REPORTS

OF THE

UNITED STATES TAX COURT

KENNETH ALLEN AND BARBARA L. ALLEN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket No. 22877-84.

Filed January 5, 1989.

P claimed a $25,000 charitable "contribution" to N, an organization exempt from tax under sec. 501(c)(3), I.R.C. 1954. Ten percent of the contribution originated with P, and 90 percent was borrowed from F, a for-profit entity related to N. The principal of the unsecured loan was due in 20 years. Simple annual interest, at 3 percent, was due quarterly. Three-percent interest was a below-market rate. Unbeknownst to P, the money he "borrowed" was flowing through a "money circle." Funds originating with N had been loaned to I (a related nonprofit entity), which loaned them to F, which in turn loaned them to investors to "contribute" to N, starting the circle over again. Held, under these circumstances the borrowed portion of the "contribution" is not deductible. Held, further, the circumstances of the contribution should have put P on notice that the deduction could be disallowed, notwithstanding respondent's determination of N's exempt status. Held, further, negligence addition sustained.

Todd Russell Reinstein and William L. Feinstein, for the petitioners.

Monica S. Melgarejo, for the respondent.

1

GERBER, Judge: Respondent, in a statutory notice of deficiency dated June 11, 1984, determined a deficiency in petitioners' 1981 income tax of $4,541 and an addition under section 6653(a)(1)1 for negligence of $227 plus 50 percent of the interest on the underpayment pursuant to section 6653(a)(2). The issues for consideration are generated by petitioners' contribution to the National Institute for Business Achievement. We must determine: (1) Whether any part of the claimed contribution is deductible under section 170; and (2) whether petitioners are liable for the additions to tax under section 6653(a) (negligence).

FINDINGS OF FACT

Petitioners Kenneth and Barbara Allen resided in Saugus, California, at the time their petition was filed. The stipulation of facts and exhibits are incorporated by this reference.

General Background

This case involves, inter alia, two nonprofit organizations founded by Gordon Bizar (Bizar): International Business Network (IBN) and the National Institute for Business Achievement (NIBA).

IBN, a nonprofit section 501(c)(6) organization, provides services such as education regarding the acquisition of small businesses and political lobbying on behalf of small business interests for its members. As part of its educational programs, IBN conducts seminars advising individuals how they can acquire small businesses with a very limited initial cash investment by using the assets of the business to be acquired. IBN also publishes a newsletter for its members. As a political lobbying organization, IBN has sponsored legislation at both the city and State levels to benefit small businesses. As a section 501(c)(6) corporation, IBN could not solicit contributions from the general public. Consequently, Bizar formed NIBA and transferred some of IBN's educational activities to NIBA, to be able to publicly fund the educational programs. IBN initially loaned NIBA approximately $160,000 to start its operations.

1All section references are to the Internal Revenue Code of 1954 as amended and in effect during the years at issue. All Rule references are to the Tax Court Rules of Practice and Procedure.

NIBA, a California nonprofit section 501(c)(3) tax-exempt foundation, provides education and training, typically in the form of conferences, in the techniques and skills necessary for small business ownership. Examples of conference topics are "How to Go Into Business," "How to Finance a Small Business" and "How to Manage and Administer." Conferences have been held in as many as 20 cities in a single year and as many as 1,500 people may attend conferences in a single city.

The Internal Revenue Service, by a letter dated October 21, 1980, stated that NIBA was an organization exempt from tax under section 501(c)(3) (exemption letter). This letter did not make a final determination of NIBA's foundation status under section 509(a), but it did allow NIBA to be treated as a publicly supported organization during the advance ruling period. Final exempt status was granted on November 29, 1982.

The National Diversified Funding Corporation (NDFC) is a for-profit corporation owned 60 percent by IBN and 40 percent by Bizar. Prior to 1980, NDFC engaged in various business activities, including the sale of insurance.

The Contribution Transaction

Bizar devised a plan for eliciting contributions to NIBA from members of the general public. Bizar regarded the plan as a “trade secret," and at one time tried to interest larger charitable organizations in the plan.

As a "cornerstone" of the plan, the investor made a relatively small cash contribution,2 and financed the remainder by means of a below-market interest rate loan. A document entitled "WHAT IS THE NATIONAL INSTITUTE FOR BUSINESS ACHIEVEMENT?" explained the program to potential investors:

The NIBA is a California non-profit publically [sic] supported educational foundation

The NIBA is organized under Internal Revenue Section [509 (a) (2)] and as such, contributors may deduct donations The NIBA then uses

*

Terms such as "contribution" and "loan" are used for convenience, and do not necessarily reflect the Federal tax consequences of such transactions.

the earnings on these funds to finance free and low cost seminars to the general public

THE CONCEPT

The National Diversified Funding Corporation (NDFC) will loan to a qualified borrower up to 90% of his contribution to the National Institute for Business Achievement (NIBA). Such Loan shall be made consistent with the lending policies of NDFC.

It is the purpose of the lender to aid the institute.

THE TERMS OF THE LOAN

1. Up to 90% of the Contribution.

2. Interest Rate: 3% per annum.

3. Interest Payable: [Quarterly].

4. Repayment: Principal due in 20 years.

THE MECHANICS

1. Contributor completes the enclosed loan application (Exhibit A) and returns it with a current financial statement and a copy of last year's tax return.

2. Upon approval of credit, NDFC meets contributor and spouse (if married) at its bank.

3. Contributor and spouse sign the attached note (Exhibit B) for the amount of the loan.

4. NDFC issues check payable to the contributor for the loan proceeds. 5. Contributor endorses check (above) and exchanges it for a cashier's check payable to NIBA which is then given to a NIBA representative.

EXAMPLE

[Contributor has $200,000 gross income, 55.5% tax bracket (State and Federal), $100,000 NIBA contribution. The contribution would generate a net cash surplus (from tax savings) of $45,000.]

1. If $23,726 were invested at 10% after tax return, it would yield enough cash to pay after tax interest cost on note plus pay off note at end of 20th year. This would leave $21,774 of discretionary cash available to contributor at this time.

2. If entire $45,000 were to be invested at a 10% after tax return, the amount available to pay off $90,000 loan in 20 years is $306,101.

QUESTIONS AND ANSWERS

2-Q Why is Lender willing to loan money at such low interest rates?