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:
- Dillards
- Walmart
- A&A Auto Salvage
- Derby Quick Lube
- Westar Energy
- Lowes
- T&S Tree Service
- Gene’s Stump Grinding Service
- an animal clinic
- St John’s Military School (her son’s tuition)
- 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.
