Thinking About Private Foundations

 

I’ll admit it: last month (October) left room for improvement. An unresponsive IRS and a dearth of hirable accounting talent is taking its toll here at Command Center. I am hoping that recent hiring at the IRS will take the edge off the former; I see little respite from the latter, however.

This month many of our nonprofit returns are due. That is OK, as those do not approach the volume of individual returns we prepare.

I find myself thinking about private foundations.

I would set-up a family foundation if I came into megabucks. It would, among other things, allow the CTG family to aggregate, review, discuss and decide our charitable giving as a family unit.  

But I have also been in practice long enough to see family foundations misused. A common-enough practice is to hire an … unmotivated … family member as a foundation employee.  

Let’s talk about the self-dealing rules and foundations.

First, let’s clarify what we mean when we use the term private (or family) foundation.

It is a charity – like the March of Dimes or United Way – but not as much. Think of foundations as the milk chocolate to the public charity dark chocolate. The dark chocolate is – let’s be frank – the better chocolate. Contributions to both are tax deductible, but there are restrictions on the private foundation that do not exist for a public charity. Why? Because a public charity tends to have a diverse and diffuse donor base. A private foundation can be one family – or one person. A private foundation can therefore be more disposed to get its nose in traps than a public charity.

Let’s introduce two terms: disqualified persons and self-dealing.

There are two main categories of disqualified persons. I will use the CTG Foundation (and its one donor – me) as an example.

·      Category One

o  A substantial contributor (that would be me)

o  Members of my family

o  A corporation, partnership or trust wherein I am at least a 35% owner

·      Category Two

o  Foundation directors and officers

o  Their families

A family foundation might keep everything in the family, in which case categories one and two are the same people. It does not have to be, though.

We have the players. Now we need an event, such as:

·      Buying or selling property from or to a disqualified (person)

·      Renting from or to a disqualified (unless from and for free)

·      Lending money to or borrowing from a disqualified (unless from and interest free)

·      Allowing disqualifieds to use the foundation’s assets or facilities, except on terms available to all members of the public

·      Paying or reimbursing unreasonable or unrelated expenses of a disqualified

·      Paying excessive compensation to a disqualified

In theory, that last one would discourage hiring the … unmotivated … family member. In reality … there is very little discouragement. The deterring effect of punishment is impacted by its likelihood: no likelihood = no deterrence.

A key thing about self-dealing transactions is that, as a generalization, the tax Code does not care whether the foundation is getting a “deal.”  Say that I own rental real estate in Pigeon Forge. I sell it to the CTG Foundation for pennies on the dollar. Financially, the foundation has received a significant benefit. Tax-wise, there is self-dealing. The Code says “NO” buying or selling to or from a disqualified. There is no modifying language for “a deal.”

So, what happens if there is self-dealing?

There are two tiers of penalties.

·      Tier One

o  A 10% annual penalty on the self-dealer. In our Pigeon Forge example, that would be me. If the violation is not cleaned-up quickly, the 10% applies every year until it is.

o  There may be a 5% penalty on a foundation manager who participated in the act of self-dealing, knowing it to be such. Again, the penalty applies annually.

·      Tier Two

o  The Code wants the foundation and disqualified to reverse and clean-up whatever they did. In that spirit, the penalty becomes severe if they blow it off:

§  The penalty on the self-dealer goes to 200%

§  The penalty on the foundation manager goes to 50%

You clearly want to avoid tier two.

What would impel the foundation to even report self-dealing and pay those penalties?

I like to think that the annual 990-PF preparation by a reputable accounting or law firm would provide motivation. I would immediately fire a private foundation client which entered into and refused to unwind a self-deal. I am more concerned about my reputation and licensure. I can always get another client.

Then there is the possibility of an IRS audit.

It happens. I was reading one where the private foundation made a loan to a disqualified. The disqualified never made payments or even paid interest, and this went on for so long that the statute of limitations expired. According to the IRS, it might not be able to get to those closed years for penalties, but it could force the foundation to increase the loan balance by the missed interest payments (even for closed tax years) when calculating penalties for the open years.

Yep, that is what got me thinking about private foundations.

For the home gamers, this time we discussed CCA 202243008.

A Rollover As Business Startup Got “ROB”bed

We have talked before about ROBS. This is when one borrows money from his/her IRA to start a business.  ROBS have become increasingly popular, and I have wandered in tax Siberia by being negative on them. I know a CPA in New Jersey who even used a ROBS to start his practice. I gave him some slack (but just a little) as he is a general accounting practitioner and not a tax specialist.

Here is the question I hear: what is one’s downside if it goes south? They can’t eat me, right?

My answer: you have blown up your IRA via a prohibited transaction. A prohibited is nothing to take lightly. It contaminates your IRA. All of it. Even the monies you leave behind in the IRA. This is a severe case of terminal.

Now I have a case to share with my clients: Ellis v Commissioner.

