MISSION CREEP COSTS A SECTION 501(c)(3) ORGANIZATION ITS EXEMPTION

SUMMARY: A change in function of a Section 501(c)(3) organization results in the IRS revoking its exemption.

To receive Section 501(c)(3) status, exempt organizations apply for exemption from the IRS. The exemption application provides details on what the organization intends to do, and the IRS confirms that it is an appropriate activity for a Section 501(c)(3) organization.

Many times, as organizations evolve they move into other areas and functions. Such organizations must monitor their functions and determine that the new functions are exempt functions under Code Section 501(c)(3).

In a recent Taxpayer Assistance Memorandum, an exempt organization and public charity was formed to operate a private school. Over time, its function drifted to the purchase or lease of school buildings that it then renovated, leased, and subleased to nonexempt charter schools. The IRS determined that such landlord functions were not an exempt purpose under Code Section 501(c)(3), and it revoked the exempt status of the organization.

The TAM is interesting for a number of reasons, including:

   1. It is a warning to exempt organizations that the IRS will not tolerate mission creep away from the original exempt purposes of the organization. Organizations undergoing a change in purpose and function should advise the IRS of these changes prospectively and confirm that such changes do not jeopardize exempt status.

   2. Leasing real estate is generally a nonexempt trade or business carried on for profit.

   3. At times, a business can be regarded as exempt if it is an integral part of the exempt activity of a related exempt entity. Counsel for Bibliographic and Information Technology, T.C. Memo. 1992-364. In the TAM, the lessees, while they were schools, were not exempt entities.

   4. Further, an organization may conduct a business in a charitable manner to promote the exempt purpose of an unrelated exempt organization. For example, the provision of leased space at rents well below market the levels can be exempt. Rev.Rul. 69-572. This was not helpful in the TAM because again, the lessees were not exempt organizations. Further, while the exempt organization did reduce the rents below market values, the reduction was not low enough since the exempt organization recovered its costs and also accumulated a surplus.

   5. That an organization conducts some exempt activities along with its non-exempt activities may not act to save the exemption. Here, the organization conducted an educational summer program. The TAM concluded that this constituted only a minor portion of its time and resources, and thus the activity could not be considered a substantial purpose or basis for exemption. The TAM cited the U.S. Supreme Court in Better Bus. Bureau of Washington, D.C. v. U.S., 326 U.S. 279,283 (1945) which provided "that the presence of a single non-educational [exempt] purpose, if substantial in nature, will destroy the exemption [under § 501(c)(3)] regardless of the number or importance of truly educational [or other exempt] purposes."

TAM 201438034

NO INFORMAL ABANDONMENT OF RESIDENCY ALLOWED

 

SUMMARY: The Tax Court rules against informal abandonment of resident status.

Individuals who are admitted to the US as lawful permanent residents ("green card" holders) are treated as U.S. residents for income tax purposes. Code section 7701(b)(1)(A)(i). As such they are subject to U.S. income taxes on their worldwide income. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned. Treas.Regs. section 301.7701(b)-1(b)(1).

In a recent Tax Court case, a green card holder argued that he ceased to be a U.S. resident for income tax purposes by informally abandoning his U.S. resident status by selling his Hawaii residence, moving away, and only visiting the U.S. infrequently thereafter. In support of such informal abandonment, the taxpayer cited United States v. Yakou, 428 F.3d 241 (D.C. Cir. 2005). In that case, a defendant who held a green card was able to successfully argue he was not a U.S. person under the Arms Export Control Act via having left the U.S.

The Tax Court found that Yakou did not apply. Principally, this was because the Arms Export Control Act and related law was silent on how lawful permanent resident status terminated for those purposes. Under Treasury Regulations, however, there is explicit guidance on how permanent resident status is terminated for tax purposes. Treas.Regs. section 301.7701(b)-1(b)(3) provides:

Administrative or judicial determination of abandonment of resident status. An administrative or judicial determination of abandonment of resident status may be initiated by the alien individual, the Immigration and Naturalization Service (INS), or a consular officer. If the alien initiates this determination, resident status is considered to be abandoned when the individual's application for abandonment (INS Form I-407) or a letter stating the alien's intent to abandon his or her resident status, with the Alien Registration Receipt Card (INS Form I-151 or Form I-551) enclosed, is filed with the INS or a consular officer. If INS replaces any of the form numbers referred to in this paragraph or §301.7701(b)-2(f), refer to the comparable INS replacement form number. For purposes of this paragraph, an alien individual shall be considered to have filed a letter stating the intent to abandon resident status with the INS or a consular office if such letter is sent by certified mail, return receipt requested (or a foreign country's equivalent thereof). A copy of the letter, along with proof that the letter was mailed and received, should be retained by the alien individual. If the INS or a consular officer initiates this determination, resident status will be considered to be abandoned upon the issuance of a final administrative order of abandonment. If an individual is granted an appeal to a federal court of competent jurisdiction, a final judicial order is required.

