Tax Exemption: Core Concepts & Management Strategies

1. Tax Exemption:Core Concepts&Management Strategies Terry Miller Terry@TerryMiller.biz 415-333-6320 www.terrymiller.biz AICPA NFP10 Session 111

2. Introductions • Who’s here? • Purpose Today / Framing • Order of Concepts • Conceptual: Legal / Public Policy Purposes • Specific: Reporting on Form 990 • Management: Planning Strategies • Questions as we go: universal vs. fact specific • Disclaimer

3. Objectives Objectives Issue spotting vs. memorize all nobody knows everything Know when to get help don’t be penny-wise & pound-foolish Context: the concept of “organized & operated” general legal compliance required “illegal” or in “contravention of public policy” ≠exemption

4. Session Overview • Context: organization types / regulators / a word on words • Legal concepts: Tax Exemption (The “Big Four” + 2) • Commerciality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . [earned income] • Inurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . [insiders] • Public v. private benefit . . . . . . . . . . . . . . . . . . . . . . . .[insiders OR outsiders] • Public policy advocacy . . . . . . . . . . . . . . . . . . .[1. lobbying, 2. electioneering] • Public charity status / public support tests . . . . . . . . . . [for 501(c)(3) charities] • Charitable deductions: substantiation & disclosure . . . . [for (c)(3) charities] • Miscellaneous compliance issues • Reporting: Form 990 – ‘the rubber hits the road’ • Management strategies: Planning Opportunities • Resources: • Supplemental materials • Related Sessions at NFP10

5. Context / Organization Types • Types: Nonprofit Corps, Trusts, LLCs, L3Cs … [STATE law] • Types of Nonprofit corporations (some states) • Public Benefit, Mutual Benefit & Religious • Authority: • State Constitution & Statutes • Articles of Incorporation • Bylaws • Corporate formalities – liability protection (“piercing the veil”) • SOS: Registration • IRS: Income Tax Exemption & Charitable Tax Deductions • AG: Charitable Trust & Charitable Solicitation Registration • Charitable Solicitation Registration • cy pres • ??:Sales & Property Tax Exemption, Charitable Gaming

6. “ Taxation? But we’re a nonprofit ?! ” • Nonprofit = state corporation concept • Tax law: levels of benefit by type of Exempt Organization, known by Internal Revenue Code Section • 501(c)(1) Created by Congress; (c)(2) Title Holding • 501(c)(3) Charities • Public Charities • Private Foundations • 501(c)(4) Social Welfare / Civic Leagues • 501(c)(5) Labor / Horticultural • 501(c)(6) Biz League / Prof & Trade Assoc / Chamber Commerce • 501(c)(7) Social Clubs • ….up to 501(c)(27) and beyond…501(d,e,f,k,n), 527

7. More complicated than taxable for-profits • The notion of “organized and operated” “exclusively” • Form 990 is mind-numbing • Measure whether sufficient exempt function activity is occurring to justify favorable tax treatment • “Commensurate” test • Tax Exempt (most net income not taxable) • Tax Deductible (mostly 501(c)(3) organizations) • Form 990 as a Public Communication tool • Heightened public focus stoked by scandals • 2008 Form 990 overhaul first in 30 years

8. A word on words • “nonprofit”, “not-for-profit” • “charity” • “charitable trust” • “EO” “exempt organization” “[income] tax-exempt” • “tax deductible [as a charitable gift]” “tax deduction” • “c3” “c4” … • “PF” “PC” • “new” 990 • “income” = “support” + “revenue” • “UBI” “UBTI” “UBIT” • “exclusive” “substantial” “primary” • “facts & circumstances”

9. Legal Concepts Legal Concepts: the Big Four (plus assorted details: “the fine print” )

10. Internal Revenue Code501(c) (3) (Complete! *) “(3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively forreligious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), 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 (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” * (color, bold & underlines added)

11. Internal Revenue Code501(c) (4),(5) & (6) (Complete*) “(4) (A) Civic leaguesor organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes. (B) Subparagraph (A) shall not apply to an entity unless no part of the net earnings of such entity inures to the benefit of any private shareholder or individual. (5)Labor, agricultural, or horticulturalorganizations. (6)Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.” * (color, bold & underlines added)

12. Legal Concepts: The “Big Four” • Commerciality • How much can we operate like a business and still be tax exempt? • Can we charge for services? • Private Inurement - Insiders • How much can we pay the boss? • Can we rent from the Chairperson? • Public vs. Private Benefit • Who really benefits from our work, on balance? • Politics & Lobbying • Can we support candidates for office? • Can we join a coalition to oppose legislation?

