Creating A Tax Practice

 

It has been a couple of months on the blog.

I have been helping a friend and fellow CPA, at least as much as I could.

He is approaching retirement. He sold his practice to a larger firm. I remember talking with him about it:

Him:  What do you think?

CTG: I see the Federation and the Borg. What is your win condition here?

Him:  Yes, but ….

A rationalization that begins with “yes, but” should be a sign that you are about to buy real estate in the dark.

It has gone poorly. Zero surprise. The Borg are like that.

It was a clash of cultures: entrepreneurial versus bureaucratic, advisory versus compliance, real fees versus “valued added.”

He will survive. He may yet be able to retain several clients, reopen an office, and resume practice. He however will never be the same. 

His story has given me pause.

It also reminds me of someone who recently applied for tax-exempt status with the IRS.

More specifically, 501(c)(4) status.

As we have discussed before, Section 501 is the master key - so to speak – to tax-exempt status. The gold standard is 501(c)(3), which is both tax-exempt and contributions to which are tax deductible. That is about as good as it gets. The (c)(4) is a different beast: it is tax-exempt but contributions are not tax deductible. Why the difference? A (c)(4) frequently has an active advocacy role: think AARP, for example. That advocacy can rise to the level that it equals – or exceeds – the nonprofit motivation behind the organization.

Someone had the idea to form a tax practice as a nonprofit.

The nonprofit employs tax professionals licensed as attorneys, CPAs, enrolled agents and tax preparers with years of experience practicing worldwide taxation.”

How will it generate revenues?

The Corporation is a full-time tax service company supported by memberships and donations.”

How does this thing work?

There is a three-tier membership-based structure.

The first tier includes US taxpayers having hardship. The organization will charge per hour for complicated cases but not charge for simple cases.

The second tier is membership-based. One pays X dollars and receives comprehensive tax services.

The third tier is gauzy “feet on the ground” personnel including support volunteers.

I am not seeing it. Tier one is fee-based except for some pro bono work. Tier two is a flat-out copy of a boutique medical practice. I do not even know what tier three is, other than some filler when completing the tax-exempt application.

Why would someone go through this effort?

One of the main reasons for you to apply for the tax-exempt status is to meet the requirements established by TAS (Taxpayer Advocate Service) to be eligible for LITC (Low Income Tax Clinic) grants.”

Ahhh!

Along with one of your Board members personal investment and professional involvements, you have already generated the interest of several high-net-worth prospective donors.”

Methinks we found the motivation here.

The IRS saw it too:

The benefits provided by you are primarily for your paying members and you operate in a manner like organizations operated for profit. Thus, you are not operated exclusively for the promotion of social welfare within the meaning of Section 501(c)(4).”

BTW this is referred to as an “adverse determination” by the IRS. If a practitioner is aware that the IRS will come in adverse, it is not uncommon to withdraw the application. It allows the opportunity to fight another day.

The taxpayer did not withdraw in this case, and the adverse determination was issued as final.

Does this mean that the taxpayer cannot operate an organization with the pro bono and boutique fees and whatever feet-on-the-ground? Of course not. It just means that it will have to file and pay taxes – just like any other profit-seeking business.

What it cannot do is pretend to be tax-exempt.

This time we discussed IRS TEGE Release Number 202539014 dtd 9.26.25.

Seeking Tax Exempt Status By Lessening The Burden Of Government

Let’s introduce Captain Obvious: if you want charitable tax-exempt status from the IRS, you need to have a charitable purpose.

Let’s look at New World Infrastructure Organization’s application for tax-exempt status.

It starts with two individuals: Scott and Pam Johnston.

They owned a business called The Pipe Man Corp (TPMC). Scott was the president and Pam the vice-president

TPMC was organized to develop a portable pipe manufacturing system, working and shaping pipe in larger-than-usual sizes. Combine these pipes with road infrastructure and a business opportunity was created.

TPMC never got started. I guess it needed angel investors, and the investors never appeared.

