How ’96 Law on Financial Abuses Has Been Applied by IRS in Four Cases

When a charity posts operating losses of $31-million in a single year and cuts back on programs, it may seem odd that its entire board of trustees should make nearly $1-million each.

However, that’s what happened in 1994 at the Bernice Pauahi Bishop Estate, in Honolulu. The

estate was established more than a century ago to create and support the Kamehameha Schools for native Hawaiian children.

The trustees who ran the estate were the most prominent involved in the four cases in which the Internal Revenue Service is known to have decided that individuals should be fined under the 1996 law that imposes penalties on charity officials who receive compensation that is out of line with their duties, or who make or approve sweetheart financial deals that benefit people affiliated with a charity. Nonprofit officials found guilty of receiving what the IRS calls an “excess benefit” not only pay fines, but also are ordered by the IRS to repay whatever amount they improperly received.

According to the IRS, which began investigating the school in the 1990s, the trustees should not have been paid more than $160,000 each from 1990 to 1996. It also charged that the trustees had used estate funds for their personal expenses and focused on the estate’s commercial activities at the expense of its charitable purpose of running an educational institution. The trustees argued that their management of the estate’s assets justified their salaries.

Matters came to a head in 1999, when the Internal Revenue Service said that unless the trustees were removed the school could lose its tax-exempt status. One trustee resigned, and a Hawaiian probate judge agreed to remove the other four.

$6.5-Million Sought

After the state of Hawaii had settled its own case against the estate, the IRS pursued the trustees under the 1996 law. Although the revenue service has not disclosed any details of its actions against them, a court document that became public showed that the IRS was seeking a total of $6.5-million from at least one trustee.

The trustees announced in 2001 that they had settled with the IRS. They did not disclose for how much, but the Honolulu Star-Bulletin reported that anonymous sources said that the settlement amounts were about $40,000 per trustee. The full story may never be known because a Hawaii court has agreed to seal the settlement records.

Evelyn Brody, a professor at Chicago-Kent College of Law, says that if that figure is accurate, the low sum the IRS collected raises a question about how effectively it will be able to enforce the law. A $40,000 settlement, little more than a slap on the wrist given the sums the trustees were accused of taking, would suggest “that the big fish will still get away, while the administrative apparatus urges charities to document, report, and track every possible infraction,” Ms. Brody says.

Tax experts consider another case brought under the 1996 law to be a bigger victory for the IRS, but not a complete win.

In June, the U.S. Tax Court ruled that Sta-Home Health Agencies of Carthage, Greenwood, and Jackson, Miss., which provide home health care and other health services, had sold their assets too cheaply to for-profit corporations and ordered the corporations to repay the nonprofit groups $5.2-million, plus penalties that could reach up to $1.25-million. (Michael T. Caracci and Cindy W. Caracci v. Commissioner of Internal Revenue, 118 T.C. 25). The buyers of the assets were considered to have received an “excess benefit” by getting them for less than they were actually worth.

Though the court levied the penalties, they don’t make much of a practical difference: The same family owns the nonprofit groups that sold the assets and the for-profit groups that bought them. Over all, the Caracci family members don’t appear to be losing much if anything, says Marc Owens, formerly the IRS’s top charity regulator and now a lawyer in Washington. “They’re repaying the money to themselves,” he says.

The nonprofit groups that the Caraccis are supposed to repay now exist on paper, but do not provide any charitable services, and don’t have anything to do with the money. Realizing this, the IRS argued in court that the nonprofit groups should lose their tax-exempt status — which would have forced the Caraccis to make reparation to some other charities that provide health-care services in the region where their nonprofit groups operated. However, the tax court disagreed, saying that imposing the fines was sufficient penalty.

Such situations should not occur in the future, says Mr. Owens. He notes that regulations issued by the IRS last year, but not in time to govern the Sta-Home case, say that in such a case, the money to be repaid would have to have gone to another charity.

Founders of Charities

While those were the only two cases known to have gone to court under the 1996 law, the IRS has also applied the law in at least two other cases. In neither case did the IRS disclose the names of the organizations or individuals involved.

In one case, the revenue service concluded that the entire salary paid to the founder of a charity was an excess benefit because the group was unable to document the number of hours he worked or the services he provided, or to show that it had attempted to set the salary based on a comparison with similar nonprofit groups. The IRS also said that undocumented loans repaid by the charity constituted an excess benefit. The founder, a used-car salesman, set up the group to allow people to donate their automobiles to charity. As is its policy, the revenue service did not say whether any penalties had been levied (Technical Advice Memorandum 2002243057).

In another case, the IRS told one of its local offices that it could use the 1996 law to challenge the salaries of a couple who provide consulting services to a nonprofit health-care group. The IRS said the couple are the nonprofit group’s former chief executive and his wife, and therefore have substantial influence over the organization — which means they are covered by the 1996 law.

In addition, the revenue service said that even though IRS rules say charities can avoid penalties by conducting a compensation study to determine the pay scale was at market rates, the charity was not protected by its study because it was completed six months after the consultants’ salaries were set (Technical Advice Memorandum 200244028).