The Office of Chief Counsel recently released Field Service Advice 20260401F, addressing a promoted strategy involving the transfer of nonvoting limited liability company (LLC) units to a tax-exempt entity. This Field Service Advice (FSA) provides a critical roadmap for tax professionals regarding the Service’s aggressive application of the economic substance doctrine, the assignment of income doctrine, and partnership validation rules under Section 704(e) to dismantle purported tax-minimization structures involving charitable giving.

For CPAs and Enrolled Agents advising clients on complex estate planning or charitable strategies, this memorandum serves as a stark warning against arrangements where the taxpayer retains dominion and control over assets nominally transferred to a charity.

Factual Background: The "Strategy"

The situation involves taxpayers (a husband and wife) who engaged in a "Strategy" devised by an advisor to earn investment income "in a tax-free environment" while simultaneously claiming charitable contribution deductions.

The mechanics of the transaction were as follows: The Taxpayer-Husband established an LLC (LLC1) and transferred nonvoting interests to a tax-exempt Organization (Organization1) to fund a purported donor-advised fund (DAF). The Taxpayers retained 100% of the voting interests and management control. The Taxpayers funded the LLC with marketable securities and cash, opening a brokerage account in their names as members of LLC1.

Under the LLC’s operating agreement, the Manager (Taxpayer-Husband) allocated a high percentage (Percentage1) of partnership items—income, gain, loss—to the tax-exempt Organization1, and a much smaller percentage (Percentage2) to the Taxpayers. This allocation was reflected on the Schedule K-1, allowing the bulk of the investment income to ostensibly flow to the tax-exempt entity.

Despite the transfer of nonvoting units, the Taxpayers maintained "signatory authority to manage the investment and business activities of LLC1". Furthermore, the Taxpayers utilized LLC funds for personal use. The FSA notes that "Taxpayer-Husband withdrew funds from the LLC1 Brokerage Firm brokerage account," which were only later "papered as loans" to the Taxpayers to utilize an amendment to the operating agreement allowing secured loans to "qualified borrowers".

The Taxpayers’ Position

The Taxpayers claimed two primary tax benefits: First, they claimed a charitable contribution deduction in Year 3 equal to "the asserted appraised fair market value of the nonvoting interests transferred" to Organization1. Second, they sought to shield investment income from taxation. As the FSA details, "Taxpayer reported its Percentage2 distributive share of LLC1’s investment loss," while Organization1’s significantly larger share of investment income "escaped taxation" due to its 501(c)(3) status. The Taxpayers explicitly admitted that "one of the intents of this arrangement was for their assets to grow in a ‘tax free environment’".

IRS Legal Analysis: Economic Substance Doctrine

The Service’s primary argument for disregarding the transfer relies on the economic substance doctrine under Section 7701(o). The FSA asserts that "the transfer of nonvoting units to Organization1 lacks substance and must be disregarded," resulting in all income and capital gains being allocated to the Taxpayers.

The Service applied the two-prong test codified in Section 7701(o):

Subjective Inquiry: The IRS concluded the Taxpayers had no valid business purpose. The "Taxpayers took those measures for no purpose other than tax savings". The memorandum highlights that the structure allowed Taxpayers to obtain a deduction and avoid income tax "while maintaining complete control over the assets, and unbridled use of the assets, as evidenced by three withdrawals... which were later characterized as loans".
Objective Inquiry: The IRS determined the transaction did not meaningfully change the Taxpayers’ economic position. "Taxpayer-Husband remained in control of all assets held by LLC1," and "Organization1 was in the same position as to the assets before and after the purported contribution to Organization1, as it held no enforceable right to those assets".

The FSA starkly concludes: "Taxpayer-Husband’s transfer of interest in LLC1 is disregarded because it lacks economic substance".

Rejection of Bona Fide Partner Status Under Section 704(e)

Even if the entity were respected, the IRS argues Organization1 cannot be treated as a bona fide partner. Citing Culbertson v. Commissioner, the Service analyzed whether the parties intended to join together in the present conduct of an enterprise.

The FSA determines Organization1 was "a partner in name only" based on the following:

No Upside Potential: Although the operating agreements required mandatory distributions, "Taxpayer-Husband as Manager disregarded those terms and failed to [make] the required mandatory distributions".
No Downside Risk: Organization1 "paid nothing for its interest in LLC1 and it never made, nor was it required to make, any capital contributions".
No Realizable Value: Organization1 could not sell its interest due to strict transfer restrictions and the fact that the interest held no value without the Manager’s consent to distribute.

Consequently, the Service views the nonvoting interests as having "no value" because the operating agreements were merely "statements of intention to make a gift in the future".

Application of the Assignment of Income Doctrine

The memorandum invokes the assignment of income doctrine to tax the income allocated to the charity back to the Taxpayers. The Service cites United States v. Basye for the principle that "he who earns income may not avoid taxation through anticipatory arrangements".

Because the Taxpayers never parted with dominion and control over the assets, "Taxpayers only assigned the income for purposes of the Form 1065". The IRS distinguished this case from Palmer v. Commissioner and Rev. Rul. 78-197 (which generally respect charitable gifts followed by redemptions). The FSA states those authorities are "clearly distinguishable... since both the decision in Palmer and Rev. Rul. 78-197 are premised on a structure with a charity that receives a donation of an interest from the donor that had value". Here, the IRS position is that "the nonvoting interests in LLC1 have no value" and the structure was "created solely to give the illusion that the charity received something of value".

Denial of Charitable Contribution Deduction

Finally, the FSA disallows the Section 170 charitable deduction on two grounds: lack of charitable intent and failure to substantiate.

Regarding charitable intent, the Service applied the Singer Co. test, looking for a contribution made with no expectation of financial return. The FSA argues the "Taxpayers’ predominant purpose in transferring the nonvoting interests... was to engage in the Strategy for which they received substantial, identifiable financial benefits in return" (specifically, tax-free growth and personal use of funds).

Regarding substantiation, the Taxpayers failed strictly technical requirements:

Contemporaneous Written Acknowledgment (CWA): The Taxpayers did not attach a CWA to their return. Furthermore, for a DAF, the CWA must state the sponsoring organization has "exclusive legal control over the assets contributed." Organization1 could not make this statement "because it had no legal control over the assets contributed".
Qualified Appraisal: Because the deduction exceeded $500,000, Section 170(f)(11)(D) requires a qualified appraisal be attached to the return. The Taxpayers failed to do so.

Conclusion

The conclusions reached in FSA 20260401F are comprehensive and severe for the taxpayers involved.

Transfer Disregarded: The transfer of nonvoting interests is disregarded under the economic substance doctrine.
Income Reallocated: All partnership income allocated to the tax-exempt entity is taxable to the Taxpayers under the assignment of income doctrine,.
Deduction Denied: The charitable contribution deduction is disallowed entirely due to lack of donative intent and substantiation failures.

Tax professionals should note the Service’s finding that the charity "participat[ed] in a tax shelter scheme" and operated as a vehicle to assist the promoter. This suggests that in addition to the taxes and interest owed, substantial penalties and scrutiny regarding the tax-exempt status of participating charities are likely outcomes of such strategies.

Prepared with assistance from NotebookLM.