HOW TO KEEP YOUR NONPROFITS OUT OF TROUBLE WITH THE IRS
Transcription
HOW TO KEEP YOUR NONPROFITS OUT OF TROUBLE WITH THE IRS
HOW TO KEEP YOUR NONPROFITS OUT OF TROUBLE WITH THE IRS by LISA A. RUNQUIST Revised January, 2001 1. Introduction Nonprofit organizations are big business. Because of this, and because of their unparalleled growth, nonprofits are receiving attention like they never have before, both from Congress, and because of this, from the Internal Revenue Service. Another more disturbing reason is the spate of highly publicized scandals involving individuals profiting at a charity's expense. While nonprofits may be big business, we, as a society, have very different ethical expectations of them: "I think I have one message for you today and that is -- I may put it loosely -the horse is out of the barn, and it is trampling on the crops. ... The problems are enormous.... if something is not done very soon the public, the donors, and the Treasury will continue to be ripped off. ... while there have always been some bad apples, over the last 10 or 20 years, their numbers have swelled, and their brazenness has grown." -- Mr. Ormstedt, Assistant Attorney General for the State of Connecticut, at the August 2, 1993 hearing of the House Ways and Means Subcommittee on Oversight. Under these circumstances, anyone who participates in the oversight of a nonprofit organization would be well advised to pay close attention to its operations. There is one standard I would recommend be used to evaluate every activity of the nonprofit is: How will this look on the front page of your local newspaper, in an article written by someone unsympathetic to the cause? 2. The Tax Exempt Status of Nonprofit Corporations 2.1 The Structure of Tax Exemption For Nonprofits, Generally. 2.1.1 Numerous Categories of Exemption Exist. Under Section 501(c) of the Internal Revenue Code there are 27 possible tax exempt categories, each with its own special rules (the last two were added as part of the Health Insurance portability and Accountability Act of 1996). Other exemptions are available under other sections of the Code for certain instrumentalities of government, religious and cooperative corporations, homeowners associations, and political organizations. All federally tax-exempt organizations do not pay taxes on some or all of their income. But only exemption under Section 501(c)(3) of the Internal Revenue Code not only exempts the organization from tax on the broadest range of sources of income, but also gives the organization's financial supporters (i.e., contributors and benefactors) a personal tax deduction for their contributions. Otherwise, contributors to a nonprofit are generally only entitled to a personal tax deduction if the contribution is deductible under some other tax rule (such as a business expense deduction). For this reason, even though gaining and maintaining Section 501(c)(3) status imposes substantial restrictions on a nonprofit's operations, most charitable organizations seek exemption under Section 501(c)(3) of the Internal Revenue Code. Section 6 of these materials focuses on them. Other than Section 501(c)(3), the most common nonprofits are exempt under Section 501(c)(4) as social welfare organizations, Section 501(c)(5) as trade unions, Section 501(c)(6) as chambers of commerce or trade associations, and Section 501(c)(7) as social clubs. No one is sure whether the assignment of Section 501(c)(13) to cemetery associations is coincidence or note. Organizations exempt under each of these sections, as well as the other categories of Section 501(c), must each adhere to the special rules and requirements of their tax exempt status, although the rules are generally less strict and pervasive than for charities exempt under Section 501(c)(3). 2.1.2 Most Organizations Must Apply For Determination of Exempt Status. As noted in paragraph 2.2 above, merely incorporating an entity under the California Nonprofit Corporation Law does not automatically confer exempt status for State or Federal tax purposes. There are a few categories of organizations that can elect a particular nonprofit tax treatment when the organization files its tax return (e.g., nonprofit community associations filing under Section 528 of the Internal Revenue Code). However, with the exception of churches and some very small charities, charities and most other nonprofit corporations do not qualify for special tax exemptions unless and until the corporation applies for tax exemption under a particular classification of tax exempt organization and receives a favorable determination of exempt status from the IRS. All organizations wishing to be exempt in California must apply with the State Franchise Tax Board; many other states do not require separate filing, but recognize the IRS determination as being controlling. For corporations desiring a federal determination of exempt status as a section 501(c)(3) charitable organization, the application for determination of tax exempt status is made by filing Form 1023, "Application For Recognition of Exemption" with the IRS within 15 months following the end of the month in which the entity was organized if the organizers desire the exemption to relate back to the date of formation (can be automatically extended to 27 months), and filing California form FTB 3500 with the Franchise Tax Board within 12 months of the date of incorporation. 3. Charitable Tax Exempt Status Under Section 501(c)(3) 3.1 Basic Requirements for Exemption. Section 501(c)(3) of the Internal Revenue Code defines the category of tax-exempt charitable organizations to be: " . . . organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes . . . or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda or otherwise attempting to influence legislation, and which does not attempt to participate or intervene in any political campaign." 3.2 Charitable Organizations Must Carefully Observe Technical Requirements To Maintain Their Exemption. To qualify as a charity an organization must satisfy the following six requirements: 3.2.1 A charity must have one or more exempt purposes. Among the multiple exempt purposes listed in Section 501(c)(3), the terms charitable, educational, and scientific are amplified generously by the Regulations. The Regulations define charitable broadly. The term includes not only relief of the poor and distressed (the traditional common law definition of charity) but the advancement of education, religion, or science; lessening the burdens of government; and promoting social welfare by activities which are designed "(i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency." Advocacy activities do not preclude 501(c)(3) status unless the nature or level of such activities rises to the point where the organization is an "action" organization. Educational activities, for purposes of Section 501(c)(3), include both the instruction of individuals in order to improve their abilities, and "the instruction of the public on subjects useful to the individual and beneficial to the community." "Scientific" in the context of 501(c)(3) refers to the conduct of scientific research efforts in the public interest. Scientific research will be considered as being carried on in the public interest if (1) the results of the research (including any intellectual property resulting from it) are made available to the public on a nondiscriminatory basis, or (2) the research is performed for a federal government agency or a state or a political subdivision of a state, or (3) the research is "directed toward benefiting the public." The Regulations give four examples of scientific research in which the purpose is considered to be in the public interest: educating college or university students; discovering a cure for a disease; seeking scientific information which is then published in some "form that is available to the interested public" such as a thesis or journal; and "scientific research carried on for the purpose of aiding a community or geographical area by attracting new industry to the community or area or by encouraging the development of, or retention of, an industry in the community or area." 3.2.2 A charity must be organized exclusively for exempt purposes. An organization satisfies this test only if its governing document (here called "articles") limits its purposes to one or more exempt purposes within the scope of Section 501(c)(3) and does not "expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes." In practice, the IRS requires charities to include in their articles language limiting their political activities. Furthermore, a charity's assets must be irrevocably dedicated to one or more exempt purposes. Thus, either the articles or applicable state law must provide that the assets must be distributed upon dissolution either to a governmental entity for a public purpose, or to another charity or charities for "the general purposes for which the dissolved organization was organized." 3.2.3 A charity must be operated exclusively for exempt purposes. This heading, which is derived from the language of Section 501(c)(3) itself, is in fact deceptive. The statute uses the word exclusively, but the Regulations make clear that it is sufficient to be operated primarily for exempt purposes and that an "insubstantial part" of the charity's activities may be devoted to non-exempt purposes. If the organization changes either its purposes or its activities, the organization must let the IRS know of the change. One method is to attach a statement explaining the change to Form 990. The organization should point out the change from the activities/purpose originally described in the exemption application. 3.2.4 No net earnings or assets of the charity may inure to the benefit of any private person. Section 501(c)(3) contains the specific requirement that "no part of the net earnings of [the organization] inures to the benefit of any private shareholder or individual . . . ." This is, in effect, a bar on the unjust enrichment of a charity's insiders -- its founders, members of its governing body, senior employees, indeed anyone in a position to exert significant influence on the charity. The IRS Chief Counsel's office has stated: "Inurement is likely to arise where the financial benefit represents a transfer of the organization's financial resources to an individual solely by virtue of the individual's relationship with the organization, and without regard to accomplishing exempt purposes." Where the benefit to the insider (or any other private party) is an unavoidable byproduct of actions taken for the organization's exempt purpose, however, there is no inurement. The IRS has taken the position that "all persons performing services for an organization have a personal and private interest [in that organization] and therefore possess the requisite relationship necessary to find private benefit or inurement." But the Tax Court has taken a narrower view. Rather than assume that all employees are insiders for purposes of the inurement rule, the Tax Court has stated that an insider is one who has a unique relationship to the organization, by which the insider, by virtue of his or her control or influence over the organization, can cause the organization's funds or property to be applied for the insider's private purposes. Private inurement in the form of excessive executive compensation and other excess insider benefit transactions is discussed at Paragraph 6 below, along with recent legislation giving the IRS a new enforcement tool in this area. 3.2.5 A charity may not support or oppose candidates for public office. The IRS considers this prohibition to be absolute. The Chief Counsel's office has stated that "an organization described in Section 501(c)(3) is precluded from engaging in any political campaign activities." However, a variety of activities by charities relating to elections have been found not to constitute prohibited electioneering. For example, where students in a political science course were required to participate in political campaigns of their own choosing as part of their course work, or where the college provided facilities and faculty advisors for a student newspaper that published student-written editorials on political matters, the IRS has ruled that the college was not itself participating in a political campaign. Furthermore, certain nonpartisan voter education activities are permitted. In Revenue Ruling 78-248, the IRS described various voter education activities and indicated when they did and did not constitute prohibited participation in political campaigns. Where all members of Congress are included in a summary of voting records on legislation on a wide range of topics, and neither the content nor the presentation of the publication implies or expresses an opinion as to the member or the vote, the publication does not constitute prohibited political activity. However, where the publication limits its focus to particular issues of importance to the organization, "its emphasis on one area of concern indicates that its purpose is not nonpartisan voter education." A charity publishing such a voter guide would lose its tax-exempt status for participation in a political campaign. A charity may, however, solicit, and publish in a voter guide, statements of the positions of all candidates on a wide variety of issues which are selected "solely on the basis of their importance and interest to the electorate as a whole. Neither the questionnaire nor the voters guide, in content or structure, evidences a bias or preference with respect to the views of any candidate or group of candidates." However, if the questions "evidence a bias on certain issues," the charity is considered to be participating in a political campaign in violation of Section 501(c)(3). Charities are subject to an excise tax targeted at political expenditures under IRC Section 4955. The tax, equal to 10% of the political expenditure, may be imposed in addition to revocation. A further a 2.5% tax may be imposed on the organization's manager who knowingly agrees to the expenditure. Final Regulations implementing Section 4955 were published on December 5, 1995. Thereafter, this political excise tax was imposed, perhaps for the first time, in 1996 (see TAM 9609007). Political campaign intervention by 501(c)(3) charities is a hot topic with the IRS and increasingly with Congress. Political activities are likely to result in not just warnings, but revocations. This is an area that the IRS has repeatedly indicated is of special interest. One case has already resulted in a revocation. In 1992, the Church at Pierce Creek placed an ad in the Washington Times which stated: "Christians Beware: Do not put the economy ahead of the Ten Commandments. Did you know that Gov. Bill Clinton -- supports abortion on demand -- supports the homosexual lifestyle and wants homosexuals to have special rights -- promotes giving condoms to teenagers in public schools? Bill Clinton is promoting policies that are in rebellion to God's laws ... HOW, THEN, CAN WE VOTE FOR BILL CLINTON?" After auditing the church, the IRS revoked the church's tax exemption. The U.S. District court upheld the IRS's revocation of exempt status, stating, "While plaintiffs probably are correct that the revocation has imposed a burden on their ability to engage in partisan political activity .. they have failed to establish that the revocation has imposed a burden on their free exercise of Religion." Branch Ministries Inc., et al., v. Charles O. Rossotti, No. 95-0724 (PLF) (D.D.C. March 30, 1999). On appeal the United States Court of Appeals upheld this decision on May 12, 2000. And in March of 1998, the Christian Broadcasting Network announced that it had reached an agreement with the IRS whereby it would retain its exempt status as a 501(c)(3) organization, but because it intervened in partisan politics, it would lose its exempts status for 1986 and 1987, would make a significant payment to the IRS, agree not to take part in prohibited campaign activities, and take other steps, such as increasing the number of outside directors, to ensure tax compliance.(1) Other churches and religious organizations that take steps to become publicly involved in partisan politics can expect to be reported to the IRS by Americans United for Separation of Church and State, which has made complaints about several churches recently, and is expected to continue its vigilance in this area. Issues concerning political activity by charities is not limited to religious organizations. In 1999, it was discovered that 53 PBS TV and radio stations had exchanged or rented mailing lists to various Democratic groups. Minnesota Public Radio reported on its website on 12/28/99 that it was being sued by the Minnesota Attorney General's office for having swapped donor lists with the Democratic National Committee and other political organizations. 3.2.6 A charity may not devote a substantial part of its activities to attempting to influence legislation. Put another way, a charity (other than a private foundation) may engage in legislative lobbying without risking its taxexempt status, so long as lobbying is an insubstantial part of its overall activities. Public charities other than churches may avoid being subject to the vague term "insubstantial" by taking advantage of the provisions of Sections 501(h) and 4911. The former defines substantiality with reference to a charity's expenditures on lobbying using a sliding scale of expenditures, and the latter defines precisely what is and is not lobbying in the context of Section 501(c)(3) organizations. Even under the insubstantiality rule, much advocacy commonly conducted by charities does not rise to the level of lobbying. A charity can attempt to influence the action of government officials aside from legislative decisions, advocate its views through public interest litigation, convene conferences on public policy issues even if those issues are controversial, and express its views on those issues through advertisements, all without necessarily engaging in lobbying as the IRS understands the term. 3.3 Public Charity Status. Federal tax law divides charities into two categories: public charities and private foundations. Because private foundations are subject to extensive regulations, and because donors to public charities may claim more generous tax benefits than donors to private foundations, an organization which has been classified as a public charity must monitor its operations to ensure that it retains its privileged status. Under Section 509(a), a charity is presumed to be a private foundation unless it can prove that it is a public charity. 3.3.1 Statutory "Public Charities" (Non Private Foundations). Some charities qualify as public charities regardless of the source of their income or their relationship with other charities. The most frequently encountered charities of this type are: (a) Churches. The Internal Revenue Manual states that at least some of the following factors must be present (though all are not required, and no single factor is determinative) if an organization is to qualify as a church for tax purposes: a distinct legal existence; a recognized creed and form of worship; an internal ecclesiastical government; a formal code of doctrine; a distinct religious history; a membership not associated with any other church or denomination; ordained spiritual leaders who have completed a prescribed course of study; a literature of its own; a congregation which meets regularly; regularly held religious services; a program of religious instruction for young people; an established place of worship; and schools for the preparation of ministers. (b) Schools. Section 170(b)(1)(A)(ii) defines a school as "an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." (c) Hospitals. A charity whose principal purpose is providing medical or hospital care, medical education, or (in limited circumstances) medical research is a public charity. (d) Governmental Units. A donation to a state, the District of Columbia, a possession of the U.S., or any political subdivision of these is treated as a donation to a public charity, so long as the gift is made for exclusively public purposes. 3.3.2 Public Charities Supported Through Donations. A charity may qualify as a public charity under Sections 170(b)(1)(A)(vi) and 509(a)(1) because it receives financial support from a sufficiently broad base of donors. The charity must satisfy one of two mathematical public support tests, both of which exclude from the calculation income from the performance of exempt functions. (a) One-third Test. To satisfy this test, the charity must derives at least one third of its revenues from donations, but the denominator of that fraction may only include a limited portion of funds received from individual and corporate donors and private foundations ("includible public support"). This test is most appropriate for charities with a relatively large pool of smaller donors and/or with substantial government and public charity support. (b) Ten Percent Facts/Circumstances Test. This test requires the charity to derive at least 10% of its revenues from includible public support. In addition, the charity must offer evidence of facts and circumstances showing that it is, in fact, supported by the general public and not dominated by a small group of donors. 3.3.3 Public Charities Receiving Exempt Function Income. A charity may qualify as a public charity under Section 509(a)(2) if it derives at least a third of its total support from a sufficiently diverse group of consumers of its exempt-purpose goods or services and it derives not more than a third of its total support from investment income. 3.3.4 Supporting Organization Public Charities. A charity may qualify as a public charity under Section 509(a)(3) by virtue of its relationship with one or more other public charities which it is organized and operated to support, even if it cannot satisfy any of the mathematical public support tests. 6.3.5 Private Foundations. If an organization does not meet one of the tests set forth above, the organization will be a private foundation. It remains exempt under Section 501(c)(3), but is subject to a 2% excise tax on net investment income, may be subject to additional excise taxes,(2) and is subject to increased scrutiny in any operation that involves its substantial contributors. Any organization that may be considered a private foundation should seek experienced legal counsel. 3.4 For Profit Entities as Exempt Organizations. In a number of instances, state law has required an organization to be formed as a for-profit entity. In at least several instances, the IRS has been willing to overlook the formal "profit" nature of the entity, and recognize the exempt substance of the entity. for example, on December 10, 1998, the IRS issued an exemption to Alliance Medical Group P.C. of Mount Holly, N.J., on the basis that the professional corporation was controlled by its 501(c)(3) parent and provided medical care, on a charitable basis, to the community. Similarly, a trust company, which is required in California to be formed as a business corporation, has also received an exempt determination from the IRS. And the IRS, in its 2000 FY 2001 Continuing Professional Education publication found that if a Limited Liability Company was formed in a state that only allowed the LLC to be a business entity, that LLC could still be an exempt organization, if it otherwise qualified. In all these cases that involve substance over form, it is necessary that there be restrictions in the formation documents sufficient to assure the IRS that what would otherwise be a for profit entity is under the control of an exempt organization. 