Non-Profits Lose Tax-Exempt Status for Failing to File Returns

On June 8, 2011 the Internal Revenue Service announced the names of 275,000 non-profit organizations that lost their tax-exempt status because they did not file legally required forms for three consecutive years. That means about 14% of existing non-profits lost their tax-exempt status. Most of the organizations that lost exempt status are charities but some are homeowners associations, civic associations, college fraternities, and other non-profit entities.

Nearly 10,500 of the organizations that lost their exempt status were based in Pennsylvania. More than 100 of them gave a Lancaster address.

If an organization appears on the list, it is because IRS records indicate the organization had a filing requirement and did not file the required returns or notices for 2007, 2008 and 2009.

The IRS thinks that the majority of the organizations are defunct. Some organizations claim they were on the list in error. Donors who made what they thought were tax-deductible contributions to organizations prior to the IRS’s publication of the list will still be able to deduct the donation on their taxes.

The Pension Protection Act of 2006 requires most tax-exempt organizations to file an annual information return or notice with the IRS. Small organizations (with less than $25,000 in revenue per year), which previously hadn’t been required to file tax reports, had to do so for the first time in 2007. Churches aren’t included; they still don’t have to file. The filing requirement is met by filing Form 990, 990-EZ, or 990-N.

Since passage of the 2006 law, the IRS has made extensive efforts to inform organizations of the changes. In 2010 the IRS published a list of at-risk groups and gave smaller organizations an additional five months to file required notices and come into compliance. About 50,000 organizations filed during this extension period.

Tax-exempt status is important for multiple reasons. Contributions by donors will not be tax deductible if the organization is not tax-exempt. The organization does not qualify for an exemption from the sales tax if the status is not currently tax-exempt. The organization must file a corporate tax return and pay income tax if it is not tax-exempt.

The revocation of tax-exempt status can’t be appealed or reversed. Organizations subject to automatic revocation that wish to have their tax-exempt status reinstated must file an application for exemption and pay the appropriate user fee. The IRS will allow small organizations (those with annual gross receipts of $50,000 or less for 2010) applying for reinstatement to pay a lesser application fee of $100 instead of the usual fee of $400 or $850. Also, the IRS will treat eligible small organizations applying for reinstatement before December 31, 2012 as having established "reasonable cause" for their filing failures, meaning their tax-exempt status will be reinstated retroactive to the date it was automatically revoked.

To find out if a nonprofit is on the list, go to www.irs.gov/charities. OpenData also provides on its website a searchable combined list. Go to http://opendata.socrata.com.

Failing to comply with annual reporting obligations is not the only way to lose your tax-exempt status. A non-profit may not provide private benefit to any officers, directors or employees. This is the prohibition against "private inurement."

A tax-exempt organization may engage in lobbying but on a restricted basis. If the organization contacts or urges the public to contact a member or employee of a legislative body to propose, support, oppose legislation, and the activities are substantial, the tax-exempt status is at risk. The rules are complicated and many organizations do not engage in lobbying as a matter of policy so as not to run afoul of the complex rules.

Political campaign activity is prohibited absolutely. The organization may not directly or indirectly participate or intervene in any political campaign on behalf of or in opposition to any candidate for public office. An exempt organization may invite a political candidate to speak at an event provided that the organization ensures that 1) it affords an equal opportunity to political candidates seeking the same office, 2) it does not indicate support for or opposition to the candidate, and 3) no political fund-raising occurs. Equal access is not necessary if the candidate is a public figure speaking in a non-candidate capacity.

Activities generating excessive unrelated business income and failure to operate with an exempt purpose also put the exempt status at risk.

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Bryn Mawr Bank Buys Hershey Trust Company Private Client Group

The beleaguered Hershey Trust Company is much in the news.  On February10, 2011, former Hershey Trust board member Robert Reese filed a petition in the Dauphin County Orphan's Court asking the court to compel current and former members of the trust company's board of directors to redress "breaches of trust."  Reese filed the petition on February 10, 2011 and an amendment to the petition of February 11. 2011.

This follows much bad press about alleged self-dealing on behalf of the board by acquiring Pumpkin World and Penn Wren Golf Course at grossly inflated prices. (And wouldn't you know it?  Board members had interests in the purchased land.)

