Scholarship trust loses exemption for trustee withdrawals

Plain-English summary

A private-foundation trust made college scholarships but its sole trustee also regularly withdrew substantial trust funds for personal purposes. The trustee recorded the withdrawals as a note receivable, yet there were no signed loan documents, negotiated interest rate, or repayment schedule, and none of the money had been repaid. The personal withdrawals substantially exceeded the trust’s scholarship distributions and left it unable to continue its exempt activity. The IRS concluded that the trust’s funds inured to the trustee’s private benefit and revoked its Section 501(c)(3) exemption.

Ruling snapshot

• Question: Did substantial, undocumented withdrawals by the trustee cause private inurement and failure of the Section 501(c)(3) operational test?
• Outcome: Revocation effective July 1, 20XX.
• Key authorities: IRC § 501(c)(3); Treas. Reg. §§ 1.501(c)(3)-1(c), 1.501(c)(3)-1(d)

Full text (IRS public release)

DEPARTMENT OF THE TREASURY

Internal Revenue Service

TE/GE EO Examinations
1100 Commerce Street M/C 4920 DAL
Dallas, TX 75242
TAX EXEMPT AND
GOVERNMENT ENTITIES Date: MAR 19 2018
DIVISION

Person to Contact:
Number: 201829013 Identification Number:

Release Date: 7/20/2018 Telephone Number:
In Reply Refer to:

LAST DATE FOR FILING A PETITION
UIL: 501.03-00 WITH THE TAX COURT:

CERTIFIED MAIL - Return Receipt Requested

Dear

This is a Final Adverse Determination Letter that your exempt status under section 501(c)(3)
of the Internal Revenue Code (IRC) is revoked. Recognition of your exemption under IRC
section 501(c)(3) is revoked effective July 1, 20XX.

Our adverse determination was made for the following reason(s):

You have not demonstrated that you operated exclusively for an exempt
purpose as described in section 501(c)(3).

Treasury Regulation section 1.501(c)(3)-1(d)(1)(ii) provides that an
organization is not operated exclusively for exempt purposes unless it serves a
public rather than a private interest. We hereby determined that you operated
for the benefit of private interests of a private individual by regularly
providing substantial sums to a trustee without appropriate justification.

Contributions to your organization are not deductible under section 170 of the Internal
Revenue Code.

You are required to file Federal income tax returns on Form 1120. These returns should be
filed with the appropriate Service Center for the year ending June 30, 20XX, and for all years
thereafter.

Processing of income tax returns and assessment of any taxes due will not be delayed should
a petition for declaratory judgment be filed under section 7428 of the Internal Revenue
Code.

As you were a private foundation as of the effective date of the revocation, you are a taxable
private foundation until you terminate your private foundation status under section 507 of
the Internal Revenue Code. In addition to your income tax return, you must also continue
to file Form 990-PF by the 15th day of the fifth month after the end of your annual
accounting period.

If you decide to contest this determination in court, you must initiate a suit for declaratory
judgment in the United States Tax Court, the United States Claim Court or the District
Court of the United States for the District of Columbia before the 91st day after the date this
determination was mailed to you. Contact the clerk of the appropriate court for the rules for
initiating suits for declaratory judgment.

The Taxpayer Advocate Service (TAS) is an independent organization within the IRS that
can help protect your taxpayer rights. We can offer you help if your tax problem is causing a
hardship, or you’ve tried but haven’t been able to resolve your problem with the IRS. If you
qualify for our assistance, which is always free, we will do everything possible to help you.
Visit taxpayeradvocate.irs.gov or call 1-877-777-4778.

We will notify the appropriate State Officials of this action, as required by section 6104(c) of
the Internal Revenue Code.

If you have any questions, please contact the person whose name and telephone number are

shown in the heading of this letter.
Sincerely yours,

Maria Hooke
Director, Exempt Organizations Examinations

Enclosure:
Publication 892

Date:
September 7, 2017

Internal Revenue Service Taxpayer Identification Number:

IRS Tax Exempt and Government Entities
Exempt Organizations Examinations

Department of the Treasury

Form:

Tax Year(s) Ended:

Person to Contact / ID Number:

Employee ID:
Contact Telephone Number:

Contact Fax Number:
Manager’s Name / ID Number:

Employee ID:
Manager’s Contact Number:

Response Due Date:

Certified Mail — Return Receipt Requested
Dear

We've proposed adjustments to the amount of tax you owe for the tax year or years listed
above. The enclosed report of examination explains the proposed adjustments as well as any
required correction.

