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GOVERNANCE FOR NONPROFITS
First Run Broadcast: April 14, 2016
1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)
Nonprofit and tax exempt organizations of every size are complex organizations. Boards of
directors need to recruit and retain talented management, supervise the investment of
endowments in often volatile markets, engage profit-making corporations in joint ventures, and
ensure the integrity of systems and policies in environment of increased governmental and public
scrutiny. Effective governance of these organizations is essential to advancing the nonprofit’s
mission. When governance fails, the organization itself and its directors are exposed to potential
liability. This program will provide you with a real-world guide to major governance issues for
nonprofits, including fiduciary duties of directors and officers, managing endowments, executive
compensation issues, compliance and conflicts of interest.
Governance issues for nonprofit organizations
Current IRS and attorneys general investigation and enforcement priorities
Best practices for determining executive compensation
Fiduciary duties, potential liability, and indemnification of nonprofit directors and
officers
Joint ventures between nonprofits and profit-making ventures
Current issues in the investment management of endowments
Compliance issues, including Form 990
Speaker:
Michele A. W. McKinnon is a partner in the Richmond, Virginia office of McGuireWoods,
LLP, where she an extensive tax-exempt organization and charitable giving practice. She has
more than 30 years’ experience representing public charities, major colleges and universities,
supporting organizations, large private foundations, and charitable trusts. She is a Fellow in the
American College of Trust and Estate Counsel and formerly served as its Virginia State Chair.
Ms. McKinnon received her B.A. from the University of Virginia, her J.D., magna cum laude,
from the University of Richmond School of Law, and her L.L.M. in taxation from the College of
William & Mary Marshall-Wythe School of Law.
Michael Lehmann is a partner in the New York office of Dechert, LLP, where he specializes in
tax issues related to non-profits and in the tax treatment of cross-border transactions. He advises
hospitals and other health care providers, research organizations, low-income housing
developers, trade associations, private foundations and arts organizations. He advises clients on
obtaining and maintaining tax-exempt status, executive compensation, reorganizations and joint
ventures, acquisitions, and unrelated business income planning. Mr. Lehmann received his A.B.,
magna cum laude, from Brown University, his J.D. from Columbia Law School, and his LL.M.
from New York University School of Law.
VT Bar Association Continuing Legal Education Registration Form
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Governance for Nonprofits Teleseminar
April 14, 2016 1:00PM – 2:00PM
1.0 MCLE GENERAL CREDITS
PAYMENT METHOD:
Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________
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NO REFUNDS AFTER April 7, 2016
Vermont Bar Association
CERTIFICATE OF ATTENDANCE
Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: April 14, 2016 Seminar Title: Governance for Nonprofits Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
Michael Lehmann
Dechert, LLP - New York City
(o) (212) 698 3803
FIDUCIARY ISSUES IN VOLATILE TIMES
I. The Background: Directors of nonprofit organizations are subject to three “fiduciary” duties: care,
loyalty and obedience (to mission).
A. Managing a nonprofit organization in a troubled economy puts acute stresses on each of those
fiduciary duties, but especially on obedience and loyalty.
B. Loss of revenues from government contracts, public and foundation donations and shrunken
endowments has been forcing boards to consider what to do: simply scale back programs and initiatives –
take more serious actions.
II. The principally relevant fiduciary concern is duty of obedience.
III. Possible Solutions in Volatile Times (beyond simply scaling back):
A. Asset sales
B. Accessing restricted funds
C. Loans from board members
D. Closing, merging, affiliating
IV. Asset Sales
A. Sales of non-core, unrestricted assets: The NYPL sales
B. Sales of core program assets: The MEETH-type sales
V. Access to Restricted Funds
A. Renegotiation with donors.
B. Cy Pres proceeding – court petition.
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C. Othmer cases are leading precedents in New York.
VI. Loans from Board Members
A. Not necessarily per se impermissible - but by-laws, state nonprofit law and conflict of interest
policies must be carefully examined.
B. Where permissible, loans should be adequately documented.
C. Even where loans are permissible and documented, caution is generally advisable.
VII. More Drastic Alternatives: Closing, Merging, Affiliation
A. If scaling back does not keep the organization viable, the Board must consider other
alternatives: closing, merging, or perhaps an affiliation or strategic partnership.
B. The core fiduciary duty again is obedience to mission. The MEETH case is the leading case
in New York regarding how a board needs to think about what to do if scaling back doesn’t work.
VIII. Closing/Merging/Affiliating
A. Closing is typically subject to court and state attorney general supervision.
1. Closing typically involves selling/disposing of assets and dissolving. In many states,
dispositions in these circumstances bump into the “cy pres” or “quasi cy pres” rules.
