Charity Fraud in the News – Michael Meyer and the Family Office Foundation

Last Saturday, Forbes reported on the indictment of Michael Meyer for the promotion of his allegedly fraudulent charitable-donation tax shelter, the Ultimate Tax Plan. Meyer and his associates and the charities he created have been the subject of federal law enforcement interest for more than a decade, and the indictment recounts numerous acts of fraud and deception. Additional information can be found in the Tax Court petition filed in July by the Family Office Foundation, a charitable entity created by Meyer, to contest its denial of tax-exempt status. The appendix includes the adverse determination letter from the IRS, which provides a detailed description of the Ultimate Tax Plan and how it was supposed to work.

The acts described in the indictment are clearly fraudulent. As the Forbes article points out, many of the transactions involved backdating transaction documents to a previous year, and “[a]nything that involves backdating is bad.” Backdated transactions reflect clear deception, and “[j]uries can … easily understand that one cannot take a deduction for 2016 for something that didn’t happen until 2017.” Furthermore, “if a tax strategy has a name, then it probably doesn’t work.”

However, the strategy includes at least one component that the IRS appears to view as impermissible that I would love to learn more about, partially because it is facilitated by donor-advised funds. The Ultimate Tax Plan involves the following structure. First, a donor-advised fund sponsoring organization (let’s call it “Charity”) is created. Second, each client creates an LLC with controlling interests and noncontrolling interests. The client retains the controlling interest and donates the noncontrolling interest to the Charity. The client then takes a charitable tax deduction for fair market value of the noncontrolling LLC interest. In the actual Ultimate Tax Plan, this transaction (allegedly) includes all sorts of shenanigans like the aforementioned backdating, transactions that appear on paper but were never executed, dramatic mis-valuations of the donated noncontrolling LLC interest, an explicit promise that the Charity would sell back the LLC interest to the “donor” at a fraction of the value taken as a tax deduction, and many others. But more interesting to me than all the shenanigans is the fact that the IRS appears to take the position in the adverse determination letter that the donation of noncontrolling LLC interests to the Charity inherently fails to qualify as a charitable contribution because “the Bogus Charities never had dominion or control over any of the purported contributions.” By permitting the donor to transfer a noncontrolling interest in the LLC that the donor continues to control, “the donor can take a tax deduction for a ‘charitable contribution’ while maintaining the economic benefit and control of the donated asset.”

Again, the (alleged) shenanigans clearly make Meyer’s scheme fraudulent and cause the Family Office Foundation to fail to qualify as a tax-exempt organization. But I’m not sure the IRS is on such firm legal grounds if it wants to argue that a donation of a noncontrolling interest in an LLC that continues to be controlled by the donor automatically fails as a charitable contribution because the charity never obtains dominion and control. (I’m sure some readers know this law better than me, and would love help if I’m just wrong about this). Obviously, any time a charity receives a donation of corporate stock, it does not thereby receive the right to obtain any distribution from the stock or demand that the company repurchase it. Generally, at least for publicly-traded stock, that’s not a problem for the charity because it can sell the stock and use the proceeds to pursue its charitable activities (or not, at its discretion). My understanding is that the general principle is true for donations of illiquid property as well: the fact that there is not a ready market for a donated asset may affect the valuation of that asset (a so-called liquidity or marketability discount), but it does not render the donation void. A charity that receives a donation of an illiquid asset, like a noncontrolling interest in a closely held firm, is considered to have sufficient dominion and control over the asset to treat the transaction as a completed donation. The fact that the charity doesn’t have the power to compel the firm to make distributions or convert the ownership interest into cash does not negate the fact of the donation. The fact that the charity has expressly agreed to sell the property back to the donor at a fraction of its reported value of course would negate the substance of the transaction, but not the mere fact that it is a noncontrolling interest in a firm that the donor continues to control.

It is true that there is a poorly defined body of law that holds that a charity has to undertake at least some actual charitable activities in order to qualify for exemption, and so the charity has to actually receive some cash from somewhere that it can spend on pursuing its charitable activities. The IRS determination letter calls this the “substantial present economic benefit test.” But for the purposes of our hypothetical, let’s assume that the Charity manages to get its hands on enough cash to satisfy the substantial present economic benefits test.

The reason I’m interested in this structure, if it could be pursued without all the shenanigans that make it obviously illegal, is because it appears to be substantially facilitated by the current legal treatment of Donor Advised Funds. If the Charity had to be a Private Foundation because it was receiving donations from a single person or family, current law would prevent it from continuing to own a substantial interest in the donated LLC, taking a deduction for the fair-market value (rather than basis) of the donated LLC interest, and from spending less than 5% of its assets every year, etc. In other words, the Family Office Foundation case might be an example of a structure that (if dramatically cleaned up) still illustrates an abusive but currently legal use of Donor Advised Funds.  The big commercial DAF sponsoring organizations, like those created by Fidelity and Vanguard, would never permit such an abusive use even if legal. I think the IRS and Congress should focus on relatively low-hanging fruit of closing these DAF loopholes rather than getting tied up deciding whether to make dramatic changes to the DAF laws.

-Benjamin M. Leff