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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
Under §4958(c)(3),1 if a supporting organization described in §509(a)(3) makes a grant, loan, payment of compensation or other similar payment to a disqualified person, then, for purposes of the "intermediate sanctions" rules of §4958, the payment is treated automatically as an "excess benefit transaction." As a result, the disqualified person is subject to an initial (first tier) tax of 25% of the amount of the payment, and an organization manager that participates in the making of the payment, knowing that it was a prohibited payment to a substantial contributor, is subject to a tax of 10% of the amount of the payment (subject to a maximum of $20,000 per transaction).
The term "disqualified person" means, with respect to any transaction, any person who was, at any time during the five-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.2 Paragraph (C) provides that "disqualified persons" also include any 35%-controlled entity, including a partnership.
However, if it is established to the satisfaction of the Secretary that: (1) a taxable event (excess benefit transaction) was due to reasonable cause and not willful neglect, and (2) such event was corrected within the correction period3 for such event, then any qualified first tier tax imposed with respect to such event (including interest) shall not be assessed and, if assessed, the assessment shall be abated and, if collected, shall be credited or refunded as an overpayment.4
Applicable Treasury regulations5 provide that an organization manager's participation in a transaction is due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence. Thus, the absence of "willful neglect" does not necessarily establish the presence of "reasonable cause."
"Foundation" is an organization recognized as tax-exempt under §501(c)(3) and classified as a supporting organization under §509(a)(3). "Taxpayer" is a limited liability company in which "Disqualified Person" (DP), a former director of the Foundation, owned more than a 35% interest as of the date of the loan transaction described below. DP resigned from the Foundation's board of directors within five years of the date of the taxable event.
The Foundation held a note secured by a company's property and business assets that was in default and desired to sell it at a public foreclosure auction. DP, acting through Taxpayer, desired to purchase the note and sought a loan from the Foundation to finance the purchase.
On Date 1, Taxpayer purchased the note from the Foundation at a public foreclosure auction with funds lent to Taxpayer by the Foundation. On Date 2, Taxpayer sold the note to an unrelated third party. On Date 3, the Foundation's accountants informed the Foundation that the loan to purchase the note resulted in an automatic excess benefit transaction under §4958 because of Taxpayer's derivative status as a disqualified person.
On Date 4, Less than 30 days after discovering the excess benefit transaction (and well within the taxable period), Taxpayer returned to the Foundation both the principal balance and all interest accrued on the loan.
On Date 5, the Foundation filed Form 4720, Return of Certain Excise Taxes under Chapters 41 and 42 of the Internal Revenue Code, for the taxable year in issue, to report the first tier excise tax on taxable expenditures under Section 4958. At the same time, Taxpayer requested abatement of the first-tier tax on the basis that Taxpayer "reasonably relied" upon the legal advice of counsel.
On Date 6, approximately half a year after the discovery and reporting of the excess benefit transaction, legal counsel (Counsel) provided a letter describing oral advice given regarding the transaction on Date 1. Counsel stated that, shortly before Date 1, upon being asked about the proposed loan, he orally advised the Foundation that neither DP nor Taxpayer were disqualified persons with respect to the Foundation because DP was a former board member.
However, Counsel later stated that this advice was erroneous and explained that he had failed to consider the five-year look-back rule in §4958(f)(1)(A) for determining who is a disqualified person and the treatment of loans from a supporting organization under §4958(c)(3). Pursuant to this rule, DP was a disqualified person with respect to the Foundation because he was a Foundation director within a five-year period ending on the date of the transaction that gave rise to the excess benefit transaction. Taxpayer was also a disqualified person with respect to the Foundation because DP owned more than a 35% controlling interest in Taxpayer at the time the taxable event occurred. Therefore, the Foundation's loan to Taxpayer, a disqualified person, resulted in an automatic excess benefit transaction.
Exercising its discretion under §4962(a), the IRS determined in TAM 201503019, that the first tier excise tax should not be abated. The IRS noted that Taxpayer corrected the taxable event for the year at issue within the correction period. It also stated that Taxpayer's failure to comply was not willful; that the term "willful" implies the existence of a "voluntary, conscious, and intentional" failure to exercise the care that a reasonable person would observe under the circumstances. An act cannot be willful if – as in this case - the foundation, DP and Taxpayer did not know it was an act to which the foundation rules apply.
However, the IRS continued, "a mere finding of no willful neglect does not, in itself, justify abatement." Taxpayer must still establish reasonable cause, and ignorance of the law is not reasonable cause – defined as the exercise of "ordinary business care and prudence.6" The ruling states:Generally, reliance in good faith on the advice of counsel may establish reasonable cause and show not willful neglect where the taxpayer has obtained advice from a competent tax professional on the specific tax matter and the taxpayer has provided the advisor with all the necessary and relevant information to make a determination. … Furthermore, a taxpayer may reasonably rely on the advice of counsel even if the advice given is erroneous, such as in this case. … However, reliance on the advice of counsel alone does not establish reasonable cause; the attendant facts and circumstances must also support reliance.
In this case, Taxpayer failed to offer any evidence showing that its reliance on the advice of counsel was reasonable. First, Taxpayer provided no information about Counsel's expertise. Second, Taxpayer provided no evidence that it provided necessary and accurate information to Counsel. In his letter, Counsel states that he has represented the Foundation since its inception, but he failed to state whether he represented Taxpayer in this matter as well. Additionally, although Counsel's letter does not specifically state which party sought his advice; the wording of the letter implies that the Foundation sought the advice, noting that Counsel advised Foundation that it would be permissible for it to enter into the transaction. Accordingly, no evidence exists that Taxpayer actually sought the advice of counsel.
In short, Taxpayer's reliance in this instance was not reasonable.
The intermediate sanctions rules, like the private foundation rules, are complex, particularly as they apply – post PPA – to supporting organizations (and donor-advised funds). Certain transactions, including loans and even the payment of compensation are per se excess benefit transactions. Taxpayers would be well advised to avoid any financial involvement with a supporting organization in the absence of a written, well-reasoned (and factually supported) opinion of counsel.
For more information, in the Tax Management Portfolios, see Roady, 476 T.M., Intermediate Sanctions, and in Tax Practice Series, see ¶6510, Charitable Organizations.
3 Section 4963(e)(1) provides that term "correction period" means, with respect to any taxable event, the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under §6212 of a notice of deficiency with respect to the second tier tax imposed on such taxable event.
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