitable deduction. Judicial precedence in this area has the Court reviewing the form and objective features of the transaction. One can argue noble heart and best intentions, but the Court was not going to spend a lot of time with the subjectivity of the deal.

The taxpayer was loaded for bear: the written agreement with the city did not mention that taxpayer received anything in return. To be doubly careful, it also stated that – if there was something in return – it was so inconsequential as to be immeasurable.

Mike drop.

The IRS pointed out that – while the above was true – there was more to the story. The taxpayer wanted more than anything to have the development plan approved so they could improve the quality of life make a lot of money. The city council wanted a new plan before approving anything, and that plan required the taxpayer to increase green space and reduce density.

Taxpayer donated the land. City council approved the project.

Nothing to see here, argued the taxpayer.

The Court refused to be blinkered by looking at only the written agreement. When it looked around, the Court decided the deal looked, waddled and quacked like a quid pro quo.

The taxpayer had a back-up argument:

If there was a quid pro quo, the quid was so infinitesimal, so inconsequential, so Ant-Man small as to not offset the donation, or at least the lion’s share of the donation.

I get it. I would make exactly the same argument if I were representing the taxpayer.

The taxpayer trotted out the McGrady decision. The facts are a bit peculiar, as someone owned a residence, a developer owned adjoining land and a township was resolute in preserving the greenspace. To get the deal to work, that someone donated both an easement and land and then bought back an odd-shaped parcel of land to surround and shield their residence. The Court respected the donation.

Not the same, thundered the Tax Court. McGrady had no influence over his/her deal, whereas taxpayer had a ton of influence over this one. In addition, just about every conservation easement has some incidental benefit, even if the benefit is only not having a crush of people on top of you.

The quid quo pro was not incidental. It was the key to obtaining the city council’s approval. It could not have been more consequential.

And it was enough to blow up a $11,040,000 donation.

Whereas not in the decision, I can anticipate what the tax advisors will do next: capitalize the land into the development costs and then deduct the same parcel-by-parcel. Does this put the taxpayer back where it would have been anyway?

No, it does not. Why? Because the contribution would have been at the land's fair market value. Development accounting keeps the land at its cost. To the extent the land had appreciated, the contribution would have been more valuable than development accounting.

Our case for the home gamers was Triumph Mixed Use Investments II LLC, Fox Ridge Investments, LLC, Tax Matters Partner v Commissioner, T.C. Memo 2018-65.

Should I Have A Separate Bank Account For …?

One of the accountants recently told me that a client had asked whether he/she should set-up a separate bank account for their business.

The short answer is: yes.

It is not always about taxes. An attorney might recommend that your corporation have annual meetings and written minutes – or that you memorialize in the minutes deferring a bonus for better cash flow.  It may seem silly when the company is just you and your brother. Fast forward to an IRS audit or unexpected litigation and you will realize (likely belatedly) why the recommendation was made.

I am skimming a case where the taxpayer:

·      Had three jobs

·      Was self-employed providing landscaping and janitorial services (Bass & Co)

·      Owned and operated a nonprofit that collected and distributed clothing and school supplies for disadvantaged individuals (Lend-A-Hand).

The fellow is Duncan Bass, and he sounds like an overachiever.

Since 2013, petitioner, Bass & Co …, and Lend-A-Hand have maintained a single bank account….”

That’s different. I cannot readily remember a nonprofit sharing a bank account in this manner. I anticipated that he blew up his 501(c)(3).

Nope. The Court was looking at his self-employment income.

He claimed over $8 thousand in revenues.

He deducted almost $29 thousand in expenses.

Over $19 thousand was for

·      truck expenses

·      payment to Lend-A-Hand for advertising and rental of a storage unit

He handed the Court invoices from a couple of auto repair shops and a receipt from a vehicle emissions test.

Let’s give him the benefit of the doubt. Maybe he was trying to show mileage near the beginning and end of the year, so as to establish total mileage for the year.

Seems to me he next has to show the business portion of the total mileage.

Maybe he could go through his calendar and deposits and reconstruct where he was on certain days. He would still be at the mercy of the Court, as one is to keep these records contemporaneously.  At least he would field an argument, and the Court might give him the benefit of the doubt.

He gave the Court nothing.

His argument was: I reported income; you know I had to drive to the job to earn the income; spot me something.

True enough, but mileage is one of those deductions where you have to provide some documentation. This happened because people for years abused vehicle expenses. To give the IRS more firepower, Congress tightened-up Code Section 274 to require some level of substantiation in order to claim any vehicle expenses.

And then we get to the $9,360 payment to Lend-A-Hand.

Let’s not dwell on the advertising and storage unit thing.