3.5 Restrictions on Contributions - Donor Advised Funds. Donor advised funds continue to be one of the fastest growing developments, and one of the least understood areas. There is no reference to donor advised funds in the Internal Revenue Code, and only a few cases that use the term. However, it is being used as a viable alternative to either a private foundation or a supporting organization. The principal issue for the IRS is whether or not the donor has surrendered enough control to warrant a current donation, or whether the donor is not entitled to a donation until there has been a distribution from the donor advised fund to its final distributee. A principal case in this area is The Fund for Anonymous Gifts v. IRS (D.C. Circuit 4/12/99), No. 97-5142. In 1997, the denial of the exempt status of The Fund for Anonymous Gifts by the IRS was upheld by the district court, because its governing instrument allowed donors to place "conditions subsequent" on their donations, permitting them to retain investment control. The Fund appealed, and retroactively amended its governing instrument to delete this provision. On this basis, the D.C. Circuit court granted the exemption in 1999, and remanded it to the district court to determine if it was publicly supported. In a private letter ruling issued in August of 2000, the IRS determined that contributions to an internet based donor advised fund could be considered support from the general public. The organization represented that it will confirm that each recommended recipient is a qualified public charity listed in its database, and that no questions as to public accountability have been raised. It was determined by the IRS that the due diligence that would be performed by the organization in reviewing recommendations from donors using its database would be a clear exercise of dominion and control over the funds.(3) 4. Conflicts of Interest One area of corporate law that has become increasingly important in the nonprofit arena, is that of conflicts of interest. Directors of a nonprofit corporation are expected to adhere to a fiduciary standard, when exercising their responsibilities. 4.1 What Is Meant By "Fiduciary Duty"? 4.1.1 General Definition. Modern usage of the concept of a fiduciary includes any person who has a duty to act primarily for the benefit of others in matters connected with the undertaking. The cases speak of a "special confidence reposed in one who, in equity and good conscience, is bound to act in good faith and with due regard to the interests of the person who has reposed that confidence." The type of persons who are commonly referred to as fiduciaries include trustees, attorneys and corporate directors. 4.1.2 The Strict Trustee Standard of Duty. Cases involving strict fiduciary relationships, such as cases involving claims against trustees, also impose the rule that the fiduciary cannot exert pressure or influence on the party the fiduciary is serving or take any selfish advantage of his or her trust. Trusteefiduciaries are also prohibited from dealing with the subject matter of the trust in a way which benefits the interests of the trustee or prejudices the beneficiary, unless the fiduciary is acting in the utmost good faith and with the full knowledge and consent of the beneficiary. 4.1.3 The Standard Applied to Directors of Nonprofit Corporations. The directors of both business and nonprofit corporations have been described in numerous cases as owing a fiduciary duty to their shareholders or members, as well as to the corporation. However, it is well established that a strict trustee standard of duty, which would prohibit any self-dealing with the corporation, regardless of the benefit conferred, is generally not what is intended or required (at least not in California). "A trustee is uniformly held to a high standard of care and will be held liable for simple negligence, while a director must have committed 'gross negligence' or otherwise be guilty of more than mere mistakes in judgment." (Stern v. Lucy Webb Hayes School, 1974, 381 F.Supp. 1033.) There was substantial concern among the drafters of California's Nonprofit Corporation Law that, if too strict a standard was imposed on directors by the Corporations Code, it would be difficult, if not impossible, to get qualified individuals to serve. There was also concern that application of the strict trustee standard would require charities to decline to participate in transactions in which the organization's directors were willing to provide goods or services at below market rates. (See H. Oleck, Nonprofit Organizations' Problems (1980).) The statutory resolution of these issues reflects these concerns. 4.2 Statutory Definition of the Directors' Standard of Conduct (The "Duty of Care"). The standard of conduct prescribed for directors of nonprofit public benefit corporations is essentially the same standard that the Legislature has imposed on business corporations under Corporations Code Section 309. That standard, as applied to public benefit, mutual benefit and religious corporations, is found in Corporations Code Sections 5231, 7231, and 9241 and is generally referred to as the directors' "duty of care." The basic rule reads as follows: "A director shall perform the duties of a director, including duties as the member of any committee of the board, . . . in good faith, in a manner the director believes to be in the best interests of the corporation, and with such care, including reasonable inquiry, as is appropriate under the circumstances." Directors are authorized to rely on information, opinions, reports or statements, including financial statements, prepared or presented by: (a) One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented; (b) Counsel, independent accountants and other persons as to matters which the director believes to be within such person's professional or expert competence; or (c) A committee of the Board upon which the director does not serve as to matters within the committee's designated authority. and for religious corporations, (d) Religious authorities and ministers, priests, rabbis or other persons whose position in the religious organization the director believes justify reliance. In relying on the opinions or reports of others, the director must, of course, act in good faith and conduct reasonable inquiry when the need for such inquiry is indicated by the circumstances. The director must also be free of any knowledge which would cause reliance on data received from others to be unwarranted. 4.3 The Directors' Duty of Loyalty 4.3.1 Generally. The admonition found in Sections 5231, 7231 and 9241 that a director must act in a manner that the director believes to be in the best interests of the corporation has often been termed the "duty of loyalty." The duty of loyalty has generally been construed as an obligation of the corporate directors to act in the best interests of the corporation and all of its members, including the members of minority factions, and to administer their corporate powers for the common benefit. See Remillard Brick Co. v Remillard-Dandini Co. (1952) 109 Cal.App.2d 405. This is in keeping with the fundamental nature of a nonprofit, to advance and achieve the corporate purpose, rather than to benefit the interests of any private individuals. Directors are to champion the best interests of their organization (which may include their constituents), rather than personal or selfish interests. To help ensure that persons with selfish interests are not making corporate decisions, CCC § 5227 requires that at least half of a California nonprofit public benefit corporation's directors must not be compensated by the nonprofit for services (other than nominal payments to directors for serving as such). Amendments to this section in 1996 give it teeth, by giving certain persons standing to sue to enforce it. 4.3.2 The Corporate Opportunity Doctrine. A common law component of the director's duty of loyalty is referred to as the "corporate opportunity doctrine". Under this doctrine, if a director becomes aware of an opportunity or transaction that would be of interest or benefit to the corporation he or she serves, the director is bound to disclose the opportunity to the corporation and permit it to take advantage of the opportunity if it so desires. If a full disclosure of the opportunity is made and the corporation declines to act, the director is then free to pursue the transaction for his or her own advantage. The basis for the doctrine is the "unfairness on the particular facts" of the director taking personal advantage of an opportunity that should rightfully accrue to the corporation. See Industrial Indemnity v. Golden State Company (1953) 117 Cal.App.2d 519. 4.3.3 Statutory Regulation of Self-Dealing Transactions. In speaking of a director's duty of loyalty, the thought is that a director should avoid participating in, or seeking to influence, any transaction involving the corporation where the director has a conflict of interest. The California Nonprofit Corporation Law contains no such bright line rule, although the Attorney General's representatives argued in favor of a complete ban on any self-dealing by nonprofit directors. Instead, Corporations Code Sections 5233 and 9243, and to a lesser degree, 7233 present a complicated statutory scheme for approval of "self dealing transactions", defined as any transaction to which the corporation is a party, and in which one or more of its directors has a material financial interest. Failure to follow proper procedures can result in strict sanctions on directors of public benefit and religious corporations, and to some degree mutual benefit corporations who engage in self-dealing transactions. The complexity of the statutory prohibition on "self-dealing transactions", especially with regard to public benefit and religious corporations, reflects an attempt by the Code's drafters to accommodate most of the concerns expressed by the Attorney General, while permitting some types of transactions between a corporation and one or more of its directors which might be of substantial benefit to the corporation. Most of the sections' complexity revolves around the attempt to define what transactions are included and excluded from the term "self-dealing". In addition, there is no attempt in the statute to define the term "financial interest" or the word "material". It is also unlikely that the prohibitions of these sections extend to most transactions involving relatives of a director (other than the director's spouse) or to transactions between the corporation and another corporation in which the director is merely an officer. The following specific situations are excluded (Corp. Code §§ 5233(b), 9243(b)): (a) Actions of the Board fixing director or officer compensation; (b) Transactions which are part of the corporation's public, charitable or religious program which are approved by the corporation in good faith and without unjustified favoritism, even if one or more directors or their families are benefited as part of a class of persons intended to be benefited by the program; and (c) Any transaction of which the interested director or directors have no actual knowledge, and which does not exceed the lesser of one percent of the gross receipts of the corporation for the preceding fiscal year or $100,000. Finally, there are several ways which the Code permits a transaction which otherwise would be prohibited as falling within the definition of a self-dealing transaction. Such participation is permitted if it is approved or validated in any one of the following ways (Corp. Code §§ 5233(d), 9243(d)): (a) The Attorney General can approve the transaction, either before or after it is consummated; (b) If a religious corporation, the transaction may be approved by the members of the corporation who are not directors, after disclosure of the material facts and the director's interest; (c) The transaction can be validated by proving that: (i) the corporation entered into the transaction for its own benefit; (ii) the transaction was fair and reasonable as to the corporation; (iii) the Board approved the transaction in advance with knowledge of the director's interest and by a majority vote (without counting the vote of the interested director(s)); and (iv) that prior to approving the transaction the Board considered and in good faith determined, after reasonable investigation under the circumstances, that the corporation could not obtain a more advantageous arrangement with reasonable effort; or (d) The transaction can be validated by approval of the transaction by a committee or person authorized by the board so long as it is established that: (i) the approving committee or person utilized the standards that the Board must follow under (b), above; (ii) it was not reasonably practicable to obtain prior Board approval; and (iii) the Board, after determining that the requirements for committee approval had been satisfied, ratifies the transaction at its next meeting by a vote of a majority of the directors (excluding the vote of any interested director). Note that under California law, a self-dealing transaction, itself, is not void, voidable or invalid. Instead, the focus is on making the interested director disgorge his or her profits in the matter and making the organization whole. The Court can order the director to make an accounting and pay the profits to the corporation, require the interested director to reimburse the corporation for the value of any corporate property used in the transaction, or require the interested director to return or replace corporate property lost in the transaction or to account to the corporation for the proceeds of any property sold and to pay those proceeds, plus interest, to the corporation. 4.4 IRS' Position on Conflicts of Interest The duty of loyalty requires that when a director is making a decision on behalf of the corporation, he/she must be looking out for the corporation's best interests, rather than his/her own. When a decision could benefit or harm the director personally, then the director is considered to have a conflict of interest. This has become a particular concern to the IRS, especially with regard to private benefit and private inurement issues. In the 1995 (for 1996) Exempt Organizations CPE Technical Instruction Program Textbook, the IRS addresses this concern over possible private benefit or private inurement issues "that may arise because of the relationship between an exempt organization ... and its physician employees/contractors, Officers, Directors and key employees. In most situations, the best protection for a charitable trust is a well-defined,written policy governing conflicts of interest." This concern over conflicts of interest continued in the 1996 (for 1997) Exempt Organizations CPE Technical Instruction Program Textbook, in an article entitled, "Community Board and Conflicts of Interest Policy. The IRS describes the purpose of a conflicts of interest policy as being: "to protect the exempt organization's interest in transactions or arrangements that may also benefit an officer's or director's private interest. The primary benefit of a conflicts of interest policy is that the board can make decisions in an objective manner without undue influence by persons with a private interest. The presence and enforcement of a conflicts of interest policy can also help assure that an exempt health care organization fulfills its charitable, properly oversees the activities of its directors and principal officers, and pays no more than reasonable compensation to physicians and other highly compensated employees." FY 1997 CPE Textbook Chapter C, p.18-19. Both of these articles focus specifically on the health care industry. However, it must be noted that everything set forth in these articles are equally applicable to non-health care exempt organizations. Although not required, either by California law or the Internal Revenue Code to be in the bylaws, the IRS "favorably views organizations having policy statements in their by-laws which clearly identify situations where a conflict might arise." FY 1996 CPE Textbook Chapter P, p.386-7. This discussion has been more fully enunciated in the 1997 Textbook. To begin with, "A substantial conflicts of interest policy should include the following provisions: A. Disclosure by interested persons of financial interests and all material facts relating thereto. B. Procedures for determining whether the financial interest of the interested person may result in a conflict of interest. C. Procedures for addressing the conflict of interest after determining that there is a conflict: 1. Requiring that the interested person leave the meeting during the discussion of, and the vote on, the transaction or arrangement that results in the conflict of interest; 2. Appointing, if appropriate, a disinterested person or committee to investigate alternatives to the proposed transaction or arrangement; 3. Determining, by a majority vote of the disinterested trustees present, that the transaction or arrangement is in the organization's best interests and for its own benefit; is fair and reasonable to the organization; and, after exercising due diligence, determining that the organization cannot obtain a more advantageous transaction or arrangement with reasonable efforts under the circumstances; and 4. Taking appropriate disciplinary and corrective action with respect to an interested person who violates the conflicts of interest policy. D. Procedures for adequate record keeping. The minutes of the board meeting and all committees with board-delegated powers should include: 1. The names of the persons who disclosed financial interests, the nature of the financial interests, and whether the board determined there was a conflict of interest; and 2. The names of all persons present for discussions or votes relating to the transaction or arrangement; the content of these discussions, including any alternatives to the proposed transaction or arrangement; and a record of the vote. E. Procedures ensuring that the policy is distributed to all trustees, principal officers and members of committees with board-delegated powers. Each such person should sign an annual statement that he or she: 1. Received a copy of the conflicts of interest policy; 2. Has read and understands the policy; 3. Agrees to comply with the policy; 4. Understands that the policy applies to all committees and subcommittees having board-delegated powers; and 5. Understands that the organization is a charitable organization that must engage primarily in activities that accomplish one or more of its tax-exempt purposes to maintain its tax-exempt status. F. Procedures for applying the policy to a compensation committee should include: 1. Restrictions barring physicians who receive, directly or indirectly, compensation from the organization, for services as employees or as independent contractors, from membership on its compensation committee; and 2. Restrictions precluding a voting member of a compensation committee who has a conflict of interest in the organization from which the member receives compensation, directly or indirectly, from voting on matters pertaining to that member's compensation. FY 1997 CPE Textbook Chapter C, p. 21-23 The textbook goes on to suggest that the nonprofit, as part of its system of controls, conduct periodic reviews of the activities to ensure that the organization is operating in a manner consistent with accomplishing its charitable purpose, and does not result in private inurement or impermissible private benefit. It also includes a Sample Conflict of Interest Policy (revised again by the IRS in 1999), a copy of which is attached as Exhibit A, hereto. Adopting and complying with a conflict of interest policy will assist the organization in carrying out its responsibilities to avoid private inurement or private benefit, addressed in the intermediate sanctions rules (see below). 5. Private Inurement, Excessive Compensation, Intermediate Sanctions, and Control 5.1 Basis for Revocation of Exemption Probably the most common reason today for revocation of exemption is inurement. This is also the area that appears to make it to the front page of the newspaper most quickly. As a result, the compensation paid to executives, insiders, directors, and officers, should be carefully reviewed. If the organization is reluctant to have this information made public, it is likely that the IRS will find it to be unreasonable, and thus in violation of the requirement that no funds of a nonprofit inure to the benefit of any private individual. Inurement has also been the principal concern raised by Congress as a reason for providing for additional regulation of exempt organizations: "What concerns us today is the fact that some charitable organizations have abused the public trust and have allowed tax-deductible contributions to inure to the benefit of select privileged insiders. Our Subcommittee looked at the tax returns for the 250 largest tax-exempt organizations and the salaries of the top 2,000 executives at these organizations. We found that 15 percent of these executives were paid more than $200,000 per year and that there are 38 individuals making more than $400,000. In addition, review of these returns causes me to continue to ask myself: (1) `Is it appropriate for a charitable organization to shift $5 million, tax-deductible dollars to its for-profit subsidiary; (2) should a medical school vice president be allowed to borrow $1 million, interest free, to buy and renovate his house; (3) should charitable contributions be used to pay a $1 million salary to the chairman of an educational organization; and (4) should the administrator of a small pension plan be paid $500,000 in salary.' Also, press reports call into question whether tax-deductible donations should be used to provide charity officials with extravagant perks, like luxury cars, servants, chauffeurs, country-club memberships, and extremely lucrative severance packages." -- J. J. Pickle, Chairman, at the 6/15/93, hearing of the Oversight Subcommittee of the House Ways and Means Committee. And at the second 1993 hearing on the subject of exempt organizations, Congressman Pickle continued with additional examples: "We have learned of the following examples where charities used charitable assets for personal gain.... with assets from one charitable organization, an executive paid his child's college tuition, leased a luxury car for his wife, had his kitchen remodeled, and rented a vacation house at the beach. The charity permitted him to charge almost $60,000 in personal expenses to the organization's American Express Card. ... at a tax-exempt hospital, the CEO used charitable assets to pay for such personal items as liquor, china, crystal, perfume, airplane, and theater tickets. The hospital also picked up the tab for the CEO's country club charges, and catered lunches to the tune of approximately $20,000. ... another charity paid $200,000 for its executive director's wedding reception, and tropical island honeymoon. The charity also plunked down $90,000 for the downpayment on the director's home, and had enough left over to pay for his trip to a desert health spa.... "Moreover, the contributors may never learn exactly how their donations are being spent by such charities. Many of the abuses I just cited were not reflected on the Forms 990 filed by the charities with the Internal Revenue Service." --J.J. Pickle, Chairman, August 2, 1993 hearing of the House Ways and Means Subcommittee on Oversight. The determination of reasonableness of compensation, as well as what benefits are taxable to the individual are the same for exempt organizations as it is for taxable corporations. Section 162 and its regulations apply to exempt organizations and their employees. Any private benefit received by an individual, in addition to being reasonable, must also be incidental to the benefits received by the organization. In December of 1997, the Tax Court ruled in United Cancer Council v. Commissioner, 109 T.C. 17 (1997) that the IRS properly revoked the exempt status of the organization, retroactively to when it first entered into an arrangement with a fundraiser, Watson and Hughey Company, to conduct direct mail fundraising solicitations. During the five years of the contract, UCC received $29 million in contributions, of which it netted $2 million in profits. W&H, directly and indirectly, received $8 million for its services. The court found that W&H, even though it was a third party and not an officer or director, exercised exclusive control over the fundraising activities, and had substantial control over UCC's finances. Therefore, because of this control, W&H was found to be