Today we have this news: 

HERSHEY, Pa., Feb. 21, 2011 /PRNewswire/ -- Hershey Trust Company ("HTC") announced today that it has entered into a definitive agreement with Bryn Mawr Bank Corporation ("Bryn Mawr Trust") under which Bryn Mawr Trust will acquire the entire HTC Private Wealth Management Group (the "PWMG Business").  The transaction, which is subject to various closing conditions, including HTC and Bryn Mawr Trust both receiving regulatory approval, is expected to be completed within 90 days.

"The Hershey Trust Company has been taking ongoing steps to return its full focus to its core mission of managing the assets of the Milton Hershey School Trust," said LeRoy S. Zimmerman, chairman of the HTC Board of Directors.  "Selling our private wealth management business to Bryn Mawr Trust is another positive step to help us achieve that goal while doing so in a manner that is in the best interests of the group's private clients."

HTC expects the transition to Bryn Mawr Trust to be seamless and to have minimal impact on clients.  Bryn Mawr Trust is acquiring the entire PWMG Business, including the full team of client services personnel.  In addition, the Group will remain at its current location at West Chocolate Avenue in Hershey.  "Our clients can be assured that following the completion of the sale they will continue to work with the same team and receive the same high quality advisory and fiduciary services that they currently receive," said William F. Christ, President, Hershey Trust Company, PWMG.

"We carefully considered the sale of the PWMG Business and determined that Bryn Mawr Trust was the right buyer," Christ said.  "Bryn Mawr has a long and venerable history in the region and a culture rooted in tradition similar to ours.  Importantly, they share our commitment to customer service.  In addition, Bryn Mawr Trust and its subsidiaries offer a full range of personal and business banking services, and our clients will have access to additional services beyond those we currently offer.  We look forward to working with Bryn Mawr Trust during the coming months to ensure a smooth transition."

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Enforcement of Charitable Pledges

If my father promises to give me money to buy a grand piano for my birthday and then reneges, can I sue him for the money? Is a promise to make a gift legally enforceable? In general, no, I cannot sue him to force him to give me the money for the grand piano.

But what if after he makes the promise I go to the piano store and sign a contract with the store to buy the piano? I relied on his promise. When a person reasonably relies to his or her detriment on another’s promise to make a gift, the promise becomes enforceable. Then I can sue him.

The same analysis applies in the context of a pledge to a charity. When we think of a charitable contribution, we think of a contribution that is freely given. However, most courts view charitable pledges as legally enforceable commitments. Whether or not the pledge is enforceable is a matter of state law.

Under general principals of contract law, a charitable pledge is enforceable if it is a legally

binding contract. There must be an agreement between the donor and the charity, and there must be "consideration" given in exchange for the pledge. That is, the charity must agree to do something (or not do something) in exchange for the promised donation.

It is also "consideration" if a charity has relied on a pledge to its detriment even though that reliance was not requested by the donor as consideration. The legal doctrine applied here is called "promissory estoppel." In the law of contracts, the doctrine of promissory estoppel provides that if a party changes his or her position substantially either by acting or forbearing from acting in reliance upon a gratuitous promise, then that party can enforce the promise although the essential elements of a contract are not present.

Actions that constitute such reliance based on the pledge include soliciting other donors, incurring costs, entering into contracts, or borrowing money based on the expectation that the donor’s promise will be kept. Promises by other donors can be the consideration for the pledge that the charity seeks to enforce. Courts have been very liberal in finding reliance such as where there are specific fund-raising goals for pledges or naming opportunities.

In some states, a charitable pledge is enforceable even without consideration or detrimental reliance as a matter of public policy. For example, in Ohio, a pledge is considered to be just like a promissory note.

In Pennsylvania, any written promise is enforceable despite the absence of consideration or reliance if the writing states that the maker intends to be legally bound. (33 P.S.§6)

According to the Financial Accounting Standards Board, unconditional promises must be listed as assets on the charities financial statements and reported as revenue when the pledge is made. Lenders will often use pledges as collateral for a loan to the charity.

The directors of a nonprofit corporation or the trustees of a charitable trust may have a duty to pursue the collection of legally enforceable pledges. In general, directors and trustees have a

fiduciary duty to protect and preserve assets. If a donor has declined to fulfill a pledge and clearly has adequate resources to fulfill the pledge, the charity may have a fiduciary duty to enforce the pledge. A breach of fiduciary liability can result in personal liability for the director or trustee.

