Sunday, June 29, 2014

Creative College Funding Plan Fails

Originally published on Passive Activities and Other Oxymorons on May 4th, 2011.

Their are certain types of tax chiselling that I find particularly perniscious.  Anything involving exempt organizations that is at all shady always disturbs me.  Sometimes the humorous element mitigates the offense.  Like the regular church goer who always drops a couple of Benjamins in the plate or the fellow who started an exempt organization to distribute his own sperm.  (The Darwinian implications of his plan are rather frightening.  Imagine the world slowly being taken over by the descendents of a group of women disinclined to collect sperm in the traditional manner and that one guy.)

Dr. Setty Gundanna Viralam's scheme had no such redeeming quality, not even originality:

In 1998 P-H transferred stocks and cash to X, an organization described in I.R.C. sec. 501(c) that was not a private foundation. X sent P-H acknowledgment letters for the stock transfers which stated that no goods or services were provided for the “donation” of the stocks. X sold the stocks in 1998. X maintained a segregated account for P-H in its records, reflecting the stocks and cash received, the proceeds from the sales of the stocks and their reinvestment, the dividends and interest generated by the assets in the account, and the disbursements from the account in subsequent years.

Promotional materials provided to P-H by X represented that P-H would be able to direct the distribution of the funds in the account for purported charitable purposes, including student loans and as compensation for the performance of charitable services by P-H or members of his family. P-H anticipated at the time of the transfers of the stocks to X that account funds could be used for student loans to his children. Ps claimed a charitable contribution deduction on their 1998 Federal income tax return equal to the fair market value of the stocks and the cash transferred to X.

(P-H must stand for "Petitioner-Husband" i.e. Dr. Viralam.The spouse is Prabhavathi Katta Viralam.)  Here is the part of the case that I found the most amazing:

Petitioner Setty Gundanna Viralam (petitioner) owned a 50-percent interest in a medical practice, which he sold in 1998 for $2,262,500, generating a taxable gain of $2,261,750 in that year.

The only Florida physician that I could find by that name is a pediatrician.  A sale of a pediatric practice for over $4,000,000 is truly astounding.  I suspect that there is an interesting story behind that story.  Frequently, medical practices have little or no fair market value. Note that Dr. Viralam's basis was $750.00.

Dr. Viralam began getting some financial planning ideas from a company called xelan (There seems to be a difference of opinion about whether it is supposed to be capitalized.)  To those enamored of more traditional sounding names it was also referred to as Economic Association of Health Professionals, Inc.  I thought the more exotic name had to have some sort of of Greek origin (Xenophon, xenophobia), but it is actually an invented word:

`x', the individual's savings required to finance lifestyle costs through life expectancy, with 'elan' the French word meaning a lifestyle of personal freedom.” 

I wasn't able to confirm that definition of 'elan' instead getting:

elan - ardor: a feeling of strong eagerness (usually in favor of a person or cause); "they were imbued with a revolutionary ardor"; "he felt a kind of religious zeal"

elan - dash: distinctive and stylish elegance; "he wooed her with the confident dash of a cavalry officer"

elan - enthusiastic and assured vigor and liveliness; "a performance of great elan and sophistication"

I have a pretty good bs detector and the name alone is enough to elevate its reading.  I don't give myself bs detecting points when I have the benefit of hindsight, though.

At any rate the plan sounded pretty neat:

Donors and their family members may work for and be compensated by their family public charities for good works (teaching, research, or providing pro bono services) they perform on behalf of their family public charities. *** The Financial Education Program also explained with reference to Foundation accounts that Your family then is the advisor to that fund as to the way the money is invested. And the growth on the invested money accrues tax deferred. Anytime you want to you could take the money out of your family public charity and pay yourself compensation to do good works. The Foundation also offered Foundation account holders a student loan program whereby Foundation account funds could be disbursed as loans for college and graduate school tuition and related expenses. The program's terms further provided that the loans could be repaid (with interest) either through repayments generally commencing 5 years after graduation or by the recipient's providing charitable services for designated periods. A xelan financial counselor wrote petitioner in April 1998 recommending that he “Establish a Foundation account for charitable giving, income tax reduction planning, estate tax reduction, educational funding, and future retirement planning.”

I really wish that this worked.  There are physicians I know who would actually squirrel away a significant portion of their income in a plan this so that they would be able to pay themselves to work with Medecins Sans Frontieres.  Using the money to make student loans to your own kids is definitely over the top, though.

