Circuit Court Affirms Denial of Tax-Exempt Status for Special Needs Trust.
(Parker's Federal Tax Bulletin: July 22, 2013)

Where there was no donative element to fees charged by a trust, which to all appearances operated as a commercial, for-profit enterprise, the trust did not qualify as a tax-exempt organization. Family Trust of Massachusetts, Inc. v. U.S., 2013 PTC 179 (D.C. Cir. 6/18/13)

The Family Trust of Massachusetts, Inc. (FTM) was founded by Peter Macy, a private Massachusetts attorney who specializes in elder law. Peter incorporated FTM as a special needs trust in 2003. He serves as President, Treasurer, and sole Executive Director, and his law office is listed as FTM's principal place of business. His duties include supervising the day-to-day business matters of the FTM, including financial matters, bookkeeping, and corresponding directly with outside parties. He works with the FTM daily, averaging 260 hours a year.

In 2005, FTM applied for a determination from the IRS that it is a Code Sec. 501(c)(3) organization and therefore tax exempt. Since 2005, FTM's clientele has increased from 20 beneficiaries to over 300. After the IRS failed to issue a notice of determination, FTM filed suit in district court, seeking the court to declare FTM exempt from federal income tax. The IRS argued that FTM acts as an adjunct to Peter's private elder law practice, reaching only a select group of the relatively affluent disabled to whom trustee services might be provided profitably.

The district court concluded that FTM had not demonstrated that it met the requirements necessary to be a Code Sec. 501(c)(3) tax-exempt organization. The critical inquiry, the court said, was whether FTM's primary purpose for engaging in its sole activity was an exempt purpose, or whether its primary purpose was the nonexempt one of operating a commercial business producing net profits for FTM. The court observed that, in applying the operational test to determine whether an organization meets the requirements to be tax-exempt, courts have relied on the commerciality doctrine. The major factors courts have considered in assessing commerciality are the particular manner in which an organization's activities are conducted, the commercial hue of those activities, and the existence and amount of annual or accumulated profits.

The district court found it difficult to escape the obvious correlation between FTM's increasing profits and the Peter's increasing salary derived from those profits. When examining this fact in light of other factors, such as the absence of the solicitation of charitable contributions, the court concluded that FTM's profit margin appeared to be more a product of a growing commercial enterprise than a tool for expanding the pooled investments that might enable beneficiaries to reap a greater return or enjoy reduced fees. Further, the court said, the manner in which Peter and other members of the legal community went about connecting eligible individuals with FTM's services suggested that those services were a commercial product in disguise being touted by Peter and others who made referrals to the trust. The fact that Peter founded the program as a result of his law firm's specialization in advice regarding trusts, estate planning, guardianship, and probate matters for elderly clients, and that his legal office remained listed as FTM's principal place of business, only reinforced for the court the idea that FTM's services provided a marketable product to offer potential clients. And though procurement of new clientele for Peter's law practice may not have been the sole purpose of FTM, the district court viewed this inevitable benefit as amounting to more than just an incidental nonexempt purpose. FTM appealed.

The D.C. Circuit affirmed the lower court's decision and held that FTM was not operated exclusively for a charitable purpose. To all appearances, the D.C. Circuit said, FTM operates as a commercial, for-profit trustee because it charges fees to establish and manage the pooled trusts and retains residual fundsthe residualsfrom the accounts of deceased beneficiaries. The court saw no evidence that the fees FTM charged were below market rate, much less below costat least if the residuals were taken into account. Nor, the court noted, had FTM used its burgeoning residuals revenue to offset or waive trust management fees. The charitable purpose of FTM's operations was further undercut by the commercial trappings of its operations, the court stated. The interrelationship between FTM and Peter's law firm, with FTM's headquarters being in Peter's law offices, and the fact that Peter referred clients to FTM and performed legal services for it as well, cast FTM's operations as a commercial offshoot of Macy's elder law practice.

For a discussion of the tests that must be met for an organization to be classified as a Section 501(c)(3) organization, see Parker Tax ¶60,510.

Parker Tax Publishing Staff Writers

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