There are tax issues as well. Charities enjoy tax exemption granted by the IRS. One of the conditions is that a charity not give its assets away except to another charity. Forgiving a pledge could be construed as a gift back to the donor - obviously an improper action for a charity. Forgiving a pledge could be a prohibited benefit for which sanctions could be imposed on the organization for giving a disqualified person an excess benefit.

While charities have the right to sue donors who default on pledges and while the directors owe duties to the charity to conserve its assets, they probably do not have an absolute duty to sue defaulting donors. So far, no court has held a charity liable for refusing to enforce a pledge. The costs of pursuing such legal action and the damage such a lawsuit might do to relationships with other donors are appropriate for the board to consider.

Most charities routinely file claims in a deceased donor’s estate to secure payment of a pledge. This is considered to be routine and is not seen in the same way as a suit against a living donor. Suing living donors in default has pubic relations ramifications.

As with any contract, a charitable pledge will not be enforced if certain defenses to recovery exist such as where the donor was a victim of undue influence or fraud. If a pledge is small or the debtor is in financial trouble, the prudent course may be not to seek to enforce the pledge.

Directors and trustees are placed in the unenviable position of deciding whether to accept a significant write-off of the charitable organization’s assets or putting pressure on donors to honor their pledges which, in turn, may jeopardize future donations.

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Charitable Deduction Scams

Tax cheaters will try anything.

"There is no kind of dishonesty into which otherwise good people more easily and frequently fall than that of defrauding the government."

 

                                                                                                              Benjamin Franklin

Here are a few charitable deduction scams that the IRS and Justice Department officials have been focusing on:

Kickbacks. A charity solicits donations. It asks for a very big donation, and then secretly promises a refund. The donor takes an income tax deduction for the big donation, gets a tax benefit, and then the charity gets gives back a big portion of the donation. The result - the charity gets a donation, the donor gets a big tax deduction but gets most of his money back. The U.S. Treasury is left holding the bag. On June 16, 2008 the Wall Street Journal reported on such a scam carried on by the Spinka religious group where up to 95% of the "contributions" were returned to the donors. Three participants have pled guilty, but several more participants and leaders of five charitable organizations will go to trial later this year. One "donor" who pled guilty will pay more than $1.5 million in back taxes. The investigation continues, and the IRS expects to find more than 100 "donors."

This is a large scale version of the fraud where a person puts a check for $100 into the collection plate, takes out $90 in change, then deducts the whole $100.

Big game scam. Treasury has cracked down on the trophy hunting industry. Hunters were writing off the cost of hunting vacations by engineering charitable deductions for the donation of their skinned or mounted "trophies" to a charity. The charitable deduction of a grossly over-appraised donation was often enough to cover the cost of the hunting trip.

Professional preparers. Government officials have been cracking down on professional tax return preparers who make up phony charitable deductions. These preparers curry favor with their clients claiming to get them bigger refunds or lower tax bills - because of the inflated and fraudulent charitable deductions or other scams.

Tom Herman, writing for the Wall Street Journal, warns: Beware of anyone who bases his or her fee on the size of your refund, or who promises a bigger refund than anyone else, or who prepares your return but refuses to sign it. Also, never, ever, sign a blank return.

CEO gifts of stock. Dave Yermack’s study of CEOs who make large gifts of stock found that they tend to make large gifts of stock right before the price falls. This uncanny coincidence leads him to surmise that these gifts are back-dated. In his study he reports that "[t]ests used to infer the backdating of executive stock option awards yield results consistent with the backdating of CEO family foundation stock gifts." at inflated values (with the collusion of the museums) for inflated tax deductions.

Fake churches. Some individuals declare their home a church and that they are clergy (with a mail-order ordination) for that church. This involves not only income tax fraud, but also an attempt to get exemption from real estate taxes. Usually the officers and members of the church are just family members. The "minister’s" income is claimed to be the church’s income and, therefore, tax exempt.

Disguised payments. According to the IRS, there has been a marked increase in the number of instances where taxpayers have taken charitable deductions for tuition payments. When tuition is paid to a private school that is run by a religious organization or other non-profit, the check may only have the name of the non-profit on it as the payee. These taxpayers try to get away with reporting these fees for service as charitable donations.