Mr. Ellis accumulated a sizable 401(k). In 2005 he formed an LLC (CST) to sell used cars. He moved $319,500 from his 401(k) to an IRA to acquire the initial membership units of CST. He worked there as general manager and received a modest W-2. CST made a tax election to be taxed as a corporation. It did this to facilitate the ROBS tax planning.

Mr. Ellis, his wife and children also formed another LLC (CDJ LLC) in 2005 to acquire real estate. Mr. Ellis did not use his IRA to fund this transaction.

In 2006 CDJ LLC leased its real estate to CST for $21,800. No surprise.

Mr. Ellis also received a larger – but still modest – W-2 for 2006.

The IRS swooped in on 2005 and 2006. They wanted:

·        Income taxes of $135,936 for 2005

·        Alternatively, income taxes of $133,067 for 2006

·        Early distribution penalties of 10%

·        Accuracy-related penalties of $27,187 for 2005 or $26,613 for 2006

What set off the IRS?

·        Mr. Ellis engaged in “prohibited transactions” with his IRA.

·        When that happened, his IRA ceased to be an “eligible retirement plan” as of the first day of that taxable year.

·        Failure to be an “eligible retirement plan” means that that the IRA was deemed distributed to him.

·        As he was not yet 59 ½ there would be early distribution penalties in addition to income tax.

When did this happen? Take your pick:

·        When Mr. Ellis used his IRA to buy membership interests in CST in 2005

·        When CST paid him a W-2 in 2005

·        When CST paid him a W-2 in 2006

·        When CST paid CDJ LLC (an entity owned by him and his family) rent in 2006

OBSERVATION: Do you see the danger with the ROBS? Chances are that you will be giving the IRS multiple points at which to breach your tax planning. You have to defend all points. Failure to defend one – just one – means the IRS wins.

Code section 4975 defines “prohibited transactions” with respect to a retirement plan, including IRAs. Its purpose is to prevent taxpayers from self-dealing with their retirement plan. The purpose of a retirement plan is to save for retirement. The government did not allow tax breaks intending for the plan to be a piggybank or an alternative to traditional bank loans.

Self-dealing with one’s retirement plan is per-se prohibited. It is of no consequence whether the deal is prudent, in the best-interest-of or outrageously profitable. Prohibited means prohibited, and the penalties are correspondingly harsh.

The Court proceeds step-by-step:

(1) CST did not have any shares or units outstanding when Mr. Ellis invested in 2005. Fortunately, there was precedent (in Swanson v Commissioner) that a corporation without shareholders is not a disqualified person for this purpose.

Mr. Ellis won this one.

(2) Mr. Ellis, feeling emboldened, argued that Code section 4975(c) did not apply because he was paid reasonable compensation for services rendered, or for the reimbursement of expenses incurred, in the performance of his duties with the plan.

The Court dryly notes that he was paid for being the general manager of CST, not for administrating the plan. Code section 4975(c) did not apply. Ellis was a disqualified person, and transfers of plan assets to a disqualified person are prohibited.

Mr. Ellis argued that the payment was from the business and not from his plan. The Court observed that the business was such a large piece of his IRA that, in reality, the business and his IRA were the same entity.

Mr. Ellis lost this one.

(3) Having determined the W-2 a prohibited transaction, it was not necessary for the Court again to consider whether the rent payment was also prohibited.

The Court goes through the consequences of Mr. Ellis blowing-up his IRA:

(1) Whatever he moved from his 401(k) to his IRA in 2005 is deemed distributed to him. He had to pay income taxes on it.

a.     The Court did observe that – since the IRA erupted in 2005 - it couldn’t again erupt in 2006. Thank goodness for small favors.

(2) Since Mr. Ellis was not age 59 ½, the 10% early distribution penalty applied.

(3) Since we are talking big bucks, the substantial underpayment penalty also applied for 2005. Ellis could avoid the penalty by showing reasonable cause.  He didn’t.

I suppose one could avoid IRA/business unity argument by limiting the ROBS to a small portion of one’s IRA. That would likely require a very sizeable IRA, and what would “small” mean in this context?

I disagree with the Court on the reasonable cause argument. ROBS are relatively recent, and takes a while for a body of law, including case law, to be developed. I find it chilling that the Court thought that the law and its Regulations were sufficiently clear that Mr. Ellis should have known better. Whereas I disagree with many of the ROBS arguments, I acknowledge that they are reasonable arguments. The Court evidently did not feel the same.

OBSERVATION: How long do you think it will be before ROBS are a “reportable transaction,” bringing disclosure to its promoters and attention to the taxpayer?

My thoughts?  I intend to give this case to any client or potential client who is considering a ROBS. I can see situations where a ROBS can still pass muster – if the taxpayer is a true and passive investor, for example. Problem is, that is not how ROBS are promoted. They are marketed to the prematurely and involuntarily unemployed, and as a way to fund a Five Guys Burgers and Fries franchise or that accounting practice in New Jersey. Odds are you will be working there, as you are too young to retire. You will not be passive. If you were passive, why not just buy Altria or Proctor & Gamble stock? You don’t need a ROBS for that.