2. Multiple Sclerosis is the leading case in NY.
3. Example/hypothetical of nursing home closure.
B. Merging
1. Merger is a state law procedure in which one organization absorbs another
organization and succeeds by operation of law to its assets.
2. Like closure, merger is typically subject to court and attorney general supervision.
3. It is extremely difficult to “undo” a merger – you can’t unscramble the egg.
4. Mergers may present significant employee issues and invariably require input from
labor and employee benefits counsel.
C. Other Alternatives to Closing and Merging: Sole Membership, Affiliations and Strategic
Partnerships
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1. There are a variety of other alternatives to closure and merger, variously described as
“sole membership,” “affiliation,” “strategic partnership” and other names.
2. Generally these are contractual arrangements between a “stronger” organization and a
“weaker” organization to provide or share resources, staff, etc.
3. “Sole membership” is a structure in which one entity effectively becomes a subsidiary
of another. The New York attorney general has litigated its right to supervise these structures, and lost.
4. “Affiliation,” “strategic partnership” and similar arrangements are pure contractual
arrangements, and typically not subject to court supervision
5. A major advantage to these arrangements, as compared to closure and merger, is that
they generally can be undone fairly easily.
* * * *
CONFLICT OF INTERESTS
I. Definition: A conflict of interest exists when someone with a fiduciary duty is in a situation where
their own self-interest and the interests of the organization might be in conflict – and thus the exercise of
the proper judgment required to fulfill the fiduciary duty is distorted.
A. Most common affected self-interest is a financial interest
B. Personal self-interests – e.g., advancement of family members
C. Institutional relationships – stockholdings, partnerships
Note: We are here discussing only board-level conflicts. There can also be issues of employee
conflicts as well, which are important, but do not concern fiduciary duties.
II. Sources of Authority
A. State Law – for example, NY Not-for-Profit Corporation Law Sections 715-716
B. Internal Governance - Certificate of Incorporation and By-Laws
C. Third Parties
D. Government Agencies – For example, NY DOH Regulation 10 NYCRR § 610.4; Bureau of
Primary Health Care PIN 98-23, HHS 48 CFR Part 74, Section 74.42
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III. Actual, Apparent and Potential Conflicts of Interest
A. Actual
B. Apparent – would a reasonable observer look at the situation and see a conflict?
C. Potential – no current conflict, but the circumstances are reasonably likely to develop into a
conflict.
IV. Every Nonprofit Organization Needs a Board Conflict of Interests Policy.
A. That’s all there is to it!
B. It doesn’t need to be elaborate – Except where state law provides to the contrary, the IRS
model conflict of interests policy is perfectly adequate for all but large and complex operating entities.
C. Oh yes – the organization needs to have it, and it needs to actually follow it, too.
V. A Conflict of Interest Has Been Identified? Managing and/or Eliminating Conflicts of Interest
A. The existence of a conflict of interest may not mean that the matter cannot proceed.
B. If the transaction presenting the conflict of interest is prohibited (by law, regulation, policy,
etc.), then that is the end of the matter – and alternative must be found and the conflict eliminated.
1. Example: Loans to directors and officers, and certain entities in which they have an
interest, is flat-out prohibited under New York Not-for-Profit Corporation Law.
C. Sometimes a conflict of interest situation can be managed – through disclosures, evaluation of
alternatives, etc.
* * * *
UNRELATED TRADE OR BUSINESS ISSUES
I. What is UBIT?
A. “UBIT” = unrelated business income tax: the whole megillah of Code Sections 511-515.
B. “UBTI” = “unrelated business taxable income:” what gets taxed by Code Section 512.
C. “UBT” = “unrelated trade or business”
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II. What is the Big Idea?
A. The general idea is to prevent unfair competition between tax-exempt organizations and tax-
paying organizations.
B. A page of history is worth a volume of logic: court decisions in Trinidad v. Sagrada Orden de
Predicadores de La Provincia del Santisimo Rosario de Filipinas and C.F. Mueller Company v.
Commissioner – the latter being a 1951 decision of the Second Circuit that found that an organization
whose only activity was operation of a commercial macaroni factory was operated exclusively for
charitable purposes on the basis that the “destination” of the income from the factory was a charitable
organization -- the law school of New York University!
III. How Does it Work?
A. The conduct of an “unrelated trade or business” gets the ball rolling.
1. A UBT is a “trade or business” that is not “substantially related” to the organization’s
tax-exempt purposes.
2. Very generally, a “trade or business” is an activity that is profit motivated.
3. Very generally, a “trade or business” is “substantially related” only if there is a
“causal” connection between the “trade or business” and the tax-exempt purposes. Note that just a need
for cash does not establish the required “causal” connection.