Overvaluations. There is much abuse in the area of charitable gifts of tangible personal property. This ranges from large scale fraud on the valuation of artwork, to over-valuing the bags of used clothing you give away. Shares of stock in the family business given to charity are also targeted for investigation for over-valuation, as are transfers of interests in real estate.

Abuse of Supporting Organizations. A taxpayer moves assets or income to a tax-exempt supporting organization or donor-advised fund but maintains control over the assets or income - thus keeping the benefit of the asset but simultaneously taking an income tax deduction for a charitable contribution.

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Hershey's Kiss-Off

The goings on at Hershey Company are always of great local interest here in Central Pennsylvania. But of more than local interest is the litigation surrounding the management of the Milton Hershey School Trust and the attempt to sell the company.

Jonathan Klick of Florida State University College of Law and Robert H. Sitkoff of Harvard Law School have published  Agency Costs, Charitable Trusts, and Corporate Control: Evidence from Hershey's Kiss-Off in 108 Colum. L. Rev. 749 (2008). Here is the abstract:

"In July 2002 the trustees of the Milton Hershey School Trust announced a plan to diversify the Trust’s investment portfolio by selling the Trust’s controlling interest in the Hershey Company. The Company’s stock jumped from $62.50 to $78.30 on news of the proposed sale. But the Pennsylvania Attorney General, who was then running for governor, opposed the sale on the ground that it would harm the local community. Shortly after the Attorney General obtained a preliminary injunction, the trustees abandoned the sale and the Company’s stock dropped to $65.00. Using standard event study methodology, we find that the sale announcement was associated with a positive abnormal return of over 25% and that canceling the sale was followed by a negative abnormal return of nearly 12%. Our findings imply that instead of improving the welfare of the needy children who are the Trust’s main beneficiaries, the Attorney General’s intervention preserved charitable trust agency costs of roughly $850 million and foreclosed salutary portfolio diversification. Furthermore, blocking the sale destroyed roughly $2.7 billion in shareholder wealth, reducing aggregate social welfare by preserving a suboptimal ownership structure of the Company. Our analysis contributes to the literature of trust law by supplying the first empirical analysis of agency costs in the charitable trust form and by highlighting shortcomings in supervision of charities by the state attorneys general. We also contribute to the literature of corporate governance by measuring the change in the Company’s market value when the Trust exposed the Company to the market for corporate control. "

The authors are critical of the PA Attorney General's role:

 "Regarding trust law, our findings imply agency costs arising from the Trust’s charitable trust form on the order of $850 million, about 15% of the 2002 value of the Trust. Although the trustees controlled more than three-quarters of the shareholder votes in the Company, they failed
to impose a value-maximizing strategy on the Company’s managers. As we have seen, the market judged the Company as being $2.7 billion (or 25.5%) more valuable when the Company’s managers were expected to be subject to the market for corporate control instead of supervision by the trustees.

Moreover, instead of reducing the agency costs associated with the Trust’s charitable trust form, the Attorney General’s intervention made those agency costs permanent. Without any offsetting financial benefit to the Trust, the Attorney General forced the Trust to retain an asset that was worth $850 million more on the open market than in the hands of the trustees. While the sale’s detractors argued that the sale would hurt other stakeholders, such as the residents of Hershey and the Company’s employees, one wonders whether their gain offsets the preservation of such enormous agency costs. The $850 million in Trust assets destroyed translates roughly into $67,000 per resident of Hershey, or $62,000 per employee of the Company—plus the Trust’s exposure to uncompensated risk was continued."   (108 Colum. L. Rev. 749 (2008) pp. 815-816) 

Juan Antunez gives these cites for more background information:

"[t]he Hershey Power Play in Trusts & Estates Magazine by Pennsylvania attorney Christopher H. Gadsden, and Daniel Gross's piece in Slate entitled Hershey Barred, whose subtitle says it all: How Pennsylvania officials screwed poor kids out of $1 billion by stopping the sale of the candy-maker. "

Blogging credit goes to Juan Antunez who writes the Florida Probate & Trust Litigation Blog as well as to Professor Gerry W. Beyer's  Wills, Trusts & Estates Prof Blog.



It's a Dog's Life

Yesterday's New York Times carried an op-ed piece by Professor Ray D. Madoff  of Boston College Law School criticizing the tax policy that provides a charitable deduction, and therefore a government subsidy, for Leona Helmsley's  $8 billion trust for the care of dogs.  

