One of the “rules of thumb” for tax planning is that “smell counts” in any tax situation. If the result just “looks bad” there’s a good chance that the courts will simply not allow it to stand. This is doubly true with regard to §501(c)(3) charitable organizations that, while technically operated under principles that serve the public good, in reality always seem to benefit a very distinct, not so public, private group—like a single family.

That turned out to be the problem in the case of the Educational Assistance Foundation for the Descendants of Hungarian Immigrants in the Performing Arts, Inc., v. United States, 2015 TNT 128-15.

The organization was founded upon the death of Julius Schaller, funded with amounts from his estate for which a deduction was claimed that reduced both the estate and generation skipping transfer taxes to zero. This transfer was the sole and only source of funding for the organization.

The organization applied for and received from the IRS an initial determination that the foundation was a tax exempt organization under IRC §501(c)(3). The organization’s purpose was to provide financial assistance to college students who descend from an immigrant from the Hungarian area of Eastern Europe and are involved in the performing arts.

In December of 2004 the organization awarded scholarships to two individuals—individuals, who happened to be direct descendants of the same immigrant from the Hungarian area of Eastern Europe—Julius Schaller. In 2005 scholarships were again awarded to the same two individuals along with one new recipient—who, coincidentally, was also a direct descendant of Julius.

The IRS eventually audited the organization and decided to retroactive revoke the organization’s exemption finding that it was actually organized and operated for a private, and not a public, purpose. The purpose being the benefit of Julius Schaller’s Will. The IRS argued the revocation should be retroactive because the organization omitted and misstated material facts in its original application for exemption.

The organization went to court to challenge this position—but the organization did not find much sympathy there.

First, as the Court noted, IRC §501 requires an organization seeking §501(c)(3) status to be organized and operated exclusively for an exempt purpose and that its net earnings do not inure to the private benefit of any individual. The Court noted the following example found in the Treasury Regulations outlining this point [Reg. §1.501(c)(3)-1(d)(1)(iii)]:

(i) O is an educational organization the purpose of which is to study history and immigration. O's educational activities include sponsoring lectures and publishing a journal. The focus of O's historical studies is the genealogy of one family, tracing the descent of its present members. O actively solicits for membership only individuals who are members of that one family. O's research is directed toward publishing a history of that family that will document the pedigrees of family members. A major objective of O's research is to identify and locate living descendants of that family to enable those descendants to become acquainted with each other.

(ii) O's educational activities primarily serve the private interests of members of a single family rather than a public interest. Therefore, O is operated for the benefit of private interests in violation of the restriction on private benefit. . . . Based on these facts and circumstances, O is not operated exclusively for exempt purposes and, therefore, is not described in section 501(c)(3).

The Court this example “on point” for the situation in this case.

The organization conceded that all scholarships had gone to descendants of Julius but argued these individual met the requirements that the IRS had blessed in the original application, thus there should be no issue of private inurement. The Court didn’t buy this logic, noting that the organization must be both organized and operated exclusively for one or more exempt purposes.

Regardless of whether the purpose described in the request is charitable, that is merely meeting the organization prong of the test. In actual operation, the organization benefitted one family—thus failing the second prong of the test.

As to the question of whether the organization’s exemption should be retroactive, the Court also sided with the IRS.

First, the Court noted that its failure to operate in a manner to benefit the public differed materially from the representations made to the IRS in obtaining exempt status. This would justify a retroactive exemption on its own.

But the organization went beyond that, making a number of misrepresentations in its application. The organization claimed that it would announce the availability of the scholarships in at least two newspapers of general circulation and named USA Today and The Forward (a newspaper that has a large number of Hungarian readers) as examples of such publications and would publicize the scholarship via internet sources. However, in fact the organization never published a newspaper ad, and only went to the internet the day after the IRS began its audit of the organization.

The Court noted this was a material misstatement because the IRS specifically made inquiries to the organization in the application process about how it would advertise the availability of such aid.

The organization also did not follow the process it outlined for selecting recipients. While it claimed an independent board (with names given in the application) would make the selections, the selection process consisted of input from the family (who were the only parties attending the meetings). While one of the listed “board members” did review the applications, she did so only for integrity as to eligibility and expenses—and that board member is also a beneficiary of the Schaller Estate and was named a successor executor and trustee of the Estate. And, again, the IRS had specifically inquired about the selection process in the application process.

Thus, the Court found, the organization’s exempt status had been properly revoked retroactively.