4. A question that surfaces constantly is this: what about performing services for an
unrelated nonprofit organization? In almost all cases, that is going to be an “unrelated trade or business.”
B. If there is an “unrelated trade or business” then, if it is “regularly carried on,” the net income
from that “unrelated trade or business” is subject to corporate tax.
IV. What Happens in Joint Ventures?
A. If the joint venture is a corporation, there are few to no UBIT issues.
1. Depending on the ownership of a corporate joint venture, Code Section 512(b)(13)
may be relevant.
2. Code Section 512(b)(13) treats certain items of income that are otherwise excluded
from UBIT as subject to UBIT in the case of a controlled entity.
B. If the joint venture is a partnership for tax purposes (which includes most LLCs), then the
activities of the joint venture are attributed to its members – this goes way, way back in the tax laws and
is not limited to tax-exempt organizations.
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1. So if there is a UBIT activity in the joint venture, it is a UBIT activity of the tgax-
exempt partner.
2. Key IRS rulings are Revenue Ruling 98-15 and Revenue Ruling 2004-51.
3. An important element of Revenue Ruling 2004-51 is that the rights and powers of the
tax-exempt partner can influence whether the joint venture activity is UBIT or not. In that ruling, the tax-
exempt partner had control over the content of educational programming, which could ensure that the
content remained consistent with tax-exempt purposes.
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GOVERNANCE FOR NONPROFITS
Compliance under Federal Tax and State Law
Best Practices for Determining Executive Compensation
Profit-Making Ventures – Structural Considerations
Michele A. W. McKinnon
McGuireWoods LLP
Richmond, Virginia
(804) 775-1060
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I. Compliance under Federal Tax and State Law
A. IRS Focus on Governance and Compliance.
1. The focus on governance is not going away.
2. The IRS continues to state its belief that a well-governed organization is
more likely to be a tax-compliant organization.
3. The IRS does not want to micromanage organizations, but does expect
them to have appropriate internal controls.
4. If organizations have not already done so, now is the time to get the
articles of incorporation, bylaws, and policies in order.
5. The IRS released a governance checksheet a few years ago for use by its
agents in audits.
a. The checksheet is to be used to determine if an organization uses
certain governance practices that might indicate whether the
organization is in compliance with the rules for maintaining tax-
exempt status.
b. The checksheet asks about the organization’s mission statement,
compensation arrangements, control of the organization, including
family or business relationships among directors, officers, trustees,
or key employees, financial oversight of the organization, and
board review of the organization’s Form 990.
c. In many cases, the checksheet overlaps with the questions asked on
the revised Form 990 as implemented in 2008.
d. The IRS plans to use the data collected with the governance
checksheet in a long-term study of the intersection between
governance practices and tax compliance.
e. The checksheet information may be a way for the IRS to determine
which organizations will be selected for a more extensive review
of operations.
6. The IRS also has its “life cycle” and governance policies for nonprofits on
its website containing six topic areas:
a. Mission Statement.
(1) Clearly articulated.
(2) Guide to the organization’s work.
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(3) Aspirational in nature.
(4) Separate from the Articles of Incorporation.
b. Organizational Documents.
(1) Articles of Incorporation – govern the relationship between
the entity and the state.
(2) Bylaws – govern the relationship by and between the
officers and directors.
c. Governing Body.
(1) Board size will depend upon the size of the organization.
(2) Board should include individuals who are deeply engaged
in the activities of the organization and who have expertise.
(3) Board must be independent.
(4) Minutes of board meetings are critical.
d. Governance and Management Policies.
e. Financial Statements and Form 990 Reporting.
f. Transparency and Accountability.
B. Governance and Management on Revised Form 990.
1. The Form 990 requests substantial information about the governing body
and management of the organization.
a. Number of voting members of the board.
b. Number of independent voting members of the board.
c. Family and business relationships among officers, directors, and
key employees.
d. Delegation of management duties to third parties.
e. Changes to articles and bylaws during the tax year.
f. Material diversion of assets.
g. Existence of members or stockholders.
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h. Contemporaneous documentation of board and committee
meetings.
i. Existence of local chapters and affiliates and policies with respect
to them.
j. Provision of copy of Form 990 to directors before filing.
k. Conflict of interest policy.
(1) Existence of written conflict of interest policy.
(2) Annual disclosure requirements under conflict of interest
policy.
(3) Method of monitoring and enforcing conflict of interest
policy.
l. Other policies.
(1) Existence of whistleblower policy.
(a) Process for handling complaints, unethical conduct,
suspected financial improprieties, and misuse of the
organization’s resources.