If you agree, you should:

1. Sign and date the enclosed Form 870-E, Waiver of Restrictions on Assessment and
   Collection of Deficiency and Acceptance of Overassessment, and return it to the contact
   person at the address listed above within 30 calendar days from the date of this letter.

2. Provide proof that you’ve made any required corrections.

3. Enclose payment of the tax, interest, and penalties. If you owe additional tax, it’s to your
   advantage to pay the full amount. Please make your check or money order payable to
   the United States Treasury. The enclosed Publication 3498, The Examination Process,
   provides additional payment information.

If you can’t pay the full amount, please call the contact person at the telephone number shown
in the heading of this letter to discuss different methods of paying, such as in installments. If
you don’t enclose payment, we'll bill you for any unpaid amounts. Publication 594, The IRS
Collection Process, is enclosed.

Letter 3614 (Rev. 6-2012)
Catalog Number 34805N

If you don’t agree, you may request a meeting or telephone conference with the supervisor of
the IRS contact identified in the heading of this letter. You also may file a protest with the IRS
Appeals office by submitting a written request to the contact person at the address listed above
within 30 calendar days from the date of this letter. The Appeals office is independent of the
Exempt Organizations division and resolves most disputes informally.

For your protest to be valid, it must contain certain specific information, including a statement of
the facts, the applicable law and arguments in support of your position. For specific information
needed for a valid protest, please refer to page six of the enclosed Publication 3498. It also
includes information on your rights as a taxpayer and the IRS collection process. Please note
that Fast Track Mediation referred to in Publication 3498 generally doesn’t apply after we issue
this letter.

If you believe your disputed issue hasn’t been addressed in published precedent or has been
treated inconsistently by the IRS, you may request technical advice. If you’d like to know more
about this process, please contact the individual identified on the first page of this letter. If you
disagree with the technical advice decision, you may appeal that decision to the Appeals office,
as explained above.

If we don’t hear from you within 30 calendar days from the date of this letter, we'll issue a
Statutory Notice of Deficiency based on the adjustments shown in the report of examination.

You have the right to contact the office of the Taxpayer Advocate. Their assistance isn't a
substitute for established IRS procedures, such as the formal appeals process. The Taxpayer
Advocate can't reverse a legally correct tax determination, or extend the time fixed by law to file
a petition in a United States court. They can, however, see that a tax matter that may not have
been resolved through normal channels gets prompt and proper handling. You may call toll-free
1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your
local Taxpayer Advocate at:

Internal Revenue Service
Office of the Taxpayer Advocate

If you have any questions, please call the contact person at the telephone number shown in the
heading of this letter. If you write, please provide a telephone number and the most convenient
time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

for Maria Hooke
Director, EO Examinations

2 Letter 3614 (Rev. 6-2012)
Catalog Number 34805N

Enclosures:

Report of Examination — Form 4621

Form 886-A, Explanation of Items

Form 4883, Exempt Organizations Excise Tax Audit Changes

Form 870-E, Waiver of Restrictions on Assessment and Collection of Deficiency
Publication 3498

Publication 594

3 Letter 3614 (Rev. 6-2012)
Catalog Number 34805N

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX
Issues

1. Do funds from the inure to and serve the private interests of Trustee, , in
   violation of the exemption requirements under Section 501(c)(3) of the Internal Revenue Code
   (Code)?
2. Does the fail to meet the operational test under Section 501(c)(3) of the Code?
3. If the fails to meet the operational test and pays funds over to private interests, should

the exemption under Section 501(c)(3) of the Code be revoked?

Facts

(Trust) formed with a Declaration of Trust signed on June 26, 19XX. The Trust received a
determination letter on March 11, 19XX granting exemption from federal tax under Section 501 (a) of the
Code as an organization described in Section 501(c)(3) of the Code and further classified as a private
foundation.

Trust was formed to accept and hold property and distribute the income and/or principal to or for the use of
charitable organizations and/or for charitable purposes within the meaning of Section 501(c)(3) of the Code.
Trust also allows the income and/or principal be distributed to states, territories, or possessions of the United
States, any political subdivision of any of the foregoing, or to the United States or the but only
for charitable purposes. Trust also states no part of the net earnings shall inure or be payable to or for the
benefit of any private shareholder or individual.

The Declaration of Trust states the trust shall continue forever unless the trustees terminate it and distribute
all of the principal and income, which action may be taken by the trustees in their discretion at any time. On
such termination, the trust fund as then constituted shall be distributed to or for the use of such charitable
organizations, in such amounts and for such charitable purposes as the trustees shall then select and
determine.

