You’re neither a donor, officer, employee, director nor incorporator of a tax-exempt charity serving the public in your home town. Yet, if you’re not careful, you may find yourself serving five years in jail for your involvement with that charity. You may also find yourself in Tax Court contesting a 25% excise tax. How could this happen?
To prevent certain individuals from benefiting from their relationship with an Internal Revenue Code Section 501(c)(3) or 501(c)(4) organization, Congress enacted IRC Section 4958, which prohibits specified “disqualifying persons” to benefit from their relationship with a charity. The consequences of being a disqualified person receiving an excess benefit are severe. There’s a 25% tax on the amount of the excess benefit and a requirement of returning the excess benefit to the charity. The tax rises to 200% for failure to correct the excess benefit after notice from the Internal Revenue Service.
A Fall From Grace
Pennsylvania state Senator Vincent Fumo wielded considerable and feared power in his ability to “get things done” for his Philadelphia constituents during a 30-year career in the legislature of Pennsylvania. A rainmaking lawyer at a national law firm, banker and holder of an Ivy League MBA, Fumo also served as ranking member of the Senate Appropriations Committee. In 1991, members of his senatorial staff incorporated at his direction Citizens Alliance For Better Neighborhoods (Citizens Alliance), which was granted IRC Section 501(c)(3) status. Its purpose was very constituent-oriented, such as street cleaning, snow and trash removal. Another longtime staff member served as its executive director and was succeeded by another. Though never maintaining any formal affiliation with Citizens Alliance, Fumo directed millions of Pennsylvania’s taxpayers’ money for its support and received an 8-figure grant from a major utility company.
In February 2007, Fumo was indicted for 137 counts of mail and wire fraud, conspiracy, obstruction of justice and filing a false tax return. The counts centered on misuse of $1 million in state funds and $1 million from the charity for personal and campaign use. Having been found guilty of all 137 counts, he was ordered to pay restitution of nearly $1.2 million. The IRS also assessed excise taxes under Section 4958 due to excess benefits transactions with Citizens Alliance between 2002 through 2004, including payments for power tools, a bulldozer (including repairs to it), as well as cell phone expenses of his chauffeurs.
Fumo litigated the tax assessment in Tax Court. The IRS made two motions for partial summary judgment arguing that Fumo was a disqualified person and received excess benefits. The Tax Court ruled that Fumo was a disqualified person for purposes of the excess benefits excise tax rule through the exercise of his substantial influence over Citizens Alliance.1
Fumo’s counsel argued that the lack of an affiliation precluded disqualified person status because he didn’t qualify as a disqualified person described in Treasury Regulations Section 53.4958-3(c).2 The Tax Court relied on the “facts and circumstances test” under Treas. Regs. Section 53.4958-3(e) to conclude that he was a disqualified person. Fumo wasn’t able to show that he didn’t have substantial influence.3
The IRS was able to convince the court that Fumo had substantial influence under Treas. Regs. Section 53.4958-3 using Fumo’s criminal trial testimony. Fumo said of Citizens Alliance: “I created it. I helped it. I guided it. I gave it strategy …. I raised money for it. If it weren’t for me, it wouldn’t exist.”4 If that testimony weren’t convincing enough, Fumo admitted on cross-examination: “I did have substantial influence over the organization. So according to that [definition under the Code] I am a disqualified person.”5
Fumo’s testimony literally conceded he was in effect a founder, substantial contributor and a controller of how the organization spent funds within the meaning of Treas. Regs. Section 53.4958-3.
Planning Implications
The facts illustrate the need for having a foundation manager independent of the control of a disqualified person. The executive director, a longtime member of Fumo’s paid staff, wasn’t likely to challenge her boss. In family-managed private foundations, the need for independence is perhaps even more acute when family members are paid little or nothing.
The case should be an unnecessary reminder for politicians and civilians alike to be extremely careful of receiving any “perks or gifts” from a tax-exempt entity. While the magnitude of Fumo’s avarice may be an outlier, that doesn’t dilute the importance of having IRC-compliant procedures to avoid such impropriety.
Although the Tax Court didn’t grant the IRS’ motion for summary judgment on the issue of the amount of the excess benefits, that question of fact is reserved for a future trial.
Endnotes
1. Fumo v. Commissioner, T.C. Memo. 2021-61 (May 17, 2021).
2. Fumo argued that his lack of holding a position as officer, director or employee with Citizens Alliance precluded him for having substantial influence, and thus, he couldn’t be a disqualified person.
3. See Treasury Regulations Section 53.4958-3(e)(3). Fumo hadn’t taken “a vow of poverty.” Nor could he deny he was in effect a contributor and a participant in management decisions.
4. Fumo, supra note 1, at p. 6.
5. Ibid.,at p. 7.