(b) Encourage reports by employees of possible
violations.
(c) Prohibit retaliation, demotion, or other adverse
action against reporting employee.
(2) Process for determining compensation of president or CEO
and other officers and key employees.
(3) Existence of written policy regarding joint venture
arrangements, if the organization participates in such
ventures.
m. Public disclosure of:
(1) Form 990 and Form 990-T.
(2) State filing of Form 990.
(3) Articles of Incorporation and Bylaws.
(4) Conflict of Interest Policy.
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(5) Financial Statements.
C. Committees of the Board of Directors.
1. Smaller boards are less likely to have a committee structure, while larger
boards may become unmanageable without committees. The use of
committees varies from organization to organization, and there is no right
or wrong way to use committees.
2. The duties of the committee will vary and the board can delegate complete
authority to a committee or reserve final authority to the full board.
3. Typical committees include:
a. Executive Committee
b. Audit Committee
c. Finance Committee
d. Compensation Committee
e. Nominating Committee
f. Investment Committee
g. Advancement or Development Committee
h. Governance Committee
i. Strategic Planning Committee
j. Business Management Committee
D. Other Policies Frequently Adopted by Nonprofit Organizations.
1. Investment Policy
2. Spending Policy
3. Fundraising or Gift Acceptance Policy
4. Document Retention and Destruction Policy
E. What Does It Mean for a Nonprofit Organization?
1. The organization should undertake a review of the organizational
documents at least every five years and add modernized language and
delete obsolete language.
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2. Directors should:
a. Attend board meetings;
b. Review meeting minutes and committee reports;
c. Review financial information and tax filings; and
d. Review audit reports and letters.
3. Officers should have consistent job expectations and descriptions, keep the
board informed, and stay within their authority.
4. The Board of Directors should establish policies and adhere to them.
II. Best Practices for Determining Executive Compensation.
A. Application of Excess Benefit Transaction Rules to Executive Compensation.
1. Internal Revenue Code section 4958 imposes an excise tax on certain
“insiders” (referred to as “disqualified persons”) that engage in an excess
benefit transaction with a public charity.
a. This tax is equal to 25 percent of the amount of the excess benefit
and is paid by the disqualified person. (The public charity is never
subject to any tax under Internal Revenue Code section 4958.)
b. If the excess benefit is not corrected, the disqualified person will
be subject to an additional excise tax equal to 200 percent of the
amount of the excess benefit.
c. Correction generally requires that the disqualified person undo the
excess benefit to the extent possible and take any additional steps
necessary to place the organization in a financial position not
worse than that in which it would be if the disqualified person were
dealing under the highest fiduciary standards.
2. Any “organization manager” (i.e., a director, trustee, or officer) who
participates in the transaction knowing that it is an excess benefit
transaction is also liable for an excise tax of 10 percent of the amount of
the excess benefit unless such participation is not willful and is due to
reasonable cause.
a. An organization manager’s participation is due to reasonable cause
if the manager has exercised responsibility on behalf of the
organization with ordinary business care and prudence.
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b. The maximum aggregate tax that can be imposed on all of the
organization managers for any single excess benefit transaction is
$20,000.
c. An organization manager must have actual knowledge of facts that
would support treating the transaction as an excess benefit
transaction. In addition, the manager must be aware that there are
limits on excess benefit transactions. Finally, the manager must
negligently fail to make reasonable attempts to ascertain whether
this was an excess benefit transaction.
d. The regulations under Internal Revenue Code section 4958 offer a
safe harbor for organization managers based upon reliance upon
professional advice. An organization manager will not be subject
to tax if the manager fully discloses the factual situation to an
appropriate professional and then relies on the reasoned written
opinion of the professional with respect to elements of the
transaction within the professional’s expertise. Appropriate
professionals include legal counsel, CPAs or accounting firms with
expertise regarding the relevant tax laws, and independent
valuation experts who hold themselves out to the public as
appraisers or compensation consultants, perform the relevant
valuations on a regular basis, are qualified to make valuations of
the type of property or services involved, and include in the written
opinion a certification that they meet these requirements.
e. Also, a manager’s participation will not ordinarily be considered
“knowing” if the requirements for the rebuttable presumption of
reasonableness (discussed below) are met.
B. Definition of Excess Benefit Transaction.
1. An excess benefit transaction occurs when a disqualified person receives
an economic benefit from an applicable tax-exempt organization, whether
directly or indirectly, and the value of the economic benefit received by
the disqualified person exceeds the value of the consideration provided by
the disqualified person to the organization (including the performance of
services). The types of transactions contemplated by Internal Revenue
Code section 4958 include:
a. Payment of Unreasonable Compensation. Internal Revenue Code
section 4958 applies to the situation in which a disqualified person
receives compensation from the organization that exceeds the
value of the disqualified person’s services to the organization. It
should be noted that in determining the reasonableness of
compensation paid in one year, services performed in prior years
may be taken into account.
