Wednesday, September 15, 2010

IRS Denies Exemption and Supporting Organization Status to DP-Controlled Entity

Tax Notes Today reports that the Internal Revenue Service has determined that an entity making numerous loans to disqualified persons and entities connected with disqualified persons failed to qualify as a tax-exempt charitable supporting organization.  The organization, ostensibly formed to support a public charity, was governed by a board, the initial members of which consisted of five trustees.  Two of the five trustees were identified as founders of the entity (and, presumably, were substantial contributors).  Two other trustees were unrelated to the founders and appointed by the supported organization.  A fifth trustee, who was a business partner of one of the founders, was appointed by joint action of the other four trustees.   The entity made numerous under-collateralized loans to corporations, the financial interests in which were held by one or more of one of the founder-trustees, his business partner-trustee and other business partners of these persons.  Additionally, the entity extended one unsecured loan to a founder-trustee.

The IRS first determined that the entity was formed to operate for the benefit of disqualified persons and related entities on account of the numerous loan transactions not engaged in at arm’s length.  Accordingly, the entity’s “primary purpose results in private benefit and inurement,” and it therefore served “a private rather than public purpose.”

The IRS also determined that the entity failed to qualify as a supporting organization on several grounds.  Most interestingly, the letter concludes that the entity was indirectly controlled by disqualified persons, thereby disqualifying it from supporting organization status.  The letter reasons as follows:

While you were not directly controlled by [the founders] at the time you were formed, you were indirectly controlled by [them] since [one of the founders] had substantial influence over [the fifth trustee] through their business relationship. Accordingly, [the founders] indirectly controlled you.

In addition, the loans evidenced control by disqualified persons, especially co-founder “M”:

From your creation … to the present you have been effectively "controlled" by M by virtue of the loans you have made to his business interests or to his wife, N, also a disqualified person. We deem the loans to his business interests as direct evidence of M's control of you within the meaning of section 1.509(a)-4(j) of the regulations. Any exempt charity operating at arm's length is not going to make 22 loans to businesses or investments in which the creator and donor has a substantial interest or to such persons' wife, unless they are controlled by the donor/creator. Due to the large number of loans, the lack of meaningful collateral, the period for which the loans were outstanding, and the disruption or interruption such loans caused to the carrying out of your charitable purpose all constitute convincing evidence of M's control of you.

For the full determination letter, see 2010 TNT 176-29.

JRB

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