This post was originally published on Forbes Jul 16, 2015
If you were planning to make a tax-deductible charitable contribution to the Educational Assistance Foundation For The Descendants Of Hungarian Immigrant In The Performing Arts, it is probably too late. The DC District Court has approved the IRS revocation of its exempt status retroactive to its founding. I love this case as it brings me back to my earliest days on forbes.com. I wrote about the original ruling that disallowed the exempt status PLR 201130018. Due to the redaction, I didn't know they were talking about Hungary, so I referred to it as the "old country", which is one of my favorite TV tropes.
A Bit Implausible
The whole thing had this air of implausibility -If your great grandfather was a Hungarian violin player or whatever, you qualified for a scholarship - which was explained by a letter. There is still an argument going on as to whether the letter should have been allowed into evidence.
The return represents an aggressive decision by us and our accountants to try to minimize our damages due to poor drafting. We formed a 501(c)(3) scholarship fund, post mortem, with the hope that the IRS will ignore the specific provisions of the will and let us do what should have done originally. Consequently, we deducted the monies transferred to the scholarship fund, thus minimizing our taxes.
It is one thing to have a clever idea and run for luck seeing if it will fly, but I have to wonder what possessed them to continue to litigate.
An Estate Tax Problem
The Foundation was an attempt to shelter some of the assets of the Estate of Julius Schaller from estate and generation-skipping tax. In the application for exemption the Foundation promised to extensively advertise the availability of scholarships including listing them on search engines. The search engine listings did not commence until the IRS audit started and advertising was limited to some letters to universities and "word of mouth" by board members.
The eligibility criteria were pretty specific. Students had to be in their junior or senior year and descended from 19th-century Hungarian immigrants who had been involved in the performing arts. As it worked the only eligible students who were located were descendants of Julius Schaller. The fairly elaborate vetting process that had been outlined in the application was never put into effect.
... according to Board Meeting minutes, dated December 27, 2004, and December 27, 2005, the selection process in actuality consisted of input from Frances Odza and Barrett Weinberger, the only two in attendance at the meetings, making motions on behalf of the Foundation to “look favorably upon the grant requests” for each of the Schaller scholarship recipients.
The real controversy in this case will play out in Tax Court where the Estate of Julius Schaller had been trying to keep out any mention of how the Foundation operated in determining whether the estate should be subject to a fraud penalty.
Is There A Lesson?
The Foundation argued that it should have had more time to get its act together before being audited and that there should be decision made about the letter, but the Court was having none of it.
The Foundation operated in a manner that inured to the benefit of one family, precluding it from having tax-exempt status. Therefore, the IRS's decision to revoke the Foundation's tax-exempt status retroactively is supported by the Administrative Record and was not an abuse of its discretion. Accordingly, the Court must grant the defendant's motion for summary judgment.
I'd like to draw a lesson from this story, but I'm not sure what it is. You can't set up a not-for-profit to just benefit your own family is one rather obvious one. The really intriguing part to me is the "damages due to poor drafting". I have to wonder whether somebody forgot about the generation skipping tax or maybe didn't realize that the nephew and nieces were actually grand nephews and grand nieces. Maybe when the Schaller decision comes out all will be made clear.
Ben Steverman wrote on the case for Bloomberg - The Estate Tax DodgeThat Went Too Far -
To keep more of their estate away from the IRS, the rich can donate art or classic cars to their own private museums or set up special trusts that send income to relatives tax-free. What they can’t do, according to Walton’s ruling, is give relatives scholarship money and call it charity.
That private museum thing is something that I had never thought about. I'll have to look into it.
One of the “rules of thumb” for tax planning is that “smell counts” in any tax situation. If the result just “looks bad” there’s a good chance that the courts will simply not allow it to stand. This is doubly true with regard to §501(c)(3) charitable organizations that, while technically operated under principles that serve the public good, in reality always seem to benefit a very distinct, not so public, private group—like a single family.
Nobody else seems to find this case as hilarious as I do. I'm trying to imagine how they thought up the concept so that scholarships could go to family members who happened to be members of a larger class of people. I'm imagining somebody saying "We can't just have it be Hungarians. Wait a second remember that crazy looking thing in the attic. I remember grandad telling me it was a cimbalon and that his dad was really great with it and so on."