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b. Unreasonable Compensation Arrangements Based on
Organization’s Income. Internal Revenue Code section 4958
provides that the Internal Revenue Service can issue regulations to
include in the definition of “excess benefit transaction” any
transaction in which the amount of any economic benefit provided
to or for the use of a disqualified person is determined in whole or
in part by the revenues of one or more activities of the organization
(but only if such revenue sharing arrangement results in an excess
benefit to the disqualified person). To date, the Internal Revenue
Service has not addressed this issue, but has reserved it.
2. Under the regulations, certain economic benefits are disregarded. These
disregarded benefits include all fringe benefits excluded from income
under Internal Revenue Code section 132, all economic benefits provided
to a person solely as a member of the charitable class the organization
intends to benefit.
3. Internal Revenue Code section 4958 does not apply to any fixed payment
made to a person pursuant to an initial contract even if it would otherwise
constitute an excess benefit transaction. An initial contract is a binding
written contract between the organization and a person who was not a
disqualified person immediately before entering into the contract. A fixed
payment is an amount of cash or other property specified in the contract or
determined by a fixed formula specified in the contract which is paid or
transferred in exchange for the provision of services. A fixed formula
may be tied to a contingency as long as no one exercises discretion in
deciding how much is paid.
C. Definition of Disqualified Person. The definition of “disqualified person” is a
key part of Internal Revenue Code section 4958. It is only transactions with
disqualified persons that come within the scope of Internal Revenue Code section
4958.
1. A disqualified person in general is any person who at any time during the
five-year period ending on the date of the transaction was in a position to
exercise substantial influence over the affairs of the organization. The
following persons are deemed to be in a position to exercise substantial
influence over the affairs of the charitable organization:
a. Voting Members of Governing Body. Any individual serving on
the governing body who is entitled to vote on any matter over
which the governing body has responsibility.
b. President, Chief Executive, or Operating Officer. Any person
who, regardless of title, has ultimate responsibility for
implementing the decisions of the governing body or for
supervising the administration, management, or operation of the
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organization. A person who serves as president, chief executive
officer, or chief operating officer has this ultimate responsibility
unless the person demonstrates otherwise.
c. Treasurer, Chief Financial Officer. Any person who has ultimate
responsibility for managing the finances of the organization. A
person who serves as treasurer or chief financial officer has the
ultimate responsibility unless the person demonstrates otherwise.
2. In addition, family members of the persons described above are
disqualified persons. Family members include the person’s spouse,
siblings (whether by whole or half blood), ancestors, children,
grandchildren, great grandchildren, and the spouses of siblings, children,
grandchildren, and great grandchildren.
3. Also, entities that are 35 percent or more controlled by the persons
described above and their family members are disqualified persons. In the
case of a corporation, control is based on owning 35 percent or more of
the total combined voting power of the corporation.
4. In addition, other persons can be disqualified persons. If a person does not
fall into one of the definite categories of a disqualified person, the
determination of whether a person has substantial influence over the
affairs of the organization is based on all relevant facts and circumstances.
Facts and circumstances that tend to indicate a person has substantial
influence over the affairs of an organization include: the person founded
the organization; the person is a substantial contributor to the organization
during the current year and four preceding years; the person’s
compensation is based primarily on revenues derived from activities of the
organization that the person controls; the person has authority to control or
determine a substantial portion of the organization’s capital expenditures,
operating budget, or compensation for employees; the person manages a
discrete segment or activity of the organization that represents a
substantial portion of the activities, assets, income, or expenses of the
organization as compared to the organization as a whole; or the person
owns a controlling interest in a corporation, partnership, or trust that is a
disqualified person. Facts and circumstances tending to show the person
does not have substantial influence over the affairs of an organization
include: the person has taken a bona fide vow of poverty as an employee,
agent, or on behalf of, a religious organization; the person is an
independent contractor, such as an attorney, accountant, or investment
manager, whose sole relationship with the organization is providing
professional advice (without having decision-making authority) with
respect to transactions from which the independent contractor will not
economically benefit either directly or indirectly (aside from customary
fees received for the professional advice rendered); the direct supervisor of
the person is not a disqualified person; or the person does not participate
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in any management decisions affecting the organization as a whole or a
discrete segment or activity of the organization.
