Originally published on Forbes.com.
So here is an idea for a tax-deductible college education. Set up a scholarship fund with seemingly neutral criteria that by wild coincidence your kid and nobody else meets. Apply for 501(c)(3) status, which is pretty much rubber-stamped now thanks to IRS under-funding and scandal induced timidity (now on Day 1332 by TaxProf count). Only it didn’t work for the organization described in Private Letter Ruling 201652029. Somehow, the IRS managed to see through the scheme to the surprise of Paul Streckfus who in his coverage wrote:
I’m surprised the IRS caught this apparent scam, especially considering its new fly-through procedures. The husband and wife who formed the organization cleverly set it up to appear objective — that scholarship recipients would be National Merit Finalists going to a particular college. But the only eligible recipient to date happens to be their son — just a coincidence, I’m sure.
The Scheme
Here is the scheme with just a little more detail.
You are seeking exemption as a private foundation. Your governing body members are D and E, husband and wife. D and E are also your selection committee. Relatives of the selection committee, officers, directors and substantial contributors are eligible for your scholarship. D and E anticipate spending approximately one hour each per year on operating the scholarship program. Their duties include writing checks to C College and interacting with the high school counselor’s office.
To qualify for a scholarship, an applicant must be a graduating senior from B high school who has been selected as a National Merit Finalist and are newly admitted to C College. C College is approximately 3000 miles from B high school.
The scholarship may be awarded for four years of undergraduate studies or completion of baccalaureate degree requirements, whichever occurs first. Recipients must enter C College no later than the fall following graduation from B high school. Scholars must remain in good academic and disciplinary standing at C College. Transfer students are not eligible.
You will pay the funds to C College over four years with the award amount to be established in the first of the four years as to each recipient. You will fund a minimum of j dollars per year, per recipient. The amount of the recipient’s first year award shall be renewed in subsequent years if the fund has sufficient value, except that the award will be reduced by j dollars per each additional recipient. Despite indicating a minimum award of j dollars and indicating that “ideally” you would fund the scholarship for j dollars, your expenses for last year show a distribution of k dollars, the entirety of your income. Further, no projections were given for the current year and beyond even though this is a four year award.
Then there is the application procedure.
A student must apply for the scholarship at least two business days before B high school’s award night, which is typically a few weeks prior to graduation. To apply, the applicant must email you with proof of graduating senior status from B high school, proof of National Merit Finalist status, and proof of enrollment at C College. The proof of graduating senior status and National Merit Finalist status can alternatively verified through B high school’s counseling office. You indicated the scholarship is publicized through the high school counselor’s office and there is no actual application form.
We can only hope that the counselor will steer one of the National Merit Finalists to C college next year.
Why The Scheme Fails
Here is why the foundation fails to be tax-exempt, in case you need it spelled out for you.
You are operated for a substantial non-exempt purpose, precluding you from exemption. D and E fund you, set scholarship criteria, control the total amount of funds awarded any oversight of the award. The criteria created to award the scholarship are so narrow that only one individual, the son of the founders, has qualified for the scholarship. Even if a graduating senior of B high school is a National Merit Finalist and wishes to attend C College, which is approximately 3000 miles away, there is only a 10% admittance rate by C College. The pool of eligible applicants annually is virtually zero. Your founders are also your selection committee and they selected their own son as the recipient of the award. This creates private inurement, precluding you from exemption.
About The National Merit Foundation
The National Merit Foundation is tax-exempt with over $160 million in assets. It has been around since 1955 and becoming a National Merit Finalist is a pretty big deal. In 2017 there are expected to be 3.5 million high school graduates. About 15,000 will be National Merit finalists. In my high school memoir series, I mention the assembly where the National Merit Finalists. for my class were announced. Two from a class of over 220 in what was considered at least among Catholics in the metro New York area an academically elite high school. As I relate in that piece, some in the audience were rather astonished at one of the two recipients who did not seem like he had a lot going for him. Giving that boost to the academically, if not otherwise gifted, is pretty much the mission of the National Merit program.
Could This Have Worked?
It might have worked just by luck of the draw, but the couple might have done a couple of things to help. They could have found some friends to act as the foundation officers, assuming, for the sake of argument, that people that self-centered actually have friends. Frankly, that might have added to the risk, so I’ll have to make that one a maybe. What might have been really helpful, though, would be to cycle the donation to the foundation through a donor advised fund. Then, technically, the money would not have been coming from them. The rise of donor-advised funds, probably not the best thing that has ever happened to philanthropy will facilitate shenanigans like this in the coming years. Paul Streckfus has written:
I’ve been told by EO tax practitioners that the abuses connected with DAFs are much greater than I or anyone else has been able to report. Eventually they expect a massive scandal involving DAFs, but to date the lid has been kept on this boiling cauldron of wayward money. Unfortunately, the folks at the IRS and Treasury are their usual clueless selves when it comes to investigating this area of burgeoning abuse.
Other Coverage
Ed Zollars had a good summary of the ruling in Current Federal Tax Developments.
For a more colorful version of this technique gone bad you might want to check out my coverage of the Educational Foundation for The Descendants of Hungarian Immigrants in The Performing Arts.