The Johnstons then organized a nonprofit corporation called New World Infrastructure Organization (New World).  Scott and Pam were its only officers and directors. TPMC granted New World permission to use its copyrights and patents, whatever that meant, given that Scott and Pam were the only two officers and were on both sides of the equation.

New World submitted an application for tax-exempt status, stating that its …

… ultimate purpose and core focus will be charitable, with … [its] main beneficiary being Federal, State and Local Government Agencies.

OK, its purpose has something to do with government.

… our research will result in encouraging Economic Development throughout the United States. It will save time, money and lessen the burden of government. The prototype machinery, after testing, will be placed into service making very large corrugated metal pipe. The pipes need to make a Highway Overpass can be made and arched in less than a week. The cost of these pipes represent a fraction of the cost of traditional methods.”

Lessening the burden of government can be a charitable mission. For tax-exempts, this generally means that a governmental unit considers the organization to be acting on its behalf. The organization is freeing up resources – people, material, money – that the governmental unit would have to devote were it to conduct the activity itself.   

It would be helpful to present a prearranged understanding with one or more government units, especially since New World was hanging so much of its hopes on the lessening-the-burden-of-government hook.

Helpful but not happening.

I am not clear how New World was lessening anything.

According to the narrative description, … [New World] intends to fulfill its charitable purpose by working with governmental agencies, engineering firms, and businesses to reduce the cost of infrastructure projects to ‘as little as one fourth current costs.’”

Wait a second. Is New World saying that its exempt purpose was to reduce the cost of projects to the government? That is not really an exempt purpose, methinks. Let’s say that you start a business and guarantee the government that you will beat a competitor’s price by 10%. That may or may not be a good business model, but you are still in business and still for-profit. Maybe a little less profit, but still for-profit.

How about if New World provided its services at cost?

… while petitioner has suggested … that it would be willing to enter into an exclusivity agreement … to sell its product at cost, it has not established through its bylaws or otherwise that it would in fact do so.”

Seems that New World wanted a profit. It is not clear what it would do with a profit, although there is the old reliable saw of paying-out profits via salaries and bonuses to its two officers and directors.

The Court saw a failed business effort slapped into a tax-exempt application. The supposed charitable purpose was to offer a lower price on infrastructure projects, which was not quite as inspiring as clothing the poor or feeding the hungry. It appeared that no governmental unit had asked to have its burdens reduced. It further appeared that there was a more-than-zero possibility of personal benefit and private inurement to the Johnstons.

Why even go to all this effort?    

I suppose the (c)(3) status would have allowed New World to obtain the funding that its predecessor – TPMC – was unable to obtain. TPMC would have issued stock or borrowed money. New World would have raised capital via tax-deductible charitable contributions.   

The Tax Court said no dice.

Our case this time was New World Infrastructure Organization v Commissioner, T.C. Memo 2021-91. 

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.

 

IRS Rejects A Religious Organization’s Tax-Exempt Application

 

We have a nonprofit application for exempt status that has gone off the rails.  

The reviewing (IRS) officer wanted them, for example, to recharter under a different category of nonprofit status.

I considered it arbitrary, but if it made him happy….

He called this week threatening to terminate his review altogether. I called him back immediately.

What happened, I asked

You have not forwarded all the information I asked for, he explained.

I faxed you several documents in early June. I said. I am unaware of having omitted anything.

I need state certification of the amendment to the charter, he replied.

Which he had not requested previously.

Fine. I called the secretary of state’s office, explaining my situation. They were very helpful and by the end of the day I received a verification that I could forward to the IRS.

The nonprofit, by the way, is a high school booster club. The IRS is treating them like they were Amazon. Folks, these are parents selling pop and snacks at high school games. All they are trying to do is buy bleachers and build restrooms nearer the athletic fields. The IRS overkill here is ridiculous.

My previous exempt application, on the other hand, went smoothly. I had one conversation with the reviewing officer and that was it.

Yes, one’s experience with the IRS can vary greatly depending on whom one is working with.

I am looking at IRS response to an application by an organization called Christians Engaged. It caught my attention for two reasons: first, the response came out of Cincinnati; second, the organization got turned down. I get curious when an application is rejected. I remember, for example, an application rejected for being little more than a masquerade for sending family members to college on a tax-deductible basis.

