A Basketball Association’s Tax-Exempt Application

 

I am looking at an IRS letter ruling wherein somebody was applying for tax-exempt status.

The main section of the Code that addresses tax-exempts is Section 501. You may already know that the premier tax-exempt is a 501(c)(3), although there are other varieties. The advantage to the (c)(3) is that:

·        The entity itself is (normally) nontaxable, and

·        Contributions to it are (again, normally) tax-deductible.  

Not everything associated with a (c)(3) is tax-exempt, of course. If you work at one, you will file and pay income taxes on your paycheck like anyone else. There are limits to the tax break.

A key limit involves non-exempt activities.

Let’s say that you want to open a school to teach car manufacturing. You have read and understood that schools are usually tax-exempt. You want to vertically scale your vision. You want to teach auto design, engineering, manufacturing and eventual sale of the said automobiles. Soup to nuts and all.

And you want the whole thing to be tax-exempt under (c)(3).

It won’t work, of course. There are private companies that manufacture and sell cars for a living. You are not making this thing tax-exempt by attaching a school to it.

In the jargon, the school would be an exempt activity.

Everything else would be non-exempt activity.

There is a famous quote from the Better Business Bureau of Washington D.C. tax case:

... a single non-exempt purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of truly exempt purposes.”

You might be able to sell a car at the end of the school year, but any sales activity must be insubstantial in comparison to all other activities. Sell a fleet of cars and you are surely doomed. 

Let’s look at our Ruling.

A member-based organization functions as a clearinghouse for basketball officials. The organization recruits, trains, certifies and assigns its coaches to officiate at elementary, middle and high schools. The school districts pay the referees directly, with pay levels varying upon experience and qualifications. The association has an assignment secretary who assigns the coaches “based on their availability and qualifications.”

The organization provides testing to assess and develop each official’s understanding of basketball rules and regulations. The organization also ensures that referees meet fitness requirements as well as maintain effective communication skills.

The organization is funded primarily by member dues, although it also receives fees from scrimmage games and basketball camps. The organization’s principal expense is the assignment secretary.

COMMENT: There is the job I want.

The IRS looked at the two overall tests for a tax-exempt:

·        How it is organized

·        How it actually operates

Let’s go to the second test.

·        There is a clear educational component to this organization. It actively educates and trains its members so they can obtain and retain employment as basketball officials.

·        There is also a clear business component. Frankly, the organization serves as placement agency for its members, almost like a union hall. That is fine, but it is not an exempt purpose. That activity serves the private economic interests of the members and is not grounds for tax exemption.

So we have the question:

Is the “non-exempt purpose” substantial enough in nature to capsize the exempt educational activities of the organization?

The IRS determined that it was substantial enough. It denied the (c)(3) application.

This time we have discussed IRS Letter Ruling 202521023.

 

Taking Tax Advice From Friends

 

I received a text message one night this past week.

I was researching living trusts on the internet. It sounds like it might work for my situation.

I had two immediate reactions:

First, excellent. I am a fan of doing your own research and understanding what an expert is recommending.

Second - and maybe more important – use the expert.

The problem with DIY tax research is that you may not know what you do not know. Granted, in many cases it might not matter as much (hey, can I deduct the mileage for my gig income?), but in other cases it might matter a lot.

Let’s talk about the Horowitz case from 2019.

Peter Horowitz was an anesthesiologist. Susan Horowitz was a PhD working as a public health analyst for the U.S. Department of Health of Human Services.

In 1984 they moved to Saudi Arabia. They lived mostly on Susan’s income while banking most of Peter’s salary.

They used U.S.-based accountants, so they knew to (and filed) federal taxes on their Saudi earnings.

One thing about a bank account in Saudi Arabia: it does not pay interest. After a couple of years, the Horowitzes got tired of that and opened a Swiss bank account. They were also concerned about untangling the Saudi account when the Saudi gig played out.

Makes sense.

The Horowitzes did not tell the U.S accountants about the Swiss account. This meant that they did not report the interest income nor did they report the existence of the foreign account to the Treasury or IRS.

Why?

Their friends in Saudi Arabia told them that they did not have to pay U.S. tax on interest earned on the Swiss account.

