If you have given a large donation to an IRS designated 501(c)(3) public charity in 2015 you all know that you get to itemize that contribution as a tax deduction on Schedule A of your Form 1040 you will file this April 2016. But there is also another option: the 501(c)(3) Family Private Foundation or PF. While the super-rich have always had PFs, Bill and Melinda Gates Foundation for example, many more American taxpayers are giving PFs a try. Your family gets significant control over the types of “grants” they make as well as substantial income and estate tax benefits. Not to mention a permanent legacy for your family for generations to come. But watch out: there are many IRS Government placed PF traps that can cause your PF to cost you more than its worth in penalty excise taxes when you get hit with an IRS Private Foundation Audit perhaps years later. So if you have any interest in forming a Private Foundation, stay with us here on TaxView with Chris Moss CPA Tax Attorney to learn the steps in properly operating a PF so that you stay clear of IRS imposed excise taxes during a routine IRS Private Foundation Audit.
The legislative history of the Private Foundation is to say the least fascinating. One of the first PFs in the early 20th century was the Rockefeller Foundation formed in 1913. Did the newly enacted income tax enacted that same year and the estate tax three years later in 1916 have anything to do with this? What do you think?
Over a 100 years and thousands of private foundations later Congress addressed the wide spread abuse of the tax exempt status of private foundations. A leading 7th Circuit case, Quarrie Charitable Fund v IRS, 603 F.2d 1274 (7th Cir US Court of Appeals 1979) and the House Ways and Means 2005 Report rewinds us back to the Tax Reform Act of 1969. The Act imposed PF excise taxes on self-dealing between the founding family and the PF and a small 2% tax on investment income. Even with these excise taxes, PFs continue to be extremely popular with many taxpayers and have evolved into Grant-Making Private Foundations (GPFs), Private Operating Foundations (POFs) and Exempt Private Operating Foundations (EPOFs’) which are relatively easy to set up and operate---that is as long as you know where the IRS traps are during an IRS Private Foundation Audit..
The first trap is easy to avoid, but apparently not to Todd v IRS US Tax Court (2002). In 1994 Todd formed the Todd Family Foundation and transferred 6,350 shares of Union Colony Bancorp to the PF. Todd took a $500,000 charity deduction on Schedule A of his 1994 Form 1040 using form 8283 Noncash Charitable Contributions as substantiation for the deduction. The IRS audited and disallowed all deductions including carryforwards to 1995-1997 arguing that there had been no qualified appraisal of the stock. Todd appealed to US Tax Court in Todd V IRS US Tax Court (2002). Judge Halpern easily finds for the Government citing IRS regulation 1.170A-13 that a qualified appraisal must be made no earlier than 60 days prior to the date of contribution, be prepared and signed by a qualified appraiser and must have been included in the tax return along with Form 8283. IRS Wins Todd Loses.
The next two traps of control and self-dealing are more complex as discussed by the IRS themselves in their article Developments in the Private Foundation Area (1990). Unlike public charities, PFs are most likely controlled by the founding family, as in Bell v IRS US Tax Court (2009). Bell owned the Bell Family Foundation and numerous other profitable business entities. Bell contributed stock in Northeast Investors Trust to the Bell Foundation and properly deducted a charitable deduction with a signed appraisal on his 1996 tax return. There were in addition subsequent charitable carryforwards to years 1997-2000. The IRS audited and disallowed all Bell’s donations to the Bell Foundation for all years claiming that Bell still controlled the stock because Bell controlled the Foundation. Since Bell still controlled the stock there was never a charitable donation to deduct because no charitable gift had ever been transferred. The Bells appealed to US Tax Court in Bell v IRS US Tax Court (2009). The Court noted that although the PF is controlled by the Bells, control alone is not sufficient to defeat the charity deduction by the Bells. Judge Wells further argues that the IRS had not cited any authority in support of their contention that merely having control over the foundation disqualifies the Bells from claiming the charitable contribution deductions for the contribution of the shares of Northeast Investors Trust to the Foundation. Indeed the Court opines, the “Self-dealing” trap is more likely to trip up PFs as per IRS Code Section 4940 through Section 4945. IRS loses, Bell Wins.
Which brings us to the trap of self-dealing. “Self-dealing’ includes the furnishing of goods, services or facilities between a PF and a disqualified person as per Section 4941(d)(1)(C). There is one exception: Section 4941(d)(2)(E) allows “self-dealing” to family members if their service was of a professional nature and their compensation was not excessive. But what about for example a janitorial service?
In Madden v IRS US Tax Court (1997), Madden’s PF, the Museum of Outdoor Arts contracted with Madden’s Maintenance Company to perform maintenance, janitorial and custodial work. The IRS audited six years’ worth of Madden’s tax returns from 1983-1989 and charged him self-dealing excise tax on all years. Madden appealed to US Tax Court in Madden v IRS US Tax Court (1997). Judge Fay reviews the legislative history involving the “personal service” exception of Section 4941(d)(2)(E) noting that in order to prevent PFs from being used by their Founders for personal gain, Congress established a set of arm’s length standards for dealings between the foundation and the Founder members or “disqualified individuals”. H. Rept. 91-413 (Part 1), at 21(1969). The Court notes that while the IRS regulations do not define the term “personal service” they offer several examples such as legal services, investment management services and general banking services. The Court therefore concluded that janitorial service was not “personal service” and that Madden was subject to the “self-dealing” excise tax under Section 4941(a)(1). IRS Wins Madden Loses.
So what can you do to set up your Private Foundation right now in 2016 and be protected during an IRS Private Foundation Audit? First, choose what area you want to make a difference in the world. One family can change the world with the properly structured PF. Look at Water Missions and see how this one family is changing the world working through the power of the Holy Spirit to provide fresh water to nations in need. Next make sure to consult with your tax attorney. She can set up your PF, including State entity formation, IRS EIN number, application to the IRS for tax exemption Form 1023 and can act as your PF in house legal counsel as well. Third transfer assets to the Foundation either in cash, stock and/or real estate and begin the journey to create your legacy. As a secondary yet important benefit your transferred assets are removed from your taxable estate saving you and your family estate tax upon your passing. Last but not least is the annual income tax savings you receive as you deduct one very large charitable donation on Schedule A of your personal tax return and make sure your Tax Attorney includes her contemporaneously prepared opinion in your tax return prior to filing that your Foundation is legal and in accordance with IRS regulations and Federal law. When the IRS comes knocking on your door years later you can rest assured you will win the IRS Private Foundation Audit. All said and done, not a bad way to change the world. Hope your Private Foundation goes well in 2016. Thanks for joining us on TaxView, with Chris Moss CPA Tax Attorney.
See you next time on TaxView,
Kindest regards and Happy New Year 2016
Chris Moss CPA Tax Attorney.