IRS Blocks LLC Charity Scheme in New Tax Ruling
In Field Service Advice Memorandum 0260401F, the Internal Revenue Service concluded that the transfer of non-voting interests in a limited liability company (LLC) to a tax-exempt Internal Revenue Code Section 501(c)(3) public charity would be disregarded for federal income tax purposes, disallowing an income tax charitable deduction and causing the transferor to be taxed on LLC income allocated to the charity because the transfer lacked economic substance, the assignment of income doctrine applied, there was no true donative intent and substantiation requirements weren’t met.
Facts
The taxpayers (Husband and Wife) funded the LLC in exchange for voting and non-voting interests. On the same day, the non-voting interests were donated to a donor-advised fund (DAF). The taxpayers transferred marketable securities to a brokerage account opened in their names as members of the LLC, and under the LLC terms, the taxpayers retained the rights to manage investment decisions and activities of the LLC; specifically, the DAF was subject to severely limited rights to transfer its LLC interest and had no mechanism to require a distribution to be made from the LLC without the LLC manager’s (Husband’s) consent. Husband, as manager of the LLC, allocated a percentage of the LLC’s income to the DAF and reflected this allocation on the LLC’s partnership tax return. The taxpayers claimed a charitable deduction for a donation of LLC units in the same year, as determined based on an appraisal. The following year, the taxpayers reported a distributive share of the LLC’s investment income, and the DAF reported a portion of such income (not subject to income tax). The taxpayers made three withdrawals from the LLC’s assets during the period in question, which they later characterized as loans.
Economic Substance Doctrine
The IRS held that the transfer of LLC interests to the DAF must be disregarded under the economic substance doctrine of IRC Section 7701(o), and all income and capital gains the LLC realized in Year 4, as well as capital accounts of the DAF, belong to the taxpayers.
Section 7701(o) clarifies that a transaction shall be treated as having economic substance if “(A) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.”
The strategy used here didn’t satisfy the first prong because the non-voting LLC interests transferred to the DAF had little to no value because the LLC’s manager (Husband) had discretion regarding distributions from the LLC, approval of a transfer of the LLC’s interests or dissolution of the LLC. The agreement called for mandatory yearly distributions, but this provision wasn’t followed. In addition, Husband, as Manager failed to follow other operating agreement provisions. Further, although the LLC operating agreement allowed secured loans to be made to “qualified borrowers” (in Husband’s consent as LLC manager), that term wasn’t defined in the LLC agreement, and there’s no evidence that the loans the taxpayers took from the LLC were secured by collateral. In short: (1) the taxpayers had unfettered access to the LLC assets (and ability to effectively invade the value of the LLC assets without recourse by the DAF) and, therefore, weren’t placed in a worse economic position by reason of contribution of the non-voting LLC units to the DAF (and conversely, the DAF wasn’t placed in a better economic position); and (2) the taxpayers’ primary purpose in creating the LLC was to shield their personal investments from income tax. Because no economic benefit was, in fact, transferred to charity, there’s little evidence supporting the taxpayers’ purported purpose of genuine charitable intent for entering into the transaction, which fails the second prong of the economic substance doctrine.
Because the purported transfer of LLC interests to DAF fails the economic substance doctrine, it’s disregarded for federal income tax purposes, and the taxpayers aren’t entitled to a charitable deduction for the transfer.
Bona Fide Partner
The IRS held that the DAF shouldn’t be treated as a bona fide partner of the LLC for income tax purposes. Under Culbertson v. Commissioner, 337 U.S. 733 (1949), a partnership interest will be respected for federal tax purposes if the parties, in good faith and acting with business purpose, intended to join together in the present conduct of the enterprise.
As noted above, the LLC assets were treated as though they were the taxpayers’ own assets because the taxpayers had unfettered access to them and failed to comply with the requirements of the LLC agreement (such as annual distributions). The DAF had no recourse for such violations and misappropriations, and no ability to transfer its LLC interest or require a distribution from the LLC. It follows from these facts that the DAF didn’t share in any upside or downside of the LLC. Further, in a genuine partnership arrangement entered into at “arms length,” a prospective partner such as the DAF would have required that numerous provisions of the operating agreement be clarified or changed. Here, the DAF made no such calls for these changes. Further, under Treasury Regulations Section 1.704-1(e)(2), if a donor has retained control of a partnership interest that they’ve purported to transfer to a donee, then the donor should be treated as remaining the substantial owner of the interest. Here, as noted above, Husband retained all control over DAF’s interest in the LLC, and DAF held no power to manage decisions regarding the LLC assets or to reap economic benefit from its interest due to its transfer restrictions and inability to require a distribution.
For these reasons, the DAF’s LLC interest should be disregarded, the DAF should be treated as never having acquired any interest in the LLC and any tax attributes (income, loss, deductions, capital accounts, credits) allocated to the DAF on the partnership tax return should instead be allocated to the taxpayers.
Assignment of Interest Doctrine
The income from the non-voting interests purportedly transferred to the DAF should be treated as taxable to the taxpayers, pursuant to the assignment of income doctrine. The “assignment of income” doctrine holds that income is taxed to the individual who earns it, regardless of any attempted assignment. Here, because the taxpayers never parted with dominion and control over income from the LLC’s assets, there was merely an attempted assignment of the income to the DAF through the LLC structure. As explained above, the LLC interests transferred to the DAF had no value. Because this structure merely created the illusion of a transfer of value to the DAF, the assignment of income doctrine applies, resulting in the income purportedly transferred to the DAF being assigned back to the taxpayers.
IRC Section 170 Substantiation Requirements
In Revenue Ruling 67-246, the IRS articulated a two-part test for a taxpayer to be entitled to an income tax charitable deduction under Section 170. First, the taxpayer must prove that its transfer to the charity exceeds the market value of the privileges or other benefits received. Second, the taxpayer must show that it transferred the excess with the intent to make a gift. Here, the taxpayers’ financial benefits from the arrangement exceeded any financial benefit the DAF received from the taxpayers, negating both parts of the test. Further, under Section 170(f)(8)(A), no charitable deduction will be allowed for any contribution of $250 or greater without a receipt submitted by the donee organization. Under Section 170(f)(11)(D), no deduction of more than $500,000 will be permitted under Section 170(a) unless the taxpayer attaches a qualified appraisal of the property to the applicable income tax return. Neither of these requirements was met, so a charitable deduction will be prohibited.