D. Definition of Organization Manager. Organization managers are also
potentially subject to the excess benefits transaction tax under Internal Revenue
Code section 4958. The term “organization manager” includes, with respect to
any applicable tax-exempt organization, any officer, director, or trustee of such
organization, or any individual having powers or responsibilities similar to those
of officers, directors, or trustees of the organization. In general, the definition is
limited to those officers, directors, or trustees of the organization with final
authority or responsibility for decisions. Independent contractors such as
attorneys, accountants, and investment managers, or advisers acting in those
capacities, are not considered organization managers. Also, the term
“organization manager” does not include any person who was an organization
manager during the last five years (unlike the term “disqualified person”). Once
an individual ceases acting as an organization manager, the tax on organization
managers cannot be imposed on such individual for transactions occurring after
the person ceased to act as an organization manager.
E. Determining Reasonableness in the Case of Compensation Arrangements
between the Organization and Disqualified Persons. Although Internal
Revenue Code section 4958 is silent as to how charitable organizations are to
evaluate whether the compensation and other benefits they are providing are
reasonable (and therefore not excess benefit transactions), the House Committee
Report provides that existing tax law standards will apply in determining the
reasonableness of compensation arrangements with disqualified persons.
1. Under the regulations, the existing tax law standards under Internal
Revenue Code section 162 apply for determining the reasonableness of
compensation. In the case of a fixed payment, reasonableness is
determined at the time the parties enter into the contract. The
reasonableness of amounts not fixed in a contract or paid pursuant to an
objective formula is determined based on all facts and circumstances, up
to and including the circumstances as of the date of the payment at issue.
2. Determination of the reasonableness of benefits included as part of the
compensation arrangement between the board and the disqualified person
must be made at the same time the board determines that the disqualified
person’s compensation is reasonable. The board cannot later claim that it
intended a particular benefit to be part of the total compensation.
a. Examples of Fringe Benefits That Should be Considered. In
making a determination as to whether a compensation package is
reasonable, all possible benefits must be considered including use
of a company car or plane; use of company credit cards; use of
lodges or vacation homes; free meals; club memberships;
unsupervised expense accounts; clothing allowances; sports/luxury
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boxes and theater tickets; below market loans and leases; free
accounting, estate planning or legal services; paid sabbaticals;
excess contributions to pension plans; reimbursement by the
organization of excise tax liability; and premiums for an insurance
policy providing liability insurance to a disqualified person for
excess benefit taxes.
b. Mid-Year Changes in Compensation. If, for example, a
disqualified person takes an unexpected trip during the year which
arguably is not an expense in furtherance of the exempt purposes
of the organization, the board of directors should decide before
paying the expense whether the benefit to the disqualified person
would make the disqualified person’s compensation unreasonable
and follow the steps required to give rise to the rebuttable
presumption of reasonableness (discussed below) before it pays the
expense.
F. Rebuttable Presumption of Reasonableness. The House Committee Report
provided an important planning tool for protecting against the application of the
excess benefit transaction excise tax, which has been incorporated into the
regulations under Internal Revenue Code section 4958. The charitable
organization may establish a rebuttable presumption that the compensation paid to
the disqualified person is reasonable.
1. There are two primary benefits of establishing the rebuttable presumption.
First, as a general rule, if the requirements for establishing the rebuttable
presumption have been met, a director’s participation in a transaction will
be due to reasonable cause. Thus, the participating directors cannot be
subjected to the 10 percent excise tax imposed on organization managers
under Internal Revenue Code section 4958. Second, meeting the
requirements for the rebuttable presumption shifts the burden of proof to
the Internal Revenue Service. The Internal Revenue Service will then
have the burden of rebutting the presumption by challenging the validity
or independence of comparables or proving that the comparables do not
reflect functionally similar positions.
2. The rebuttable presumption of reasonableness will arise only if the
following conditions are met in the case of compensation arrangements:
a. Approval by Authorized Body. The terms of the compensation
arrangement must be approved in advance by an authorized body
of the charitable organization composed entirely of individuals
who do not have a conflict of interest with respect to the
compensation arrangement. An authorized body is the board of
directors, a committee of the board of directors, which may be
composed of individuals permitted under state law to serve on such
committee, to the extent that state law allows the committee to act
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on behalf of the board of directors, or, to the extent permitted
under state law, other parties authorized by the board of directors
to act on its behalf by following procedures specified by the board
of directors in approving property transfers. For purposes of
determining whether an individual has a conflict of interest, a
member of the authorized body does not have a conflict of interest
with respect to a compensation arrangement only if the member:
(1) Is not a disqualified person participating in or economically
benefiting from the compensation arrangement, and is not a
member of the family of any such disqualified person;
(2) Is not in an employment relationship subject to the
direction or control of any disqualified person participating
in or economically benefiting from the compensation
arrangement;
(3) Does not receive compensation or other payments subject
to approval by any disqualified person participating in or
economically benefiting from the compensation
arrangement;
(4) Has no material financial interest affected by the
compensation arrangement; and
(5) Does not approve a transaction providing economic
benefits to any disqualified person participating in the
compensation arrangement, who in turn has approved or
will approve a transaction providing economic benefits to
the member.
