August 3, 2006 | Read Time: 2 minutes
TAX WATCH
A federal appeals court has dealt a significant blow to the Internal Revenue Service in its efforts to crack down on charity officials and companies that receive improper financial benefits from their connections to a tax-exempt organization.
The U.S. Court of Appeals for the Fifth Circuit reversed a U.S. Tax Court ruling involving a family that founded a network of nonprofit health-care groups in Mississippi and converted them to for-profit status. The Tax Court had ruled that the IRS was right to assess penalty fees of $1-million to $10-million on the family because it said they had undervalued the network’s assets.
Members of the Caracci family, who founded the nonprofit groups, decided in 1995 to convert them into for-profit businesses. They said the nonprofit organizations had liabilities of about $13.5-million, outweighing the groups’ assets, which they said were worth around $8.5-million. The Tax Court ruled in 2002 that the appropriate value of the assets was $18.7-million.
The Caracci case was the first major test of a 1996 law designed to crack down on people who receive inappropriately high compensation or improper financial benefits from a charity. Under the law, executives who receive such benefits can be forced to pay fines, as can trustees who approve the arrangements. The law also applies to businesses that work with a nonprofit group, or in this case, the business that resulted from the conversion of the nonprofit organizations.
In reversing the ruling, the Fifth Circuit criticized the IRS and the Tax Court for making factual and legal errors and failing to take into account the fact that once the organization converted to for-profit status, it “effectively had no ability to realize profits.”
The decision is “an embarrassment” for the tax agency, said Bruce R. Hopkins, a lawyer in Kansas City, Mo., who represents many charities.
A copy of the ruling in Michael T. Caracci et al. v. Commissioner of Internal Revenue, No. 02-60912, can be obtained online at http://www.ca5.uscourts.gov/opinions%5Cpub%5C02/02-60912-CV0.wpd.pdf.
