New York Estate Planning & Elder Law Blog
Julius Schaller was a Hungarian-American immigrant was a wealthy grocery store owner who had acquired substantial assets that exceeded the threshold for paying estate taxes. In order to avoid the tax burden, he established a special scholarship foundation for Hungarian immigrants who pursue performing arts. He named it the Educational Assistance Foundation for Descendants of Hungarian Immigrants in the Performing Arts. Estate planning attorneys often create such organizations for wealthy individuals. However, it must be a legitimate nonprofit organization.
The foundation was established as a nonprofit organization and granted tax-exempt status under Section 501(c)(3) of the Internal Revenue Code. But there was a catch. The foundation was a rouse. It hardly advertised the scholarship, and during the first two years of operation, the scholarships were only awarded to his heirs – specifically a nephew, niece, and another member of the family. This is a problem.
The IRS does not take kindly to those who set up fake organizations under the guise of providing a legitimate scholarship or philanthropic service to the public. As such, the IRS revoked the foundation’s nonprofit status, and litigation ensued.
Why did Schaller set up the Foundation?
Back when Schaller set up the foundation, an estate could only have up to $1 million before the estate tax kicked in. In his case, he had about $2.5 million in excess of the $1 million limit. So, he placed $2,595,847 in his foundation, thereby entirely avoiding a single dollar in estate taxes. Today, a person may exempt up to $5.4 million from estate taxes. This makes it far less appealing for many Americans to try schemes this today.
What made the scholarship illegitimate?
There were two basic reasons why a federal court held that the foundation was not eligible for tax exemption. First, it was “organized and operated exclusively for the benefit of Julius Schaller’s will.” See the full-text of the decision here. Second, the organization misstated key facts in its application for tax-exempt status.
The law is clear that to qualify for tax-exempt status, it must be organized for the exclusive purpose of benefiting a “public interest” rather than a “private interest.” This means you cannot establish a tax-exempt organization that benefits only your own family members. In fact, the federal court went a step further and said that none of the nonprofit organization’s funds could be paid to family and heirs of the person who created the nonprofit organization.
Additionally, Schaller’s application for 501(c)(3) status included a statement that there would be a 3-person committee made up of education professionals who would decide who received scholarships. In truth, during the first two years of operation, no such committee was formed, and only two people were involved in the decisions. Thus, the IRS viewed this as a “material misrepresentation” of the operation of the foundation. The federal court agreed, thereby retroactively revoking Schaller’s foundation and assessing hefty taxes on his estate.
This should serve as an enduring lesson that including philanthropic bequests in an estate plan can be an excellent way to reduce tax consequences; however, it must be legitimate and solely for the benefit of the public, not family and heirs.