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.

Abusing A Tax-Exempt

I am looking at a tax-exempt case that went off the rails.

There are rules in the tax-exempt area to encourage one to keep their nose clean. The rules can be different depending on whether the entity is a private foundation or not. The reason is that a foundation is generally considered more susceptible to influence than a “classic” tax-exempt, such as a 501(c)(3), as a foundation generally has a smaller pool of donors.

A doctor (Dr O) organized a 501(c)(3) called American Medical Missionary Care, Inc (AMMC) in 1998. In 2000 it applied for and received tax-exempt status from the IRS. Its exempt purpose was to operate a clinic in Michigan providing medical examination and treatment for individuals unable to afford such services.

Sounds like a great cause to me.

Dr O served as president. His spouse (Mrs O) served on the board of directors as well as secretary and treasurer over the years.

In 2013 AMMC filed its Form 990 reporting compensation of $26,000 paid Dr O and $21,000 paid Mrs O.

AMMC however issued W-2s of $26,000 apiece.

There is a mistake here, but it is not necessarily a big deal. They should tighten down the numbers going forward, though.

On its 2014 Form 990 AMMC reported no compensation to Dr or Mrs O.

Seems odd. Compensation does not tend to turn off and on like a spigot.

Meanwhile, Dr O had gotten in trouble with the Michigan Board of Medicine in 2014. He was required to pay a significant amount of money and also relinquished his medical license. Dr O eventually returned to Nigeria in 2017, leaving his wife in the United States.

The IRS selected the nonprofit for examination.

The revenue agent dug around the AMMC’s various bank accounts for 2014 and found biweekly checks to Mrs O of $1,000 each. There were also certified checks ranging from $6,000 to $10,000. In all, Dr and Mrs O had received cash, checks and money orders from AMMC totaling approximately $130 thousand.

The 990 showed the $130 grand as a loan receivable from Dr O.

Oh please.

Dr O got into trouble and needed cash. He turned to AMMC because that is where the money was. A loan implies an ability to repay and intent to collect, all within the normal course and conduct of business. I seriously doubt that is what we had here.

Dr O and Mrs O had outsized influence over the (c)(3). Who was going to tell them no, much less point out that making loans to officers and board members is minefield territory in the tax Code?

The IRS revenue agent felt the same way and assessed a tier-one penalty.

Penalties in the nonprofit area can be a bit different. There can be penalties on an individual or on the entity itself, for example. The more severe penalties revolve around “excess benefit” transactions and “disqualified persons,” which are – as you might suspect – people with substantial authority or influence over the tax-exempt. Dr O organized AMMC years before and served as its president. He was a poster child for a disqualified person.

The IRS assessed a tier-one penalty of $32,500. It also revoked the exempt status of AMMC.

Let’s walk through the tiered penalty.

The IRS assessed a tier-one penalty of $32,500 on the O's. This is 25% of the $130,000 that Dr and Mrs O drew in 2014. The reason I call it a “tier-one” is that there is a possible “tier two.” To avoid a tier-two, one has to return the money to the tax-exempt.

What happens if one fails to return the money?

The penalty goes to 200%.

This is one of the severest penalties in the tax Code, and Congress intended it that way. Years ago, the only recourse the IRS had was to revoke the entity’s exempt status. Congress felt that this response was a sledgehammer, and it instead created a set of “intermediate” penalties, shifting the burden to the person benefiting from the transaction. With that as background, Congress did not consider 200 percent as excessive.

So the O’s now had another penalty of $230,000.

COMMENT: 200 percent of $130,000 is $260,000, not $230,000. The Court made some tweaks which need not concern us here.

You may be wondering why Dr O would care, if he was safely ensconced in Nigeria.

For one, his wife was still in the United States.

And she was on the Board. She had served as secretary and treasurer. She was a disqualified person in her own right. She was also considered to be a disqualified person by being married to a disqualified person. She was not getting out of this snare.

Mrs O was going to get hammered.

She fielded a last stand:

(1) She argued that much of the money was distributed to needy people to help with rent and utilities, after-school programs for the kids and so forth.

