Tax Exempts: Watch Out for Tax Shelters!

By Joyce Underwood, CPA
Senior Manager, Nonprofit Tax Services

Although nonprofits are generally exempt from federal income tax, they have to be careful not to become involved in Abusive Tax Avoidance Transactions, otherwise known as "Tax Shelters." In addition to their own activities, and joint ventures they may enter into, nonprofits should use care with alternative investments as investments in partnerships and limited liability companies can unknowingly expose the organization to tax shelter activities within these investments. Organizations should look closely at the Schedules K-1 received from investments for shelter disclosures.

For-profit entities are often motivated to seek tax-exempt organizations to act as accommodation parties to a transaction because of their tax indifference. Although the transaction may not affect the tax-exempt entities exempt function, it provides tax benefits to a taxable third party. After all the abuse in the for-profit arena, IRS is intent on tracking down and eliminating these activities in the non-profit sector and has included a lengthy list of listed transactions on its web site, many of which rely on tax-exempts. Important new legislation enacted in May 2006 under the Tax Increase Prevention and Reconciliation Act of 2005 increases penalties on tax-exempt accommodation parties that are involved in certain prohibited tax shelter transactions and adopts new disclosure requirements.

Key provisions under the Act:

• Excise tax is imposed on tax-exempt entities that are parties to prohibited tax shelter transactions, and on entity managers who knowingly approve prohibited tax shelter transactions.
  • The amount of the tax imposed on a tax-exempt entity that is a party to a prohibited tax shelter transaction depends on whether the tax-exempt entity knew, or had reason to know, that the transaction is a prohibited tax shelter transaction.
    • In general terms, the amount of tax where the tax-exempt entity does not know, or have reason to know, that the transaction is a prohibited tax shelter transaction is equal to the product of
      • the highest unrelated business taxable income rate, and
      • the greater of the entity's net income, or 75% of the proceeds received by the entity which are attributable to the prohibited tax shelter transaction.
    • In general terms, the amount of tax where the tax-exempt entity knows, or has reason to know, that the transaction is a prohibited tax shelter transaction is the greater of-
      • 100% of the entity's net income, or
      • 75% of the proceeds received by the entity which are attributable to the prohibited tax shelter transaction.
  • The amount of the tax imposed on an entity manager who approves the entity as a party to a prohibited tax shelter transaction is $20,000 for each approval (or other act causing participation).

• Taxable parties to a prohibited tax shelter transaction must disclose that tax shelter status to any tax-exempt entity that is a party to the transaction. Under the Act, any taxable party to a prohibited tax shelter transaction, as defined in Code Sec. 4965(e)(1), must provide a statement to any tax-exempt entity which is a party to the transaction disclosing that the transaction is a prohibited tax shelter transaction.



• Tax-exempt entities must disclose participation in prohibited tax shelter transactions to IRS. Under the Act, every tax-exempt entity described in Code Sec. 4965(c), must file a disclosure of the entity's being a party to any prohibited tax shelter transaction defined in Code Sec. 4965(e), and the identity of any other party participating in the transaction whose identity is known by the tax-exempt entity. In the case of a failure to file the disclosure statement, the tax-exempt entity must pay $100 for each day during which the failure continues. The maximum penalty on failures for any one disclosure is $50,000.

Tax-exempt entities should be careful to evaluate proposed activities and alternative investments in light of the tax shelter rules. Managers and other key employees should become familiar enough with the provisions that they have an idea how to recognize a questionable activity, and, if appropriate, management should put in place procedures to evaluate transactions and document conclusions on the activities likelihood to be an abusive transaction.

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