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.

Doctor Contests Whether He Had Cancellation Of Debt Income

I suspect that I am one of few people who know where Palatka, Florida is.

When I came out of graduate school I worked as an accountant in Tampa. The firm that I was with was quite aggressive in pursuing contracts for government audits, and one of the accountants there would go to Palatka on a routine enough basis. I remember him not being overly excited about it.

In case you are curious, draw a line from Gainesville (where the University of Florida is) to St Augustine and one (sort of) crosses Palatka.  

The reason we are talking about it is that I am reading a Tax Court decision about a doctor in Palatka. It is a “pro se” decision, which means that the taxpayer represented himself/herself before the Court. I can tell that the doctor tried to ramp up on IRS procedure, but he might have been better advised to hire a CPA experienced in this area.

MEMO: We have commented on this before, but many CPAs do not practice tax, and those who do may not necessarily practice IRS procedure (other than maybe answering the occasional tax notice). 

Dr Darrell Wyatt graduated from the University of Arkansas in 1978 and is board certified in obstetrics and gynecology.

He is a baby doctor.

In 2006 he was wooed by Putnam Medical Center to move to rural Florida.

Nice thing about being a doctor is that hospitals are willing to provide “incentive” payments for things, such as moving to Putnam county Florida. The hospital made a deal with the doctor - move here and we will subsidize (read: “loan”) your practice up to $32,953 per month. That will go on for one year, and then we stop subsidizing you. At that time we would like for you to stay here and work for another 3 more years. Every month that you stay we will forgive 1/36 of the loan. Stay for 3 years and we will forgive the entire loan. Leave before then and you have to pay back whatever is still due on the loan.

He spent the year, and then he easily spent 3 more years.

The loan was forgiven in monthly increments.

The deal with Putnam Medical Center started in July, 2006. Spot the doctor a year. The 36 month period would then run from August, 2007 through July, 2010. 

He filed his 2009 return. He reported the amount forgiven in 2009. He paid no estimated taxes. He owed the IRS a boat. The IRS came in and wanted taxes and several varieties of penalties.

Let talk a little procedure.

The IRS issued a Final Notice of Intent to Levy for 2009. 

OBSERVATION: The IRS had sent a lot of correspondence to the doctor, as this is pretty far along. Levy means that the IRS can go in and tap your bank account, among other things. It is a step up from a Lien and is not a good thing.

Dr. Wyatt in turn requested a Due Process Hearing.

NOTE: The taxpayer has 30 days from the issuance of the Final Notice of Intent to Levy to request an Appeals hearing. One is still inside the IRS, but one is moving the file from Collections to Appeals. This is important as Collections truly does not care whether you owe the tax or can pay the tax, it just wants money. Appeals might cut one some slack on the amount or period over which the tax can be paid.

So far I understand. He did not pay 2009 taxes, so I presume he was under some financial distress. Surely he wanted to propose some payment alternative, and he requested the hearing because the IRS machine was going to run him over otherwise.

Wrong. The doctor presented an offer in compromise based on doubt as to liability.

OBSERVATION: The common offer in compromise is based on collectability: one does not have two nickels to rub together and is trying to get the IRS to accept some greatly reduced amount. This second type is based on the assertion: “IRS, I do not owe you, period.”

This tells me the doctor has done some homework. He submitted amended tax returns and proposed to pay approximately what his tax would have been, excluding the loan forgiveness, for tax years 2007 through 2010. 

           COMMENT: He evidently did not pay tax for four years.

The doctor did not follow certain procedural formalities, which we will spare ourselves for the time being. 

The IRS did not accept his offer. The IRS issued its Statutory Notice of Deficiency (a/k/a “SNOD”) and off they went to Tax Court.

The IRS did not his accept his offer because he did not establish doubt as to liability. In and of itself that does not bother me, as convincing the IRS on that point is like expecting your dog to not want the leftovers from your T-bone steak. 

In Court the doctor leads off his argument with:

(1) The loan was nonrecourse.

Huh? 

He is hanging his hat on that fact that the hospital never reduced the employment incentive to a promissory note. No note equals no personal liability, right?

Wrong. You can be liable and not have a written note. Granted, the written note makes it easier to prove the existence of debt, but the absence of a note does not mean that there is no debt. Had he failed to stay for 36 months, the hospital would have had right to sue under the paperwork that did exist.

