by George G. Jones and Mark A. Luscombe
A number of high-profile tax issues attracting the attention of the Internal Revenue Service, the Congress and the media over the last couple of years have involved exempt organizations.
In the IRS’s focus on tax shelters, some of the shelters viewed as abusive have had as a key element the use of an exempt organization in the structure. The IRS has even seen some cases in which the exempt organization was in fact a promoter of the shelter scheme.
In our last column, we discussed some of the problems with vehicle donations to charities. It is clear that many charities have become willing partners in donation programs without concern as to whether there is much correlation between the benefit received by the charity and the deduction taken by the taxpayer.
The IRS and members of Congress have become attuned to the possibility that part of the solution to addressing these types of transactions might be to focus more resources directly on the exempt organizations rather than just on the taxpayers utilizing the exempt entity. A lax audit environment may have encouraged exempt entities to be involved in activities that violate the tax laws and that are not closely related to their exempt purpose, as long as they receive some benefit.
Advisors to tax-exempt organizations will want to take heed of the new internal controls and procedures being put in place in response to Sarbanes-Oxley by their for-profit peers and consider setting up similar procedures to head off problems from the renewed focus on the exempt community.
Among the areas involving exempt organizations that have received attention in recent years are excessive compensation; involvement in joint ventures, tax shelters or otherwise, to the point even where control of the organization’s activities may have been turned over to a for-profit entity; participation in fundraising programs that take unfair advantage of tax code provisions, such as conservation easements and vehicle donations; the charitable activity serving as only a front for the true purpose of activities, such as some credit counseling organizations; and participation in political campaigns. These are among the areas that are causing the IRS and Congress to devote more attention to the activities of exempt organizations.
- Compensation. There have been instances cited in the media in recent years of excessive compensation received by principals of exempt organizations and improper transactions between the principals of the exempt organizations and the organizations themselves. Major exempt organizations such as United Way and The Nature Conservancy have come under scrutiny in this area. Just as many publicly held corporations are finding that they need more independence among the individuals tasked with approving compensation awards, in a post-Sarbanes-Oxley environment, many will also be expected to tighten up their procedures for reviewing and approving compensation and transactions with insiders.
- Joint ventures. Particularly in the hospital area, there has been a concern that nonprofits have entered into agreements with for-profit entities that put too much control over the assets and operations of the nonprofit into the hands of the for-profit entity.
- Tax shelters. Some of the shelter structures identified as abusive have involved the use of a tax-exempt entity as part of the transaction. In fact, IRS Commissioner Mark Everson recently observed that 14 of the 31 abusive shelter transactions currently identified by the IRS involve exempt organizations.
The tax-exempt entity often facilitates the transaction since, similar to the use of a foreign entity, it is a tax-indifferent party for U.S. tax purposes, and so assists tax avoidance by accepting allocations of income from — and giving up allocations of deductions to — taxable entities without any tax cost to itself.
Major U.S. cities are being investigated by the IRS for their involvement in transactions where they leased or sold their mass transit equipment or other municipal equipment to for-profit entities and then leased the equipment back, creating favorable depreciation deductions for the for-profit entities.
- Illegal fronts. The IRS has become concerned that many charities have been created for or are being used for the primary purpose of generating revenue for other than charitable purposes.
The IRS has been looking closely at credit counseling services that may be primarily operating to market debt consolidation loans. Some vehicle donation programs are being operated by for-profit middlemen, who garner most of the gains, leaving only a small percentage for the charity that lent its name to the scheme.
The IRS also is investigating whether some charities participated in abuse of the conservation easement provisions of the tax code to assist taxpayers in claiming improper charitable deductions.
- Failing to fulfill charitable purposes. Hospitals have also become a focus of concern in the area of failure to fulfill exempt purposes. Tax-exempt hospitals have been criticized for the lack of care provided to the poor and for excessive collection efforts being used against patients who are unable to pay. Some states have taken action to revoke the exempt status of tax-exempt hospitals, and the IRS could follow suit.
- Political activities. Churches have been a focus of concern for impermissible involvement in active support of particular political candidates. Although the IRS has seldom pulled the tax-exempt status of a church for political activities, the IRS is being pressured from both the right and the left to investigate allegations of improper political activity. The IRS has promulgated a guide for tax-exempt organizations to help them understand which activities are permitted in the political arena and which are not.
Administrative and legislative changes
The Senate Finance Committee held hearings in June 2004 on problems with exempt organizations, and the testimony covered participation in abusive tax shelters, raiding of assets by directors and insiders, exploitation of charities by fundraisers and middlemen, and the use of phony charities to evade taxes.The IRS has also announced that it will increase its audits of exempt organizations and create special initiatives to address specific problems. The IRS has commenced such an initiative in the area of credit counseling services, and is planning an initiative on charities being used as fronts for illegal purposes. The IRS abusive tax shelter initiative has included a focus on the use of tax-exempt entities. In addition, the IRS recently announced that it has set up a new Exempt Organizations Compliance Unit to focus on a variety of educational and information-based efforts.
Reforms being considered by the Senate Finance Committee might be proposed as soon as the fall of 2004. Those reforms include imposing liability on board members for irresponsible management; adding a follow-up review of exempt status every five years; requiring greater financial disclosure; requiring the chief executive officer to attest to the accuracy of tax returns; the loss of exempt status for a year for charities “accommodating” tax shelters listed as abusive by the IRS, including forfeiture of the benefits received; and restrictions on donor-advised funds, which permit a current deduction while donations are directed to charities over time.
Just as tax advisers are reviewing the new procedures required post-Sarbanes-Oxley with their for-profit clients, advisors of tax-exempt organizations will want to make sure that their exempt organization clients are attuned to the increased scrutiny coming their way, and adopt the procedures to keep them in compliance.
George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.
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