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Thursday February 22, 2018

Case of the Week

Lucky Lucy Lindstrom's 'Personal Loan' Charity


Lucky Lucy Lindstrom finished college and headed west. She started as a financial analyst with a large company in Seattle. After just four years, she became a Registered Investment Advisor (RIA) and began advising clients. Lucky Lucy also managed her own investments. With her keen insight into financial markets, Lucy soon began to move from traditional stocks and bonds into futures and commodities markets. Lucky Lucy was so successful in these markets that she now manages only her mega-dollar personal portfolio.

Somewhat late in life, Lucky Lucy discovered the wonderful world of philanthropy. She volunteered at her favorite charity and learned that giving someone in need a helping hand is even more gratifying than making another million in the futures market. Lucy had invested $1,000,000 in stock in a Canadian oil "wildcatter" with the name Northern Long Shot, Inc. This company has been drilling new exploratory wells in the far north. Recently, the stock rose from the $1 per share that she paid to over $5 per share. Lucy was delighted with her gain and decided to give the $5,000,000 in stock to a supporting organization (SO) with one of her favorite charities.

For the first two years, the SO distributed grants for charitable purposes. However, in year three, Lucy made a major mistake in her personal commodities investing. She wants to borrow $3,000,000 from the SO to "tide her over" through this difficult time. Since she needs all her assets to cover her leveraged obligations, Lucy would like to have a no-interest loan for two years. After all, she thinks, "I gave $5,000,000 to the SO, so it surely would be okay to borrow $3,000,000 at no interest for two years."


Would this plan work? Can the supporting organization give a no-interest loan to Lucy?


There is a very major problem with the no-interest loan. First, the supporting organization is a public charity that must be operated for the benefit of the public. Public charities are subject to the intermediate sanctions rules of Sec. 4958. A public charity may not engage in an excess benefit transaction. An excess benefit transaction occurs when a public charity engages in any direct or indirect transaction with a "disqualified person" and the disqualified person receives a benefit from the charity for which he or she did not pay. Excess benefits occur in many ways, including below-market loans from a public charity to a disqualified person and the payment of unreasonable compensation from a charity to a disqualified person.

A major potential issue for Lucy is the restriction on excess benefits under Sec. 4958. If a supporting organization (Type I, Type II or Type III) makes a grant, loan, payment of compensation or other similar payment to a substantial contributor or related person, there is an automatic Sec. 4958 excess benefit for the entire payment. Lucy is subject to an initial tax of 25% of the amount of the payment under Sec. 4958(a)(1). An organization manager who participated in the making of the payment, knowing that the payment was made to a substantial contributor, is subject to a tax of 10%. Sec. 4958(a)(2). Second tier taxes of Sec. 4958 may also apply to the entire payments, not just the excess value.

With this huge potential penalty, Lucy decided to forego the $3,000,000 loan from the SO and use other methods to cover her investment needs. Fortunately, the markets turned in her favor and she soon was back in excellent financial condition.

Published September 29, 2017
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