I have a bigger question:

How do you prove that his business paid the nonprofit anything?

Think about it: there is one checking account. Do you write a check on the account and deposit it back in?

It borders on the unbelievable.

And the Tax Court did not believe him.

I am not saying that the Court would have sustained the deduction had he separated the bank accounts. I am saying that he could at least show a check on one account and a deposit to another.  The IRS could still challenge how much “advertising” a small charity could realistically provide.

As it was, he never got past whether money moved in the first place.

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.

Benefitting Too Much From A Charity

I suspect that many of us know more about public charities and foundations than we cared to know a couple of years ago.

What sets up the temptation is that someone is not paying taxes, or paying extraordinarily low taxes. For example, obtain that coveted 501(c)(3) status and you will pay no taxes, barring extreme circumstances. If one cannot meet the "publicly supported" test of a (c)(3), the fallback is a private foundation - which only pays a 2% tax rate (and that can be reduced to 1%, with the right facts).

We should all be so lucky.

Let's discuss the issues of charities and private benefit and private inurement.

These rules exist because of the following language in Section 501(c):

No part of the earnings [of the exempt organization] inures to the benefit of any private shareholder or individual….”

In practice the Code distinguishes inurement depending upon who is being benefitted.

If that someone is an “insider,” then the issue is private inurement. An insider is someone who has enough influence or sway to affect the decision and actions of the organization.

A common enough example of private inurement is excessive compensation to a founder or officer.  The common safeguard is to empower an independent compensation committee, with authority to review and decide compensation packages. While not failsafe, it is a formidable defense.

If that someone is an “outsider,” then the term is private benefit.

Here is a question: say that someone sets up a foundation to assist with the expenses of breast cancer diagnosis and treatment. Several years later a family member is so diagnosed. Have we wandered into the realm of private inurement or benefit?

The Code will allow one to receive benefits from the charity – if that individual is also a member of a charitable class. In our example, that class is breast cancer patients. If one becomes a member of that class, one should sidestep the inurement or benefit issue.

The “should” is because the Code will not accept too small a charitable class. Say – for example - that the charitable class is restricted to the families of Cincinnati tax CPAs who went to school in Florida and Missouri, have in-laws overseas and who would entertain an offer to play in the NFL. While I have no problem with that charitable class, it is very unlikely the IRS would approve.

By the way, the cost of failing can be steep. There may be penalties on the charity and/or the insider. Push it too far and the organization's exempt status may be revoked altogether.

Or you may never be exempt to begin with. Let’s look at a recent IRS review of an application for exempt status.

A family member has a rare disease. You establish a foundation to "assist adolescent children and families in coping with undiagnosed and/or debilitating diseases."

The Code allows you to operate for a while and retroactively apply for exemption, which you do.

Sounds good so far.

You and your spouse are the incorporators.

This is common. You can still establish an independent Board.

Your organizing paperwork does not have a "dissolution" clause.

Big oversight. The dissolution clause means that - upon dissolution - all remaining assets go to another charity. To say it differently, remaining assets cannot return to you or your spouse.

The charity is named after your son, who suffers from an unidentified illness.

Not an issue. I suspect many foundations begin this way.

Your fundraising materials specifically request donations to help your son.

You are stepping a bit close to the third rail with this one.

Since inception, the only individual to receive funds is your son. Granted, you have said you intend to make future distributions to other individuals and unrelated nonprofits with a similar mission statement. Those individuals and organizations will have to apply, and a committee will review their application. It just hasn’t happened yet.

Problem.

The IRS looked at your application for exemption and bounced it. There were two main reasons:

First, the problem with the paperwork, specifically the dissolution clause. The IRS would likely have allowed you the opportunity to correct this matter, except that ...

Secondly, there were operational issues. It does not matter how flowery that mission statement is. The IRS reserves the right to look at what you are actually doing, and in this case what you were actually doing was making your son's medical expenses tax-deductible by introducing a (c)(3). Granted, there was language allowing for other children and other organizations, but the reality is that your son was the only beneficiary of the charity's largesse. The rest was just words.

The IRS denied the request. All the benefits of the organization went to your family, and the promise of future beneficiaries was too dim and distant to sway the answer. You had too small a charitable class (that is, a class of one), and that constitutes private inurement.

And you still have a tax problem. You have an entity that has collected money and made disbursements. The intent was for it to be a charity, but that intent was dashed. The entity has to file a tax return, but it will have to file as a taxpaying entity.

Are the monies received taxable income? Are the medical expenses even deductible? You have a mess.

The upside is that you would only be filing tax returns for a year or two, as you would shut down the entity immediately.

Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.