Why you can't give relatives scholarship money and call it charity

The IRS shuts down a scholarship fund that gave money only to family; find out how you can provide income to loved ones tax free.
JUL 09, 2015
Wealthy people have lots of ways to avoid the estate tax. But a federal judge says one family got a little too creative in dodging its tax bill. When Julius Schaller died at the age of 91 in 2003, his executors set up the "Educational Assistance Foundation for the Descendants of Hungarian Immigrants in the Performing Arts, Inc." and sent it $2.6 million of Mr. Schaller's money. (Mr. Schaller once owned a grocery business in Philadelphia called J. Schaller & Co.) The foundation's stated goal was clear in its name, and the donation provided enough of a deduction to reduce his estate's tax bill to zero. Despite the awkward, 14-word name and the highly specific purpose, the IRS initially approved the foundation's application for tax-exempt status. A year after Mr. Schaller's death, the foundation awarded its first two scholarships — to two descendants of Mr. Schaller's niece and nephew. They got another set of scholarships the next year, as did another relative of Mr. Schaller. The IRS cried foul after noticing scholarships “were made only to descendants of the nieces and nephews of Julius Schaller.” A court fight began, and on July 1, U.S. District Judge Reggie B. Walton ruled the foundation wasn't a legitimate tax break. “The Foundation's activities contravened the law in such a blatant and egregious manner that the Court could not come to any other conclusion,” Mr. Walton wrote. The foundation's lawyers argued that the scholarship was technically open to all eligible descendants of Hungarian immigrants. But it didn't follow through on promises to advertise the scholarship in newspapers, Mr. Walton wrote. It did send information to Scholarships.com and Fastweb.com in 2007, but only on the day after the IRS started an audit. Attorneys for the foundation and Mr. Schaller's executors did not return phone calls seeking comment. The wealthy have a variety of techniques to avoid the estate tax. When Mr. Schaller died, the first $1 million of an estate were exempt from U.S. estate taxes. That's now up to $5.4 million, and for married couples, it's $10.8 million, because they can effectively share their exemptions. To keep more of their estate away from the IRS, the rich can donate art or classic cars to their own private museums or set up special trusts that send income to relatives tax-free. What they can't do, according to Mr. Walton's ruling, is give relatives scholarship money and call it charity.

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