an insider, and received an impermissible private benefit. Because the net earnings were found to have inured to the benefit of a private individual, the revocation of exemption was proper. This case was reversed and remanded on appeal by the 7th Circuit on the basis is that there was no inurement; an independent contractor without other relationships to the nonprofit would not be considered an insider based on a contract negotiated at arms length. the court indicated that the IRS may have been able to prevail on a private benefit analysis, and remanded it for further consideration. A settlement was reached in April, when the IRS and UCC entered into a closing agreement that provided for loss of exempt status for the UCC from 1986 - 1989, and granted exempt status from 1990 and beyond. However, UCC also agreed not to raise any additional funds from the general public, and to limit its activities to accepting charitable bequests and transmitting such bequests to other exempt cancer councils to provide direct care to cancer patients; any assets remaining in its bankruptcy estate, after paying the IRS and other creditors will be used for the same purposes. Further, the IRS agreed not to disallow the deductibility of any contributions made during 1986-1989 on the grounds that UCC was not a qualified recipient of charitable donations. In another Tax Court case, the court upheld the 1990 revocation of a charitable organization's status, retroactive to 1983, on the basis that all or part of the net earnings (from operating bingo games) inured to the benefit of several insiders. Payment of attorney fees, when the specified indemnification procedures were not followed, was inurement, as were rent payments, as there was little evidence that rent was paid on a fair market basis. Interestingly enough, embezzled funds were not found to constitute inurement, as this was not an "intentional conferring of benefits". Variety Club Tent No. 6 Charities Inc. v. Commissioner, TC Memo 1997-575 (12/31/97). And in KJ's Fund Raisers, Inc. v. Commissioner, TC Memo 1997-424 (9/22/97), an organization raising funds to support bowling leagues was also found not exempt on the basis of private benefit; the owners of the facility where pull tabs were sold had substantial control over the operation of the exempt organization. Another case, Anclote Psychiatric Ctr. Inc. v. Commissioner, T.C. Memo 1998273, (July 27, 1998) upheld a revocation of the exempt status of an organization, after its assets were purchased by a for-profit corporation owned by its directors for less than fair market value. Because the organization allowed its assets to inure to the benefit of its directors (total sale price - $6.6 million; fair market value - $7.8 million), the court found that its exempt status was properly revoked. This was appealed to the 11th Circuit. In the Estate of Bernice Pauahi Bishop, also known as Kamehameha Schools Bishop Estate was reached in principle on August 18, 1999. The IRS had proposed revocation of the exempt status of the Bishop Estate retroactive to July 1, 1989, based on findings of substantial evidence of private benefit and inurement to private individuals including the Trustees (who were being paid $800,000 per year), evidence that the organization was operated for a nonexempt purpose, evidence of political campaign intervention, and unrelated business income not being properly reported. The Bishop Estate agreed to a reorganized structure, removal of all the incumbent trustees, and payment of $9 million plus interest, in lieu of Federal taxes or deficiencies for the period ending 6/30/96. The Agreement was approved by the Hawaii Circuit Court, First Circuit on 12/1/99, and final approval was then given by the IRS on February 23, 2000. However, the closing agreement does not extend to the Estate's taxable subsidiaries, and does not cover personal liability of the trustees. Nor does it cover state issues of imprudent management and selfdealing.(4) A settlement was reported (September 22, 2000) in the Honolulu Advertiser that the Estate would receive $14 million from the former trustees' insurance company, contingent upon the IRS releasing the former trustees from intermediate sanctions penalties.(5) Apparently at least one trustee decided not to wait for the IRS to agree to such a settlement; on August 1, 2000, one of the trustees filed in tax court, challenging an assessment of the excess benefit transactions tax for 1995-99, denying that his compensation was excessive.(6) 5.2 Intermediate Sanctions 5.2.1 Introduction. Perhaps the most important change in the last 30 years in the area of nonprofit law occurred on July 30, 1996, when the Taxpayer Bill of Rights 2 added section 4958 to the Internal Revenue Code. Section 4958 adds intermediate sanctions as an alternative to revocation of the exempt status of an organization when private persons benefit from transactions with a nonprofit organization. Intermediate sanctions allow the Internal Revenue Service to impose excise taxes (i.e., penalties) on certain persons who improperly benefit from transactions with an exempt organization. Intermediate sanctions penalize the person(s) who benefit from an improper transaction, rather than the organization. Section 4958 applies to all organizations exempt under section 501(c)(3) other than private foundations, and to those exempt under section 501(c)(4). Because section 4958 represents a major change in nonprofit tax law, it is important that you and your board fully understand what the law is, how it works and what you and your organization can do to limit the possibility of penalties being incurred under the new law. Proposed regulations for Section 4958 were issued on July 30, 1998. On January 10, 2001, Temporary Regulations were issued, effective for three years until January 9, 2004 (unless final regulations are issued earlier). Because of the number and complexity of comments to the Proposed Regulations received by the IRS from attorneys and other practitioners, as well as the compexity of the area, the Regulations were issued as temporary rather than final and the IRS will review some areas further. Of course, even in the areas that the IRS has not asked for comments, there may be further modifications before the regulations are issued in final form. However, unlike proposed regulations, Temporary Regulations are binding during their effective period. 5.2.2 History. Prior to section 4958, if a transaction with an exempt organization resulted in private inurement or private benefit, the only option available to the Service was to revoke the organization's 501(c)(3) exemption. Because this is an extreme penalty, most often hurting the beneficiaries of the organization more than the recipient of the improper benefit, the penalty has rarely been used. For several years prior to the passage of section 4958 in 1996, attempts were made to provide a less severe penalty. This goal was met in section 4958 with the adoption of what are commonly referred to as intermediate sanctions. Intermediate sanctions may be imposed in lieu of, or in addition to, revocation of an organization's exempt status. Although the intermediate sanctions law is retroactive to September 14, 1995, the effective date of the law should not be confused with the effective date of regulations adopted by the Internal Revenue Service to implement the law. Further, the force of the law (Section 4958) is different from the IRS' interpretation of it (the regulations). 5.2.3 What Organizations Are Covered? Section 4958 applies to all organizations which are or were described in Section 501(c)(3) or Section 501(c)(4) of the Internal Revenue Code at any time during the last five years, except for private foundations (which are already subject to their own excise tax law), governmental entities that are exempt from taxation without regard to section 501(a), and foreign organizations which receive substantially all of their support from non-US sources. Because most organizations are required to establish their exempt status with the IRS, an organization is considered described in Section 501(c)(3) only if it has made the requisite filing, unless it is exempt from filing under Section 508 (e.g. churches and small organizations). An organization is considered described in Section 501(c)(4) if it has applied for and received exemption from the IRS as such an organization, or has filed for recognition under 501(c)(4) or has filed an annual return as a 501(c)(4) organization, or has otherwise held itself out as being a 501(c)(4) organization, exempt from tax under Section 501(a). The organization is not described in Section 501(c)(3) or (c)(4) during any period for which a final determination or adjudication that the organization is not exempt has been made (so long as the determination or adjudication is not based on private inurement or excess benefit transactions). 5.2.4 What Individuals are Affected? Intermediate Sanctions may be imposed on any "disqualified person" who receives an excess benefit from a covered organization and on each "organization manager" who approves the excess benefit transaction. Note: Although being a disqualified person is a prerequisite to finding an excess benefit transaction, being a disqualified person does not automatically result in a finding that a transaction involves an excess benefit. If a person is not a disqualified person, then there can be no excess benefit with regard to that person. Who is a Disqualified Person? A disqualified person is any person (whether an individual, organization, partnership or unincorporated entity) which, during a five year period beginning after September 13, 1995, and ending on the date of the transaction in question, was in a position to exercise "substantial influence" over the affairs of an exempt organization. Where there are affiliated organizations, whether a person has substantial influence must be determined separately for each organization. A person may be a disqualified person for more than one organization. Disqualified Persons. Section 4958 identifies certain persons as having substantial influence as a matter of law; these persons are conclusively presumed to be disqualified persons. In addition, the temporary regulations identify additional categories of persons who have substantial influence, and are thus considered by the IRS to be presumptively disqualified. Under the statute, the following are disqualified: a. A family member (spouse, siblings and their spouses, ancestors, children, grandchildren, great grandchildren, and spouses of children, grandchildren and great grandchildren) of a disqualified person. A legally adopted child is a child of said individual. b. An organization (corporation, partnership, trust or estate) owned 35% or more, directly or indirectly, by a disqualified person or his or her family member(s). This does not include voting rights held only as a director, trustee, or other fiduciary, without any stock, profit or other beneficial interest. Other persons defined by the regulations as having substantial interest include: a. Members of the governing board of the organization who are entitled to vote on matters over which the governing body has authority (e.g., directors, elders, trustees, etc.). b. Executive officers of the organization, such as the president, chief executive officer, and chief operating officer. Regardless of the actual title used, this category includes any individual who has ultimate responsibility for implementing board decisions, or for supervising the management, administration or operation of the organization. This responsibility may rest with more than one individual. Unless a person demonstrates otherwise, any person who has a title of president, chief executive officer or chief operating officer will be considered to have this authority. c. The treasurer or chief financial officer. This category includes anyone who has or shares ultimate responsibility for managing the organization's financial assets, regardless of actual title. Again, there may be more than one individual with this responsibility, and any person with the title of treasurer or chief financial officer will be considered to have this ultimate responsibility unless he/she demonstrates otherwise. d. If a hospital participates in a provider-sponsored organization, any person who has a material financial interest in the organization (e.g., a person involved in a joint venture with the organization). Not a Disqualified Person. Conversely, there are categories of persons who, under the temporary regulations, are deemed not to have substantial influence. These include: a. 501(c)(3) organizations. b. With respect to a 501(c)(4) organization, another organization described in 501(c)(4). c. Employees who do not fit into one of the categories listed above, provided they are not highly compensated employees (as defined in section 414(q)(1)(B)(i) - compensation in excess of $80,000, as adjusted by the IRS) or substantial contributors (as defined in section 507(d)(2)(A), taking into account only contributions received during the current and the four preceding taxable years). Facts and Circumstances Test. In all other cases, whether or not an individual or organization is a disqualified person is determined by a facts and circumstances test. The temporary regulations include two lists of facts and circumstances. The first includes facts and circumstances that tend to show an individual has substantial influence. The second includes facts and circumstances that tend to show a person does not have substantial influence. a. Facts and circumstances which tend to show a person has substantial influence include: 1. The person founded the organization. 2. The person is a substantial contributor to the organization (as defined in section 507(d)(2)(A), taking into account only contributions received during the current taxable year and the four preceding taxable years). 3. The person's compensation is primarily based on revenues derived from an activity of the organization that the person controls (see further discussion about percentage payments, below). 4. The person has or shares authority to control or determine a substantial portion of the organization's capital expenditures, operating budget, or compensation for employees. 5. The person manages a discrete segment or activity of the organization that represents a substantial portion of the organization's activities, assets, income or expenses, as compared to the organization as a whole. For example, a person who manages one department that contributes significantly to the whole may be a disqualified person. 6. The person owns a controlling interest (measured either by vote or value) in an organization (corporation, partnership, trust) that is a disqualified person. 7. The person is a non-stock organization (such as a social club, homeowners association, etc.) controlled, directly or indirectly, by one or more disqualified persons. b. Facts and circumstances which tend to show a person has no substantial influence include: 1. The organization is a religious organization and the person has taken a "bona fide" vow of poverty as an employee, agent, or on behalf of the organization. 2. The person is an independent contractor (e.g. an attorney, an accountant, or investment manager or advisor) whose sole relationship to the organization is providing professional advice (without having decision-making authority) with respect to transactions from which the independent contract will not economically benefit, either directly or indirectly, apart from customary fees received for the professional advice rendered. 3. The direct supervisor of the individual is not a disqualified person. 4. The person does not participate in any management decisions affecting the organization as a whole or a discrete segment or activity of the organization that represents a substantial portion of the organization's activities, assets, income or expenses, as compared to the organization as a whole. 5. Any preferential treatment a person receives which is based on the size of the person's donation, is also offered to all other donors making a comparable contribution as part of a solicitation intended to attract a substantial number of contributions. Donor Advised Funds. The IRS has not addressed the issue of donor advised funds in the temporary regulations. It did note in its Explanation of disqualified persons, that although donors "cannot properly have legal control over the segregated fund, they nonetheless are in a position to exercise substantial influence over the amount, timing, or recipients of distributions from the fund." The IRS also requested comments concerning the issues raised by applying the fair market value standard of section 2958 to distributions from a donor advised fund to (or for the use of) the donor or advisor Organization Manager. An organization manager who participates in an excess benefit transaction, knowing that it is such a transaction, is liable for penalties unless the participation was not willful, and was due to reasonable cause. Who is an Organization Manager? An organization manager is any officer, director, trustee, or person having similar powers or responsibilities, regardless of his or her title. A person is an officer if specifically so designated under the articles or bylaws of the organization, or if he or she regularly exercises general authority to make administrative or policy decisions for the organization. If a person only makes recommendations, but cannot implement decisions without approval of a superior, that person is not an officer. The temporary regulations make it clear that an "independent contractor who acts solely in a capacity as an attorney, accountant, or investment manager or advisor is not an officer."(7) An organization manager also includes anyone serving on a committee of the board (or board designee, whether or not a member of the board), if the organization is claiming that the rebuttable presumption of reasonableness (see discussion below) is based on the committee's (or the designee's) actions. In other words, if the committee is responsible for determining the reasonableness of a transaction, and this determination is relied upon by the organization, every member of the committee will be considered an organization manager. When Does an Organization Manager Participate in a Transaction? Participation includes silence or inaction by the organization manager, when the manager is under a duty to speak or act, as well as any affirmative action. Therefore, abstention is considered consent to a transaction. However, if a manager has opposed the transaction in a manner consistent with his/her responsibilities to the organization, the manager will not be considered to have participated in the action. Knowing Participation. "Knowing" means that the manager 1) has actual knowledge of sufficient facts which indicate, based solely on those facts, the transaction is an excess benefit transaction, 2) is aware that the transaction may violate the law, and 3) negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction or is, in fact, aware that it is such a transaction. Although knowing does not mean having reason to know, under the Temporary Regulations, evidence that a manager has reason to know is relevant to determine whether the manager has actual knowledge. It is up to the IRS to prove that the manager knowingly participated. If an organization manager relies on a reasoned written opinion of an appropriate professional, his or her participation will ordinarily not be considered knowing. See "Opinion of Professional", below. In addition, an organization manager's participation is ordinarily not considered knowing if the requirements of the rebuttable presumption of reasonableness are satisfied. See "Rebuttable Presumption of Reasonableness", below. Willful Participation. Participation by an organization manager is willful if it is voluntary, conscious and intentional. It is not willful if the manager does not know (see above discussion) that the transaction is an excess benefit transaction. Due to Reasonable Cause. Participation is due to reasonable cause if the manager exercised responsibility on behalf of the organization with ordinary business care and prudence. 5.2.5 Opinion of Professional. If an organization manager, after full disclosure of all relevant facts to an appropriate professional, relies upon the advice of such professional that a transaction is not an excess benefit transaction, the person's participation will generally not be considered to be knowing and willful and will be considered due to reasonable cause, even if the transaction is subsequently determined to be an excess benefit transaction. However, to qualify, the advice must be contained in a reasoned written opinion with respect to elements of the transaction within the professional's expertise. An opinion must apply the specific facts relative to the transaction to the applicable standards and reach a reasoned conclusion. The opinion is not reasoned if it simply recites the facts and expresses a conclusion. Under the preliminary regulations, reliance was limited to opinions rendered by attorneys. However, the temporary regulations have expanded the professionals on whose written opinions an organization manager may rely to include attorneys, certified public accountants or accounting firms with expertise regarding the relevant tax law matters, and independent valuation experts (appraisers and compensation consultants). Independent valuation experts must hold themselves out to the public as appraisers or compensation consultants, perform the relevant valuations on a regular basis, be qualified to make valuations of the type of property or services involved, and include in their written opinion, a certification that these requirements are met. 5.2.6 What is an Excess Benefit Transaction? Excess Benefit Defined. Generally, an "excess benefit transaction" occurs anytime a disqualified person receives an economic benefit from an exempt organization which exceeds the value (not the cost) of the benefit provided to the organization by the disqualified person. All benefits from the organization to the disqualified person are taken into account, including every transaction which benefits a disqualified person, whether the benefit is direct or indirect, and whether the benefit is provided directly by the exempt organization or through an organization controlled by the exempt organization. Similarly, all benefits from the disqualified person to the organization are also taken into account. For example, when a pension plan benefit vests, the services performed for the years leading up to the year of vesting may be considered in determining reasonableness. The excess benefit is the difference between the value of what is received by the organization and the value of what is given by the organization to the disqualified person. With a transaction involving property, the fair market value (e.g. what would be paid between a willing buyer and a willing seller, neither being under compulsion to enter into the transaction, and both having knowledge of the relevant facts) must be examined to determine if an excess benefit has been received. [Question: what if the organization must sell, and the disqualified person offers the best price?] Reasonable Compensation. Probably the single most likely area for an excess benefit transaction involves compensation arrangements with officers, directors, and key suppliers. Any disqualified person who receives a salary in excess of reasonable compensation may be subject to penalties and operation managers participating in the approval and payment thereof may also be subject to penalties. What is Reasonable Compensation? Compensation is reasonable if the amount paid would ordinarily be paid for like services, by like enterprises, under like circumstances. Section 162 standards apply in determining what is reasonable, taking into account most benefits. The fact that a state or local legislative or agency body or court has authorized or approved a compensation package is not dispositive of whether the compensation is reasonable a. Certain benefits will not be considered in determining excess benefits. These include: 1. Nontaxable fringe benefits (excluded from income under § 132), except certain liability insurance premiums, payments or reimbursements by the organization(8) 2. Economic benefits provided to a volunteer if such benefits are normally provided to the general public in exchange for a membership fee of $75 or less per year. 3. Economic benefits provided solely on account of payment of a membership fee or of a deductible contribution if a) any non-disqualified person paying such fee or making a contribution above a specific amount is given the option of receiving substantially the same economic benefit; and b) the disqualified person and a significant number of non-disqualified persons, in fact, make a payment or contribution of at least the specified amount. 