b. Appropriate Data as to Comparability. The authorized body must
obtain and rely upon appropriate data as to comparability before
making its determination. An authorized body has appropriate data
as to comparability if, given the knowledge and expertise of its
members, it has information sufficient to determine if the
compensation is reasonable. In the case of a compensation
arrangement, relevant information includes:
(1) Compensation levels paid by similarly situated
organizations, both taxable and tax-exempt, for functionally
comparable positions.
(2) The availability of similar services in the geographic area.
(3) Current compensation surveys compiled by independent
firms.
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(4) Actual written offers from similar institutions competing
for the services of the disqualified person.
(5) For certain small organizations reviewing compensation
arrangements, the authorized body is considered to have
appropriate data for comparability if it has data
compensation paid by three comparable organizations in
the same or similar communities. A small organization is
one having gross receipts of less than $1 million per year.
c. Documentation. The authorized body must adequately document
the basis for its determination concurrently with making that
determination. For a decision to be documented adequately, the
written or electronic records of the authorized body must note the
following:
(1) The terms of the compensation arrangement that was
approved and the date of the approval;
(2) The members of the authorized body who were present
during the debate on the compensation arrangement that
was approved and those who voted on it;
(3) The comparability data obtained and relied upon by the
authorized body and how the data was obtained; and
(4) Any actions taken with respect to consideration of the
compensation arrangement by anyone who is otherwise a
member of the authorized body but who had a conflict of
interest with respect to the compensation arrangement.
3. For a decision to be documented concurrently, records 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 are taken. Records must
be reviewed and approved by the authorized body as reasonable, accurate,
and complete within a reasonable time period thereafter.
4. In the case of a contract providing for a fixed payment, the rebuttable
presumption arises at the time the parties enter into the contract. The same
rule applies for retirement benefits. If the contract does not involve a
fixed payment (except in the case of certain payments subject to a cap),
the rebuttable presumption can arise only after discretion is exercised, the
exact amount of the payment is determined, or the formula is fixed, and
the three requirements for the rebuttable presumption are met.
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G. Planning to Avoid the Excess Benefit Transaction Rules.
1. All organizations should strive to take steps to identify potential excess
benefit transactions and to raise the rebuttable presumption of
reasonableness in all cases where a compensation arrangement involves a
disqualified person with respect to the organization. The following steps
should be implemented and reviewed on a regular basis:
a. Identify Disqualified Persons. Organizations should identify
disqualified persons in their organizations. Board members,
officers, and other key employees with substantial authority over
final decisions are considered disqualified persons. In addition,
transactions with disqualified person’s family members and 35
percent controlled corporations should be identified.
b. Establish Procedures for Future Compensation Arrangements.
Organizations should adopt procedures for determining reasonable
compensation for disqualified persons and follow the steps
required to qualify for the rebuttable presumption. It is important
to remember that the three requirements for the rebuttable
presumption must be satisfied before any of the proposed
compensation is paid.
c. Establish Standards for Independent Review. The organization
should make certain that the independent review required to obtain
the rebuttable presumption is truly independent and any conflict of
interest is avoided.
d. Establish Procedures for Emergency Situations. Organizations
should consider procedures for handling unexpected benefits that
become payable to disqualified persons during the year. The
procedures should follow the steps necessary to obtain the
rebuttable presumption of reasonableness. In the case of
reimbursement of expenses, the organization should consider
requiring the disqualified person to initially pay the expense, with
later reimbursement from the organization once the proper steps
are taken to secure the rebuttable presumption of reasonableness.
2. The Internal Revenue Service has provided checklists for documenting the
establishment of the rebuttable presumption of reasonableness. One
checklist pertains to compensation arrangements and the other to property
transactions. These checklists can be accessed on the Internal Revenue
Service’s website at www.irs.gov/pub/irs-tege/m4958a2.pdf. It is
advisable for the organization to complete the checklist for each
compensation arrangement that could potentially be an excess benefit
transaction.
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H. Reporting Compensation on the Form 990.
1. The Form 990 as revamped in 2008 expanded the number of persons
whose compensation must be reported by the filing organization and
provides for further specifics on the compensation of certain individuals.
