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IRS Attacks "Charitable" Cheats

No one likes to pay taxes. Judging from the amount of money and effort that businesses and individuals expend, it's clear that paying less in taxes is a top priority throughout the nation. Entire industries rely on taxpayers looking to keep their tax bills low; firms like H&R Block (NYSE: HRB  ) and Jackson Hewitt (NYSE: JTX  ) might never have existed without them.

Unfortunately, when people find a good method for cutting their tax bills, they tend to use it as much as they can -- making gifts to charitable organizations, for example. Many taxpayers have found ways to push charitable strategies beyond the limits of the law, which has attracted the attention of the IRS. A recent article from MarketWatch says that the IRS is currently focusing on a special charitable-giving strategy known as a donor-advised fund, to ensure that taxpayers aren't exploiting its loopholes to dishonestly save some cash.

Donor-advised funds and abuse
When used correctly, there's nothing illegal about a donor-advised fund as part of a charitable giving strategy. If you just write a check to charity, you get a current tax deduction, but you give up control over how your donation will be used. Some wealthy donors, preferring to retain this control, establish private foundations that allow them to get similar tax benefits without having to decide immediately which charities will receive the donated funds. As a separate legal entity, the private foundation has a board of directors that makes decisions about which charities will receive foundation funds, how much they'll get, and when they'll get the money. However, private foundations can be expensive to establish, and they require significant attention from their donors.

Donor-advised funds represent a middle ground. These funds are set up by independent charities. For each person who wishes to donate, the charity sets up a separate donor-advised fund. In return, the donor can take an immediate deduction for the amount of the gift. The charity then generally holds the donated money until the donor tells the charity who should receive distributions. While the charity running the fund legally has the right to ignore the donor's instructions, in practice, it almost always follows them.

Unfortunately, taxpayers can use donor-advised funds to make gifts that will benefit them personally. For instance, if parents donate to a university in return for a substantial financial aid package for their child, they shouldn't be able to deduct the gift; in essence, it was used to pay for the child's tuition. In the wrong hands, a donor-advised fund can use its operating charity almost like a money-laundering scheme, making it harder to link any gifts to their ensuing personal benefit. That's what the IRS is trying to stop.

A history of abuse and IRS responses
This isn't the first time that abusive transactions in the charitable realm have resulted in increased IRS scrutiny. Taxpayers often abused the tax breaks gained by donating vehicles to charity. Prior to 2005, many charities made strong efforts to solicit vehicle donations, touting the ability of donors to deduct the vehicle's value. Many taxpayers used this opportunity to give away vehicles that were in poor condition, or even not running at all. However, when they calculated how much to deduct on their tax returns, they used average values from sources like the Kelley Blue Book, sometimes completely disregarding the condition of the vehicle. In comparison to the amount taxpayers were deducting from their returns, the actual amount of money that charities received when they sold these vehicles was far smaller.

Congress and the IRS responded with much tighter limitations on deductions for vehicle donations. Essentially, taxpayers could no longer use Blue Book values for calculating deductions; instead, they could deduct no more than whatever the charity received for selling the vehicle.

Similar episodes in the corporate tax arena have had a much larger impact. Two years ago, the IRS favorably settled with more than 1,000 taxpayers who had used a sophisticated tax shelter to try to defer income. According to a Washington Post report, the settlement brought in more than $3.2 billion. With such huge amounts at stake, it's easy to understand why companies push the limits of the law to find additional savings. Furthermore, companies like General Electric (NYSE: GE  ) and Black & Decker (NYSE: BDK  ) have been able to convince courts that some tax-saving strategies they've used have a legitimate business purpose, therefore avoiding large back tax payments to the IRS.

Spoiling the bunch
That said, some taxpayers' tendency to squeeze every dime they can from available deductions is unfortunate. Time and again, someone will finally push those breaks too far, and the IRS will step in to fight them. If the IRS wins, those abusive taxpayers pay the price in interest and penalties. But an IRS loss can be even worse for everyone, because it often prompts Congress to close the perceived loophole, eliminating the benefit even for law-abiding taxpayers.

Unfortunately, this pattern isn't likely to change. Taxpayers can only make the best of available deductions and other tax benefits as long as they're available, and hope that no one will abuse the system and ruin it for everyone.

Related articles:

You'll find a lot more information to help you through yet another tax season in the Fool's Tax Center, including articles and resources on a wide range of tax topics that are important to you.

Fool contributor Dan Caplinger won't be getting a refund this year, despite taking every deduction he could think of. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't get you in trouble.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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