Charitable LLC Scam vs. Reality

The “Charitable LLC”

It’s no surprise that people hate paying taxes.  Sometimes they hate it so much, that they will do anything to avoid paying them, including things they shouldn’t.  One such strategy that we recommend you stay away from is the so-called “Charitable LLC”.

What is promoted as a “Charitable LLC” may be structured in a number of ways.  Often, it is an LLC wholly owned by one or more qualified tax exempt charitable entities.  Some promoters suggest having a partnership where the income is attributed to the tax exempt entity, but the donor retains part or all of the equity.  In all instances, the various Charitable LLC structures involve some mechanism to cause a tax exempt entity to realize all the income tax consequences, while the Donor enjoys the benefits of ownership.  Of course, the proverbial devil is in the details.

There are many legitimate uses for LLCs and other business entities owned by tax exempt entities.  There are also a number of inappropriate abuses.  It is crucial to know the difference.

The Charitable LLC Scam

Although it is cliché, if it sound’s too good to be true, beware.

Promotors claim that a Charitable LLC can offer a variety of extraordinary benefits.  Some of the advantages we found promoted on-line include:

• Give the Donor the same tax deductions as any other charitable gift
• Be controlled by the Donor who funds it
• Allow the Donor to make money without incurring an income tax liability
• Make low or no interest loans to such Donor and the Donor’s family that may or may not ever be repaid
• Pay the Donor and the Donor’s family as employees for operating the business
• Enter into business transactions with the Donor and the Donor’s family
• Engage in political activities and make contributions that are otherwise prohibited for tax exempt organizations
• The Charitable LLC will be, and the Donor will own or have, a tax exempt entity
• The Donor and the Charitable LLC will be able to avoid the various required disclosures and other rules that govern tax exempt entities

As is often the case, while some of these benefits have a hint of reality, many if not most of them are either illusory or flat out prohibited.  It doesn’t really work this way.  Believing such hype and acting on it can have significant adverse consequences.

A federal court recently shut down a nationwide abusive tax scheme involving so-called Charitable LLCs.

No non-profit organization what knows what they are doing will enter into a transaction or structure that purports to provides such benefits.

The Proper Use of a Charitable LLC

First, it is important and useful to recognize that a tax exempt entity may set up and operate subsidiary entities including LLCs.  Such entities may in fact be tax exempt IF they operate in keeping with and pursuant to the tax exempt activities of the organization.  Such subsidiary entities may also be taxable.  Such taxes can take a variety of forms, some of which are in a way punitive.

For example, a tax exempt organization may establish subsidiary entities to own real estate, operate a soup kitchen, animal shelter, medical clinic, orphanage, or school.  A Charity can use a subsidiary to otherwise carry out its tax exempt functions.  When properly structured and operated, the revenue from such a subsidiary may be tax exempt.  Such structures which aim to mitigate risk and facilitate qualified tax exempt operations and accounting are not only permitted, they can be highly beneficial.

Likewise, a tax exempt organization may own all or part of a tax paying business entity that conducts some form of business unrelated to the tax exempt operations of the charity.  How the taxes flow depends in part on how the structure is set up and how the entity is operated.  If such a structure is taxed as a partnership or flow through entity (typically an LP or LLC or S corp), the charity will realize Unrelated Business Income (“UBIT”) from the non-exempt business, and will pay taxes accordingly.  In situations where the subsidiary entity is itself taxable (such as a C Corp or LLC taxed as a C Corp), the subsidiary entity will file and pay its own taxes, and the tax exempt parent will typically get some form of dividend.  Such a dividend will generally not be taxed to the parent charity because it is tax exempt, and appropriately structured dividends are not UBIT.

Also, if done properly, a tax exempt organization can “invest” in private equity deals that result in the charity owning a fractional interest in an LLC that operates a business.  The charity will do this for investment purposes.  It is not a device for bestowing the tax exempt attributes of the charity onto the LLC.  Even so, the business activities of the underlying LLC can trigger taxes for the charity.  Even though Charities typically try to avoid UBIT, they may make an investment that triggers UBIT because the return net of taxes is worth it.

The Charitable LLC Reality

You don’t see charitable remainder trusts (“CRT”) owning stock in an S Corp because they are not qualified as an S Corp shareholder.  As soon as a charitable remainder trust is made a shareholder or owner of an S Corp, it is subject to a 100% penalty, which essentially means all of its income goes to taxes.  The CRT is a “permitted” shareholder which means it doesn’t terminate the S election.  However, the tax hit is so high no one would do this on purpose.

A 501(c)3 tax exempt entity other than a CRT may qualify as a shareholder in an entity taxed as an S corporation.  Like other flow through entities owned by a charity, in most instances this will trigger UBIT.  Such an entity or asset class must return enough on the investment to the charity to be worth the taxes it incurs.

You don’t see charities that know what they are doing structuring deals with Donors that give Donors control over the charity’s assets.  If the Donor retains control over a purported gift to charity, the gift is not real, and may be disregarded by the IRS.

You don’t see legitimate charities encouraging Donors to violate the law based on the supposed inability of the IRS to see what is going on because of a lack of mandatory reporting.  It is never a good idea to implement a planning idea you know is wrong in the hopes that you won’t get caught.  The best tax plans are those that can survive the deepest scrutiny without worry.  If the idea of the IRS examining the details of the structure gives you pause, there is probably a problem with the structure.

Even if the structure of a subsidiary entity is done perfectly right, inadvertent activity within the subsidiary can trigger unintended adverse tax consequences.  For example, with an appropriately structured subsidiary LLC taxed as a disregarded entity providing services that qualify as tax exempt – if this entity purchases debt financed rental real estate,  it triggers UBIT for the charity.  The structure alone is not enough.  How the entity is used makes a difference.  “User error” is a very real possibility to be aware of and avoided.

Rules of the Charitable Road

One rule of thumb to watch and pay attention to is that if the charity is an owner of an entity, it must realize economic benefit of such ownership.  It cannot simply take the tax liability and not receive the economic benefit of such income.  You can’t give the nasty-tax-part of an entity to charity and keep the sweet-do-what-you-want-with-the-money-part for yourself.  This is where most Charitable LLC structures fall down.  Generally speaking, the tax consequences will ultimately flow to whoever can do as they please with the money.  A Charitable LLC is not a clever work around out of this.

Charities can and should use subsidiary entities such as LLCs to manage their operations, segregate risk, and deliver on their charitable mission.  In doing so, the structure must serve and facilitate the tax exempt mission, not the private financial interests of Donors or other parties.  The tax benefit to the Donor is the charitable deduction.  To qualify for such a deduction, the charitable gift must be completed, which means the Charity, not the Donor, then enjoys the benefits of ownership.

In general, subsidiary entities are either taxable in and of themselves, or they inherit and must comply with the same rules and obligations of the tax exempt parent entity.  Such subsidiary entities can trigger UBIT, private inurement, excise taxes, and are typically subject to self dealing rules.  To obtain and maintain the tax exempt status of the parent entity, the subsidiary entity must be owned and operated in keeping with applicable rules.

We have seen tax payers penalized for using “Charitable LLCs” or similar structures.  We have also seen the charities involved in such schemes lose their tax exempt status.

We strongly recommend that you consult with qualified tax, accounting and legal advisors before jumping into anything that sounds too good to be true.

The tried and true options such as Charitable Remainder Trusts and Donor Advised Funds are so good, there is no reason to try and get more.