Certain basic compensation information must be reported by the filing
organization. The core Form 990 (i.e., the part of the Form that must be
completed by all filing organizations) requires disclosure about
compensation of certain persons as reported on a Form W-2 or Form 1099.
The list of persons whose compensation must be disclosed was expanded
on the Form 990 and includes:
a. Current officers and directors.
b. Up to 20 key employees (who are not officers or directors) who are
defined as persons with certain responsibilities who have
reportable compensation greater than $150,000 from the filing
organization and related entities.
c. The five highest paid current employees whose reportable
compensation exceeds $100,000.
d. Former directors whose reportable compensation exceeds $10,000.
2. With respect to each of these persons, the filing organization must disclose
on the Form 990 the name and title of the person, average weekly hours,
reportable compensation from the filing organization, reportable
compensation from related organization(s), and the estimated amount of
other compensation from the University and related organization(s), such
as housing, education assistance, or insurance. In addition, the filing
organization must identify the total number of individuals being paid more
than $100,000 regardless of whether specifically reported on the Form
990.
3. The filing organization is also required to identify any independent
contractors, such as law firms, accounting firms, investment managers,
and other consultants, who receive more than $100,000 from the filing
organization and must also identify the services provided and the amount
of compensation paid.
4. If certain requirements are met, the filing organization must provide
additional and more detailed compensation information on new Schedule
J. Schedule J must be filed if (1) the filing organization is required to list
any former officer, director, key employee, or five highest compensated
employees in the core Form 990; (2) the sum of reportable compensation
and other compensation paid to any individual listed in the core Form 990
exceeds $150,000; or (3) the filing organization participated in an
arrangement in which an unrelated organization paid compensation to at
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least one of its officers, directors, key employees, or five highest
compensated employees for services performed for the filing organization.
5. For persons required to be reported on Schedule J, the filing organization
must breakdown its reporting or executive compensation into components,
including regular wages and salary, bonus and incentive compensation,
other reportable compensation, deferred compensation, fringe or
nontaxable benefits, including expense allowances and reimbursements.
6. Schedule J also requests information about the filing organization’s
general compensation practices. For any persons whose compensation
was reported in the core part of the Form 990, the filing organization is
required to disclose whether any of the following were provided by the
filing organization to the person:
a. First-class or charter travel.
b. Travel for companions.
c. Tax indemnification and gross up payments.
d. Discretionary spending account.
e. Housing allowance or residence for personal use.
f. Payments for business use of personal residence.
g. Health or social club dues or initiation fees.
h. Personal services (e.g., maid, chauffeur, chef).
7. In connection with the establishment of the chief executive officer’s
compensation, Schedule J asks whether any of the following were used:
a. Compensation committee.
b. Independent compensation consultant.
c. Form 990 of other organizations.
d. Written employment contract.
e. Compensation survey or study.
f. Approval by the Board or a compensation committee.
8. For any persons whose compensation was reported on the core part of the
Form 990, the filing organization is required to disclose whether any of
those persons:
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a. Received a severance or change in control payment.
b. Participated in or received a payment from a supplemental
nonqualified retirement plan.
c. Participated in or received a payment from an equity-based
compensation arrangement.
d. Received pay contingent upon the revenues or net earnings of the
filing organization or any related organization.
e. Received any non-fixed payments not based on revenues or net
earnings.
9. The new Schedule J also provides space for supplemental information in
the event the filing organization believes it appropriate to provide further
explanation (whether for the benefit of the public or the Internal Revenue
Service) regarding a particular compensation package, practice, or
arrangement.
III. Profit-Making Ventures – Structural Considerations.
A. Reasons for Undertaking Revenue Generating Activities.
1. Furtherance of mission.
2. Additional funding to support exempt activities.
B. Considerations for Choice of Entity.
1. Tax treatment of revenue stream.
2. Size of revenue stream.
3. Risk of liability and asset protection.
4. Management and employment issues.
C. Entity Choices.
1. Existing tax-exempt organization.
2. Separate tax-exempt organization.
3. Single member limited liability company.
4. Taxable subsidiary (usually a C corporation).
5. Multiple member limited liability company.
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6. General or limited partnership.
D. Overriding Considerations.
1. Any arrangement needs to avoid shifting undue profits or benefits to for
profits or individuals to avoid private benefit that could jeopardize the
organization’s tax-exempt status.
2. Appropriate controls should be in place to protect the exempt purposes of
the tax-exempt organization participating in the venture.
3. The structure should be designed to avoid the receipt by the exempt
organization of too much unrelated trade or business income to avoid
jeopardizing the exempt organization’s tax-exempt status.
4. The tax-exempt organization should have a joint venture policy for Form
990 reporting purposes.
