Wednesday, September 26, 2012

Federal Court Denies 501(c)(3) Tax-Exempt Status for "Family Trust" Because of Inurement and Commerciality

Search_sealEarlier this week the U.S. District Court for the District of Columbia denied exemption under section 501(c)(3) for an entity that serves as the trustee for a trust benefiting over 300 disabled and elderly individuals. The court's conclusion with respect to private inurement is not surprising given the apparent failure of the organization to provide comparability data to support the amount of compensation paid to its founder.  What is, however, somewhat troubling is the relatively thin factual findings the court makes with respect to its conclusion that the organization had a substantial non-exempt purpose under the commerciality doctrine, in part because two of the three factors relied upon the court - a reliance solely on fees and significant profits - are not uncommon among groups that routinely qualify for section 501(c)(3) status.

In Family Trust of Massachusetts, Inc. v. United States, the plaintiff organization had sought a declaratory judgment that it qualified for tax-exempt status under section 501(c)(3) after the IRS had not ruled on its exemption application within 270 days.  As detailed in the opinion, the trust overseen by the organization permits disabled recipients of Supplemental Security Income, Medicaid, and other government benefits to benefit from assets, held by the trust, that normally would be in excess of federally allowed limits.  The court found two fatal flaws with the activities of the Family Trust. 

First the individual who founded and controlled the organization had received escalating compensation (increasing to $70,000 annually in 2009) as the net revenue from the assets controlled by the trust grew (reaching $362,524 in 2009), and the Family Trust failed to provide evidence that the amount received was reasonable in light of the services provided.  More specifically, while the Family Trust asserted it had gathered comparable compensation data through informal contacts with similar organizations, it failed to provide any specific comparability data to the IRS as part of the application process. 

Second, the court concluded that the Family Trust ran afoul of the commerciality doctrine because (1) it had relied solely on the fees it imposed on its members for its revenues, as opposed to contributions or other sources of income, (2) it had a significant profit margin (that correlated with the founder's increasing salary), and (3) the founder's dual role with the Family Trust and his elder law legal practice suggested that the availability of the trust was effectively a commercial product that enhanced the attractiveness of his legal practice to potential clients (some of whom also took advantage of the trust). 


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