Since the taxpayer did not follow the above procedures, he will still be considered to be a U.S. resident regardless of any informal abandonment. The court noted that lawful permanent resident status for Federal income tax purposes turns on Federal income tax law and is only indirectly determined by immigration law. The court also was influenced by the House Ways and Means Committee report accompanying the enactment of section 7701(b)(1)(A)(i) and (6) which provided that “an alien who comes to the United States so infrequently that, on scrutiny, he or she is no longer legally entitled to permanent resident status, but who has not officially lost or abandoned that status, will be a resident for tax purposes.” H.R. Rept. No. 98-432 (Part 2), supra at 226, 1984 U.S.C.C.A.N. at 1166.

Thus, green card holders who desire to terminate their U.S. resident status for income tax purposes via abandonment should follow the procedures set out in the regulations and not rely on other mechanisms or arguments.

Gerd Topsnik v. Commissioner, 143 T.C. No. 12, 09/23/2014

APPLICABLE FEDERAL RATES–OCTOBER 2014

FREQUENT FLYER MILES–SOMETIMES TAXABLE, SOMETIMES NOT

A recent Tax Court case adds to the rules that now exist whether frequent flyer miles will be considered taxable income. Below is a summary.

1. The general rule under Announcement 2002-18 is that awarded miles, whether issued by an airline for purchasing tickets, or from other issuers (well, at least rental car companies and hotels) in exchange for purchases, is not presently taxable. The IRS reserves the right to change this rule in the future on a prospective basis.

2. That announcement indicates the awarded miles will be taxable if they are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes.

3. In Shankar and Trivedi v. Commissioner, the Tax Court ruled that the receipt of points issued by a bank that were redeemed to purchase an airline ticket were taxable. The points were a noncash award for opening a bank account, and the court characterized the points as being in the nature of interest on money. The court did not believe Announcement 2002-18 applied. A reasonable conclusion from this case is that if miles are issued in payment of compensation for the use of money, then they will be taxable as interest income.

Shankar and Trivedi v. Comm., 143 T.C. No. 5 (August 26, 2014)

INTEREST INCOME RISK ON UNPAID RELATED PARTY LOANS

SUMMARY: If interest is not timely paid on related party indebtedness, the payee may need to report original interest discount income.

------------------------------------------------------

How often do you see or implement interest-bearing related party loans (e.g., among family members or between related corporations or other entities)? Pretty often, I’m sure.

How often do you see these loans not kept current? Not a rare occurrence.

How often do you see interest income picked up on the income tax return of the holder relating to unpaid interest income? Maybe not so much.

Such holders are running a significant risk of omitting an item from income.

On what theory? Most of these taxpayers are cash basis, not accrual basis, so their method of accounting should not be giving rise to income. Section 7872 requires imputed interest income on many of these loans, but not if they have adequate stated interest (even if that interest is not paid timely) – so if there is an adequate stated interest rate on the loan, Section 7872 should not apply.

That leaves us with the original issue discount (OID) rules, and therein is the problem. The OID rules are not the easiest to work with for those that don’t have regular exposure to them. Nonetheless, let’s go through it on a simple conceptual level to see why many commentators conclude OID arises on these loans when interest is not paid currently.

The OID rules effectively put a debt obligation holder on the accrual basis for interest that accrues on the debt. Here are the steps:

1. OID exists if the “stated redemption price at maturity” (SPRM) on a debt obligation exceeds the issue price.

2. The issue price is pretty simple – effectively what was received in exchange for the debt obligation. In a plain vanilla loan, it will be the principal amount paid to the borrower.

3. The SPRM is the sum of all payments due to be made at any time under the obligation, OTHER THAN FIXED AND PERIODICAL INTEREST PAYABLE IN ANNUAL OR LESS INSTALLMENTS (I.E., QUALIFIED STATED INTEREST, OR “QSI”). Treas. Regs. §1.1273-1(b). Assume we have $100 loaned, and a promissory note that requires $100 of principal repayments over the term of the note, along with monthly interest payments at or above the required applicable federal rate. There is no OID here, because the SPRM is the same $100 as the $100 issue price – the interest payments do NOT go into the SPRM figure because they are fixed and periodical and payable in annual or less installments.

4. The possibility of late or nonpayment of interest does not in and of itself create OID, so long as the interest is “unconditionally payable.” Treas. Regs. §1.1273-1(c)(ii). Interest is unconditionally payable if (a) reasonable legal remedies exist to compel timely payment, or (b) the debt instrument contains terms that make the likelihood of late or nonpayment a remote contingency. (a) above generally means that the holder can accelerate the debt and commence enforced collection action upon default, and (b) generally means that the penalty for nonpayment is so high that the debtor will have a strong incentive to stay current. Since most debt instruments will allow for acceleration and collection action after default (after a reasonable grace period), most such debt instruments with regular interest payments will not trigger OID.