He had no argument (2). 

What was he thinking? Did he really believe …?

And then it dawned on me. 

The IRS proceeded against the doctor for one year only – 2009. He would have had debt discharge income in 2007 and 2008 also, but those years were not before the Court.

But there is a logical fallacy here: The absence of something does not necessarily mean the presence of something else. The Court was looking only at 2009, which does not mean that the IRS flubbed 2007 and 2008. 

However, consider the following language by the Court:

In his Form 12153 petitioner referenced three taxable years: 2007, 2008, and 2009. The record in the instant case does not include a copy of the final notice that prompted petitioner to file Form 12153, nor does the record include a transcript of account for any year other than 2009. As discussed infra in the text, the offer-in-compromise based on doubt as to liability that petitioner subsequently submitted referenced 2007 through 2010, i.e., the four taxable years for which amounts were forgiven and canceled by the hospital. However … the notice of determination upon which the instant case is based was issued solely in respect of petitioner’s outstanding liability for 2009.”

The doctor lost on all counts for 2009.

But I cannot help but wonder if the doctor was not so much practicing procedure for 2009 as much as running out the statute of limitations for 2007 and 2008.

Corporations Unable To File Tax Court Petitions

Over the years I have had clients that expanded aggressively into numerous states. I was continually evaluating when they reached the “trigger” to start withholding sales taxes or payroll taxes or filing income taxes with name-the-state.  

This is an area that has radically changed since I started practice three decades ago. There was a time when you practically had to have a storefront in the state before you had to start worrying about taxes. Now you have states that want to tax you should you attend a business convention there. Among the most recent lines of attack is something called “economic nexus,” meaning that - if you target the state’s citizenry as an economic market – the state figures it has enough power to tax you. Think about that for a moment. Say someone is weaving Alpaca sweaters in Miami and decides to sell a few over the internet in Illinois or Massachusetts. ANY sales into a state would trigger nexus under this theory. Many tax professionals, me included, are skeptical whether economic nexus would even survive  a constitutional challenge under the commerce clause of the Constitution.

Unfortunately the Supreme Court has refused to hear cases on tax nexus for about as long as I have been in practice, so there have been few checks-and-balances as the states claim tax superpowers for themselves.  

Let’s segue this discussion to registering a corporation to do business in a state.

A corporation or an LLC is only a corporation or LLC because a state says that they are. That is the way it works. The state wants an annual check for this, and, if asked, they will then say that you are a corporation or LLC. It is a great money tree. Paulie would have approved.

 

Let’s kick it up a notch.

Let’s say that you have an Ohio corporation. An opportunity strikes and you start doing business in Kansas. You know to worry about Kansas income taxes, sales taxes, payroll taxes, et cetera.  What you may not consider is telling Kansas that your corporation is doing business in their state. In addition to possible fines and so forth when you finally surface, there is the possibility of compromising your attorneys’ hands should something happen, such as litigation.

Or responding to an IRS notice.

That one somewhat surprised me, but it appears that California (let’s be honest: California would be among our first guesses for any incident of state tax idiocy) is making things easier for the IRS.

I am looking at Medical Weight Control Specialist v Commissioner.

Medical had its corporate privileges suspended by California, presumably for failing to pay Paulie his annual check. It happens, unfortunately. 

Medical got into it with the IRS, which eventually sent them a 90-day letter, also known as a Statutory Notice of Deficiency (or “SNOD”). 

NOTE: Appealing the SNOD is what gets you into Tax Court. The Court gives you 90 days to appeal and not a moment over. There a sad stories of people who missed it by minutes, but there is no “close enough” rule here. 

The IRS sent the SNOD to Medical in May, 2013. Medical filed its appeal with the Tax Court in June, 2013. 

I do not know what Medical’s tax issues were, but I can tell you that the IRS wanted over $1 million-plus from them. 

Medical made things right with Paulie in May, 2014.

            OBSERVATION: One year later.

Medical obtained a “certificate of reviver” and “certificate of relief from contract voidability” from California. 

Someone at the IRS must have read Sun Tzu and the maxim that the battle is won before the armies take the field. The IRS filed a motion to dismiss. Medical did not legally exist when it filed its appeal, and that which does not legally exist cannot file an appeal of a SNOD with the Tax Court.