4. Economic benefits provided to a disqualified person solely as a member of a charitable class. 5. Economic benefits to a governmental unit, if the transfer is made exclusively for public purposes. b. In determining the value of compensation for purposes of section 4958, all items of compensation must be considered, including: 1. All forms of cash and noncash compensation including salary, fees, bonuses, severance payments, and deferred and noncash compensation at the time it vests or is not subject to substantial forfeiture (see Effective Dates, below). 2. Unless excludable as a de minimus fringe benefit, the payment of certain liability insurance premiums for, or payments or reimbursement by the organization not excludable under a.1, of this section (see footnote #2). 3. All other benefits, whether or not included in gross income for income tax purposes, including but not necessarily limited to medical, dental, and life insurance, severance pay, disability benefits, expense allowances, reimbursements, and forgiveness of interest on loans. A determination of whether an item is included in gross income should be made without regard to whether the item must be taken into account in determining reasonableness of compensation for purpose of intermediate sanctions. Must be Treated As Compensation. Any benefit received by a disqualified person must be in exchange for some type of service or other benefit provided to the organization by the disqualified person, and the organization must treat it as such. Otherwise, it is treated as an excess benefit, without further consideration, and without regard to any claim of reasonableness of the total compensation package. An economic benefit will not be treated as payment for the performance of services rendered by the disqualified person unless the organization providing the benefit clearly indicates its intent to treat it as such when the benefit is paid. Except for nontaxable benefits, an exempt organization will be treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit. If an economic benefit is reported by the organization (on a Form W-2, 1099 or 990) or by the disqualified person (on Form1040) before any IRS examination is begun, this will satisfy the requirement. There may be other written contemporaneous evidence used to demonstrate this intent, such as an executed and approved written employment contract. If the failure to report was due to reasonable cause (i.e. the exempt organization can establish that there were significant mitigating factors, or that the failure arose from events beyond its control) and the organization otherwise acted in a responsible manner, the organization will be treated as having clearly indicated its intent. If there has not been the requisite withholding or reporting and the failure to report was not due to reasonable cause, then the economic benefit will be considered an excess benefit transaction. Percentage Payments. Some nonprofit organizations use revenue-sharing methods to pay for certain services. For example, a fundraiser might agree to conduct a fundraising event in exchange for a percentage of the overall revenues generated. Such arrangements have always been disfavored by the IRS. The proposed regulations issued in 1998 provided that, unlike other compensation arrangements, a revenue-sharing transaction may constitute an excess benefit transaction even if the economic benefit does not exceed the fair market value of the consideration provided in return if, at any point, it permits a disqualified person to receive additional compensation without providing proportional benefits that contribute to the organization's accomplishment of its exempt purpose.(9) In other words, the benefit can increase only in proportion to the actual services being rendered. The proposed regulations also provided that if an excess benefit is found in a transaction where the economic benefit is based on revenues, the excess benefit consists of the entire economic benefit provided in such a transaction. This means that if the proposed regulations were to be adopted as final, and any of the compensation was determined to be an excess benefit, all compensation received by the disqualified person would be treated as an excess benefit, and not just that portion that exceeds the fair market value of the consideration/services provided. Because of the extensive controversy over this position, and the many, often conflicting suggestions made to resolve the issue, the IRS has reserved a section in the new temporary regulations to cover revenue-sharing transactions, and will continue to consider this area further. The IRS has also noted that any revised regulations issued in the future on this matter will be issued again in proposed form, and will become effective only after being published in final form. In the meantime, these transactions will be evaluated under the general rules defining excess benefit transactions. The only item of guidance contained in the temporary regulations concerning this type of transaction is that the fact that a bonus or revenue-sharing arrangement is subject to a cap will be a relevant factor in determining the reasonableness of compensation. For example, an agreement to pay 20% of the income received, up to a total of $50,000, will more likely be found to be reasonable than will an agreement simply to pay 20% of the income. Indirect Economic Benefit. The temporary regulations provide that a transaction that would be an excess benefit if the exempt organization engaged in it directly will still be an excess benefit transaction if it is accomplished indirectly through either of the following ways: a. Through a Controlled Entity: If the exempt organization owns more than a 50% interest in an organization (or controls at least 50% of the directors of a non-stock organization) that organization will be a controlled entity. If it is a controlled entity, then economic benefits provided will be treated as though they were provided by the exempt organization. b. Through an Intermediary: An intermediary is any person (including another tax-exempt entity) that participates in a transaction with a disqualified person of the exempt organization. Economic benefits provided by the intermediary will be treated as being provided by the exempt organization when 1) the exempt organization provides an economic benefit to the intermediary, and 2) in connection with receipt of the benefit by the intermediary, there is evidence of an oral or written agreement or understanding that the intermediary will provide benefits to or for the use of the disqualified person, or the intermediary provides benefits to or for the use of the disqualified person without a significant business or exempt purpose of its own. 5.2.7 What happens if an excess benefit is paid to a disqualified person? What is the penalty? Correction: Return of Benefit Plus Interest. The cost of receiving an excess benefit is severe. In all cases, the excess benefit must be corrected. Correction requires the excess benefit to be undone to the extent possible, and the taking of any additional steps necessary to restore the organization to a financial position not worse than where it would be if the disqualified person had dealt under the highest fiduciary standards. The correction amount equals the sum of the excess benefit, plus interest on the excess benefit a rate that equals or exceeds the applicable Federal rate, compounded annually. The period from the date the excess benefit transaction occurred to the date of correction determines whether to use the Federal short-term rate, mid-term rate, or long-term rate. Repayment of Correction Amount. An excess benefit is corrected only by the disqualified person making a payment in cash or cash equivalents, excluding payment by a promissory note, equal to the correction amount. The disqualified person may not engage in a series of transactions to attempt to circumvent this section. Notwithstanding this requirement, if the excess benefit transaction results, in whole or in part from the vesting of benefits under a nonqualified deferred compensation plan, then to the extent the benefits have not yet been distributed, the disqualified person may correct the portion of the excess benefit resulting from the undistributed deferred compensation by relinquishing any right to receive the benefits (including earnings thereon). If specific property was transferred in the excess benefit transaction and the exempt organization agrees, the disqualified person may make a payment by returning the property. The payment will be considered to be the lesser of i) the fair market value of the property on the date the property is returned to the organization, or ii) the fair market value of the property on the date the excess benefit transaction occurred. If the payment is less than the correction amount, the disqualified person must make an additional cash payment. If the payment exceeds the correction amount, the organization may make a cash payment to the disqualified person equal to the difference. The disqualified person may not participate in the exempt organization's decision as to whether or not to accept the return of specific property. Excise Penalties. In addition to correction, the penalty on the disqualified person is an amount equal to 25% of the excess benefit. If the monies are not returned "within the taxable period", an additional tax equal to 200% of the excess benefit may be imposed. If more than one disqualified person is liable for the tax, all are jointly and severally liable. The taxable period is the period beginning on the date the excess benefit transaction occurs and ending on the earlier of the date the notice of deficiency is mailed or the 25% penalty is assessed. However, if the excess benefit is corrected within 90 days after the mailing of the notice of deficiency, the 200% penalty shall either not be assessed or shall be abated. If less than the full correction amount is paid, the 200% penalty will be imposed only on the unpaid portion. Tax on Organization Manager. A tax equal to 10% (up to $10,000 per transaction) of the excess benefit may also be imposed on each organization manager who participates in the transaction, knowing that it is an excess benefit transaction, unless the participation is not willful and is due to reasonable cause. The $10,000 is an aggregate figure; all organization managers participating in the transaction are jointly and severally liable. If the disqualified person receiving the excess benefit is also an organization manager, the 25%, the 200%, and the 10% tax can all be imposed on said person. No Need To Terminate Contract. If the contract under which the excess benefit has occurred has not been completed, termination of the employment or independent contractor relationship between the organization and the disqualified person is not required. However, the terms of compensation may need to be modified to avoid future excess benefit transactions. Correction in Case of No Longer Existing Organization. If the exempt organization no longer exists, the disqualified person must still correct the excess benefit transaction by paying the correction amount to another qualified organization, provided that organization is not related to the disqualified person. With a 501(c)(3) organization, the funds must be paid to another 501(c)(3), in accordance with the dissolution clause of the organizational documents of the exempt organization. With a 501(c)(4) organization, the correction amount must be paid to a successor 501(c)(4) organization or, if there is no successor, to another 501(c)(3) or (c)(4) organization. 5.2.8 Rebuttable Presumption of Reasonableness. In determining reasonable compensation, although Section 4958 does not contain the same, the legislative history indicated that Congress intended that there be a rebuttable presumption of reasonableness, or a "safe harbor." Under the safe harbor, compensation is presumed to be reasonable, and a property transfer is presumed to be at fair market value if (1) the compensation arrangement or terms of transfer are approved, in advance, by an authorized body of the exempt organization, composed entirely of individuals without a conflict of interest, (2) the board or committee obtained and relied upon appropriate data as to comparability in making its determination; and (3) the board or committee adequately documented the basis for its determination, concurrently with making the decision. The disqualified person/organization manager normally has the burden of proving that the compensation was reasonable. However, if the three criteria above are met, the burden of proof shifts to the IRS and the IRS must prove that the compensation was unreasonable. The IRS may rebut the presumption by furnishing sufficient contrary evidence to show that the compensation was not reasonable, or that the transfer was not at fair market value. Approval by Authorized Body. In order to be considered disinterested, the authorized body, which is made up of the board of directors, a committee of the board if authorized by state law, or to the extent permitted by local law, other parties to whom the board has delegated this duty, must not include anyone with a conflict of interest with regard to the transaction. A person will not be considered included if the person attends only to answer questions and otherwise recuses himself or herself from the meeting and is not present during the debate and voting on the transaction or compensation arrangement. A conflict of interest is present if a member is the disqualified person, is related to the disqualified person, economically benefits from the transaction, is in an employment relationship subject to the direction or control of the disqualified person, receives compensation or other payment subject to approval by the disqualified person, has a material financial interest affected by the transaction, or approves a transaction providing economic benefits to a disqualified person, who in turn has approved or will approve a transaction providing economic benefits to the member. Appropriate Data as to Comparability. An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has information sufficient to determine that the compensation is reasonable or the property transfer is at fair market value. Relevant information might include compensation levels paid by similar organizations (both taxable and nontaxable) for functionally comparable positions, the availability of similar services in the geographic area, current compensation surveys compiled by independent firms, and actual written offers from similar institutions competing for the services of the disqualified person. For property, relevant information might include current independent appraisals of the property to be transferred, and offers received as part of an open and competitive bidding process. For organizations with annual gross receipts (including contributions) of less than $1 million (calculated based on the average of the 3 prior taxable years), it is sufficient that the governing body acquires and relies upon data of compensation paid by three comparable organizations, in the same or similar communities, for similar services. No inference is intended with respect to whether circumstances falling outside this safe harbor will meet the requirement with respect to the collection of appropriate data. For example, there may not be 3 comparable organizations providing similar services, and the board may select another method to meet the objective data requirement. If the exempt organization controls or is controlled by another entity, the gross receipts of both entities must be aggregated to determine if this special rule is applicable. Note: Although obtaining this comparable data allows the organization to rely on a presumption that a transaction is reasonable, the failure to obtain the data does not, in itself, imply that the transaction is unreasonable. In addition, the organization may compile its own data rather than obtain an independent survey. Documentation. Adequate documentation requires that the written or electronic records of the authorized body state: 1) the terms of a transaction and the date it was approved; 2) the members of the authorized body present during the debate on the transaction, and those who voted; 3) the comparability data relied upon, and how the data was obtained; and 4) any actions taken with respect to consideration of the transaction by members of the authorized body who had a conflict of interest. If the authorized body determines that reasonable compensation/fair market value is actually higher or lower than the comparables obtained, the basis for this determination must be recorded. To be documented concurrently, records of the meeting must be prepared before the later of the next meeting of the authorized body, or 60 days after the final action or actions of the authorized body with regard to this decision are taken. Records must be reviewed and approved by the authorized body as being reasonable, accurate and complete within a reasonable time period after they are prepared. The fact that a transaction between the exempt organization and a disqualified person has not met the safe harbor requirements and therefore is not subject to the presumption that the compensation is reasonable, does not create an inference that the transaction is an excess benefit transaction, nor does it exempt or relieve any person from compliance with any federal or state law that imposes any higher obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of the exempt organization. 5.2.9 Effective Dates. Date of Occurrence. An excess benefit transaction occurs on the date the disqualified person receives the economic benefit for Federal income tax purposes. If the contract provides for a series of payments over a taxable year, any excess benefit transaction resulting from the payments will be deemed to occur on the last day of the taxable year (or the date of the last payment, if only for part of the year). With qualified pension, profit-sharing or stock bonus plan benefits, the transaction occurs on the date the benefit vests. With a transaction involving substantial risk of forfeiture, the transaction occurs on the date there is no longer any substantial risk of forfeiture. Effective Date of Law. The effective date of the intermediate sanctions is retroactive to September 14, 1995. The Act will not apply to written contracts in effect as of September 13, 1995, so long as the contract remains binding and there is no material change to the contract. If a contract may be terminated or cancelled by the organization without the disqualified person's consent and without substantial penalty, it is not considered binding as of the earliest date the termination or cancellation would be effective. A material change includes extension or renewal of the contract, or a "more than incidental" change to any payment thereunder. Initial Contract - When Intermediate Sanctions Apply. An initial contract is a binding, written contract between the exempt organization and a person who was not a disqualified person immediately prior to entering into the contract. Intermediate sanctions do not apply to any fixed payment (as defined below) pursuant to this initial contract, unless the person fails to substantially perform his or her obligations under the contract. A fixed payment is defined in the temporary regulations as the amount of cash or property specified in the contract or determined by a fixed formula specified in the contract, in exchange for the provision of specified services or property. A fixed formula may incorporate an amount that depends upon future specified events or contingencies, provided that no person exercises discretion when calculating the amount or deciding whether to make a payment. Contributions to a qualified pension plan or nondiscriminatory employee benefit program are treated as fixed payments. Similarly as to a written contract effective September 13, 1995, if the contract may be terminated or cancelled by the organization without the other party's consent and without substantial penalty to the organization, it will be treated as a new contract as of the earliest date that any such term or cancellation, if made, would be effective. If the parties make a material change to the contract, it is treated as a new contract as of the date the material change is effective, and if the party is a disqualified person at the time the contract is treated as a new contract, it may constitute an excess benefit transaction. Any non-fixed payments pursuant to an initial contract (e.g. an arrangement where discretion in payment is exercised) is not covered by the exception and must be evaluated to determine whether it constitutes an excess benefit transaction. In making this determination, all payments and consideration exchanged, including fixed payments made pursuant to an initial contract, are taken into account. Determination of Reasonableness of Other Contracts/Payments. For all contracts other than initial contracts, reasonableness of a fixed payment (as defined above) is determined based on the facts and circumstances existing as of the date the parties enter into the contract. However, if there is substantial non-performance, reasonableness is determined based on all facts and circumstances from the date of entering into the contract up to the date of payment. If a payment is not a fixed payment under a contract, then the determination must be made, based on all facts and circumstances, up to and including circumstances as of the date of payment. However, the organization cannot argue that the compensation is reasonable, based on facts and circumstances existing at the time a contract is questioned. Again, if a written binding contract may be terminated or cancelled by the organization without the other party's consent and without substantial penalty to the organization, it will be treated as a new contract as of the earliest date that any such termination or cancellation, if made, would be effective. And if the parties make a material change to the contract, it is treated as a new contract as of the date the material change is effective. Date for Rebuttable Presumption. For a fixed payment, the requirements for the rebuttable presumption of reasonableness must be satisfied prior to the effective date of the contract. If this is done, the rebuttable presumption applies to all payments made or transactions completed in accordance with the contract. If the payment is not a fixed payment, the organization can rely on the rebuttable presumption described below only after the exact amount of the payment is determined or a fixed formula is specified, and the requirements for the presumption are subsequently satisfied. If a contract contains a nonfixed payment subject to a specified cap, the authorized body may establish a rebuttable presumption at the time the contract is entered into if: i) prior to approving the contract, appropriate comparability data indicating that a fixed payment to the disqualified person of up to a certain amount would be reasonable compensation; ii) the maximum amount payable (both fixed and nonfixed) will not exceed this total; and iii) the other requirements to establish a rebuttable presumption of reasonableness are satisfied. 