When Charitable Intentions Go Awry – Avoiding a Tax Deduction Disallowance

Philanthropic, high-net-worth individuals often seek to make charitable contributions. Their reasons are often driven by the desire to benefit their community and make a difference, with the additional benefit of receiving a tax deduction on their income tax return. However, in light of recent IRS guidance, these philanthropically minded taxpayers should be wary of recently promoted “Charitable LLCs.”

Charitable LLC Fraudulent Tax Scheme

On December 4, 2024, the IRS advised high net-wealth taxpayers to be aware of promoters encouraging so-called “Charitable LLCs”. Under this tax scheme, taxpayers are assisted in the creation of limited liability companies (LLCs), which are to be funded with cash or other assets in exchange for fees paid to the promoters. After establishing the LLC, taxpayers are instructed to donate a majority percentage of nonvoting, non-managing membership units in the LLC to a charity (often to a pre-designated charity that the promoter controls). The promoter will often supply the taxpayer with an appraisal supporting the valuation of the transferred membership units. Following the “donation,” the taxpayer maintains control of the LLC voting units and reclaims the cash or assets for personal use. Some promoters will also prepare documents so that taxpayers may buy back their donated property at a significantly discounted price after a period of time.

Despite the promoters’ claims, this promoted arrangement does not entitle taxpayers to a charitable contribution deduction. Generally, taxpayers cannot deduct a charitable contribution of less than their entire interest in the property while retaining rights to control the donated interest or later buy back assets under IRC Sec. 170(f)(3)(A).

Increased IRS Audits

The IRS is actively working to increase compliance of high-income taxpayers. This attention has led to an increase in the number of audits of these taxpayers, with a significant number of examinations focused on charitable donation deductions. During 2023, the IRS completed 175 audits of high-income, high-net-worth taxpayers, resulting in tax adjustments of $38 million. As of September 6, 2024, the IRS collected an additional $1.1 billion from another 1,600 high-income, high-net-worth taxpayers. To avoid these issues on audit, taxpayers must be wary of promoters promising any charitable deductions that seem too good to be true.

Red Flags for Taxpayers to Watch Out For

The IRS advised taxpayers to look for the following red flags that could indicate a promoted Charitable LLC scheme:

• Promoters marketing a transaction as a way for taxpayers to grow their wealth “tax-free” while also receiving the benefit of a charitable donation deduction;
• A transaction’s requirement that an entity be created without any business activity other than facilitating a charitable deduction;
• Donating property interest to a charity where the charity has no control over the assets;
• The donation of an LLC interest that loans cash and/or other assets back to the taxpayer for personal use after donation;
• The taxpayers’ retained right to reclaim the donated interests back from the charity at less than fair market value;
• The promoters’ requirement that the donation be made to a certain charity or that a certain appraiser is used to value the assets

Deductions for Proper Donations are Still Allowed

Taxpayers may still make charitable donations of closely held business interests and properly claim the resulting charitable contribution deduction. To do so, taxpayers should:

• Obtain a qualified appraisal from a qualified appraiser as to the value of the donated closely held business interest;
• Properly substantiate the donation with a fully completed Form 8283, Noncash Charitable Contributions, and contemporaneous written acknowledgment from the charity (for donations exceeding $250); and
• Ensure the charity receiving the donation has exclusive legal control over the contributed assets.

High-income taxpayers seeking donations should work with a trusted tax advisor to structure their charitable giving in a way that makes sense for their circumstances. If a structure seems too good to be true, it likely is.

Taxpayers should work with a team of financial and tax advisors to craft a plan that will allow them to meet their charitable goals without exposing them to IRS audits. Contact EisnerAmper today to make sure your charitable contributions are structured correctly and avoid potential pitfalls.