Problem was: she had no records to substantiate any of this. She had not drawn checks in a manner commensurate with this storyline, although she testified that she would hold and re-deposit the certified checks back into the (c)(3) if and as needed. The Court was – by this point – quite skeptical of anything she had to say.

(2)  She argued that much of the money represented compensation to either her or both Dr O and her.

This was her best argument, but unfortunately this route was closed to her.

You see, AMMC should have issued W-2s if it intended for the monies to represent compensation. The tax-exempt did not issue W-2s for 2014. It did not even authorize compensation in its minutes. Some things have to be done currently, and this is one of those things.

A W-2 (or 1099) would have saved a penalty equal to twice its face amount. That is, a $26,000 W-2 to Dr O would have saved a penalty of $52,000 ($26,000 times 200%).

It was a worst-case scenario for the O’s.

Then again, they abused AMCC. That money did not belong to the O’s. It belonged to the (c)(3). The exempt purpose of AMMC was to assist the poor with access to medical care, not to enrich its founding family after the loss of a medical license.

Our case this time was Ononuju v Commissioner, T.C. Memo 2021-94.

 

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.

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.

Losing Bankruptcy Protection On Your IRA

You probably know that monies in your IRA are protected from bankruptcy. No one intends to go there, but it’s nice to know that you have that safeguard.

What do you have to do to void that protection?

Enter Ernest Willis and his IRAs (Willis v Menotte).

Willis opened a self-directed IRA with Merrill Lynch in March, 1993. On December 20, 1993 he withdrew $700,000to help him with a real estate transaction. On February 22, 1994 he put the $700,000 back in the IRA.

NOTE: Let’s count the days… 12 + 31 +22 = 65 days. You may remember that you can withdraw money from your IRA and not have it count as a distribution IF you replace it within 60 days. Looks like Willis missed his count.

In January, 1997 Willis had problems with the stock market. He had to put money into his brokerage account (I presume he was on margin), so he wrote checks back and forth between his IRA and the brokerage account. The settlement takes a few days, so he could keep the brokerage account afloat by swapping checks. Since he was replacing the IRA monies within 60 days, he did not have a distribution.

Somewhere in here Willis partially rolled-over his Merrill Lynch account to AmTrust and Fidelity.

In February, 2007 Willis filed for bankruptcy. The creditor wanted his IRA. Willis said NO NO and NO. The IRA is protected by Bankruptcy Code Section 522(b) (4) (A). “Go away” says Willis.

The bankruptcy court takes a look at the IRA transactions. An IRA is not allowed to participate in certain transactions (called “prohibited transactions”) with its fiduciary. Guess what? If you direct a self-directed IRA, you are a “fiduciary.” Willis tapped into his IRA and did not replace the money within 60 days. The 60 days is not a suggestion; it is the statute. He didn’t make it. He put the money back in there, but this was not horseshoes. This was a prohibited transaction.

The court was also not too amused with the check swapping scheme and his brokerage account. The court observed that this had the effect of a loan between Willis and his IRA. An IRA cannot loan money, and it especially cannot loan money to its fiduciary. This was a prohibited transaction.

The bankruptcy court held against Willis. He appealed to the district court. That court sustained. Willis next appealed to the Eleventh Circuit, and the circuit court has just sustained the district court. Willis has lost.

How much money was in these IRAs? The Merrill Lynch account alone was over $1.2 million.

I have known clients to “borrow” from their IRA, and I especially remember one doing this while Rick and I worked together at another firm a few years ago. I remember counting down and sweating the 60 days. This was a sensitive client, and – if it blew up – I was going to take massive damage. Willis unfortunately did not keep it to 60 days. He must have been strapped, because he wound up borrowing from friends and family. He put the money back into the IRA, but he had missed the window. The later episode with the check swapping was just icing on the cake.

The court pointed out that once the IRA was tainted, the taint followed the partial rolls to the other two IRAs. His three IRAs were unprotected and could be actioned by his bankruptcy creditors.

Willis thought he was clever. He got schooled, and the tuition was expensive.