How Could This Be Otherwise?

Published date01 September 2020
Date01 September 2020
September 2020 5
Bruce R. Hopkins’ Nonpr ofit Counsel DOI:10.10 02/n pc
majority (7-2) wrote: “When a school with a religious
mission entrusts a teacher with the responsibility of
educating and forming students in the faith, judicial
intervention into disputes between the school and
the teacher threatens the school’s independence in
a way that the First Amendment does not allow.”
The Court, on June 30, ruled (5-4) that states, once
having implemented a program providing financial
assistance (such as scholarships) for access to private
schools, cannot exclude religious schools from partic-
ipation in the program (Espinoza v. Montana Depart-
ment of Revenue). The state’s supreme court struck
down such a program, on the grounds it violates the
state’s constitution. The Supreme Court, however,
concluded the state court ruling violated the First
Amendment’s Free Exercise Clause. [10.1(a)(i)]
In an advice memorandum released on June 26, the
IRS’s Office of Chief Counsel concluded that a promo-
tion that uses an ostensible charitable remainder annuity
trust as the basis for the position that capital gain on the
sale of highly appreciated property is permanently elim-
inated fails to “produce the claimed tax results” (Chief
Couns. Adv. Mem. 2020-006). The scheme involves a
CRAT funded with interests in a closely held business
and farmland. The annuity amount is provided by means
of the purchase of annuities, including single-premium
immediate annuities.
The Office recommended that the validity of the
CRAT be challenged on the basis that there are disqual-
ifying terms in the trust instrument, with the tax law
results being that the claimed charitable deductions are
to be disallowed and the trust regarded as a taxable
entity, causing sales of the contributed property to be
taxable. The IRS’s lawyers also advanced an assign-
ment-of-income argument by which gain on the assets’
sales is taxed to the grantors.
Other arguments are posited, on the assumption that
the CRAT is qualified. One argument is that the CRAT dis-
tributed the annuity contract to the income beneficiaries
but in doing so violated the rule that no amount other
than the annuity amount may be paid to any person other
than the remainder interest charity (because the value of
the policy would far exceed the required annuity pay-
ment). The other argument is that the beneficiaries have
incorrectly reported by including only the ordinary income
on the annuity contract (IRC § 72) and not the current or
accumulated capital gain on the sale of the assets as part
of their distribution (IRC § 664(b)). [12.2]
Tax professionals are familiar with the law that a tax de-
duction is not allowed for an amount that is allocable to
tax-exempt income (IRC § 265(a)(1)). The rule applies where
a taxpayer incurred expenses for purposes for which tax-ex-
empt income was received; to permit the deduction would
be to permit a double tax benefit (e.g., Rev. Rul. 83-3).
The IRS’s Office of Chief Counsel was asked whether
this no-deduction law applies in connection with the char-
itable contribution deduction that is generally allowed in
computing unrelated business taxable income (IRC § 512(b)
(10)). This issue arose because, in most instances, all of a
tax-exempt organization’s income, other than unrelated
business income, is tax-exempt income. Quite sensibly (and
fortunately), the IRS’s lawyers ruled that the no-deduction
rule does not apply to this deduction because a charitable
contribution “is not allocable to tax-exempt income, but
instead arises from a donor’s charitable intent to volun-
tarily transfer money or property without receiving any
benefit in return” (Chief Couns. Adv. Mem. 202027003).
It was noted in this memorandum that courts have
looked to whether the expenses were “intended to
be covered” by tax-exempt income or whether the
expenses would not exist “but for” the exempt income
(e.g., Induni v. Commissioner (2d Cir. 1993)). It may
also be noted that the deduction statute states that the
deduction is allowed whether or not directly connected
with the carrying on of a trade or business. [25.7(b)]
The Office of the National Taxpayer Advocate, newly
headed by Erin M. Collins, issued its latest annual report to
Congress on June 29. The report charges, as does its prede-
cessors in recent years, that the Form 1023-EZ ap plication
process is enabling many entities to become recognized by
the IRS as exempt charitable organizations even though
they fail the organizational test. The report’s recommen-
dations in this regard include greater IRS scrutiny of or-
ganizing documents and review of applicants’ websites.
The IRS responded to this criticism, first by asserting “legal
inaccuracies” in the report. Indeed, the advocate’s report
opens with the startling observation that “[o]rganizations
recognized by the IRS as exempt under Internal Revenue
Code § 501(c)(3) may be exempt from federal tax.” Having
boldly staked out that position, the report states that the IRS
“confers” tax-exempt status, which, of course, it does not
do. The IRS correctly points out that the application’s request
for a statement of purpose complies with the tax regulations.

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