Let’s set this up:

(1)  The organization was organized in Texas in 2019.

(2)  The founder and president is a former Republican Congressional candidate and a preacher.

(3)  The vice president is a former Promise Keepers prayer coordinator and a homeschool mom.

(4)  The secretary is a millennial managing Republican field teams in Collins county, Texas.

Sounds 2021-ish.

The organization’s mission statement includes the following:

a.    Regular prayer for the nation

b.    Impact culture by voting every election

c.    Encourage political education and activism

d.    Educate Christians on the importance of prayer, voting and nonpartisan political engagement

Got it. There is noticeable call-to-action here.

So what are the activities of Christians Engaged?

(1)  Hold weekly prayer meetings for state and federal leaders, including distribution of program outlines to participating churches.

(2)  Maintain a website and social media providing educational materials and connections for Christians to become politically active.

(3)  Educate believers on issues central to biblical faith, such as the sanctity of life, the meaning of marriage, private versus governmental ethics, religious liberty, and so on.

(4)  Conduct educational activities, including a course in political activism, with a basis in Biblical and Christian value systems.

(5)  Educate on how to select between imperfect candidates as well as political party impact on elected officials.

Tax-exempts have to be careful when they approach political activities.  The type of exempt we are discussing here is the (c)(3) - the most favorable tax status, as contributions to a (c)(3) are tax-deductible.

As a generalization, a tax-exempt is permitted to advocate on issues affecting them, the community, society and the nation. Think environmental protection or domestic abuse, for example, and you will get a feel for it.

What it cannot do is lobby (at least, not to any significant extent).

What is lobbying?

An obvious example is direct lobbying: contacting an elected or government official with the intent of influencing new or existing legislation.

Less obvious is indirect lobbying, sometimes referred to as grassroots lobbying. Rather than contacting an elected or government official directly, the goal is to influence and motivate the public to do so.

To me this definition is soapy water. A tax exempt is allowed to advocate, and obviously it will advocate on behalf of its mission statement. An early education (c)(3) will, for example, advocate with the goal of getting someone to leave the couch and take action on early education matters.  

We have to tighten-up the definition of grassroots lobbying to make it workable.

How about this:

Attempt to influence the general public through communications that:

·      Refer to specific legislation

·      Reflect a point of view on said legislation, and

·      Include a call to action

Better. It seems that a general education or exhortation mission – and leaving specific legislation or candidates alone - will fit into this definition.

What did the IRS reviewing officer see in the Christians Engaged application?

(1)  The activities approach that of an action organization, involving itself with political campaigns and candidates.

How, me asks?

The organization involves itself on issues prominent in political campaigns, instructing what the Bible says about the issue and how the public should vote.

(2)  The issues discussed are more commonly affiliated with certain candidates of one political party rather than candidates of another party, meaning the organization’s activities are not neutral.

(3)  The organization itself is not neutral, as it instructs people on using and voting the Bible. 

(4)  The organization serves the interest of the Republican party more than incidentally, meaning it serves a substantial nonexempt purpose.

 Huh?

Let’s just quote the IRS: 

Specifically, you educate Christians on what the Bible says in areas where they can be instrumental including the areas of sanctity of life, the definition of marriage, biblical justice, freedom of speech, defense, and borders and immigration, U.S. and Israel relations. The bible teachings are typically affiliated with the [Republican] party and candidates.”

That took a turn I did not expect.

I expected an analysis of applying soapy-water standards of grassroots lobbying to societal reality in the 21^st century.  

We got something … else.

The matter is being appealed, of course.

No Shareholder, No S Corporation Election

 Our case this time takes us to Louisville.

There is a nonprofit called the Waterfront Development Corporation (WDC). It has existed since 1986, and its mission is to development, redevelop and revitalize certain industrial areas around the Ohio river downtown. I would probably shy away from getting involved - anticipating unceasing headaches from the city, Jefferson county and the Commonwealth of Kentucky - but I am glad that there are people who will lift that load.

