What To Do When You Contribute $275,000 To A Not-For-Profit Which Has Never Filed For Federal Tax Exempt Status?

What To Do When You Contribute $275,000 To A Not-For-Profit Which Has Never Filed For Federal Tax Exempt Status? That's A Lot of Money To Leave On The Table, So The Taxpayer Got Creative....

William Delaney, EA
Westwood, MA

Waterfront Fashion Week, Inc. was organized in KY as a nonstock, nonprofit corporation on May 8, 2012.  At all relevant times, Clinton Deckard was Waterfront’s President and one of its three Directors.  Although state chartered as a not-for-profit, the corporation never applied for federal tax-exempt status.

During its existence, Waterfront produced an event for the benefit of another KY nonprofit corporation; the event lost money; Waterfront made no “cash charitable contribution” to the other nonprofit.  Apparently, this was the full extent of Waterfront’s charitable activity in KY.  It was mostly funded by Mr. Deckard’s $275,000 “contribution” made sometime in August 2012.

The corporation was administratively dissolved on Sept. 28, 2013 for failure to file its 2013 annual report.  Waterfront subsequently filed a reinstatement application, which was accepted.  On Sept. 30, 2014, the corporation was again administratively dissolved because it failed to file an annual report.  (KY apparently is a quick draw state; neither MA nor RI would react so quickly).

Now for the really creative part of this narrative (believe me, you cannot make this up---it really happened).  On Oct. 28, 2014 (almost one month after the administrative dissolution), Waterfront filed a Form 2553 (S corporation election) with the IRS, retroactive to May 8, 2012.  Mr. Clinton Deckard signed the form as President of the corporation and also as its 100% shareholder (give that man a prize for hutzpah).

On Jan. 13, 2015, Waterfront filed forms 1120S for stub year 2012 and calendar year 2013, reporting operating losses of $277,967 and $3,239 respectively.  As its sole shareholder, Mr. Deckard received a Schedule K-1 on which these non-passive operating losses were passed-through to him; the losses were claimed on his federal Schedule E and deducted against his federal 1040 income.  So, now he had recovered his $275,000 “contribution” to the corporation!  Great tax planning, except for one little thing…the IRS came calling and issued, not surprisingly, a notice of deficiency.

Oh, but it gets better.  Now for the counter argument that the IRS (how can it be) is not correct…

The IRS asserted that the S election was invalid and that Mr. Deckard was not a shareholder in Waterfront (how dare they challenge his sworn affidavit).  So, how did Mr. Deckard defend himself against the notice of deficiency?  Read on…

He first argued substance over form (one of your editor’s favorite themes, but one which doesn’t work in this context).  Mr. Deckard “…asserts that he intended Waterfront to be a for-profit entity and ‘objectively operated’ it ‘consistently with it being a for-profit entity that he owned entirely’”…and that he was “mistakenly unaware of these formalities of corporate law” so he treated the corporation as if he were “the sole owner in every practical sense.”

The U.S. Supreme Court, when confronted with a somewhat similar argument, stated:  “While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.”  Comm. v. Nat’l Alfalfa Dehydrating & Milling Co, 417 US 134, 149 (1974).

OK, there goes one asserted position, so let’s try another…lack of tax-exempt status.

“Petitioner (i.e. Deckard) suggests that because Waterfront never gained tax-exempt status (which it never sought), it should be regarded as a for-profit corporation.  For-profit corporations have shareholders,” which somehow circumvents the fact that Waterfront is [was, because it has been administratively dissolved] a nonstock KY corporation.

Problem is that Deckard is right, in part.  Waterfront is a filer of a federal 1120, but not because it is now a stock corporation.  Instead, this is a default filing when you fail to obtain tax-exempt status.  So, why cannot an 1120 filer elect S corporation status?  Because that is an election made by the shareholders, of which there are none, Mr. Deckard’s assertion notwithstanding.  Under the KY statute, as is the case with most states, a not-for-profit corporation does not have shareholders, owners, and/or capital stock.  Clinton Deckard v. Comm. of Revenue, 155 T.C. No. 8, 9/17/2020.