5. The problem is that in determining whether interest is unconditionally payable, the loan default provisions are not taken into account if the lending transaction does not reflect arm's length dealing and the holder does not intend to enforce the remedies or other terms and conditions. When the debt is between related parties, the question of arm’s length dealing probably always is a question, but that alone is not enough to find that the interest is not “unconditionally payable.” The second requirement of intent to enforce is a harder question to determine in advance. But once there is a default on an interest payment, if the holder does not impose the requisite harsh penalty or does not commence enforcement action, that would appear to be strong evidence of the holder’s intent not to enforce the remedies or other terms and conditions, at least at that time.

Thus it would appear that in related party loan situation, if the creditor defaults on an interest payment and the holder does not begin enforced collection action, that OID probably starts to accrue – either thereafter or possibly back to the commencement of the loan. Failure of the holder to report OID may subject the holder to penalties and interest on omitted income.

Perhaps the imposition of a significant monetary penalty on the payor for the late payment is enough to obviate the risk of OID under the provisions described under (b) under my discussion at 4. above without the need for the holder to commence enforced collection action. However, since there is still a question of intent to enforce, unless and until such penalty is actually collected it would appear the OID risk remains.

Note that the OID rules do not apply to all debt instruments, especially as to debt instruments issued in exchange for property – such instruments may be governed by other Code provisions such as Section 483.

HOMESTEAD STATUS WITHOUT CURRENT USE OR POSSESSION; INTERACTION OF HOMESTEAD SUCCESSOR RIGHTS WITH TERMS OF MARITAL SETTLEMENT AGREEMENT [FLORIDA]

Under Florida law, a decedent will be restricted in devising his or her homestead property at death. If those restrictions apply, surviving spouses and heirs received the interests they would receive under intestacy law. For this reason, among others, a determination is often needed whether residential property qualifies as “homestead” for these purposes.

In a recent Florida case, at the time of the decedent’s death his decedent’s former wife was living in the former marital home with the two children of the marriage pursuant to a provision in a marital settlement agreement awarding the former wife exclusive use and possession until the youngest child graduated from high school. After that, the residence would be sold and the proceeds split between the former husband and wife. The decedent held a tenants in common ownership interest in the residence with his former wife.

The decedent did not reside in, or otherwise have any use or possession of the residence at his death. The court nonetheless found it to be homestead property. How so?

It is a common misconception that a decedent must reside on the property for it to be his homestead. It is enough that the owners family resides on the property. Here, the decedent’s sons, whom he still supported financially, continued to live on the property.

Homestead status was relevant here since it resulted in the decedent’s new wife obtaining an interest in the homestead that she would not have otherwise received, pursuant to Florida intestacy provisions that apply to homestead property. Interestingly, even though the new wife received this interest (here, a life estate), she took that interest subject to the rights of use granted to the former spouse and required sale provisions under the marital settlement agreement. It was argued that the marital settlement agreement removed the property from homestead status – the court instead allowed the homestead status and the resulting dictated ownership at death, but left the successor owners subject to the limitations and terms of the marital settlement agreement as to the use and disposition of the homestead.

Estate of Friscia v. Friscia, 39 Fla. L. Weekly D1810a (August 27, 2014)

INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS (4th Quarter 2014)

The IRS has announced the interest rates that will be imposed on late taxes, and paid on tax refunds, for the 4th quarter of 2014.

TAX LEVY RECIPIENTS MUST ACT FAST - REALLY REALLY FAST, LIKE, SUPERMAN FAST

JPMorgan Chase Bank , N.A. receiving a notice of levy against the assets of one of its depositors. Two hours later, the taxpayer went to the bank and withdrew $40,000, before the bank froze the account (it actually took the bank 2 days to fully process the levy).

The IRS sought to hold the bank liable for the $40,000. The bank countered that it only had to act to freeze the account within a reasonable period of time – and two hours is not reasonable. The District Court found for the IRS.

The Court noted there are only two statutory defenses for the bank under Code Section 6332. The first is that the defendant “did not possess any property or rights to property of the taxpayer,” and second, that “the property was subject to a prior attachment or execution.” Neither applied here, so the bank had to raise equitable defenses such as reasonableness.

The Court could find no “reasonableness” exception under Code Section 6332. While there is one as to the imposition of an ADDITIONAL 50% penalty that the IRS could apply, the statute does not provide one for the base liability of the property holder.

There were other issues here, such as whether the IRS improperly tipped off the taxpayer of its intent to levy, to the prejudice of the bank, but they do not appear to have impacted the Court’s analysis of the bank’s statutory obligations.

So…failing to act within 2 hours was too long a wait for the bank. Under the reasoning of the opinion, a 1 minute delay in freezing the account may likewise have imposed liability on the bank, as ridiculous as that may be. This is very dangerous precedent for those that receive notices of levy – unless they act to protect the levied property instantaneously, they suffer risk of being guarantors of the tax liabilities of their customers.

U.S. v. JPMORGAN CHASE BANK, 114 AFTR 2d 2014-XXXX, (DC CA), 08/15/2014