Ms. Madoff points out:

" While some choose to contribute to broad public goals, the law does not require it. In recent years, charitable status has been recognized for organizations with purposes as idiosyncratic as promoting excellence in quilting and educating the public about Huey military aircraft."

                                                                                                                                             Leona Helmsley and Trouble

The policy issues are similar to those involved in the discussion of huge endowments, see our prior post on Harvard's tax exemption for its mega-endowment.

As a tax policy matter, the charitable deduction, for income tax as well as estate and gift tax, is intended to promote giving to charities to relie the burdens of government and to provide a public benefit.   As is often the case with tax incentives, taxpayers take the incentive ball and run with it - often to extreme ends.  Professor Madoof points out, quite rightly, in my opinion, that it is time to reassess this tax incentive when it results in $ 8 billion in assets being exempted from the estate tax:  

"In Mrs. Helmsley’s case, given that her fortune warranted an estate tax rate of 45 percent, her $8 billion donation for dogs is really a gift of $4.4 billion from her and $3.6 billion from you and me.
To put it in perspective, our contribution to Mrs. Helmsley’s cause equals approximately half of what we spend on Head Start, a program that benefits 900,000 children."

Blogging credit goes to Professor Paul Caron Associate Dean of Faculty, Charles Hartsock Professor of Law, University of Cincinnati College of Law.  Read his take here.  Blogging credit also to Linda L. Beale, Associate Professor at Wayne State University Law School.  Click here to read her post.

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Endowment 5% Spending Rule?

Check out The Debate Room at BusinessWeek.com

Wealthy Colleges:  Ante Up

Colleges and universities should be required to spend 5% of their endowments every year or risk losing their tax-exempt status.  Pro or con?

Challenges to University Tax Exemptions

Taxing authorities are increasingly challenging the tax-exempt status of nonprofits. More and more nonprofits look like businsses. They charge fees and sell products and services to raise money. As state and local govenrments face declining tax revenues, exempting these institutions from taxation makes less and less sense.

James D. Miller, an Economics professor from Smith College wrote an article entitled "Massachusetts Should Tax Harvard.” He says:

“Some Massachusetts legislators want to tax rich colleges. Under their proposal, as reported on Inside Higher Ed, Massachusetts colleges would pay a 2.5 percent tax on all assets over $1 billion. (The idea is part of a broader push to question whether some colleges with hefty endowments are inappropriately hoarding wealth while continuing to raise their tuitions sharply.) Nine schools, including Harvard and Smith College (my employer), are wealthy enough to be subject to the tax”. Harvard’s endowment is over $35 billion.

The Senate Finance Committee has been looking at the idea of requiring colleges to pay out a minimum proportion of their endowment funds. The problem is that universities with huge endowments are not doing enough to help students afford college. Instead, they raise tuition at an alarming rate. One proposed solution is to force institutions to pay out at least 5% of the endowment annually, just like private foundations are currently required to do. After all, where is the public benefit in hoarding the money?

Universities, like other charities, are given tax exemptions because they provide a public benefit or reduce the burdens on governemnt. Is growing your endowment year after year while you raise tuition a public benefit?

Two Senators  wrote the presidents of 136 colleges wrote the presidents of 136 colleges in January 2008 asking for data and explanations about their admissions, financial aid and endowment spending policies and practices. “We would appreciate additional information about tuition costs and your institution’s endowment,” which receive “very generous tax breaks under the Internal Revenue Code,” the two senators wrote. “We want to better understand how these tax benefits for higher education endowments are improving education and making undergraduate studies more affordable for low and middle income families today.”

Lynne Munson, a research fellow at the American Enterprise Institute is coming out with a book tentatively titled Scrooge U. Munson says “decades of hoarding” have resulted in a situation whre “it would take a rainy day of biblical proportion to require significant tapping into these stockpiles.” When institutions face budget difficulties, she said, they are “far more likely to cut educational expenditures than to tap into endowments.”

Pressure works. In December, Harvard announced a decision to limit annual tuition and room and board costs to 10% of income for families earning $120,000 to $180,000. This puts a limit of $18,000 on expenses for these families. Below $120,000 the percent of income drops steadily until it reaches zero at $60,000. The full cost of a year at Harvard is $45,600. A number of other universities have jumped on the band wagon - University of Pennsylvania, Yale and Stanford, to name a few. Now that sounds more charitable, doesn’t it?