5.2.10 Application to churches. The intermediate sanctions law applies to churches. It should be noted, however, that section 7611, which controls the process for initiating and conducting a church audit, also applies to any inquiry into whether an excess benefit transaction has occurred between a church and a disqualified person. If there is a reasonable belief that a section 4958 tax is due from a disqualified person, this will satisfy the reasonable belief requirement needed to initiate a church audit. 5.2.11 Revocation may still occur. The intermediate sanctions law does not affect the substantive standards for tax exemption under section 501(c)(3) or (c)(4). Therefore, even if a transaction is not an excess benefit transaction under the intermediate sanctions laws, it may still be found to be illegal. The ability of the IRS to revoke the exempt status of an organization that engages in private inurement or private benefit has not been modified. Intermediate sanctions simply provide another weapon in the arsenal of the IRS. The IRS may use either or both weapons. If an excess benefit transaction occurs and the IRS is not convinced that it will not happen again, the exempt status of the organization is likely to be in jeopardy. The first set of cases in 1999 resulted in penalties being assessed in excess of $83 million, plus loss of exempt status. Petitions have been filed in the Tax Court for redetermination of deficiencies, with the first set for trial in September of 2000.(10) Currently, all intermediate sanctions cases are being coordinated with the National Office, both on the technical side and the chief counsel side.(11) 5.2.12 State Regulators. Although the intermediate sanctions law is a federal law, the Service has pointed out that intermediate sanctions may also bring state regulation problems. See EOTR Weekly, Vol. 12, No. 4, 10/26/98, page 1. 5.3 Control of Organization/Operation for Exempt Purposes/Joint Ventures. A related issue, which has been addressed principally in the area of health care entities is how much control the exempt organization has in a joint venture with for-profit entities. If the exempt has insufficient control, the joint venture can put the exemption at risk. On March 4, 1998, Rev. Rul. 98-15, 1998-12 IRB was issued to provide some guidance in this area. Two situations are discussed therein; in the first, the exempt status of the hospital is retained because it continues to operate exclusively for a charitable purpose, with only incidental benefits to the for-profit. In the second, however, the nonprofit fails to establish that it will continue to operate exclusively for exempt purposes. In the "good" scenario contained in the revenue ruling, the charity elected the majority of the directors of the joint entity, and the agreement provided that charitable interests overrode any fiduciary duty to maximize profits. In the "bad" scenario, the charity elected one-half of the directors of the joint entity, and the management of the day-to-day operations was contracted to a subsidiary of the for-profit, and was renewable indefinitely by the subsidiary. Although it addresses the specific area of whole hospital joint ventures, the IRS has pointed out that this ruling is designed to carry out Congress's intent that charities use their funds for appropriate charitable purposes, and not to provide a substantial private benefit to another entity, and should be reviewed by any entity intending to enter into a joint venture arrangement with a forprofit.(12) A recent Tax Court Case, Redlands Surgical Services v. Commissioner of Internal Revenue, 113 T.C. No. 3, filed July 19, 1999, held that the nonprofit had ceded effective control over the operations of the partnerships, and thus conferred an impermissible benefit. As a result, it is not operated exclusively for exempt purposes. It is currently being appealed.(13) In recent letter ruling, LTR200041038, issued July 20, 2000, the IRS determined that the participation of a 501(c)(3) organization, as the member/manager of a limited liability company taxed as a partnership, with the remaining members being for-profit entities, would not impair the exempt status of the organization, as the purpose was substantially related to the accomplishment of the organization's purposes (long term conservation efforts). Because the limited liability company elected to be taxed as a partnership, the service determined that the activities of the LLC would be attributed to the (c)(3) organization. The letter ruling does not contain any determination of whether unrelated business income would result.(14) 6. Disclosure /Reporting Requirements. As further described in the following paragraphs, charities that provide benefits to their donors must disclose the value of those benefits to the donors; donors who wish to claim charitable income tax deductions must obtain records from the charitable recipient to substantiate the gift; and charities must make certain information available to the general public on request. The IRS issued final Regulations on some of these matters, effective December 16, 1996. 6.1 Donor Substantiation. Under Section 170(f)(8), donors who claim a deduction for a charitable contribution of $250 or more are responsible for obtaining from the donee charity, and maintaining in their records, substantiation of that contribution. The document substantiating the contribution must be a contemporaneous written acknowledgment from the charity -- that is, it must be received by the earlier of (a) the date the donor actually files the tax return for the year in which the gift was made, or (b) the due date (including extensions) of the return. The IRS does not require any particular form. However, the notice must contain the following information: (a) The amount of cash paid and a description (but not necessarily the value) of any non-cash property transferred to the charity; (b) Whether or not the charity provided any goods or services in consideration for the cash or property; (c) A description and good faith estimate of the value of any goods or services provided by the charity in consideration for the cash or property; and (d) If applicable, a statement indicating that the charity has provided intangible religious benefits as described below. Separate contributions of less than $250 will not be aggregated, although abuse of this rule (such as a donor writing multiple checks to a single charity on one day to avoid triggering the substantiation requirement) will be addressed by Regulations. If the goods and services consist solely of intangible religious benefits, the charity is not required to describe or value those benefits. It is sufficient merely to state the fact that only intangible religious benefits were provided. Intangible religious benefits are those provided by an organization which is organized exclusively for religious purposes and which generally are not sold in a commercial transaction. However, tuition for education leading to a recognized degree, goods available commercially, and the like are not considered intangible religious benefits even if provided by an exclusively religious organization. Many taxpayers contribute to charities through payroll deductions. The IRS's recent Regulations clarify the substantiation rules for such donations. Specifically, taxpayers may substantiate donations made by payroll deduction by a combination of two documents: (a) A pay stub, IRS Form W-2, or other employer-source record showing the amount withheld from the taxpayer's compensation, and (b) A pledge card or other document prepared by the charitable recipient, which states that the charity did not provide any goods or services in return for the taxpayer's payroll deduction contributions. Donors to charitable remainder trusts and charitable lead trusts need not obtain substantiation for their contributions. However, substantiation is required for gifts to pooled income funds. Where a taxpayer incurs out-of-pocket expenses in the course of donating services to a charity, the recipient charity typically has no independent information as to those expenses. If the expenses are large enough to require substantiation in order for the taxpayer to claim a deduction, the IRS will accept a combination of two records: (a) The taxpayer's normal records of the expenses in question, and (b) The charity's written acknowledgment describing the services provided by the taxpayer, the date on which they were provided, whether or not the charity gave the taxpayer any goods or services in return and, if so, a description and good faith estimate of their fair market value. If a partnership or S-corporation makes a charitable gift of $250 or more, that entity -- not the partners or shareholders -- is treated as the taxpayer for purposes of the substantiation and disclosure rules. The partnership or Scorporation must obtain the receipt for gifts of $250 or more, and the charity must disclose quid pro quo benefits to the partnership or S-corporation, not to the individual partners or shareholders. Once applicable Regulations have issued, charities will have the option of filing a form with the IRS setting forth the information required to be provided to donors, in lieu of providing it to the donor. 6.2 Disclosure Regarding Quid Pro Quo Contributions. A charitable contribution is only deductible to the extent that it exceeds the fair market value of any goods or services provided by the charity to the donor.28 This comports with the requirement that the donor must intend to make a charitable gift. Until 1995, charities had no obligation to inform donors of this limitation on the deductibility of these gifts. Now, Section 6115 requires each charity that receives a quid pro quo contribution in excess of $75 to provide a written disclosure statement to the donor. A quid pro quo contribution is one in which the charity provides the donor with goods or services in return for the donor's contribution. The charity must disclose in writing, in connection with the solicitation or receipt of funds in connection with return benefits, the following information: (a) The disclosure statement must make clear that the deductible portion of the donor's gift is limited to the excess of the amount of any money (or the value of any property) transferred to the charity over the value of the goods or services provided by the charity to the donor. (b) The disclosure statement must also contain a good faith estimate of the value of the goods or services provided by the charity. If there is no disclosure statement from the charity, the donor will find it difficult, if not impossible, to rebut the presumption that what the donor paid for the goods or services was what the donor believed their value to be -- and, thus, that there is no charitable gift. Certain goods and services are excluded by the Regulations from the disclosure obligation, for ease of administration or to make the compliance burden on charities reasonable. For example, in either of the following two instances, goods are considered too insubstantial to reduce the value of a charitable gift: (a) Benefits may be disregarded if they have a fair market value of less than 2% of the amount of the contribution and the fair market value is less than $67 for 1996 (adjusted annually for inflation). (b) Goods may be disregarded if the cost of the item to the charity (as opposed to its market value) is $6.70 or less for 1996 (adjusted each year for inflation). Some membership benefits are so difficult to value that the Regulations permit both charities and donors to disregard them. Member benefits may be disregarded for purposes of donor substantiation and charity reporting, only if the benefits are given as part of an annual membership; offered in return for a payment of $75 or less, even if the donor decides to contribute more; and fall into one of the following two categories: (a) Low-Cost Events. This category covers admission to events open only to members, where the cost to the charity per person (excluding allocable overhead) is not more than $6.70 in 1996. The figure will be adjusted for inflation annually. (b) Rights That Members Can Exercise Frequently. This category includes free admission to a facility (such as a museum), free parking during performances, gift shop discounts, and the right to purchase tickets before the general public may do so. Note, however, that rights and privileges available only to donors of more than $75 may not be disregarded. These member benefit rules also apply to company contributions where the goods or services are provided to company employees. A charity may use any reasonable method to make a good faith estimate of the value of goods and services. However, the donor may not rely upon an estimate if the donor knows, or has reason to know, that the estimate is not reasonable (for example, if the donor is a dealer in the type of goods or services in question). An estimate is not in error if it is within the typical range of retail prices for the goods or services. If the goods or services are not available in a commercial transaction, the charity may make a good faith estimate by reference to the fair market value of similar or comparable goods or services. Some opportunities, such as the right to have dinner with a celebrity, have no actual dollar value for purposes of the substantiation rules. Thus, valuation is not required. 6.3 Disclosure Obligations for Non-Cash Gifts. A donor must file Form 8283 for non-cash gifts for which a deduction is claimed in excess of $500; if the deduction exceed $5,000, the donor must obtain a qualified appraisal, and the donee charity is required to sign the donor's Form 8283, verifying its receipt of the donated property. Donors are subject to penalties for overvaluation of donated property. If the charity was required to sign a donor's Form 8283, then if the charity disposes of some or all of the contributed property within two years after receipt, other than by using the property or distributing it for free in furtherance of its exempt purposes, it must file Form 8282. 6.4 Disclosure Obligations to the General Public. Federal tax law requires tax-exempt organizations to make certain documents available for public inspection. 6.4.1 Exempt Organizations in General. Currently, exempt organizations are required to make their federal application for tax exemption (Forms 1023, 1024, etc.), and their federal informational returns (Forms 990, 990-EZ, 990PF, etc.) available for inspection by anyone who requests to see them. This is still the law. However, in addition to this requirement, beginning June 8, 1999 (March 13, 2000 for private foundations), exempt organizations must also provide copies of these documents (or any part of them), without charge, other than a reasonable fee for reproduction, and actual postage costs to anyone who requests them, either in person or in writing. The following is a summary of these new requirements. Please note that this is a summary, and that there are still many areas which will require clarification. What type of organization does this apply to? It applies to every organization that has received an exempt determination from the IRS under any section of 501(c) or 501(d). This includes churches that have established their exempt status. Even though they do not have to file Form 990 and thus do not have to make these forms available for inspection, they must still make the Form 1023 available for inspection, and make copies available if requested. It also applies to non-exempt private foundations and nonexempt charitable trusts described in Section 4947(a) that are subject to Section 6033 information reporting requirements. Although the April, 1999 regulations putting these requirements into effect specifically exclude private foundations, the final regulations for private foundations were issued in January of 2000, effective March 13. In addition, the requirement that 3 years of 990-PF's must be furnished begins with the 2000 filing. Where can someone come to inspect/get copies of the documents? What if we have more than one office? What if we do not have a regular office? The documents must be made available for inspection at the organization's principal office, and (if the organization has more than one office) any regional or district offices, during regular business hours. A regional or district office is any office that has either full or part-time paid employees, whose aggregate number of weekly working hours is normally at least 120 (e.g. three full time employees or their part-time equivalents). However a site is not a regional or district office if the only services provided are to further the exempt purposes of the organization (such as a day care center, clinic, etc.) and the site does not serve as an office for management staff, other than those involved solely in managing the exempt function activities at the site. An organization with regional or district offices has 30 days from the date its informational return is filed with the IRS to provide copies to the regional or district offices. The organization may have a representative in the room during the inspection. However, the person inspecting must be allowed to take notes freely, and if he/she has brought along a copier, to copy the document. If the organization does not have a permanent office, or has limited office hours, it may comply with the public inspection requirements by making the documents available for inspection at a reasonable location, within a reasonable time period after receiving the request (within 2 weeks), and at a reasonable time of day. It may mail copies of the requested documents in lieu of allowing an inspection, but may not charge the requester unless he/she consents to pay the charge. How much can we charge if they want copies? The organization can charge a reasonable fee, which the regulations define as no more than the fee charged by the IRS for providing copies. This currently is $1.00 for the first page, and $.15 for each additional page. In addition, it may charge the actual postage costs incurred in providing the copies. The organization may require the individual to pay the fee before providing the copies. If payment is required before the copies are provided and the organization receives a written request, it must advise them of the amount due within seven (7) days from the date of receipt of the initial request. The organization must also respond to any questions from potential requesters concerning the fees for copying and postage of each document, with and without attachments, so that payment may be included with the request. If prepayment is not required, consent from the requester must be obtained before the copies are provided if the charge for copying and postage will exceed $20.00. The organization must accept any payment made by cash or money order; it may accept payment in another form. If the request is made in writing, an option to pay either by personal check or by credit card (one or the other) must be provided. If the requester is advised as to what the fee is and they do not pay the fee within 30 days, or if they pay by check and the check does not clear, you may disregard the request. Note: If the individual brings a copier to the inspection, he/she must be allowed to make copies directly, at no charge. How soon do we need to provide copies of the requested documents? Requests Made In Person. If the request is made in person at the principal, regional or district offices during regular business hours, copies of the documents should be provided on the day the request is made. If there are unusual circumstances where fulfilling the request will place an unreasonable burden on the organization, copies must be provided no later than the next business day after the unusual circumstances cease to exist, or the fifth business day after the request, whichever occurs first. Unusual circumstances would include such occurrences as receipt of requests that exceed the organization's daily capacity to make copies, requests received shortly before the end of the business day that involve substantial copying, or requests received on a day that the managerial staff capable of fulfilling the request are involved in a special assignment. A local agent may be retained to process requests made in person for copies of the documents. However, the agent must be located within reasonable proximity of the office, the name, address and telephone number must be immediately provided to the requester, and the agent must timely furnish the copies. Requests Made In Writing. An organization receiving a written request for a copy of its application or annual report(s) shall mail each copy within 30 days of receiving the request. However, if payment is required in advance, it must mail the copy within 30 days from the date it receives payment, as long as it has notified the requestor, within 7 days from the date it received the initial request, of its prepayment policy and the amount due. If the requester consents, the document may be furnished by electronic mail; it will be considered to be furnished on the date the document is successfully transmitted. A local agent may be retained to process written requests for copies. However, the agent is bound by the terms and conditions (including deadlines) that apply to the organization itself. Exactly what part of the Exemption Application can someone inspect/ obtain copies? The application for tax exemption must include any prescribed form (e.g. Form 1023 or Form 1024), all documents and statements filed as a part of the application or as part of any follow-up correspondence in support of the application, and any letters or documents issued by the IRS in regard to the application, including additional questions about the application. If there is no prescribed form (for example, with an application for a group exemption), the application includes the application letter, copy of the articles of incorporation, bylaws, financial statements, statements describing the organization, its purpose and its activities, and statements showing the sources of the organization's income and the disposition thereof, and any other documents required by the IRS or submitted in support of the application. Note that if an application is still pending with the IRS and an exempt status is not yet determined, nothing need be furnished. In addition, if there is a part of the application that the IRS is required to withhold from public inspection, the organization need not make that part of the application available. We don't know where our Exemption Application is. What do we do? If the application had been filed before July 15, 1987, and the organization did not have a copy of the application on July 15, 1987, it does not have to be made available. However, if the application was filed on or after July 15, 1987, or if the organization had a copy available on that date, you must find the application. What Informational Returns have to be provided? What must be provided as part of the Return? An exact copy, as filed with the IRS, of any federal informational return (Forms 990, 990-EZ, 990-PF, 990-BL, and Form 1065) must be made available, including all schedules, attachments and supporting documents. This includes any amended return. Except for private foundations, you may delete the name and address of any contributor (make sure they are on a separate schedule, easily redacted, so that the IRS does not inadvertently release this information). You also do not have to make available form 990-T (unrelated business taxable income), Schedule A of Form 990-BL, Schedule K-1 of Form 1065, Form 1120-POL, or 990PF. Each form must be made available for a period of three (3) years from the later of the date the return is required to be filed (plus extensions), or the date it is actually filed. Any amended return also must be made available for three (3) years from the date it is filed with the IRS. What if the requester only wants part of the document? If the requester clearly identifies the requested part or schedule, then that part must be furnished. The organization may not charge the requester for the entire Form 990 if only Schedule A is requested. What if I think there is a harassment campaign against my organization? If the IRS district director for the key district in which your organization's principal