GPSolo Magazine - March 2005
Charities And Tax Shelters: Old Wine In New Bottles?
Tax-exempt organizations described in section 501(c)(3) enjoy several tax benefits that make them particularly well suited to be targets for abuse by aggressive promoters of tax shelters. First, there is the charitable contribution deduction. Section 170 allows individuals and corporations that contribute to section 501(c)(3) organizations to deduct the amount of cash or, generally, the fair market value of property contributed. Second, section 501(c)(3) organizations enjoy entity-level exemption from federal income taxation under section 501(a). Thus, bonafide section 501(c)(3) organizations can generate net income from their exempt activities without federal income tax, and those earnings can be used to fund additional exempt activities or investments. Third, while section 501(c)(3) organizations are subject to the unrelated business income tax (UBIT) on income they derive from carrying on an unrelated trade or business, Congress has enacted many exemptions from and modifications to those rules.
Abuse of the charitable contribution deduction. The easiest way to abuse the charitable contribution deduction is to overvalue tangible and intangible property contributed to a section 501(c)(3) organization. For example, in Notice 2004-7, 2004-3 I.R.B. 310, the Service identified a number of problematic charitable contributions of intellectual property, including transfers of nondeductible partial interests in intellectual property and overvaluations of intellectual property. The Notice advised taxpayers that the Service would disallow all or part of these improper deductions and could impose accuracy-related penalties. In addition, the Notice advised promoters and appraisers that the Service intends to review promotions of transactions involving improper deductions of intellectual property and that the promoters and appraisers of the intellectual property may be subject to penalties. New rules limiting the charitable deduction for patents and other intellectual property were added by the American Jobs Creation Act of 2004 and became effective for contributions made after June 3, 2004.
Overvaluation is also a problem in car donation programs. Although legitimate sponsors provide accurate information regarding valuation, unscrupulous promoters openly facilitate the overstatement of valuations. As a result, tax-exempt organizations often derive little economic benefit from these programs relative to the amount deducted. In TAM 200243057, the Service suggested that the operator of a car donation program might be subject to the aiding and abetting penalties found in section 6701. In Rev. Rul. 2002-67, 2002-2 C.B. 873, the Service provided important valuation guidance to sponsors of legitimate car donation programs. New rules applicable to con- tributions of vehicles became effective on January 1, 2005.
A critical element to the success of transactions involving the overvaluation of charitable contributions is the willingness of a charitable organization to provide the receipt that substantiates a contribution of $250 or more, that includes a description of any benefit provided by the donee, and that contains a good-faith estimate of the benefit’s fair market value.
Abuse of the entity-level exemption. The Chronicle of Philanthropy recently reported that a promoter in Utah was recommending the formation of supporting organizations described in section 509(a)(3) to “support” a large number of tax-exempt organizations. The individuals forming the supporting organizations would then contribute appreciated property to the organization and claim a deduction for the fair market value of the contributed property. The charitable organization would sell the appreciated property, incurring no tax on the built-in gain, and then loan some or all of the sales proceeds to the contributor.
The problem is that these transactions are not designed to benefit the charity. The abuse of section 509(a)(3) organizations typically creates an opportunity for the contributor to convert appreciated property into a private source of credit that the section 509(a)(3) organization extends without regard to the credit worthiness of the contributor or the realistic likelihood that the exempt organization will be repaid or repaid with fair market value interest.
Donor-advised funds are another area of abuse. Donor-advised funds allow donors to have a greater voice in how the amounts they contribute are expended. Although responsible asset managers have established donor-advised funds that are among the largest charitable organizations in the United States, other promoters have established funds that lack the constraints found in legitimate donor-advised funds. Such funds are then used to make private-school tuition and similar payments, thus converting non-deductible payments into ostensibly deductible charitable contributions.
The Service has also identified several tax avoidance schemes based on universally rejected frivolous arguments. One was the establishment of a corporation solely for the purpose of avoiding tax on the taxpayer’s income. The promoters of this scheme, which is being marketed through seminars, establish one-person, nonprofit religious corporations claiming to be a “bishop” or an “overseer” of a phony religious organization or society.
Exploiting the unrelated business income tax rules. The S corporation tax shelter is the classic example of this abuse. In that transaction, owners of S corporations attempted to avoid the tax on the S corporation income by donating S corporation nonvoting stock to an accommodating section 501(c)(3) organization, while retaining the economic benefits associated with that stock. In a typical transaction, the corporation issues nonvoting stock and warrants for such stock to its existing shareholders on a pro rata basis. The warrants may be exercised at any time over a period of years, and the strike price on the warrants is set at a price that is at least equal to 90 percent of the purported fair market value of the newly issued nonvoting stock on the date the warrants are granted; the taxpayer takes the position that the warrants cause the fair market value of the nonvoting stock to be substantially reduced.
The original shareholders donate the nonvoting stock to a section 501(c)(3) organization, take a charitable contribution deduction, and claim that 90 percent of the S corporation’s income is allocable to the exempt organization. Although section 513(e) generally makes the distributive share of income from an S corporation to a section 501(c)(3) organization taxable as unrelated business income, the participating charitable organization presumably has sufficient net operating loss carry- overs from other unrelated trades or businesses to shelter this income, which is earned but not distributed. Pursuant to one or more agreements, the exempt organization can require the S corporation or the original shareholders to purchase its non-voting stock for an amount equal to its fair market value at the time the shares are presented for repurchase. The net effect of these transactions is that the section 501(c)(3) organization is expected to receive a share of the total economic benefit of stock ownership that is substantially lower than the share of S corporation income allocated to it.
This type of transaction is troublesome for several reasons. First, it raises a question concerning the proper valuation of the contributed stock, and it also requires an accommodating charitable organization to provide the required section 170(f)(8) receipt to substantiate the contribution. Second, the participating exempt organization must have substantial net operating loss carryovers from other activities; it is, in effect, trafficking in its net operating losses.
What’s a charity to do? Even legitimate organizations must be wary of promoters that bring them tax-motivated transactions. At a minimum, the contribution and investment policies of any charity should make it clear that the organization will not participate in listed transactions. In addition, charities should be wary of becoming involved in aggressive programs designed to generate large charitable contribution deductions that provide little net economic benefit to them.
Douglas M. Mancino is a partner in the law firm of McDermott Will & Emery LLP in Los Angeles, California. He can be reached at email@example.com.
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