In 2001 they moved back to the U.S. That Swiss account had grown to $1.6 million. Peter called the bank every year or two to keep an eye on the account.

COMMENT:  I would too.

Fast forward to 2008, the year that UBS got in trouble with the (non)reporting on Swiss bank accounts. UBS notified the Horowitzes that they would be closing the account. Peter traveled to Switzerland and moved the funds to another bank. Susan travelled the next year to add her name to that account.

Peter opened a “numbered” account, which meant that a number rather than a name identified the account. He also requested the new bank to not send correspondence (termed “hold mail” - something the IRS did not like).

Why?

The bank explained:

… these services allowed U.S. citizens to eliminate the paper trail associated with undeclared assets and income they held … in Switzerland.”

This is going downhill.

In 2009 Peter started reading about IRS enforcement on foreign bank accounts. He and Susan decided to consult a tax attorney.

The Swiss account was now worth nearly $2 million.

They learned that they were supposed to – all along – have been reporting that account.

 In 2010 they closed the Swiss account, repatriated the funds and applied for a voluntary Treasury disclosure program.

Good idea.

They filed amended returns for the interest income, as well as filing FBARs disclosing the existence of the foreign account.

The interest income was not inconsequential: they sent the IRS more than $100 grand in back taxes.

Got it. It was going to hurt, so they might as well rip the band-aid.

In 2012 they opted out of the voluntary disclosure program (OVDP).

COMMENT:  The default ODVP penalty was 27.5%. I suspect - but do not know for certain - that they were hoping for a better penalty result during the audit process. Considering the Swiss account had neared $2 million, the penalty alone would have been around a half-million dollars.

In 2014 the IRS sent notices. The Horowitzes, their accountants and the IRS conferred but failed to reach an agreement.

The penalties now became an issue. The base FBAR penalty is $10 grand per instance. The IRS however saw the Horowitzes behavior as willful, meaning they wanted enhanced penalties. To muddy the waters further, the law had changed. What used to be a maximum $100 grand penalty was now the greater of $100 grand or 50% of the account.

COMMENT: You may also know the FBAR by its current name: FinCEN Form 114.

The Horowitzes protested. Their behavior was not willful, and - even if it was - the old penalty (maxed at $100 grand) should apply.

The Court was short on the willfulness issue.

The court acknowledged that the couple ‘insis[ed] that neither of them had actual knowledge on the FBAR requirement.’ But, relying on United States v. Williams …., it reasoned that willfulness in the civil context ‘covered not only knowing violations… but reckless ones as well’.”

In particular, the court pointed to the fact that the tax returns signed by the Horowitzes ‘included a question of whether they had foreign bank accounts, followed by a cross-reference’ to the FBAR filing requirement. It also found significant that, by their own account, the Horowitzes had ‘discussed their tax liabilities for their foreign accounts with their friends’ but failed to ‘have the same conversation with the accountants they entrusted with their taxes for years’.”

The Horowitzes appealed.

They argued that they messed up, but that mistake was not willful. The enhanced penalties should not apply.

The IRS countered: “willfulness” in this context includes recklessness, which standard was met by:    

The Horowitzes never asking their tax preparer whether they had to report the Swiss bank accounts,

The Horowitzes asking their friends about international tax matters demonstrated their awareness of potential issues,

The Horowitzes knew to report their Saudi earnings and U.S.-based interest income from domestic banks, and

The Horowitzes signed their tax returns without reviewing them with any care.

Here is the Court:

… their only explanation for not disclosing foreign interest income related to some unspecified conversations they had with friends in Saudi Arabia in the late 1980s. Yet, if the question of whether they had to pay taxes on foreign interest income was significant enough to discuss with their friends, they were reckless in failing to discuss the same question with their accountant at any point over the next 20 years.”

Taking all of these circumstances together, the record indisputably establishes not only that the Horowitzes ‘clearly ought to have known’ that they were failing to satisfy their obligation to disclose their Swiss accounts, but also that they were in a ‘position to find out for certain very easily’.”

How much are we talking about across the years?

Including interest and penalties, it was close to $1 million.

Our case this time was Horowitz v US, No. 19-1280 (4^th Cir. 2020)