Special Needs Trust Set Up by Elder Law Attorney Doesn't Qualify as an Exempt Organization
(Parker Tax Publishing October 18, 2012)

The manner in which a trust's founder and other members of the legal community went about connecting eligible individuals with a special needs trust's services suggested that those services were a commercial product in disguise; thus, the trust did not satisfy the operational test to be designated as a tax-exempt entity. Family Trust of Massachusetts, Inc. v. U.S., 2012 PTC 262 (D. D.C. 9/24/12).

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.

On November 21, 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 did not demonstrate that it met all three requirements necessary to be a Code Sec. 501(c)(3) tax-exempt organization. The court noted that, under Code Sec. 501(a) and (c)(3), an organization must prove that:

(1) it is organized and operated exclusively for an exempt purpose.
(2) its net earnings do not inure to the benefit of any private shareholder or individual.
(3) its activities do not attempt to influence legislation.

To determine if an organization is operated exclusively for an exempt purpose, the court said, the critical inquiry is whether FTM's primary purpose for engaging in its sole activity is an exempt purpose, or whether its primary purpose is the nonexempt one of operating a commercial business producing net profits for FTM. The court observed that, in applying the operational test, 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 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 said 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.

According to the court, the claim that Peter contributed about $100,000 of unpaid services to FTM was flawed because it ignored the requirement in Reg. Sec. 53.4958-4(b)(1)(ii)(A) that a comparison be made between the level of Peter's compensation and the amount that would ordinarily be paid for like services by like enterprises under like circumstances. The court cited the publication, Special Needs Trust: Administration Manual, which states that a special needs trust does not have to be administered by an attorney. Rather, laypersons, such as friends and family of a person with disabilities, and . . . professionals, including attorneys, financial planners, and social workers are capable of administering a special needs trust.

The court then addressed the requirement that net earnings of a Code Sec. 501(c)(3) not inure to the benefit of any private shareholder or individual. Although control of financial decisions by individuals who appear to benefit personally from certain expenditures does not necessarily indicate inurement of benefit to private individuals, the court stated, those factors coupled with little or no facts in the administrative record to indicate the reasonableness and appropriateness of the expenses are sufficient to suggest that there is indeed prohibitive private inurement. Since the record clearly demonstrated Peter's overwhelming control of FTM, while at the same time revealing an absence of comparability data showing the reasonableness of his compensation, the court said it could not be assured that it was not sanctioning an abuse of the revenue laws by conferring tax-exempt status on FTM. According to the court, the manner in which Peter and other members of the legal community went about connecting eligible individuals with FTM's services suggested to the court that those services were a commercial product in disguise being touted by Peter and others who made referrals to the trust. The facts 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 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 court viewed this inevitable benefit as amounting to more than just an incidental nonexempt purpose.

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.

Staff Contributor Parker Tax Publishing

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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