Within Article Fifth of the Declaration of Trust, the number of trustees shall be at all times not less than two.
Whenever for any reason the number is reduced to one, one or more additional trustees shall be appointed
by the trustee or trustees by written instruments signed and acknowledged. The trustee or trustees, whether
original or successor, shall have full authority to act even though one or more vacancies may exist.

Article Fifth continues in stating the trustees are authorized to pay to themselves amounts for reasonable
expenses incurred and reasonable compensation for services rendered in the administration of the trust. In
no event, however, shall any trustee who has contributed to the trust ever receive any compensation
thereafter.

Catalog Number 20810W Page 1 www.irs.gov Form 886-A (Rev. 5-2017)

Schedule number

Form 886-A Department of the Treasury — Internal Revenue Service or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX

For the tax year ending June 30, 20XX, the Trust’s Form 990-PF Return of Private Foundation, Part VIII
listed two trustees: and . The Trust filed Form 1099-MISC, Miscellaneous

Income, for for calendar years 20XX and 20XX reporting trustee fees of $0 and $0,
respectively. The Trust calculates the trustee fees as a percentage of the asset base each year, which is
typical in the industry.

The Trust’s Form 990-PF for the tax year ending June 30, 20XX showed the following asset balances at the
beginning of the year and at the end of the year:

Beg of Yr End of Yr
Cash $0 $0
Savings 0 0
Equipment 0 0
Other notes and loans receivable 0 0
Totals $0 $0

The Trust had no liabilities at the beginning or end of the tax year.

Part IX-A of the Trust’s Form 990-PF described its activities as issuing college scholarships to qualified
candidates. During the examination of the Trust’s Form 990-PF for the tax year ended June 30, 20XX, the
examiner confirmed this activity. The Trust pays full tuition to one or two recipients each year.

Part VII-B, line 1 of the Trust’s Form 990-PF marked the box indicating that the trust had borrowed money
from, lent money to, or otherwise extended credit to a disqualified person. Further, the return was marked
that this act failed to qualify as an exception to the act of self-dealing as defined in the Regulations.

The Trust also filed a Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal
Revenue Code, at the same time it filed the Form 990-PF for the tax year ended June 30, 20XX. This form
described the act of self-dealing as “Loans from foundation to Trustee” with the date of the act stated as
“various.” The form calculated the act of self-dealing for both the disqualified person and the foundation
manager. The amount involved for the self-dealing transaction correlated with the total amount of the note
receivable shown on the Trust’s return Form 990-PF: $0. The Form 4720 included a statement that
described the corrective action taken: “The foundation trustee borrowed $0 from the trust. This amount was
not repaid as of the end of the reporting period.” An additional handwritten note printed in all capital letters
stated: “Trustee has full intent and detailed plans for prompt repayment of all amount borrowed. (plus
interest).”

During the examination of the Trust’s Form 990-PF for the tax year ended June 30, 20XX, the examiner
reviewed the accounting records and identified the following list of transactions under the category, Note
Receivable from Trustee:

CHART DELETED

Catalog Number 20810W Page 2 www.irs.gov Form 886-A (Rev. 5-2017)

Schedule number

Form 886-A Department of the Treasury — Internal Revenue Service or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX

To this total, the accountant made the following adjustment in order to arrive at the $0 note receivable
amount used as the amount involved for the act of self-dealing shown on the Form 4720:

Total Amount from Note Receivable from Trustee category $ 0
Less adjustment for mis-categorized rental exp (dtd 8/16/20XX ( 0)
Less Trustee Fees (compensation) per filed Form 1099-MISC ( 0)

Total Self-Dealing transaction amount involved $ 0

During the examination of the Trust’s accounting books and records, the examiner expanded the review to
include the subsequent tax year ending June 30, 20XX. The Trust has not filed a Form 990-PF for this tax
year. The accounting records for this tax year also included the category, Note Receivable from Trustee; the
transactions in this category for the tax year ended June 30, 20XX are as follows:

CHART DELETED

In correspondence dated July 20, 20XX, the Trustee explained an additional $0 should be added to the Note
Receivable from Trustee total. This amount is for attorney’s fees incurred on December 15, 20XX
originally charged as a Trust expense. The Trustee explained the discussions with the attorney were
personal and regarding any legal consequence to her as a result of borrowing money from the trust. Since
the discussions were on a personal level rather than about the Trust, she concluded the amount should be
expensed to the Note Receivable from Trustee category.