One of those individuals was Clinton Deckard, who wanted to assist WDC financially, and to that effect he formed Waterfront Fashion Week Inc. (WFWI) in 2012. WFWI was going to organize and promote Waterfront Fashion Week – essentially a fundraiser for WDC.

Seems laudable.

Mr Deckard had been advised to form a nonprofit, on the presumption that a nonprofit would encourage people and businesses to contribute. He saw an attorney who organized WFWI as a nonprofit corporation under Kentucky statute.

Unfortunately, Waterfront Fashion Week failed to raise funds; in fact, it lost money. Mr Deckard wound up putting in more than $275,000 of his own money into WFWI to shore up the leaks. There was nothing to contribute to WDC.  What remained was a financial crater-in-the-ground of approximately $300 grand. Whereas WFWI had been organized as a nonprofit for state law purposes, it had not obtained tax-exempt status from the IRS. If it had, Mr Deckard could have gotten a tax-deductible donation for his generosity.

COMMENT: While we use the terms “nonprofit” and “tax-exempt” interchangeably at times, in this instance the technical difference is critical. WFWI was a nonprofit because it was a nonprofit corporation under state law. If it wanted to be tax-exempt, it had to keep going and obtain exempt status from the IRS.  One has to be organized under as a nonprofit for the IRS to consider tax-exempt status, but there also many more requirements.

No doubt Mr Deckard would have just written a check for $275 grand to WDC had he foreseen how this was going to turn out. WDC was tax-exempt, so he could have gotten a tax-deductible donation. As it was, he had ….

…. an idea. He tried something. WFWI had never applied for tax-exempt status with the IRS.

WFWI filed instead for S corporation status. Granted, it filed late, but there are procedures that a knowledgeable tax advisor can use. Mr Deckard signed the election as president of WFWI. An S election requires S corporation tax returns, which it filed. Mind you, the returns were late – the tax advisor would have to face off against near-certain IRS penalties - but it was better than nothing.

Why do this?

An S corporation generally does not pay tax. Rather it passes its income (or deductions) on to its shareholders who then include the income or deductions with their other income and deductions and then pay tax personally on the amalgamation

It was a clever move.

Except ….

Remember that the attorney organized WFWI as a nonprofit corporation under Kentucky statute.

So?

Under Kentucky law, a nonprofit corporation does not have shareholders.

And what does the tax Code require before electing S corporation status?

Mr Deckard has to be a shareholder in the S corporation.

He tried, he really did. He presented a number of arguments that he was the beneficial owner of WFWI, and that beneficial status was sufficient to allow  an S corporation election.

But a shareholder by definition would get to share in the profits or losses of the S corporation. Under Kentucky statute, Mr Deckard could NEVER participate in those profits or losses. Since he could never participate, he could never be a shareholder as intended by the tax Code. There was no shareholder, no S corporation election, no S corporation – none of that.

He struck out.

The sad thing is that it is doubtful whether WFWI needed to have organized as a nonprofit in the first place.

Why do I say that?

If you or I make a donation, we need a tax-exempt organization on the other side. The only way we can get some tax pop is as a donation.

A business has another option.

The payment could just be a trade or business expense.

Say that you have a restaurant downtown (obviously pre-COVID days). You send a check to a charitable event that will fill-up downtown for a good portion of the weekend. Is it a donation? Could be. It could also be just a promotion expense – there are going to be crowds downtown, you are downtown, people have to eat, and you happen to be conveniently located to the crowds. Is that payment more-than-50% promotion or more-than-50-% donation?

I think of generosity when I think of a donation. I think of return-on-investment when I think of promotion or business expenses.

What difference does it make? The more-than-50% promotion or business deduction does not require a tax-exempt on the other side. It is a business expense on its own power; it does not need an assist.

I cannot help but suspect that WFWI was primarily recruiting money from Louisville businesses. I also suspect that many if not most would have had a keen interest in downtown development and revitalization. Are we closer to our promotion example or our donation example?

Perhaps Mr Deckard never needed a nonprofit corporation.