The Tax Court denied a taxpayer’s claim for a deduction for a contribution of stock to a charitable foundation that the foundation used to set up a family public charity account in which the taxpayer’s contribution was segregated for investment and future distribution at the taxpayer’s discretion.
In 1998, Setty Viralam, a doctor, transferred stocks to xélan Foundation (also known as the Economic Association of Health Professionals, Inc.), which the IRS recognized at the time of the transfer as a public charity. Xélan sent Viralam acknowledgment letters for the stock transfer stating that it had provided no goods or services for the “donation” of the stocks. Xélan sold the stocks in 1998 and maintained a segregated account for Viralam in its records, which reflected the stocks received, the proceeds from the sales of the stocks and their reinvestment, the dividends and interest generated by the assets in the account, and the disbursements from the account in subsequent years.
Promotional materials that xélan provided to Viralam represented that he would be able to direct the distribution of the funds in the account for purported charitable purposes, including as compensation for the performance of charitable services (good works) by Viralam or members of his family. Xélan also offered contributors a student loan program through which account funds could be distributed as loans for college and graduate school tuition and expenses.
On his 1998 federal income tax return, Viralam claimed a charitable contribution deduction equal to the fair market value of the stocks transferred to xélan. In 2001 and 2002, at Viralam’s request the foundation transferred a total of $70,299 from his account to the University of Pennsylvania to pay his son’s tuition and related expenses. The son executed loan documents that obligated him to repay the amounts transferred, plus interest, in cash or by providing designated amounts of charitable services. Between 1998 and 2005, Viralam paid xélan over $29,000 in management and administration fees.
After examining Viralam’s 1998 return, the IRS issued a notice of deficiency for 1998 disallowing the charitable contribution deduction Viralam claimed for his transfer of stock to xélan. Viralam challenged the IRS’s determination in Tax Court.
The Tax Court’s Decision
The Tax Court held that Viralam was not entitled to a deduction for his contribution of stock to xélan. It found that Viralam had not made a deductible charitable contribution because he did not surrender dominion and control over the property transferred to the foundation and because he did not properly substantiate the contribution.
The Tax Court found that Viralam retained dominion and control over the property transferred primarily for two reasons: He used funds from his account with the foundation to make student loans to his son, and he could have made distributions of account funds to compensate himself or members of his family for the performance of good works. Although Viralam did not take the distributions for the education expenses until years after 1998, the Tax Court noted that xélan brochures prominently stated that account holders could use distributions for student loans, and Viralam testified that he had contemplated using distributions for this purpose when he set up the fund. Therefore, the Tax Court found that at the time Viralam transferred the stocks to the foundation, he understood that account assets could be used for student loans, which according to the Tax Court supported the conclusion that Viralam did not cede dominion and control over the property transferred to xélan.
Considering the option to receive compensation for the performance of good works, the Tax Court found that while Viralam did not actually seek any such payments, the ability to do so was evidence that xélan intended—and Viralam understood—that when he made the transfers, he could retrieve the transferred property or its proceeds. The Tax Court pointed out that with respect to donor-advised funds, courts have treated similar options as evidence of retained dominion and control (New Dynamics Found., 70 Fed. Cl. 782 (2006)). The court further noted that the standards for determining what qualified as good works were expressed in very general terms. Thus, the Tax Court found that the option to receive compensation for good works further proved that Viralam retained dominion and control over the property he transferred to xélan.
Topping off the IRS’s arguments for disallowing Viralam’s claimed charitable deduction was its assertion that Viralam had not properly substantiated the contribution with a contemporaneous written acknowledgment of the contribution by the donee organization as required by Sec. 170(f)(8). In particular, the IRS claimed that Viralam had not provided an acknowledgment from xélan that contained a description and good-faith estimate of the value of any goods or services provided in return for his transfer of the stock to the foundation. Under Regs. Sec. 1.170A-13(f)(6), this includes goods and services provided in a year other than the year in which the taxpayer makes the contribution to the donee organization. The Tax Court, reiterating its earlier finding that Viralam expected at the time he transferred the stock to xélan that the foundation would make student loans to his children, concluded that Viralam made the transfer in exchange for goods or services. Because the acknowledgments from xélan that Viralam offered as substantiation of the transfer stated that no goods or services were provided, the Tax Court held that Viralam had failed to substantiate the contribution under Sec. 170(f)(8).
This case highlights the fact that a taxpayer cannot turn a nondeductible expense into a deductible expense simply by inserting a charitable organization into the mix. While this is obvious to CPAs, it is often not obvious to people who, regardless of their intelligence and education, are not knowledgeable about taxes. When it closed down xélan and related entities in 2004, the Department of Justice stated that approximately 4,000 doctors had bought xélan’s tax reduction schemes (Department of Justice press release (11/4/04)).
CPAs should monitor the financial activities of their clients to the extent possible to help them avoid being taken in by promoters of tax avoidance schemes like the one in this case.
Viralam, 136 T.C. No. 8 (2011)