office is located determines that your organization is the subject of a harassment campaign (requests are part of an effort to disrupt the operations of your organization, rather than to collect information), and that compliance with these requests are not in the public interest, you are not required to provide copies. Facts supporting the finding of a harassment campaign would include a sudden increase in the number of requests, an extraordinary number of requests made through form letters or similarly worded correspondence, requests that contain language hostile to the organization, evidence that the organization has already provided the requested documents, and the like. If you believe that you may be the target of a harassment campaign, you should contact our office so we can assist you in determining what steps you may want to take, which may include applying for a determination that you are the subject of a harassment campaign, and suspending compliance. It would be appropriate to keep a log of all requests, whether in person or written, so that if a harassment campaign is instituted against your organization, you will have evidence of the type and number of requests normally being received, and documentation of the increased burden. You may disregard any request for copies of all or part of any document beyond two received within a 30 day period, or four received within a one year period, from the same individual or the same address, without a determination of harassment from the district director. What if we are under a group exemption? Application for tax exemption. If your organization did not file its own application for tax exemption, you must still, upon request, make available for inspection or provide copies of the application as filed by your parent organization, including any documents submitted to include your organization under the group exemption letter. If your parent organization submits a directory of organizations covered by the group exemption letter, you only need furnish the application itself, and the pages of the directory that specifically refer to your organization. Annual information return. If your organization does not file its own annual information return, you must upon request, make available for inspection or provide copies of the group returns filed by the parent organization. If the return has a separate schedules for each organization covered, you may omit schedules that relate only to other organizations. General. You have a reasonable amount of time (generally no more than two weeks) to comply with the request made in person for public inspection or copies. Where the requester seeks inspection, you may mail a copy of the documents within this same time period instead of allowing an inspection; in such a case you may charge for copying and postage only if the requester consents to the charge. For requests for copies made in writing, you must comply with the same time limits that are discussed elsewhere in this letter. The requester may also request, from the parent organization at its principal office, inspection or copies of the application for group exemption or the group returns, and the material submitted to include the local organization specified by the requester. If I post these documents on my website, do I still have to make them otherwise available? If you have made the documents widely available, you do not have to provide a copy of the documents; however, you must still make the documents available for public inspection as described above. You must also notify any individual requesting a copy where the documents are available (including the website address). If the request is made in person, the notice must be given immediately. If the request is made in writing, notice must be provided within 7 days of receiving the request. To be widely available, you must comply with the following: 1) The document(s) must be posted to your website or as part of a database of similar documents on another website; 2) the website clearly informs readers that the document is available and provides instructions for downloading it; 3) the document is posted in a format that exactly reproduces the document as it was originally filed with the IRS, except for information permitted by statute to be withheld from public disclosure; 4) any individual with access to the Internet can access, download, view and print the document without any special hardware or software (other than software that is readily available to members of the public without payment of any fee), and without payment of a fee to your organization or to the entity maintaining the website; 5) there must be procedures in place to ensure the reliability and accuracy of the document posted. If the posted document is altered, destroyed or lost, it must be corrected or replaced. Currently, the only format that complies with the requirements set forth above is the PDF format. However, this may change, and the IRS is not mandating a specific format, as long as the requirements above are met. You should note that even if you do not post your 990 on the web, it may be posted for you. See, e.g., http://www.guidestar.org/, and http://nccs.urban.org/. Some state attorneys general have also indicated that they may be posting 990's and other information that is filed with them. Although this might eventually fulfill the requirement that your organization furnish copies, it does not currently, as the requirement is for both the 1023 and 3 years of 990's (except for private foundations where the 3 year requirement begins with the 2000 filing). What is the penalty if I do not make the documents available? An individual who has been denied inspection or a copy of an application for tax exemption or an annual information return may notify the IRS of the possible need for enforcement action. The penalty for failure to comply with the public inspection or copying requirements is $20 per day during the time the failure continues. For the annual information returns there is a maximum penalty of $10,000 per return. 6.4.1 Requirements for Private Foundations. As noted above, although the regulations discussed above specifically exclude private foundations from their coverage, the Tax and Trade Relief Extension Act of 1998 extended the same public disclosure requirements to private foundations. Final regulations were issued in January, and were effective March 13,2000. The law only applies to returns filed after that date; therefore, prior 990's do not have to be produced (which means that it will be 2002 before 3 years worth of 990-PF's will be able to be obtained. Private foundations will no longer be required to publish a notice each year, in a newspaper of general circulation, to advise the public that its tax returns are available for inspection, although in one state there has been an attempt to require this publication to comply with state statutes. Private foundations cannot redact information about their donors from the disclosed form. 6.4.2 State Law May Require Other Disclosures. In California, charities (other than religious corporations) whose annual gross receipts are normally more than $25,000 must file Form CT-2 each year with the Attorney General's Registry of Charitable Trusts. Form 990 must be attached. Any member of the public may review these records. 6.4.3 Turning a Requirement Into an Opportunity. Since the public, including a potentially hostile press, has the legal right to see a charity's tax returns, it is important to prepare the returns with this disclosure in mind. Advisors should view the returns as public relations documents and attempt to highlight the organization's strengths and put in context any information which might otherwise put the organization in a bad light. For this reason, we recommend Board-level review of Form 990 prior to filing. It should be noted that even if the organization itself is not making its Forms 990 available on the web, at least one organization is now doing so. See http://www.guidestar.org. Guidestar is currently generating approximately 1 million hits per week, according to Debra Sinclair, spokesperson for Philanthropic Research(15), which owns and operates the guidestar site. 6.5 Form 990 - General. Forms 990 are required to be filed by almost every organization exempt under Section 501(c)(3) of the Internal Revenue Code. As set forth above, they must also be made available for inspection to anyone who requests them. They are also used as the principal document required to be filed in approximately 35 states. One item to note is that the 990 now reflects the accounting standards contained in FASB Statements No. 116 and 117: an organization that has used the accrual method of accounting, is now obligated to follow the FASB standards in completing the 990. Under Statement 116, nonprofits are required to recognize contributions when the pledges are received, rather than when the contribution is actually made, unless it is a conditional pledge, in which case it is recognized when the condition(s) are substantially met. It also requires nonprofits to distinguish between contributions that are permanently restricted, temporarily restricted, and unrestricted. At the 11th Annual Health Care Tax Law Institute held 4/25/95, and again at a Practicing Law Institute held on 7/17/95, Marcus Owens, director of the IRS Exempt Organizations Division, noted that the IRS Exempt Organizations Division has been told by the Justice Department Tax Division that not enough criminal referrals were coming its way. According to the Justice Department and the FBI, failure to file a complete Form 990 is an indication that the organization might be engaged in unlawful activities. In addition, failure to file a complete and accurate form may be considered fraud. If an incomplete or inaccurate Form 990 is filed, the officers and directors may now be facing, not only civil but criminal penalties (i.e. jail). It should be noted that the IRS is concerned about the correctness of the information being reported on the 990. For example, IRS Exempt Organization Review Branch Chief David Jones has noted that a significant number of "fairly large and important institutions were going out and raising significant amounts of money and were not reporting fund-raising expenses on their Forms 990," although many of these organizations did report fund raising expenses on their audited financial statements.(16) 7. Deductibility of Contributions 7.1 What Not to Disclose: Don't Give Donors Tax Advice. Any detailed discussion of the rules applicable to a donor's ability to deduct a gift to a charity as a charitable contribution are beyond the scope of this material. The rules are complex and extensive. More importantly, while a charity naturally needs to understand the regulatory scheme applicable to its donors, and how that scheme may affect their giving, charities should avoid giving donors tax advice. Deductibility depends on a variety of factors relating to the individual donor's tax situation that are generally beyond the knowledge, and not the business, of the charity. The risks to a charity of giving donors incorrect advice far outweigh the benefits of helping donors with their personal tax planning - donors should be advised to seek their own tax counsel's advice. We include a few of the most common general rules here, with emphasis on recent changes. 7.2 What is a Contribution? Contributions must be voluntary. If a "contribution" is required, it is not deductible. Any restriction on the use of donated property lowers the value of the gift. If an event is sponsored, recognition of the sponsor is allowed but if the recognition extends to promotion of a product, it is considered advertising. See "Unrelated Business Income, Corporate Sponsorship Issues." To the extent the donor receives a benefit back, no deduction is allowable. However, de minimis guidelines as set forth in Rev. Proc. 90-12, 1990-1 C.B. 471, as amplified by Rev. Proc.. 92-49, 1992-1 C.B. 987, and as modified by Rev. Proc. 92-102, 1992-2 C.B. 579, provide that insubstantial benefits received by the contributor may be disregarded in certain situations. 7.3 Donations of Services; Volunteer Expenses. A donation of services - of the donor's volunteer time - is not deductible. However, expenses of the volunteer incurred to render volunteer services are deductible as charitable contributions. For charitable use of an automobile, the standard mileage rate after 1/1/98 is $.14 per mile ($32.5 per mile for business use). If the expenses are for personal travel, if there is any significant amount of personal pleasure associated with the travel, the charitable deduction is denied, and no deduction is available for travel by a volunteer's spouse as such. 7.4 What Gifts of Property Can Be Deducted? Gifts of inventory, property that would produce ordinary income on sale, are deductible only to the extent of basis. Gifts of capital assets, in general, are deductible to the extent of full fair market value when given to the public charity (not private foundation). A gift of tangible personal property to a publicly supported organization is deductible to the extent of fair market value if the property is of a kind that would generate long term capital gain if it were sold, as long as it is reasonable to anticipate that the charity will use the property for a purpose related to its exempt function. 7.5 Contributions of Appreciated Property. Sections 56 and 57 were modified by the 1993 tax law changes to provide that the difference between fair market value and adjusted basis of donated appreciated property will not be treated as a tax preference item for purposes of determining alternative minimum tax. This allows donors to deduct the fair market value of gifts of appreciated property, the use of which is related to the exempt organization's tax exempt purpose (excluding inventory, etc.). It does not repeal the related use rule for gifts of tangible personal property (the taxpayer is limited to basis unless the property is used by the donor to carry out its exempt purpose), and the donor must have held the appreciated property more than one year. 7.6 Gifts of Appreciated Property to Private Foundations. Section 170(e)(5), which allows individuals to deduct the fair market value of appreciated stock contributed to a private foundation has been expiring every year; the last reinstatement was through the Small Business Job Protection Act which reinstated the provision for gifts made on or after July 1, 1996, through May 31, 1997. A provision in the $80 billion tax cut package approved 9/17/98 by the House Ways and Means Committee proposed to make this permanent. 7.7 Donations of Mortgaged Property. There are several issues that arise from the contribution of mortgaged property to a charity. First, from the exempt organization's viewpoint, a mortgage on property not used by the nonprofit in the exercise of its exempt purposes will result in the property being considered to be debt financed. This may result in unrelated business income. If, however, the nonprofit does not assume the mortgage or make payments on it, the liability may be avoided for up to 10 years. Of course, if the property is not used for exempt purposes, then there may not be an exemption from property taxes available. From the donor's standpoint, there may be additional concerns. One is determining what the value of the donated property actually is (full fair market value where the sale would have generated long-term capital gain, reduced by any amount which would have generated short-term gain or ordinary income if sold). Special rules such as those regarding depreciation recapture, may also convert what otherwise would be capital gain into ordinary income. In addition, the value of the gift is reduced by the amount of the mortgage, even if the mortgage is non-recourse, and the donor agrees to pay it. Standard rules concerning substantiation and acknowledgment continue to apply. The donation will also be treated as a bargain sale, which is triggered by the property being sold for less than fair market value. This results in the donor being able treat, as a charitable contribution, the difference between fair market value and the price paid by the nonprofit. However, the donor's adjusted basis in the property is divided between the sale portion and the gift portion, and the donor is treated as having received income equal to the difference the amount paid by the nonprofit and the portion of the donor's adjusted basis allocable to the sale portion. 7.8 Travel There is no charitable deduction allowed for travel expenses incurred when performing volunteer services unless there is no significant amount of personal pleasure. No deductions are allowed for spousal travel. 7.9 Gifts of Partial Interests Fractional Undivided Interests, -- the charitable donee must have exclusive possession for a portion of each year representing its interest. (Cannot retain a life estate interest and get a deduction, unless it is personal residence or farm - Sec. 170(f)). 7.10 Club Membership Fees. Section 274(a)(3) was added to the Internal Revenue Code in 1993 to eliminate the ability to deduct "amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or other social purpose. This section, which did not receive much publicity prior to the 1993 tax law changes, has become a significant issue with a number of clubs, such as the Rotarians, etc., who have requested that they be exempted from the law. It is clear that this section affects clubs organized under Section 501(c)(7), and perhaps others as well. 7.11 Nonprofits May Now Own S Corporations The Small Business Job Protection Act of 1996 now allows tax-exempt organizations described in Section 401(a) or 501(c)(3) to be shareholders of S Corporation stock. The tradeoff, is that such an ownership interest shall be treated as an interest in an unrelated trade or business, and will therefore be taxable to the nonprofit. 8. Unrelated Business Income 8.1 General. Although, as discussed above, tax-exempt organizations are generally exempt from taxes on their income, they are generally taxable on income generated by commercial-type activities engaged in for fundraising purposes. The logic of this position is that, in engaging in such activities for profit, they compete with non-exempt businesses, and tax-exemption would be an unfair and unwarranted advantage. IRC Sections 511 through 514 and the accompanying Regulations set forth the scope of the unrelated business income tax (UBIT) and its exemptions and exclusions. An exempt organization must report unrelated business income in excess of $1,000 per year by filing IRS Form 990-T, regardless of whether any tax is actually owed on such income. 8.2 Definitions. Section 511 imposes a tax on unrelated business taxable income, which is defined in Section 512 as the gross income derived by any exempt organization from any unrelated trade or business regularly carried on by it, less allowable deductions which are directly connected with the conduct of that trade or business. 8.3 Relatedness. Section 513 defines an unrelated trade or business to mean a trade or business whose conduct is not substantially and causally related to the accomplishment of the exempt organization's purposes, other than through the production of funds. In other words, to be related, the operation of the business must make an important contribution (other than financial) to the nonprofit's exempt-purpose program. 8.4 Exemptions. Section 513 exempts from the definition of "unrelated trade or business" any trade or business-(a) which is substantially conducted by volunteers, or (b) which is conducted for a charity primarily for the convenience of its members, students, patients, employees, and the like, or (c) which consists of selling donated merchandise. Section 513 also contains special rules for a number of activities, including the sale of advertising, the operation of trade shows and conventions, and the sale or exchange of mailing lists. 8.5 Examples of Exclusions. Section 512(b) contains numerous modifications to the definition of unrelated business taxable income, including these: 8.5.1 Passive Investment Income. Dividends, interest, and similar passive investment income are excluded from the reach of the unrelated business income tax, as are gains from the disposition of investment property. However, interest and annuities (but not dividends) received from a controlled organization are taxable as unrelated business income. Control, for this purpose, means an 80% interest, reflected either in stock ownership or in an interlocking of directors, trustees, or other representatives. 8.5.2 Royalties. Section 512(b)(2) excludes "all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income."29 However, royalties from controlled organizations, as defined above, are taxable. The IRS has begun to look closely at whether a nonprofit is being paid for the use of intellectual property (a tax-free royalty) or for services provided to a commercial entity (a taxable fee for service). For example, payments for the use of a nonprofit's mailing list have been the subject of much litigation, most recently in the context of affinity credit cards. See Paragraph 9.10 for further details. 8.5.3 Rent. Section 512(b)(3) excludes income received from the rental of real property. However, there are numerous exceptions to this general rule, and transactions should be structured carefully to ensure that the income can properly be excluded from tax. For example, if the tenant is a controlled organization, as defined above, the rental income is taxable. If the property is debt-financed, a proportion of the rental income will be taxable, as discussed below. Income from the rental of personal property is taxable unless the personal property is leased with real property and the rent attributable to the personal property is no more than 10 % of the total rent from all the property leased. Rent may be computed based on a fixed percentage of sales or receipts. However, if the determination of the rent amount depends wholly or partly on the income or profits derived by any person from the leased property, the income is taxable. A nonprofit landlord may provide normal maintenance services; however, if the nonprofit landlord provides services primarily for the convenience of the tenant, the rental exclusion no longer applies. 8.5.4 Research. Sections 512(b)(7) and (8) exclude income and deductions related to the conduct of research for a governmental agency or by a college, university, or hospital. Section 512(b)(9) excludes income and deductions "in the case of an organization operated primarily for purposes of carrying on fundamental research the results of which are freely available to the general public," regardless of the person or entity for whom the research was performed. 8.6 Debt-Financed Income. Exempt organizations, like other entities, sometimes borrow money to acquire income-producing property. Section 514 provides that income from debt-financed property is taxable in the proportion that the organization's acquisition indebtedness bears to its equity in the property. The taxable proportion of the income diminishes as the debt is paid off. If the property is sold while indebtedness remains, the capital gains on the sale are taxed proportionately. Intricate technical rules apply, and there are several exceptions. For example, if at least 85% of the property is used for purposes substantially related to the organization's own exempt purposes, the rental income is not taxed. The tax on unrelated debt-financed income also does not apply where the exempt organization acquires real estate in the neighborhood of its own facilities, which it plans to use for exempt purposes within 10 years of acquisition, and the organization rents the property to others in the interim.30 8.7 IRS Concerns. The IRS is extremely concerned about the level of UBIT noncompliance. There are at least three problems: 1) Many organizations that should be filing Forms 990T are not doing so. 2) Many of the Forms 990T filed are incomplete. 