As part of the package Dr. Viralam received an attorney's opinion:

After establishing his Foundation account, petitioner received a letter from the law firm of Conner and Winters, legal counsel to the Foundation. The letter expressed an opinion that it was more likely than not that a contributor would be entitled to a deduction for a charitable contribution to the Foundation. The letter represented that the opinion expressed therein was based on an examination of the Foundation's certificate of incorporation, its bylaws, resolutions of its board of directors, and representations made to the Commissioner of Internal Revenue in connection with the Foundation's application for recognition of section 501(c)(3) tax-exempt status. However, the letter stated that Conner and Winters had not examined any documents pertaining to, and would not render an opinion as to the tax effect of, any of several programs of the Foundation, including “donor advised distributions”, “educational loans”, and “charitable service [performed by a donor] for the Foundation”. The letter expressly disclaimed any opinion on the tax effect of “any specific charitable or other activity of the Foundation or any donor with respect to the Foundation”.

Here is my version of the letter:

Dear Dr. Viralam

The IRS has not revoked the 501(c)(3) status of this organization - yet.  So if you give it money, its probably deductible.  We will certainly not stick our neck out on all the really neat parts of the plan that the snake oil salesmen told you about.  Caveat emptor.

As far as I can tell the whole xelan thing was shut down in 2005.  What is at stake in this case though are charitable contributions for 1998 and gain from the sale of the donated property. As it worked out the largest use of the account's funds was student loans to Dr. Viralan's son, Vinay. I doubt that perfect execution would have salvaged this plan, but execution was less than perfect :

On July 6, 2001, Vinay executed documents with respect to the $17,247 loan for his tuition and expenses at the University of Pennsylvania. The documents included a “Commitment Agreement” (commitment agreement) and an “Education Expense Repayment Agreement” (repayment agreement).

In the commitment agreement Vinay agreed to participate in the Foundation's “Educational Funding Program” and, in return for receiving educational loans from the Foundation, to provide 2,000 hours of charitable work for the Foundation for each year of educational expenses advanced. The commitment agreement stated that if Vinay did not undertake sufficient charitable work to repay the educational expenses advanced, he would repay the Foundation all educational expenses advanced that were not reduced by charitable services, together with interest according to the terms of the repayment agreement. Finally, the commitment agreement stated that “the student will provide regular reports, at least annually, of his or her progress in the course of study and intended work, as well as, his or her plan to meet the obligations of the Agreement.”
The Foundation's approval of petitioner's son as a student loan beneficiary was perfunctory. The Foundation sent petitioner a distribution request form on which the approval for a student loan for Vinay had already been signed by a Foundation official before petitioner executed the form. There is no evidence that the Foundation reviewed Vinay's qualifications or otherwise exercised any independent judgment in selecting him for a student loan. In the circumstances, it is obvious that the selection of Vinay as a beneficiary of the Foundation's student loan program arose from his relationship to petitioner and as a result of petitioner's direction.

Although the commitment agreement required Vinay to provide an annual report, there is no evidence that he did so.

On September 16, 2003, respondent issued petitioners a notice of deficiency for 1998 disallowing their claimed charitable contribution deduction for the transfers of stocks (and cash  ) to the Foundation and determining an accuracy-related penalty. Eleven days earlier, petitioner arranged for an entity he and Vinay controlled to pay the Foundation $70,300, the total of the distributions to the University of Pennsylvania on Vinay's behalf from petitioner's Foundation account.  This payment was credited to petitioner's Foundation account. The Foundation thereupon waived all interest that had accrued under the terms of the repayment agreement and returned the commitment agreement and repayment agreement to Vinay marked “paid in full”, along with a letter confirming that the $70,300 payment had fulfilled Vinay's obligation to the Foundation.

So on to the penalties.

We find that petitioners were negligent because petitioner failed to make a reasonable attempt to ascertain the correctness of a deduction which would seem to a reasonable or prudent person to be “too good to be true” under the circumstances. A reasonable or prudent person would have perceived as “too good to be true” a deduction for a supposed charitable contribution where the amounts deducted could be used to fund student loans for his own children. The same is true with respect to the avoidance of capital gains taxes on the sales of stocks where the proceeds remained under petitioner's control for use by his children. To the extent petitioner ascertained the validity of the charitable deduction or capital gains exclusion from xelan's employees or its printed materials, there was an obvious conflict of interest on the part of persons promoting xelan's programs.

What about that great legal letter ?

Thus, while the letter specifically identified the student loan program petitioner contemplated using, it expressly refrained from offering any opinion concerning the tax effects of participation in the program and confined itself merely to describing certain features of the program. If anything, the Conner and Winters letter should have put a professionally educated person such as petitioner on notice that further inquiry was warranted concerning the student loan program.

It will be interesting to see if there are more xelan cases coming.

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