The expanded review of the books and records included the calendar years of the disqualified person.
Therefore, the review of the transactions continued to December 31, 20XX. On this date, the Trust had an
ending balance of $0. The transactions for the Note Receivable category listed in the accounting records for
the period July 1, 20XX to December 31, 20XX are as follows:

CHART DELETED

With the adjustments for the mis-categorized rent expense in August 20XX and the additional expense for
the personal attorney’s fee in December 20XX, the total adjusted amount withdrawn and categorized as
Notes Receivable from Trustee for the tax periods ending June 30, 20XX, June 30, 20XX, and December
31, 20XX, is as follows:

CHART DELETED

Catalog Number 20810W Page 3 www.irs.gov Form 886-A (Rev. 5-2017)

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX

From this total, amounts paid as Trustee Fees (compensation) shown on the Form 1099-MISC for calendar
years 20XX and 20XX are deducted. [No trustee fees were paid and no Form 1099-MISC was filed in
calendar year 20XX.] Thus, the adjusted total amount for the Note Receivable from Trustee is below:

CHART DELETED

During the examination of the Trust’s Form 990-PF for the tax year ended June 30, 20XX and the related
filing of the Form 4720, the examiner determined the self-dealing transaction reported on the filed Form
4720 incorrectly used the tax year of the Trust, rather than the tax year of the disqualified person and the
foundation manager. The correct tax year for the reporting of an individual’s self-dealing transactions is the
calendar year. Therefore, the Taxpayer and Foundation Manager agreed to file an amended Form 4720 to
report the acts of self-dealing during the calendar year ending December 31, 20XX. The amendment not
only corrected the tax year from the June 30, 20XX ending date to the December 31, 20XX ending date, but
also correspondingly reduced the amount involved for both of the self-dealing acts reported on the original
Form 4720 to reflect the withdrawals that occurred only in the 20XX calendar year. The new amount
involved for the act of self-dealing was calculated for the amended return as follows:

CHART DELETED

is currently the sole trustee for the Trust; the second trustee shown on the Form 990-PF for the
tax year ended June 30, 20XX resigned his position sometime after the end of the tax year. To date, the
remaining sole trustee has not appointed a second trustee position. As the sole trustee, has
unlimited and exclusive access to the Trust assets, including all banking, savings and investment accounts.
records all Trust transactions in the accounting software,

recorded in the category she named Note Receivable from Trustee in the accounting
each amount she withdrew for personal purposes. She also recorded additional amounts in this category for
expenses incurred where she did not have sufficient documentation (such as a receipt) to substantiate a Trust
expense for exempt purposes within the meaning of Section 501(c)(3) of the Code.

The following chart shows the category of distributions and expenses of the trust for the tax years ending
June 30, 20XX and June 30, 20XX.

CHART DELETED

Catalog Number 20810W Page 4 www.irs.gov Form 886-A (Rev. 5-2017)

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX

Law

Section 501(c)(3) of the Code provides, in part, exemption from federal income tax to organizations that are
organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, as
long as no part of the organization’s net earnings inures to the benefit of any private shareholder or
individual.

Federal Tax Regulations (Regulations) Section 1.501(c)(3)-1(a)(1) provides that in order to be exempt as an
organization described in section 501(c)(3) of the Code, the organization must be both organized and
operated exclusively for one or more of the purposes specified in that section. If an organization fails to
meet either the organizational or operational test, it is not exempt.

Regulations Section 1.501(c)(3)-1(c)(1) states an organization will be regarded as operated exclusively for
one or more exempt purposes only if it engages primarily in activities which accomplish one or more
exempt purposes specified in Section 501(c)(3) of the Code. The Regulations further clarifies that an
organization will not be regarded as operated exclusively for exempt purposes if more than an insubstantial
part of its activities is not in furtherance of exempt purposes.

Regulations Section 1.501(c)(3)-1(c)(2) further specifies that an organization is not operated exclusively for
one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private
shareholders or individuals.

Regulations Section 1.501(c)(3)-1(d)(1)(ii) provides that in order to meet the operational test, an
organization must serve a public purpose rather than private interests. Thus, the organization must establish
that it is not operated for the benefit of private interests such as designated individuals, the creator or his
family, or the persons who directly or indirectly control the organization.

Regulations Section 1.501(a)-1(c) defines private shareholder or individual within this section 501 as
persons having a personal and/or private interest in the activities of the organization.

Rev. Rul. 66-103, 1966-1 C.B. 134 holds that an organization whose primary activity is to provide awards
and grants, including scholarship and fellowship grants, to needy individuals who would otherwise not be
able to pursue their studies for lack of funds, qualifies for exemption under section 501(c)(3) of the Code.
The organization is primarily engaged in a charitable activity of providing relief of the poor.