3) Many of the Forms 990T filed contain incorrect or misleading information. In fact, "... a recently released publication called "The IRS Research Bulletin.' the 1992 issue ... one article ... it's kind of the first official analysis of the unrelated business income tax/taxpayer compliance measurement program that was done on a sample of 1986, calendar '86 and fiscal year '87 990-T's a couple of years ago. ... The study calculates something called the `voluntary compliance level' which is a ratio that basically is derived from how much you fessed up to on your 990-T, and then how much you fessed up to one the dust of the audit had settled, and the difference between those two, this ratio, is the voluntary compliance level and for public charities, it's around 56 percent. ..." -- Marcus S. Owens, IRS, Director, Exempt Organizations Technical Division at the 6/7/93 Spring meeting of the American Bar Association Tax Section, Exempt Organizations Committee. In other words, when the IRS performs an audit on a 990-T, it can expect that almost half of the forms will result in more tax being owed than was disclosed and paid. And this was among the organizations that were voluntarily filing. Even when UBIT is paid, the amounts are generally small. An analysis of IRS records shows tat of 1.1 million tax exempt organizations that generate some 1.1 trillion a year in revenues, only 44,890 organizations claimed UBIT, resulting in a tax of $373.4 million.(17) 8.8 Cost Allocations. The regulations say that cost allocations (between exempt activities and activities subject to tax) must be done on a reasonable basis, and must be consistently followed. However, there are no guidelines for this, and the burden of proving reasonableness is on the practitioner. Only that portion of expense proximately related to business activity can be deducted. Several items to consider, is how would the method look described on the front page of the newspaper? Secondly, if you have losses each year on an unrelated business, the Service will be concerned about why you are engaging in it. Document everything you do. And unrelated business income as shown on the Form 990, should match the figures on Form 990-T. 8.9 Corporate Sponsorship Issues In addition to the standard types of income, marketing opportunities for exempt organizations continue to multiply. Much of this is in the area of cause related marketing, where a business solicits business by appealing to the charitable tendencies of the purchaser. As a result, we have seen affinity credit card arrangements, long distance telephone services, sale of grocery store script, and the like. We have also seen corporate sponsorship of exempt activities continue to expand. For example, the Cotton Bowl is now the Mobil Cotton Bowl. The issue raised is whether the money paid to the exempt organization is a donation which is nontaxable to the organization, or whether it is advertising, which is taxable as unrelated business income. After some 15 years of litigation, proposed regulations, revised proposed regulations, and continuing discussion on the matter, the issue of corporate sponsorship appeared to be resolved by a provision in the Taxpayer Relief Act of 1997 (the "Act"), which sets forth new corporate sponsorship standards which basically follow the 1993 proposed regulations, with some exceptions. Although the law was not retroactive, the IRS stated that it would apply the standards to old corporate sponsorship cases as well. If the message goes beyond display of the corporate name and logo, and includes a qualitative or comparative language, this will be found to be advertising, subject to unrelated business income tax. It now appears that the issue continues to be still alive and well. New proposed regulations were recently released that contain several controversial measures. The 1993 regulations focused on the nature of the services provided by the exempt organization rather than the benefit received by the sponsor. However, the Act provided that qualified sponsorship payments (payments made by a person engaged in a trade or business with respect to which there is no arrangement or expectation that such person will receive any substantial return benefits other than the use or acknowledgment of the name or logo) are not subject to UBIT. Under the proposed regulations, a substantial return benefit is found to mean any benefit other than (1) use or acknowledgment of the payor's name or logo; or (2) goods or services having an insubstantial value under existing IRS guidelines (e.g. fair market value of not more than 2 percent of the payment or $74, whichever is less). Even more controversial is the provision that the right to be the exclusive sponsor of an activity is generally not a substantial return benefit. 8.10 Mailing Lists/ Affinity Cards Section 513(h) allows exempt organizations to rent or exchange lists with other exempt organizations. For a number of years, the IRS took the position that this means that the rental of mailing lists to nonexempt organizations gives rise to UBIT. The position taken by the exempt organizations is that payment for the mailing lists is simply a payment of a royalty, which is excluded from UBIT. The IRS, on the other hand, took the position that services were also provided by the organization. The organization may exercise quality control over the use of the name (see LTR 7841001). Clearly it is necessary that the use of the organization's name in conjunction with its mailing lists be done in such a way as to not violate the organization's integrity. However, the issue is when does the exercise of quality control turn into performance of service? In the Sierra Club Inc. v. Commissioner Internal Revenue Service cased decided by the Ninth Circuit on June 20, 1996, the court accepted the argument of the Commissioner that tax exempt royalties must be passive in character; however, it found the steps taken by the Sierra Club with regard to the rental of its mailing list to be sufficient to find that no active involvement had occurred. On the matter of its affinity card program, the summary judgment was reversed, and was sent back to the district court for further consideration. On remand, Sierra Club Inc. v. Commissioner, T.C. Memo 1999-86, the Tax Court decided that income from the affinity credit cards constituted nontaxable royalties. In so doing, the court took the same position as it has inprior cases, such as Mississippi State Alumni Association v. Commissioner, T.C. Memo 1997-397. This case was followed by decisions in two additional tax court cases decided June 22, 1999 - Common Cause v. Commissioner, 112 T.C. Memo 23, No. 1392127 and Planned Parenthood Federation of America, Inc. v. Commissioner, T.C. Memo 1999-206, No. 13922-97, where the court found that payments received for mailing lists are nontaxable royalties, and thus not subject to UBIT. Finally, on October 4, 1999, the Ninth circuit, ruling on the merits of an affinity card case, determined that income earned by two alumni associations through affinity card programs, was nontaxable income. It found that a little bit of service (about 12 hours per year per association) did not convert royalty payments into unrelated business income. Shortly thereafter, Marcus S. Owens announced that the service would probably stop litigating such arrangements, and suggested that reasonable allocation would be an appropriate approach. And on December 16, 1999 a memorandum from Jay Rotz, then an official in the IRS' exempt Organizations Division, clearly stated that further litigation in similar cases should be closed. It should be noted that in all of these situations, the charity took steps to make sure it was not directly providing services along with the mailing list. In fact, in the memorandum from Jay Rotz he noted that: "In the cases decided in favor of the taxpayer, the facts showed that the involvement of the exempt organization was relatively minimal, and the organizations generally hired outside contractors to perform most services associated with exploitation of the use of intangible property." Therefore, it is possible that future cases could be brought if the IRS found significant services to be provided by the charity. Therefore, suggestions to avoid being the test case in future litigation include: Clearly state in the agreement that the income being received is royalty income and refer to the agreement as a licensing agreement. Any agreement should be clear that no services are being provided by the nonprofit; in addition, specific services should not be rendered, other than reviewing materials for purpose of quality control. Services needed should be rendered by an organization other than the nonprofit (perhaps a for-profit subsidiary), or a separate agreement setting forth such services should be drafted. In either case, the nonprofit or its subsidiary should plan to pay taxes on the funds generated from the service agreement. As part of this, no improvements/updates should be made to the mailing list by the nonprofit in excess of those that are needed for use by the exempt organization itself, nor should the organization send out mailings or otherwise solicit for the for-profit entity (especially not using the nonprofit postal privileges). The charity should not bear any financial risk. The agreement should also make it clear that this is not a joint venture or partnership of any kind. 8.11 Travel Tours Travel tours being sponsored by colleges, universities, churches, museums and other nonprofits continue to be challenged by for-profit tour groups, who claim that they are being unfairly competed with. The question is whether the tour is substantially related to the purpose of the nonprofit, and whether it is educational, etc. or is really a disguised vacation. As stated by Jere W. Glover of the Small Business Administration in a letter to the Treasury Department (6/27/96): "Unfortunately, the inherently subjective nature of the 'substantially related' test, difficulties in its administration, and extremely limited guidance have contributed to a perception of fundamental unfairness by the small business community, particularly in the travel industry... Rather than enabling nonprofits to serve traditional educational tour markets for which exemption is appropriate, small businesses complain that this exemption has emboldened tax-exempts to maintain and expand into those market segments with the highest disposable income, the largest number of professionals, the most educated customers, and the least need for tax exemption." A formal educational program, emphasized in the solicitation materials, is recommended for any organization desiring to put on such a tour. Organizations should be prepared to provide documentation on the purpose and intent of the tour, including such facts as the number of hours allotted for instruction and the amount of educational material included. Effective February 7, 2000, the IRS released final travel tour regulations (T.D. 9974). The final regulations adopt a general facts and circumstances approach. Although no specific factors determine relatedness, there are a number of indicators, such as why a particular tour was chosen, how it is promoted, and its operation. Some factors that may be looked at are whether academic credit is given, the presence or absence of lectures, the percentage of time spent on instruction, whether written reports are required, and instructor qualifications. Contemporaneous documentation is helpful. 8.12 Gaming Activities The IRS has been making a study of how much an organization makes from various gaming activities, such as casino nights, pull tabs and pickle cards (a game of chance authorized by some state statutes). The proceeds from these are generally subject to UBIT unless operated by volunteers. See IRS Pub. 3079. It should be noted that there are exceptions: In TAM 199941043 (June 28, 1999) that addresses a situation involving pull-tab revenues in the State of Washington, it was noted that the 1973 Gambling Act for the State of Washington requires that the entire net income of any gambling activity be used for the lawful (exempt) purpose of the organization.(18) Because of this, the IRS found that these payments were not voluntary charitable contributions, but were ordinary and necessary business expenses. As such, they would be deductible under Section 162 at the time the expenditure is actually made, to offset any unrelated business income.(19) It should also be noted that the IRS is actively auditing gaming activities. See Section 17.2.3, below. In addition to resulting in UBIT, if all of the income of the organization is derived from such activities, the organization will be found to be a private foundation. See, e.g. Education Athletic Association Inc., v. Commissioner, Tax Court No. 6396-98x (3/10/99). Another recent development in California has to do with raffles. Raffles have been illegal in California. The California Constitution was amended by initiative, to allow the Legislature to authorize private, nonprofit, eligible organizations to operate raffles to provide funding for beneficial and charitable works, subject to specified requirements. SB 639 was passed on August 30, 2000, was enrolled and signed by the governor in September of 2000. It will be effective July 1, 2001. Any entity that wishes to use raffles as a means of raising funds should review this law, as it has specific requirements, including a requirement that it register annually with the Department of Justice (Attorney General). 8.13 Associate Member Dues Associate members are those individuals who join an organization in order to receive certain membership benefits, but who generally are not otherwise involved with the purpose of the organization. Often these individuals are nonvoting. For example, an associate member may join to take advantage of an insurance program offered by the nonprofit to its members. The IRS did consider dues from associate members to be unrelated business income. See, e.g. Rev. Proc. 95-21, 1995-1 C.B. 868; National League of Postmasters of the U.S. v. Comm'r, T.C. Memo 1995-205. However, this view appears to have changed, at least in part; in TAM 9742001, associate member dues in a trade association context were determined to be related and not taxable. 8.14 Operation of a Trade or Business In a recent Technical Advice Memorandum, it was determined that an organization that operated a tea room and a gift shop in conjunction with a consignment shop, would continue to be exempt under Section 501(c)(3), but that income from the tea room and gift shop would be subject to UBTI. The organization had a purpose of assisting needy women to earn a living by means of their own handiwork, and the consignment shop provided a place where items produced by needy women would be exhibited and sold. The organization determined that having a gift shop, that sold items purchased from for-profit vendors for resale, is necessary to draw the clientele, and that the tea room, only accessible through the gift/consignment shop, also enhances the experience, thus attracting more customers. Section 1.501(c)(3)-1(e) of the Regulations holds that an organization may be exempt even if it operates a trade or business as a substantial part of its activities if the trade or business is in furtherance of the organization's exempt purposes, and the organization is organized and operated for a substantial exempt purpose, and not with a primary purpose of carrying on an unrelated trade or business. In this case, the organization clearly had an exempt purpose, and the unrelated trade or business was not the primary purpose of the organizations. However, for the operation to be exempt from UBIT, the activity "from which the gross income is derived, must contribute importantly to the accomplishment of those purposes." This requirement was not met. Therefore, although the organization continued to be exempt, it was required to pay taxes on the income derived from the tea room and gift shop. 9. Political Activity As is discussed above, political activity is strictly prohibited by 501(c)(3) exempt organizations. However, other exempt organizations are not subject to the same restrictions. For example, if a 501(c)(4) is primarily organized and operated to do something other than partisan candidate politics, it can carry on candidate activity as a secondary activity. Rev. Rul. 81-95. Under 527(f), an exempt organization (e.g. a 501(c)(4)) must also pay taxes on investment income to the extent of its political expenditures. Federal campaign finance law prohibits corporations from using general treasury funds to make contributions in cash or in kind to candidates for federal office, but permits expenditures related to a federal campaign as long as the expenditures do not pay for express advocacy. On July 30, 1996, the Federal Election Commission filed a suit against the Christian Coalition, which applied for but had not received exemption under Section 501(c)(4) of the Internal Revenue Code, alleging that it has violated campaign finance laws by promotion of Republican candidates and distribution of partisan voter guides. In 1999 it was reported that its application for exemption was denied by the IRS. The Christian Coalition was more successful in convincing a federal judge that its voters guides did not violate the Federal Election Laws, although the judge did find the Coalition responsible for penalties for express advocacy of Newt Gingrich in his 1994 reelection campaign, and for sharing a mailing list with Oliver North's 1994 campaign for senate. On February 25, 2000, the Christian Coalition filed suit against the IRS, alleging that they were discriminated against with the denial of their exemption. Primarily political organizations are organized under Section 527, adopted in 1975. Under Section 527, income consisting of contributions, dues, exempt function-type activity from political events and bingo is tax exempt. Everything else is probably taxable - either as UBIT, or investment tax. If you have $100 or more of investment income, you must file 1120-POL, and pay tax at the 34 percent corporate tax rate. A 527 organization cannot do anything nonpolitical. There has been significant activity in the area of Section 527 organizations recently. This was the result of several factors. First, Section 527 organizations do not have to file an exemption application as do 501(c)(3) organizations. Secondly, because Section 527 organizations are generally highly regulated by federal election law disclosures, there has been no separate reporting required by the IRS. Thirdly, In the late 1990's the IRS issued several private letter rulings holding that in an organization engages in "voter education" activities that are intended to influence the outcome of an election, the organization may qualify as a political organization under Section 527. Finally, a 1996 district court case held that an organization that developed ideas and circulated them generally to candidates and supporters, this was not to be considered a direct contribution to any particular federal candidate. As a result such an organization was not subject to the disclosure rules of the federal election law. The confluences of these factors has resulted in a number of organizations that have worked to indirectly influence elections without directly contributing to a political candidate did not have to report to anyone. When this was publicly disclosed, Congress put campaign reform on the fast track, and on July 1, 2000, Clinton signed into law a new disclosure law that required these "secret" Section 527 organizations to register with the IRS within 30 days. This information would be made public by the IRS within 15 days after receipt. Disclosure reports must be filed every three months during an election year, with additional reports required 12 days before, and 30 days after an election. These reports must include the name, address and occupation of persons receiving $500 from or more, or contributing $200 or more to the organization. The IRS quickly began to make these reports available through the internet, as required by the law. 10 Lobbying Lobbying expenses are no longer deductible. If a tax-exempt organization engages in lobbying, the portion of dues allocable to lobbying are nondeductible, and members must be notified of the portion projected to be used for such lobbying. Alternatively to such notification, a tax may be paid by the organization on the amounts used for lobbying at the highest corporate tax rate. If this tax is paid, the entire membership dues are deductible. In addition, a gift to a charitable organization may not be dedicated as a charitable gift if the organization is engaged in lobbying on matters of direct financial interest to the donor's trade or business. This change in the law has attracted a substantial amount of attention, in large part because of the difficulty in applying the law. In addition, there have been numerous requests for clarification of the law, including suggestions that the definition of lobbying be limited. In 1995, a revenue procedure that would explain when an organization meets the requirements of section 6033(e)(3) for exemption from the notice and reporting requirements relating to lobbying activities was issued.(20) In addition, final lobbying regulations were issued. T.D. 8602, EOTR, vol. 12, no. 2, p. 399 (Aug. 1995) 10.1 Lobbying Disclosure Act The Lobbying Disclosure Act went into effect at the beginning of 1996. This Act requires charities that lobby to register and file semi-annual reports if it employs a lobbyist, and expects to or does incur lobbying expenses of $20,000 or more in a six-month period. A lobbyist is defined as someone who makes at least two lobbying contacts in a six month period and spends at least 20% or his or her time lobbying. Once an organization registers, it must file semi-annual reports, even if it does not meet one or both of these requirements during the six month period, unless and until it terminates its registration. And registration may not be terminated unless the organization has stopped all lobbying efforts, and does not intend to resume the same. 11 Exempt Organization Pension Plans. 11.1 401(k) Plans. One of the changes made by Congress in 1996 through the Small Business Job Protection Act is that tax-exempt organizations are now eligible to use Section 401(k) plans as a part of their retirement program (Section 1426). The principal advantage of this is that many people are familiar with Section 401(k) plans and will thus be comfortable using them for their nonprofit. In addition, 403(b)'s are only available for 501(c)(3) organizations; 401(k)s are available for all exempt organizations. However, it should be noted that there may be more benefits available through the use of a 403(b) plan, so nonprofits should not automatically assume that a 401(k) plan should be used. The 401(k) plans do have the advantage that the employer does not have to offer the plans to all employees, they are portable, have more investment options and fewer administrators. It should be noted that an organization that has a 403(b) plan cannot transfer the funds to a 401(k), and generally cannot distribute the funds to participants. Therefore, if an organization has a 403(b) plan in existence, it will have to continue to maintain it, even if it "terminates" it by withholding additional contributions. 11.2 403(b) Plans. 