Tax Court: Charity Avoids Transferee Liability For Taxes, Penalties, and Interest

March 8, 2012

Highlights

Summary

In Salus Mundi Foundation v. Commissioner, the Tax Court ruled that three private foundations were not liable as transferees for unpaid income taxes and accuracy-related penalties potentially owed by an S corporation. The S stock was transferred to a predecessor foundation, and then sold to a buyer, who offset built-in gains in the stock through a listed tax shelter transaction.

Extended Summary

All stock in the corporation had been held in a marital trust created at the death of a decedent some years earlier. The assets of the corporation were largely marketable securities with very low basis and high fair market value.

Shortly before the stock sale, at the widow's request, the marital trust transferred about one-third of the S corporation stock to a private foundation she and her late husband created some years previously. The foundation later transferred the proceeds of the stock sale and all other assets to three foundations controlled by the couple's children, as more fully described in PLR 200046041. The latter three foundations were the parties to the present proceeding.

The purchaser of the S corporation stock offset the built-in gains with paper losses in a transaction that was later listed in Notice 2000-44 as a tax shelter. The IRS sought to recharacterize the transaction as a sale of the S corporation's assets followed by a liquidating distribution to its shareholders. In addition, the IRS sought to hold the widow and the foundations liable as transferees of the S corporation's unpaid liabilities. An analogous "intermediary transaction" theory was later articulated in Notice 2001-16, and itself identified as a tax shelter transaction.

In 2010, the Tax Court ruled that the widow individually could not be held liable as a transferee, because the separate legal existence of the marital trust should not be disregarded, despite the fact it had, apparently mistakenly, filed income tax returns as a "grantor" trust for a number of years.

Similarly, in the present case, the Tax Court ruled that prior to the issuance of Notice 2001-16, the seller did not have a duty to inquire as to an unrelated purchaser's possible strategies for sheltering the built-in gains.

CPC Commentary

In this case, the closely held stock was transferred to the three foundations by a related foundation, and so the charities might well feel comfortable with receiving stock from another charity, that had just obtained a PLR!

Nevertheless, there are several lessons. First, any charity receiving a gift of closely held stock where there is a "buyer in the wings" should be aware of Notice 2001-16. The charity, as seller, may have a duty to inquire into the motives of other parties, especially if it is suspicious that the buyer could be involved in a listed tax shelter transaction.

Second, a charity should consider receiving noncash gifts only in the form of a newly-formed SMLLC. The IRS may always argue that the ultimate recipient of an asset is liable for unpaid taxes, penalties, and interest. If the noncash asset is first placed into a SMLLC by the donor, and then gifted to the charity, the charity's other assets are not at risk, even if the gifted assets may be at risk.

From a practical standpoint, one might suggest that the charity create the SMLLC, and that the donor transfer the asset to the SMLLC. However, the deductibility of the donor's contribution under Section 170 to a "see through" entity such as the SMLLC has still not been specifically sanctioned by the IRS. We consider the failure of the Service to issue a favorable ruling in this area to be unreasonable, and that the gift is clearly as deductible under Section 170 if given to a SMLLC as if given directly to the charity, but there is still no favorable ruling on the books. For more detail on this issue, see our earlier submission to the IRS.

Third, a charity should consider a gift agreement, whereby the donor insulates or protects the donee charity from any transferee liability, contractual obligations attached to the owner of the stock, environmental cleanup, and similar types of hidden liabilities. If the donor objects to such an agreement, the charity should be cautious - maybe the gift is not really a gift!