Rev. Rul. 69-257, 1969-1 C.B. 151 holds that an organization providing scholarships selected from a broad
class of applicants on the basis of scholastic standing, qualifies for exemption under section 501(c)(3) of the
Code. The organization is primarily engaged in the charitable activity of advancing education.

In Better Business Bureau of Washington D.C., Inc. v United States, 326 U.S. 279, 283 (1945), the Supreme
Court held that the presence of a single non-exempt purpose, if substantial in nature, will destroy the
exemption regardless of the number or importance of truly exempt purposes.

Catalog Number 20810W Page 5 www.irs.gov Form 886-A (Rev. 5-2017)

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX
Government’s Position
The Trust paid $0 and $0 in the tax periods ending June 30, 20XX and June 30, 20XX,
respectively. These payments do not include the trustee’s fees paid and reported on the Forms 1099-MISC
for the calendar years 20XX and 20XX. These distributions to , at 0 percent and 0 percent of the

total Trust expenses in each respective tax year, represent a substantial part of the total distributions paid out
of the Trust each year.

In comparison, the Trust distributed $0 and $0 in scholarships in the tax periods ending June 30, 20XX and
June 30, 20XX, respectively. The scholarship distributions represent the exempt use of the Trust funds. Yet
the percentage of the total distributions for this exempt use of funds is only 0 percent and 0 percent for each
tax year and only 0 percent as a total over the two tax years.

, as foundation manager and trustee, had control over the Trust accounts and books and approved
all payments and withdrawals to herself. From July 2, 20XX until November 13, 20XX, she directly
withdrew funds, wrote checks to herself, or paid unsubstantiated expenses from the Trust account in 0
separate transactions. She listed all of these transactions under the account she titled “Note
Receivable from Trustee.”

While the term “note receivable” may imply that the withdrawals are loans, has not signed any
written agreement, note, or loan receivable/payable document with the Trust for any of the individual
withdrawals or for a total of the withdrawals. and the Trust have not negotiated any interest rate
or a stated repayment period. Therefore, regular withdrawals from the Trust are not a bona fide
lending of money or loan with the Trust.

The Trust has not established that the payments to were made for any religious, charitable,
educational, scientific or literary purposes. The payments to were not paid to an educational
institution or as scholarship payments for educational purposes, which is the exempt purpose of the Trust.

The withdrawn amounts are also not compensation because , as trustee and foundation manager,
received a trustee fee for the trust management services she provided. The trustee fees were reported on the
Form 1099-MISC filed in the calendar years 20XX and 20XX. Adjustments were made to the Note
Receivable from Trustee accounting category to reduce the totals in this category for the amounts
considered paid to for the trustee fees.

Thus, the withdrawals and payments to are not an exempt use of funds; they were paid to serve her
private interests. This violates the prohibition against the inurement of organizational funds to private
individuals. Also, compared to the amount of scholarships paid for educational purposes, the payments to
are more than an insubstantial part of the Trust’s distributions. As a result, the Trust does not satisfy the
operational test under Section 501(c)(3) of the Code.

Catalog Number 20810W Page 6 www.irs.gov Form 886-A (Rev. 5-2017)

Form 886-A Department of the Treasury — Internal Revenue Service Schedule number or exhibit
(May 2017) Explanations of Items
Name of taxpayer Tax Identification Number (last 4 digits) | Year/Period ended
6/30/20XX
6/30/20XX
6/30/20XX

With Trust funds inuring to the private benefit of an individual and the failure to meet the operational test
under Section 501(c)(3) of the Code, the Trust’s exemption should be revoked.

Taxpayer’s Position

As noted on the filed Form 4720 and throughout the examination, has stated that she intends to
pay back the full amount withdrawn from the Trust plus interest. However, to date, she has not repaid any
amounts to the Trust. stated in correspondence received May 25, 20XX, that she has been writing
a book and creating an enterprise. She asserts the proceeds from the sale of the book and the subsequent
operation of the enterprise will have sufficient revenues so that she can eventually repay the Trust.

Conclusion

The Trust fails the operational test because a substantial part of its activities privately benefited and inured
to an individual. Additionally, since the Trust has only $0 remaining in the bank account, it cannot pay out
any more scholarship distributions. The Trust is no longer conducting any exempt activities. As a result,
the exemption for the Trust should be revoked. The effective date of the revocation is the first day of the tax
year in which the Trust failed to meet the operational test. The distributions to began in July
20XX, which is the first month of the tax year ending June 30, 20XX. Therefore, the effective date of the
revocation is July 1, 20XX.

Catalog Number 20810W Page 7 www. irs.gov Form 886-A (Rev. 5-2017)