403(b) plans continue to have other advantages, including the fact that the section 415 limit is twice as high, and an employer can avoid ERISA with a salary -reduction only plan. 11.2.1 Section 403(b) Plans - Tax Sheltered Annuity Voluntary Compliance Program One of the surprises to come out of the CEP program was the number of exempt organizations that have Section 403(b) plans that are considered by the IRS to be out of compliance. The most common problem appears to be excess contributions. Specifically, sponsors exceed the maximum exclusion allowance (approximately 20 percent of includible compensation under code section 403(b)(2), they claim elective deferrals in excess of the $9,500 limit of code section 402(g); and they exceed the 415 limitation on allocations of $30,000. Other common problems are with the salary reduction agreements, and violations of access restrictions on funds. Other problems such as employers not making the required amount of matching contributions, violations of nondiscrimination requirements, or mistakes in the design and operation of the plan, which are planwide, have also been found. In addition, 403(b) plans are only available for 501(c)(3) organizations; apparently some 501(c)(6) organizations have also attempted to use this form of pension plan. These problems can be summarized as being operational, demographic, and eligibility failures. Although the ultimate consequence of noncompliance is that the entire contribution may be includible in each employee's gross income if the plan loses its status as a 403(b) plan, the consequences to the organization can also be painful. Robert Architect of the IRS Employee Plans Technical and Actuarial Division, speaking at a 6/1/95 meeting of the IRS Baltimore Key District Benefits Conference in Philadelphia noted that in one case, a teaching university with an affiliated hospital misclassified working students as students rather than employees, and was forced to pay $6.5 million for nondiscrimination violations, including the inability of students to make salary reduction agreements. As a result of the large numbers of exempt organizations not in compliance with the law, the IRS has taken a number of steps to educate its agents as well as the exempt organizations. However, because the initial response of the IRS to institute a Tax Sheltered Annuity Voluntary Correction Program, which went into effect May 1, 1995, and permits an employer with a tax sheltered annuity program to voluntarily identify and correct defects, also required the payment of sanctions, many organizations decided simply to close down their plans. This was not the result that the IRS was looking for, and they have since issued Rev. Proc. 99-13 which provides for other alternatives: If the self-correction option is exercised, there are no fees or sanctions; if there is a service approved correction, there are fees but no sanctions. However, if the resolution is as a result of an examination by the IRS, then sanctions will be imposed. The service will not pursue individual inclusion or employer's federal income tax liability if one of these procedures is followed. See also new exam guidelines for 403(b) plans which were finalized in April of 1999, contained in 7.7.1: Employee Plans Exam Guidelines Handbook Chapter 13: 403b plans. See also Rev Proc 2000-16 which includes changes in methodology and in formal requirements in the Tax Sheltered Annuity area. According to Robert J. Architect, senior tax specialist in the IRS's EP Division, the Service will continue examinations in this area. In addition to the Coordinated Examination Procedure exams discussed below, specific exams were to be done in each geographic region in fiscal 2000. Therefore, nonprofits can expect continued activity concerning 403(b) plans. 11.3 Section 457 Plans. There are several problems concerning 457 plans that have been frequently discovered by the IRS, according to Catherine L. Fernandez, an attorney in Branch 1, IRS Office of Associate Chief Counsel (EP-EO), speaking at a health care organization tax conference on 10/9/97. One is that when an employer maintains both a 457 and a 403(b) plan, the $7500 deferral limit (now $8,000, effective 1/1/98 - see Notice 97-58) is often violated, and the catch-up provision that allows an employee to exceed this limit in the three years leading up to retirement often is not administered properly. Further, distributions may not be made for reasons other than death, disability or retirement. Probably the most significant change in this area is that Section 457 Plans are now under the oversight of the new TE/GE division of the IRS. See discussion of IRS reorganization. As a result, it can be expected that there will be heightened scrutiny. The IRS is currently working on new regulations. Robert J. Architect of the TE/GE Employee Plans Division reported that, in addition to the 403(b) plan audits his division will continue to conduct, it will be reviewing 457 arrangements as well.(21) 12. Worker Classification: Employees v. Independent Contractors. Whenever an organization is audited, the IRS will review the issue of misclassification of employees. The GAO estimates that the government loses 1.6 billion dollars annually as a result of the misclassification of employees as independent contractors. The IRS finds exempt organizations to contribute more than their fair share to this loss. If your exempt organization has individuals being paid as independent contractors, you should look carefully at this area and determine if, following the common law guidelines, the individual qualifies. A written contract would be highly recommended. If the individual is not clearly an independent contractor, the organization can expect to be challenged in this area. Section 530 of the 1978 tax act continues to provide some relief in this area. However, this requires that the worker must have been consistently treated as an independent contractor, the organization must have treated others in a similar position in the same manner, the organization must have filed all required federal tax forms (including Forms 1099), and the organization must have a reasonable basis for treating the worker as an independent contractor. However, changes to the Small Business bill have modified Section 530 to provide more protection to the employer. If the organization cannot function without the individual, the IRS will view the individual as an employee. Workers compensation programs are also auditing organizations in this area, and assessing back payments based upon their findings. The Service is now willing to look at employment tax issues on a special, expedited basis under a classification settlement program announced in March of 1996 (Announcement 96-13). Revised instructions have recently been released. Under the CSP, graduated settlement offers are available, which are intended to simulate the results that would be obtained if the business/ nonprofit had exercised its right to an administrative and/or judicial appeal.(22) 13. IRS Audits of Exempt Organizations 13.1 Coordinated Examination Procedure. After many years of auditing exempt organizations on a "hit and miss" type basis, the IRS developed a coordinated examination procedure that it began using in 1991 to audit exempt organizations. As explained by IRS Commissioner, Honorable Margaret Milner Richardson, at the 6/15/93, hearing of the Oversight Subcommittee of the House Ways and Means Committee on the federal tax laws applying to tax-exempt organizations: "Several years ago, we assessed the effectiveness of our traditional exempt organization audit efforts, and we determined that our traditional approach of using an exempt organization agent to examine a large exempt organization was not adequate to audit conglomerates and other systems that included taxable subsidiaries, joint ventures and other complex arrangements and transactions. "Consequently, we began using a new examination approach to strengthen our exempt organization enforcement program. This new approach, which we refer to as the coordinated examination program or CEP, sometimes it's called, was designed and implemented to enable our field agents to audit effectively increasingly complex activities of large exempt organizations such as hospital systems and universities. ... "Before we implemented this coordinated examination program, exempt organization audits were typically limited to reviewing the activities of tax exempt organizations and verifying the accuracy of the information that was reported on the Form 990 information return and any Form 990T, which is the exempt organization business income tax return. ... We concluded that these audits were simply not adequately examining transactions that included related or affiliated taxable entities, such as taxable subsidiaries, joint ventures, partnerships and related individuals." One reason for the coordinated audit program is, as is mentioned above, to provide a method of adequately examining the large tax-exempt organizations. Another outcome of the program is to allow the IRS to develop and improve guidelines for the audit of different types of exempt organizations. By having a concentrated audit program in specific areas, the IRS is able to determine the types of problems that most commonly occur in an area, so that future audits can be more specifically directed. This is expected to provide greater consistency in the audit process and to permit a more effective allocation of resources. Less than two years later, Marcus Owens, director of the IRS's Exempt Organizations Division, reported that the CEP audits in the EO area "have been successful in all ways." In a speech given by Mr. Owens on 11/15/95 to the Capital Area Chapter of the Maryland Association of CPA's, one audit closed with a $130 million unrelated business income tax deficiency. Owens noted in October of 1999 that the average assessment of recently settled cases is $2.5 million, discounting a couple of extraordinarily large settlements.(23) The FY 2000 EP/EO Workplan issued August 18, 1999 reported that: " From FY 1991 through March 31, 1999, 130 CEP cases were closed nationwide." As of October, 1999, there were 83 CEP examinations in progress. Of these, 40 were of health care entities, and 20 involved colleges and universities. A number of audits are of joint ventures, and control continues to be the important factor.(24) The CEP exams will continue to occupy a large part of the IRS examination activities. However, according to Thomas R. Burger, IRS Director of Employment Tax Administration and Compliance, fewer cases are randomly selected. Rather, most CEP audits now result from leads or from tax returns that "don't pass the smell test." The concentration are those with "a high probability of error." (25) 13.2 Consequences of CEP and Other Audits/Areas of Continued Audit Focus With the CEP audits, the IRS has been focusing on several specific areas, principally health care and colleges and universities. The results continue to justify expansion of large-case audits. At least one health care provider has had its exempt status revoked as a result of a CEP audit. The reason for such revocation appears to be as a result of inurement resulting from the purchase and sale of physician practices, and from excessive compensation. Additional revocations are likely. In addition to the complete CEP audits, it is expected that correspondence examinations, office audits, and targeted issue examinations will be pursued in the EO area. 13.3 Audit Guidelines. The IRS has been issuing audit guidelines that set out what the auditors will be looking for in their CEP audits. Because they set forth clearly the concerns of the IRS, they should be reviewed, even by entities that are not directly affected. These guidelines should be examined, as they indicate the types of concerns the IRS has, along with the position being taken by the IRS on the various matters. 13.4 Advice to Directors and Officers When an organization is facing an audit, officers and directors must be advised of the possible consequences up front. As noted by former IRS commissioner Lawrence B. Gibbs, now with Miller and Chevalier, Washington, at the 11th Annual Health Care Tax Law Institute on 4/25/95, "You can't imagine what it's like with officers and directors that have not been kept up to speed, to have you walk in and tell them there is a proposed revocation ... [or] an agent shows up, shows his badge, reads a Miranda warning, and wants to talk." If someone does show his badge, taxpayers would be well advised to refrain from making any statements, and retain criminal legal counsel immediately. In responding to an audit, the organization should focus on rules and procedure as well as substance. Keep a detailed log of what the IRS is asking for and what you are giving to them. If the IRS states that it has destroyed certain original records, ask if the IRS has such documents on microfilm or microfiche. If an extension of time for assessments is requested, the organization may limit the application of Form 872 to a particular tax. APPENDIX A - IRS SAMPLE CONFLICTS OF INTEREST POLICY (Revised 1999)(26) Article I Purpose The purpose of the conflicts of interest policy is to protect the Corporation's interest when it is contemplating entering into a transaction or arrangement that might benefit the private interest of an officer or director of the Corporation. This policy is intended to supplement but not replace any applicable state laws governing conflicts of interest applicable to nonprofit and charitable corporations. Article II Definitions 1. Interested Person Any director, principal officer, or member of a committee with board delegated powers who has a direct or indirect financial interest, as defined below, is an interested person. If a person is an interested person with respect to any entity in the health care system of which the Corporation is a part, he or she is an interested person with respect to all entities in the health care system. 2. Financial Interest A person has a financial interest if the person has, directly or indirectly, through business, investment or family -a. an ownership or investment interest in any entity with which the Corporation has a transaction or arrangement, or b. a compensation arrangement with the Corporation or with any entity or individual with which the Corporation has a transaction or arrangement, or c. a potential ownership or investment interest in, or compensation arrangement with, any entity or individual with which the Corporation is negotiating a transaction or arrangement. Compensation includes direct and indirect remuneration as well as gifts or favors that are substantial in nature. A financial interest is not necessarily a conflict of interest. Under Article III, Section 2, a person who has a financial interest may have a conflict of interest only if the appropriate board or committee decides that a conflict of interest exists. Article III Procedures 1. Duty to Disclose In connection with any actual or possible conflicts of interest, an interested person must disclose the existence of his or her financial interest and must be given the opportunity to disclose all material facts to the directors and members of committees with board delegated powers considering the proposed transaction or arrangement. 2. Determining Whether a Conflict of Interest Exists After disclosure of the financial interest and all material facts, and after any discussion with the interested person, he/she shall leave the board or committee meeting while the determination of a conflict of interest is discussed and voted upon. The remaining board or committee members shall decide if a conflict of interest exists. 3. Procedures for Addressing the Conflict of Interest a. An interested person may make a presentation at the board or committee meeting, but after such presentation, he/she shall leave the meeting during the discussion of, and the vote on, the transaction or arrangement that results in the conflict of interest. b. The chairperson of the board or committee shall, if appropriate, appoint a disinterested person or committee to investigate alternatives to the proposed transaction or arrangement. c. After exercising due diligence, the board or committee shall determine whether the Corporation can obtain a more advantageous transaction or arrangement with reasonable efforts from a person or entity that would not give rise to a conflict of interest. d. If a more advantageous transaction or arrangement is not reasonably attainable under circumstances that would not give rises to a conflict of interest, the board or committee shall determine by a majority vote of the disinterested directors whether the transaction or arrangement is in the Corporation's best interest and for its own benefit and whether the transaction is fair and reasonable to the Corporation and shall make its decision as to whether to enter into the transaction or arrangement in conformity with such determination. 4. Violation of the Conflicts of Interest Policy a. If the board or committee has reasonable cause to believe that a member has failed to disclose actual or possible conflicts of interest, it shall inform the member of the basis for such belief and afford the member an opportunity to explain the alleged failure to disclose. b. If, after hearing the response of the member and making such further investigation as may be warranted in the circumstances, the board or committee determines that the member has in fact failed to disclose an actual or possible conflict of interest, it shall take appropriate disciplinary and corrective action. Article IV Records of Proceedings The minutes of the board and all committees with board-delegated powers shall contain 1. the names of the persons who disclosed or otherwise were found to have a financial interest in connection with an actual or possible conflict of interest, the nature of the financial interest, any action taken to determine whether a conflict of interest was present, and the board's or committee's decision as to whether a conflict of interest in fact existed. 2. the names of the persons who were present for discussions and votes relating to the transaction or arrangement, the content of the discussion, including any alternatives to the proposed transaction or arrangement, and a record of any votes taken in connection therewith. Article V Compensation 1. A voting member of the board of directors who receives compensation, directly or indirectly, from the Corporation for services is precluded from voting on matters pertaining to that member's compensation. 2. A physician who is a voting member of the board of directors and receives compensation, directly or indirectly, from the Corporation for services is precluded from discussing and voting on matters pertaining to that member's or other physicians' compensation. No physician or physician director, either individually or collectively, is prohibited from providing information to the board of directors regarding physician compensation. 3. A voting member of any committee whose jurisdiction includes compensation matters and who receives compensation, directly or indirectly, from the Corporation for services is precluded from voting on matters pertaining to that member's compensation. 4. Physicians who receive compensation, directly or indirectly, from the Corporation, whether as employees or independent contractors, are precluded from membership on any committee whose jurisdiction includes compensation matters. No physician, either individually or collectively, is prohibited from providing information to any committee regarding physician compensation. Article VI Annual Statements Each director, principal officer and member of a committee with board delegated powers shall annually sign a statement which affirms that such person -a. has received a copy of the conflicts of interest policy, b. has read and understands the policy, c. has agreed to comply with the policy, and d. understands that the Corporation is a charitable organization and that in order to maintain its federal tax exemption it must engage primarily in activities which accomplish one or more of its tax-exempt purposes. Article VII Periodic Reviews To ensure that the Corporation operates in a manner consistent with its charitable purposes and that it does not engage in activities that could jeopardize its status as an organization exempt from federal income tax, periodic reviews shall be conducted. The periodic reviews shall, at a minimum include the following subjects: a. Whether compensation arrangements and benefits are reasonable and are the result of arm's-length bargaining. b. Whether acquisitions of physician practices and other provider services result in inurement or impermissible private benefit. c. Whether partnership and joint venture arrangements and arrangements with management service organizations and physician hospital organizations conform to written policies, are properly recorded, reflect reasonable payments for goods and services, further the Corporation's charitable purposes and do not result in inurement or impermissible private benefit. d. Whether agreements to provide health care and agreements with other health care providers, employees, and third party payors further the Corporation's charitable purposes and do not result in inurement or impermissible private benefit. Article VIII Use of Outside Experts In conducting the periodic reviews provided for in Article VII, the Corporation may, but need not, use outside advisors. If outside experts are used their use shall not relieve the board of its responsibility for ensuring that periodic reviews are conducted. 1. EOTR Weekly, Vol. 9, No. 13, march 30, 1998, page 1. 2. The following is a summary of the excise taxes on private foundations contained in the Internal Revenue Code: § 4940 -- 2% tax on net investment income; this may be reduced to 1% if a sufficient amount is donated to qualified charities. § 4941 -- 5% tax on any disqualified person participating in an act of self dealing; 2.5% on the foundation manager. §4942 -- 15% tax on undistributed income that should have been distributed during the year (must distribute 5% of FMV of assets). §4943 -- 5% excise tax on excess business holdings (20% - or 35% if the foundation does not control the entity, less the % held by a disqualified person). §4944 -- 5% excise tax on jeopardizing investments. §4945 -- 10% tax on foundation, 2.5% tax on foundation manager on amounts paid that are not in furtherance of the exempt purposes (taxable expenditures). Grants by private foundations to individuals (scholarships) must be awarded on an objective and nondiscriminatory basis, with the procedure approved beforehand by teh IRS, to avoid a taxable expenditure classification. See Rev. Proc. 76-47 (1976-2 C.B. 670). 3. Exempt Organization Tax Review, November, 2000, Vol 30, No. 2, p. 166-8. 4. Exempt Organization Tax Review, September, 2000, Volume 29, No. 3, p. 398-9. 5. Exempt Organization Tax Review, October, 2000, Volume 30, No. 1, p. 16. 6. Henry Haalilio Peters v. Comm'r, Tax Ct. Dkt. No. 8446-00, reported in Exempt Organization Tax Review, November, 2000, Volume 30, No. 2, p. 204. 7. Reg. § 53.4958-1T(d)(2)(i)(B). 8. Unless it is excludable as a de minimis fringe benefit, a payment of liability insurance premiums for or the payment or reimbursement by the organization will be included in compensation if said payment or reimbursement is: (i) of any penalty, tax or expense of correction owed as a result of an excess benefit payment, or (ii) is of unreasonable expenses incurred in a civil judicial or civil administrative proceeding arising out of the person's performance of services on behalf of the exempt organization, or (iii) is an expense resulting from the person's willful and unreasonable act or failure to act. Reg. § 53.4958-4T(b)(1)(ii)(B)(2). 9. Reg. Section 53.4958-5(a). 10. See EOTR, Vol. 27, No.2, February 2000, page 317 for complete list of these cases. 11. Exempt Organization Tax Review, November, 2000, Volume 30, No. 2, p. 126. 12. See discussion in EOTR Weekly, Vol. 10, No. 9, June 1, 1998, p. 1-2. 13. For an historical review of this area, see "Joint Ventures With For-Profits After Revenue Ruling 98-15", by ___________________, EOTR, March, 2000, Volume 27, No. 3, p. 441, et. seq. 14. See EOTR, November, 2000, Vol 30, No.2, p. 164. 15. The Exempt Organization Tax Review, January 2000, Vol. 27, No. 1, p. 21. 16. EOTR Weekly, Vol. 20, No. 2, 10/9/00, p. 9. 17. 18. WAC 230-12-110. 19. See also South End Italian Independent Club, Inc., v. IRC, 87 T.C. No. 11 (7/22/86) and Women of the Motion Picture Industry, et. al. v. IRC, T.C. Memo 1997-518. 20. 21. EOTR Weekly, 11/6/00, Vol 20, No. 6, p. 36. 22. See Vol. 15, No. 3, EOTR p. 444 (December 1996) 23. See Volume 26, No. 3, The Exempt Organization Tax Review, page 367 (December, 1999) 24. See Volume 26, No. 3, The Exempt Organization Tax Review, page 362 (December, 1999). 25. EOTR Weekly, Vol. 16, No. 11, December 13, 1999, page 2. 26. Continuing Professional Education Exempt Organizations Technical Instruction Program for FY 2000 Copyright © 2001 Runquist & Zybach LLP