Medical fought hard, they really did, but California law was against them. The Tax Court agreed with the IRS and dismissed the appeal.

And there went $1 million-plus.

Now, every state is different, so the answer for an Ohio corporation (say) might be different from a California corporation. But I will ask you what I would ask a client: is it worth it to test the issue?

The IRS seems to have caught on to this Oh-you're-a-California-corporation-sorry-about-your-luck thing. I see that another California taxpayer – Leodis C Matthews, APC – got its appeal bounced when the IRS made virtually the same argument.

Please remember to pay Paulie.

Why Does The IRS Want To Tax Donations Raised For A Cancer Patient?

Have you heard of a website called GoFundMe?

We are talking crowdfunding, and the technology is a dozen or so years old. It is made possible by the internet. Think of a cause, a website and a means to process payments from interested parties. The cause can vary. It might be a business startup, unexpected medical expenses, a legal defense or even a wedding fund.

There are number of crowdfunding websites, bit today our story involves GoFundMe.

I am reading the story of Casey Charf, a young Omaha woman who in 2013 was involved in a bad car crash. She had broken her neck and back. While in the hospital the doctors discovered that she had cancer.

She was interviewed by local television and her story went viral. There were fundraisers for her medical expenses, and toward that end her sister set up a GoFundMe account.

More than a thousand people donated online, raising over $50,000.

Casey has spent the last two years on medical travel and receiving treatment. The cancer unfortunately is still there, but at least it does not appear to be spreading.

In March of this year the IRS dropped in. They sent a notice that the monies raised through GoFundMe should have been reported as taxable income, and to please remit over $19 thousand in taxes, penalties and interest.

Needless to say Casey Charf is contesting the matter.

And I think she will win.

I speculate, but I think I know what triggered the IRS notice. I suspect Casey received a Form 1099-K notice.

The IRS uses the Forms 1099 series to have a third party report amounts paid you and likely representing income. A bank would send you a Form 1099-INT for interest paid on your savings, for example.

The 1099-K follows in that spirit, but it is sent by payment processors. This immediately tells us that we are dealing with debit or credit cards. Why did this enter the tax Code? Think eBay. People were conducting business activities but not sending the government its due. Congress therefore mandated that the companies that processed the payments issue annual 1099s, and it delegated to the IRS how to handle further details.

The IRS published Form 1099-K and said that the payment processor was required to file the form if (1) gross payments to a person exceeded $20,000 or (2) there were more than 200 transactions with a given person.    

GoFundMe uses WePay as its payment processor. I am willing to bet nickels to dollars that WePay issued a 1099-K to Casey Charf.

And the IRS sent a notice.

Why?

Because the IRS presumes that 1099-Ks are for business activity.

I suspect the IRS was trying to find a “business” number on the tax return that matched or exceeded the 1099-K. Finding none it churned out a notice.

Can the IRS not tell that monies are being raised for a charitable cause?

In short, no, not really.

And there is the unfortunate, inside truth of today’s IRS: every year more and more functions are being automated. The practice started out innocently enough: have third parties send information to the IRS and then have IRS computers match that information to your tax return. 

That worked well enough years ago, when reporting requirements were much lighter. They are becoming – if they haven’t already become – onerous, as the IRS wants to know every creak in the economy so Congress can tax it. Many of these notices are wrong, but they still cause angst and cost taxpayers professional fees. The dirty secret is that the IRS is intentionally shifting the cost of administering tax law to taxpayers with all these notices. They can send out anything and force you to explain how they are wrong. Fail to explain and the IRS can (and likely will) assess you.

Back to our story.

I see no reasonable tax theory under which these payments are income to Casey. There is no business activity, nor is there an employment or contractor relationship providing a backdrop for earnings from personal services. I suppose one could argue that it is akin to a lottery or bag of money found on the street, but that seems a stretch.

There is a donative intent, although as structured the amounts raised do not appear to rise to the level of a tax-deductible donation. There are strict rules with deducting payments made directly to an individual, and for the most part they require the participation of a 501(c)(3).

From a tax perspective these payments most closely resemble a gift. Gifts are not taxable.

Which is why I believe Casey Charf will win on this issue.

More importantly, may Casey have a full and speedy medical recovery.