Tax Shelters

In the last decade or so, the I.R.S. has increased its attention to the role that tax-exempt organizations play in facilitating abusive transactions. This activity has culminated in The Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”). TIPRA enacted significant new penalties for certain tax-exempt entities that are parties to “prohibited tax shelter transactions.” TIPRA also created new disclosure and reporting requirements for parties to such transactions. The legislation applies to both current and past transactions to the extent such transactions generate income after August 15, 2006.

Under TIPRA, prohibited transactions include:

  • Transactions the I.R.S. has announced through guidance that are considered potentially abusive.[1]
  • Transactions that are “substantially similar” to currently listed transactions; and
  • “Subsequently listed” transactions the I.R.S. determines are potentially abusive at a point in the future after the exempt organization becomes a party to the transaction.

On April 1, 2004, the Treasury Department and the I.R.S. issued Notice 2004-30 (the “Notice”) describing an abusive tax avoidance transaction involving S corporations and tax-exempt entities. According to the Notice, the transaction involved the gift of S corporation stock to a tax-exempt entity which, due to agreements governing the gift and the stock, was determined by the I.R.S. to “artificially shift the incidence of taxation on S corporation income away from taxable shareholders to the exempt [shareholder] . . .” while the taxable shareholders retained “the economic benefits associated with the [gifted] stock.” The Notice stated that the transactions and any transaction that is “substantially similar” to it will be considered to be “listed transactions” and that tax-exempt entities will be treated as “participants” in such transactions based solely on their acceptance of the gift. The I.R.S. currently lists Notice 2004-30 transactions on its list of Large and Midsized Business Divisions Tier 1 Compliance Issues.[2]

The typical structure of a charitable family limited partnership (“CFLP”) that is at risk of being deemed “substantially similar” to the transaction outlined in the Notice is as follows:

  • The general partner is the donor, the donor’s family member(s), or a limited liability company or other entity controlled by the donor or the donor’s family member(s);[3]
  • The general partner has complete control over the investment, management and disposition of the assets of the CFLP, subject only to very limited approval rights of limited partners;
  • The general partner has sole discretion to make calls for additional capital and require the limited partners to make contributions or face dilution of their limited partnership interests;
  • The general partner can cause the CFLP to enter into, and has control over the determination of the terms and conditions of, any transactions between the CFLP and any other party, including the donor and the donor’s affiliates;
  • With limited exceptions, the limited partners have no right to review, monitor, approve or otherwise participate in the decisions of the general partner in managing the CFLP; and
  • The limited partners have no right to withdraw from the CFLP for any reason without the general partner’s consent.

If the general partners of a CFLP  has operated the partnership in a manner that shifts the incidence of taxation away from the taxable general partner while retaining the economic benefit of the partnership assets, it is likely that the I.R.S. would conclude that the CFLP transactions are “substantially similar” to the S corporation listed transaction, which invokes penalties and mandatory reporting requirements.

Penalty Excise Taxes.  TIPRA enacted a two tier excise tax that applies to tax-exempt entities that engage in “prohibited tax shelter” transactions. Prohibited tax shelter transactions include “listed” transactions, any transactions “substantially similar” to listed transactions and certain “reportable” transactions.

The partnerships that were accepted prior to the issuance of the Notice in 2004 are subsequently listed transactions. For subsequently listed transactions, the penalty is a product of the highest unrelated business taxable income rate (currently 35%) and the greater of:

1)         any income that is properly allocable to the period beginning on the later of (a) the date the transaction is identified by the I.R.S. as a listed transaction or b) the fI.R.S.t day of the tax year; or

2)         75% of the proceeds received by the entity which are attributable to the prohibited tax shelter transaction and are properly allocable to the period beginning on the later of: (a) the date the transaction is identified as a listed transaction, or (b) the fI.R.S.t day of the tax year. Thus, the excise tax could apply even if the tax-exempt entity makes no profit on the transaction.[4]

In cases of “knowing participation,” organizations could be subject to an excise tax at the greater of 100 percent of its net income or 75 percent of the proceeds from the covered transaction, with no defense for reasonable cause.[5]

There is also a manager-level tax imposed on the entity manager who (1) approves or otherwise causes the entity to be a party to a prohibited tax shelter transaction at any time during the tax year; and (2) knows, or has reason to know, that the transaction is a prohibited tax shelter transaction.[6]

TIPRA also requires tax-exempt entities to disclose their participation in prohibited tax shelter transactions to the I.R.S. and requires others that participate in the prohibited tax shelter transactions to disclose to tax-exempt entities that such transactions may be covered by TIPRA. A tax-exempt entity that is a party to either a “listed” or “reportable” transaction will be subject to the new penalty and disclosure requirements.

The failure of charitable organization to report its participation in such a transaction could result in the imposition of penalties that might be imposed if the transaction is determined to be abusive or otherwise improper.  It is important to note that the failure to report penalty may be imposed regardless of whether the I.R.S. ultimately determines that the transaction was abusive.  In addition to the applicable penalties, an investigation of the organization’s participation in a listed transaction may be viewed unfavorably by existing and potential donors.

To avoid penalties, we recommend charitable organizations who may have accepted similar assets as gifts take the following steps:

  • Make a protective disclosure on Form 8886-T;
  • Contact the general partnership of each partnership that charitable organization holds an interest in informing them of the transfer of assets from the Foundation to charitable organization and requesting additional information regarding the partnership and its operations;
  • Review the information obtained to determine whether any of the partnerships are in fact substantially similar to the listed S-corporation transaction and if so, whether they have been operated in an abusive manner;
  • If any of the partnerships seem like they might be substantially similar to the listed S-corp. transaction and have been operated in an abusive manner, demand that the partnerships purchase charitable organization’s interest for fair market value. Note that fair market value will include a discount for lack of control and lack of marketability and will not necessarily reflect the full value of the partnership’s underlying assets.
  • Pursue judicial dissolution of any partnerships that have uncooperative general partners.

Our experience has been that once donors are aware of the potential consequences, some are willing to negotiate a purchase of the limited partnership interests in exchange for a settlement of claims. Others may be unresponsive or refuse to negotiate, causing the organization to file for a judicial dissolution of the partnership based upon the general partner’s breach of its duties to charitable organization as a limited partner.

In cases where the value of the interest supports pursuing a recovery, the charitable organization may have a duty to pursue a reasonable settlement to avoid providing impermissible benefits to private interests. Similarly, the more egregious the facts, the less willing the charitable organization should be to reduce the amount it will accept for its interest because the egregiousness of the facts may indicate a likelihood of success in litigation.


[1] Currently listed transactions can be found on the I.R.S. website at http://www.I.R.S..gov/businesses/corporations/article/0,,id=120633,00.html.

 

[2] See, http://www.I.R.S..gov/businesses/corporations/article/0,,id=120633,00.html.

[3] When used in this memorandum “donor” shall mean donor or a described donor related party.

[4] I.R.C. §4965(b)(1)(A).

[5] I.R.C. §4965(b)(1)(B).

[6] I.R.C. §4965(a)(2).

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