RSF's Likely Violation of Section 4943 Internal Revenue Code

In its January 23, 2017 Schedule 13D filing, Meridian raises important questions concerning the potential that Michael Arlen Davis (MAD) and/or Rudoph Steiner Foundation (RSF) or the two collaborators together have committed violations of Section 4943 of the Internal Revenue Code.

In its Schedule 13D filing, Meridian notes that MAD frequently adjusted his shareholdings in Cyanotech including several suspect transfers of shares to RSF.
"In its May 6, 2016 letter to the company's board of directors, Meridian noted that Davis appeared to be making transfers to RSF whenever necessary to maintain his holdings below a 20% ownership threshold.  In Amendment No. 7, Meridian focused on a series of transactions that it believes demonstrate Davis' transfers to RSF as a deliberate mechanism to keep his direct holdings below 20%.  As disclosed in Davis' February 20, 2014 Form 4 filing, Davis acquired 50,000 shares of Cyanotech in open market purchases on February 19, 2014. One day prior, on February 18, 2014, Davis transferred 30,769 shares to RSF.  Shortly after these back-to-back transactions, Davis reported his ownership stake in the company at 19.8%.  Were it not for the transfer to RSF immediately prior to Davis' 50,000 share purchase, Davis' ownership interest would have exceeded 20%."
Meridian then notes that Davis operates through a network of supposed not-for-profit entities with 501(c)(3) tax-exempt certifications.  RSF also claims 501(c)(3) tax-exempt status.  Thus both are subject to the ownership limitations and penalties created by Section 4943 of the Internal Revenue Code for "excess business holding" in a business enterprise. 
"An 'excess business holdings' is any holding of voting stock in excess of 20%
Accordingly, were Davis/Skywords found by the IRS to hold more than 20% of Cyanotech at any time during any year, Davis/Skywords would be subject to an excise tax for that year equal to 10% of the value of such excess holding.  In addition, if, at the close of foundation's taxable year, the foundation still has excess business holdings in such enterprise, the IRS would impose an additional tax equal to 200% of such excess business holdings."
Meridian notes that Davis seems to be attempting a "work-around" to the Section 4943 restrictions, splitting the Cyanotech stake he acquired between his family foundations and RSF. 

Analysis of Likely Section 4943 Violation by RSF

26 U.S. Code § 4943, which is titled “Taxes on excess business holdings,” provides that the combined holdings of a private foundation and all of its disqualified persons are limited to 20 percent of the voting stock in a business enterprise.  A  private foundation found to have excess holdings in a business enterprise may become liable for an excise tax based on the amount of the excess holdings.   Such excise tax is equal to 10 percent of the value of any such excess holdings determined as of the day such excess holdings were the greatest.  Section 4943(b) provides that, in addition, if, at the close of the taxable period with respect to such holdings, the foundation still has excess business holdings in such enterprise, an additional tax equal to 200 percent of such excess business holdings will be imposed.

Section 4943(c) provides that the permitted holdings of any private foundation in an incorporated business enterprise is (i) 20 percent of the voting stock, reduced by (ii) the percentage of the voting stock owned by all disqualified persons.

Section 4943 uses the definition of “disqualified person” set forth in 26 U.S. Code § 4946, which provides in relevant part: “the term “disqualified person” means, with respect to a private foundation, a person who is (A) a substantial contributor to the foundation,”

Section 4946 invokes the definition of “substantial contributor” provided in 26 U.S. Code § 507(2)(A): “any person who contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the foundation before the close of the taxable year of the foundation in which the contribution or bequest is received by the foundation from such person. In the case of a trust, the term “substantial contributor” also means the creator of the trust.” 

Section 507(2)(C) provides that “a person shall cease to be treated as a substantial contributor with respect to any private foundation as of the close of any taxable year of such foundation if—
(I) during the 10-year period ending at the close of such taxable year such person (and all related persons) have not made any contribution to such private foundation,
(II) at no time during such 10-year period was such person (or any related person) a foundation manager of such private foundation, and
(III) the aggregate contributions made by such person (and related persons) are determined by the Secretary to be insignificant when compared to the aggregate amount of contributions to such foundation by one other person.”

RSF is a 501(c)(3) entity and thus a private foundation.  Cyanotech is a “business enterprise.”  RSF currently holds 16.5% of the voting stock of Cyanotech and MAD currently holds 16.8% of such votng stock.

Davis is a Disqualified Person.   Review of the 2011 Form 990 tax returns filed by Skywords Family Foundation and RSF indicates that that Skywords made contributions to RSF during the year totalling $2,786,000.  This represented approximately 28% of the aggregate $10,355,278 in contributions received by RSF that year.

As Davis’ Skywords Family Foundation contributed more than 2% of the total contributions received by RSF in 2011, Davis and Skywords meet the definition of “substantial contributor” and are therefore each and together a “disqualified person” under Section 4943 and will remain such for at least 10 years following such year.

RSF’s Excess Business Holdings.  Pursuant to Section 4943(b), RSF’s permitted holdings in Cyanotech is equal (ii) to 20 percent of the voting stock, reduced by (ii) the percentage of the voting stock owned by all disqualified persons.  Since Davis is a disqualified person owning approximately 16.8% of Cyanotech’s voting stock, RSF’s permitted holding is 3.2% (20.0% less 16.8%).  Accordingly, RSF’s excess business holdings in Cyanotech is 13.1% (calculated by taking RSF’s holding (16.3%) and subtracting its permitted holding (3.2%)).

RSF’s excess business holdings originated in 2011 and have continued through the close of the taxable period ended 2016. RSF is subject to an initial excise tax of 10% of its excess business holdings in Cyanotech and an additional tax of 200% of such excess business holdings “at the close of the taxable period with respect to such holdings, the foundation still has excess business holdings in such enterprise.”

Thanks to Michael Arlen Davis, when the IRS gets around to calculating the penalty to be assessed against RSF under Section 4943, the bill is likely to be in the range of tens of millions of dollars.