Real clunker: how not to take car donations. (Taxing Issues).

Details of the Internal Revenue Service's (IRS) approval of a car donation program operated on behalf of a charity were covered in this column a few months back. The IRS issued a private letter ruling approving a program after several years of dire warnings about them.

A recent technical advice memorandum now gives some insights about what concerned the IRS.

In TAM 200243057, dated July 2, 2002 and made public in late October, the IRS analyzed a car donation program run by a Section 501(c)(3) charity set up for the primary purpose of running the program. A technical advice, memorandum is a communication between the IRS National Office and a field agent on issues arising in an examination. IRS policy required agents to request technical advice in all intermediate sanctions cases. The memorandum deals with the potential imposition of intermediate sanctions penalties under Code Section 4958 on the founder of the charity.

Facts of the case

B, a used car salesman, created the charity in question in July, 1998. Donors of vehicles could designate another charity as the. ultimate beneficiary of the sales proceeds from the car. They could also let the charity choose the ultimate recipient by having the donation go to the charity's general fund.

B's son, D, operated a used car lot. The charity used the lot as the base of its operations. It also used another site for some auctions. The charity's original directors were B, B's wife, B's father-in-law and a CPA. B ran all of the charity's activities.

The CPA resigned in November 1998 after expressing concerns about the charity's methods of operation. In early 2000, B and his family resigned and new directors were appointed. Most of the new directors had previously worked for the charity.

The IRS examination of the charity revealed that many donors were advised to claim excessive contribution deductions. B provided them with retail Kelley Blue Book values and the relevant tax forms, even though some of the vehicles could not be driven and were sold for scrap.

There were numerous transactions between the charity and B and B's family. There were alleged loans from B to the charity for start-up costs. Documentary evidence, including Form 990, was inconclusive on these loans. For example, the balance sheet showed loans from officers, but the response to the question on Schedule A of Form 990, asking for details of such loans, indicated that there were none. In 1998, funds were transferred from the charity to B in alleged repayment of these loans.

The charity arranged towing of the donated vehicles. It contracted with a company owned by D, B's son. This company had not done towing previously. No competitive bids were solicited by the charity. The evidence showed the fees charged by D's company were excessive, as the new trustees subsequently contracted with several companies for substantially less. In some cases, D's company charged for two-tows, one to one lot used by the charity and a subsequent tow to the other lot.

The charity arranged and paid for a leased vehicle for B to use personally. B's wife, daughter and son drove donated vehicles. The charity paid for the maintenance of these vehicles. None of the users accounted for the use of these vehicles.

The charity paid rent on the used car lot. The lot was also used by other entities owned by B and his family, none of which reimbursed the charity for part of the rent.

B had drawn a salary from the charity in 1999. When he resigned in 2000, the new board agreed to pay him for back pay and severance. None of these board members were independent of C. The charity also paid for insurance on behalf of B's family after B had terminated his formal relationship. Finally, the charity paid the towing company owned by B's son for the purchase of various equipment purportedly used in the operation. No appraisal was obtained to support this transaction.

IRS analysis

This memorandum represents one of the first indications of the use by the IRS of the sanctions created by Congress in 1996. There have been a few court cases that involved substantial amounts, but this is the first time a TAM has been made public. The memorandum reviews the statutory provision of Section 4958 and the regulations that were finalized early this year.

The first conclusion is that B was a disqualified person with respect to the charity during the years in question. As B was the founder, president and a director, the conclusion that he was a disqualified person is not surprising. The memorandum also determines that B was an organization manager, as he served on the board of directors.

These conclusions then allow the memorandum to treat many of the transactions listed above as excess benefit transactions, subject to tax under Code Section 4958.

The charity paid B a salary during 1999. However, there was no evidence as to how many hours B worked nor of the services he provided. The board never formally approved the salary, and there was no comparative data used to determine the compensation.

According to the IRS, B aided and abetted donors in overstating their contribution deductions by providing excessive valuations. Therefore, the IRS concluded that all of B's compensation was an excess benefit, unless the charity provides documentary evidence of time spent by B in legitimate charitable activities.

The value of the use of the vehicles by B, his wife, daughter and son were also excess benefits to B as there was no accounting for their use. The value was never reported as compensation to anyone on W-2 or 1099 forms or on the charity's Form 990. Further, the payments under the severance agreements were also considered excess benefits to B.

The loan repayments also were considered excess benefit transactions. There was no credible evidence that the loans were made or what their terms were. Money was apparently transferred back and forth between the charity and other entities when needed, without regard to formalities. The memorandum allows the parties to provide "credible, probative evidence" of the loans and their terms to the examining agent in order to reduce the penalties.

The excessive payments to the towing company owned by B's- son were also deemed excess benefit transactions. Both payments for towing and the purchase of equipment appeared excessive. The payments in excess of fair market value were excess benefit transactions to D and the towing company. The memorandum also considers them excess benefits to B as he authorized them and they were made to the "natural object- of his bounty." The parties share joint and several liability for these penalties.

The payment for rent on the property used by related companies and the insurance payments were also deemed excess benefits to B. The charity received no benefit from paying rent on space it did not use or need.

In summary, there were 10 categories of transactions that were deemed excess benefits to B. The memorandum also suggests the imposition of organization manager penalties against B under Section 4958, thus subjecting him to double penalties for the same transactions. While the specific amounts are not disclosed in the public copy of the memorandum, other commentaries have indicated that the total potential penalties amount to more than $1 million.

In addition to the intermediate sanction penalties, the memorandum also recommends -the imposition of penalties on B for aiding and abetting an understatement of tax liability, due to the excessive valuations. It also recommends an additional penalty under Code Section 6684 for willful and flagrant violations of the excise tax rules under Section 4958 and other sections.

Summary

The technical advice memorandum has little to do with the operation of a car donation program, other than making it clear that you should conduct these programs and all other activities at arm's length. It does, however, point out that the IRS is serious about intermediate sanctions for excess benefit transactions.

The issuance of the memorandum so soon after the ruling approving the car donation program provides a powerful contrast in how charities should operate. If your organization does not have a working conflict of interest policy, it should adopt and follow one as soon as possible. If your board is not independent of management, you should also consider the wisdom of that situation.

In general, if you operate in a business-like fashion, dealing at arm's length with all parties, you should have little fear that the IRS will challenge your operations.

Harvey Berger is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: [e-mail].