13. Commerciality -1 • History • destination test, until • NYU / Mueller Macaroni, circa 1950 • Pizza parlor example: “operated for” charitable (not commercial) purpose • “Exempt function income” / program service revenue • income as a by-product of program activity • The concept of Unrelated Business Income (Tax) • trade or business • regularly carried on • unrelated to the exempt purpose

14. Commerciality -2 • Common problem / error: technical assistance • substantially below cost • Useful exclusions from UBI follow from definition • passive – not “carried on” at all • interest, rents & royalties (watch out for debt-financed property) • gains & losses • not regularly carried on • substantially by volunteers – not “trade or business” • sale of donated merchandise – not “trade or business” • convenience of patrons – “related” • All revenues are one of these three: • Related Exempt Function Income (a/k/a “program svc revenue”) • UBTI • UBI but for exclusion

15. Commerciality -3 • Qualified Sponsorship Payments (v. advertising) • no price & item, inducement to buy, comparative messaging • watch out for web links! • RESOURCE: Session 19 (qualified sponsorships) • Dual types For-Profit & Nonprofit/EO: (e.g. hospitals) • usually means there will be specific guidance • frustrating issue: evolutionary enterprises (e.g. schools): poaching • RESOURCE – Session 55 (hospitals & community benefit) • Commercial sub-activities • when UBI activity becomes jeopardizing: substantial (?) • for-profit subsidiary

16. Private Inurement -1 • about INSIDERS(power to exercise major influence) • History: William Aramony • (resigned 1992, convicted 1995, released 2001) • Need for “Intermediate Sanctions” – IRC 4958 • Continued concern driven by juicy scandals: Smithsonian, American University, Irvine Foundation, etc etc etc • Excess compensation most common issue • “Excess Benefit Transactions” includes loans & other (buy/sell/rent) • T. Pattara says Grassley on a tear about this (recent news about Grassley & Boys & Girls Clubs) – Congress as a wild card

17. Private Inurement -2 • Conflicts of Interest / Conflict of Interest Policies • Definition? • IRS: concerned about self-dealing • Confidential information? “Settling scores”? • Who covered? • IRS: directors & officers (they define officer to include CEO & CFO) • All employees? Volunteers? • What relationships to report? • IRS: close family & business • Domestic partners? Best friends? • How declared? • IRS: at least annually – report all relationships that could give rise • Duty of loyalty – develop sensitivities to disclosure & openness • How monitored & enforced? • Disclosure & recusal is usually enough

18. Private Inurement -3 • Section 4958 Overview: (c)(3) pub charities & (c)(4) orgs • Penalties doubled by Pension Protection Act • Severe – on individuals • notion of “intermediate sanctions” scrambled up by Caracci case • 4958 “rebuttable presumption” basics – re: “disqualified persons” • Written comparables, saved with minutes • Disinterested majority of board, with interested party/parties out of room • Good faith determination best interest of the organization • Prior to transaction • Some in Congress want safe harbor steps required • IRS considers it best practice; pressure to report • IRS concerned about quality of “comparables” • Risks: notion of “Automatic” Excess Benefit Transactions / Listed Property • RESOURCES: Session 48 (intermediate sanctions) Session 53 (comparability audits)

19. Public v. Private Benefit -1 • 501(c)(3)’s & 501(c)(4)’s • Subtle / requires step back & ask: “who really benefits?” • NOT about insiders, necessarily • avoid: “more than incidental private benefit” • “the presence of private benefit, if substantial in nature, will destroy tax-exempt status regardless of an organization’s other charitable purposes or activities” – Marcus Owens on Better Business Bureau case (Resources) • Charitable class – how big? Public? • Private Benefit: IRS’ new all-purpose hammer? • “commensurate” test • “efficiency & effectiveness” • dovetails with public skepticism

20. Public v. Private Benefit -2 • Famous cases • American Campaign Academy • Consumer Credit Counseling • current: Seller-financed Down Payment Assistance • Governance as indicator of risk: audit flag • v. denial of exemption application • unpredictable • good governance policies & controls; Owens’ paper (Pg 111-64), e.g.: • broad Board • clear records on achievements • conflict of interest & whistleblower policies • commitment to proper arm’s length • outside auditor & if big enough, internal auditor • greater disclosure than required • accountable plan for reimbursements • compensation process use rebuttable presumption

21. Public Policy Advocacy:Lobbying v. Politics • Key distinction: Lobbying v. Candidate Electioneering • big danger in jumbling them !! • [C3 Public Charity] Lobbying = legislation • including work on referenda even though elections involved • [C456] Lobbying = legislation • plus certain executive branch decision making • Electioneering = candidates for elected office • some targeted lobbying IS electioneering

22. Public Policy Advocacy: Lobbying -1 • 501(c)(3) Public Charities • History: 1930, 1934, 1955, 1970, 1990 • Expenditure Test v. Substantial Part Test • Expenditure Test: more objective (IRC 501(h), Regs 4911) • Direct v. Grassroots lobbying • “Specific legislative proposal” • Substantial Part Test: “facts & circumstances” • 501(c)(3) Private Foundations • No explicit lobbying (earmarked / restricted) • Some wiggle room (general support, or project support less than the non-lobbying portion of the project) • mostly they just don’t want to hear about it 

23. Public Policy Advocacy: Lobbying -2 • 501(c)(non-3) Exempt Organizations • Unlimited if related to exempt purpose • 501(c)(4)’s (NRA, Sierra Club, etc) lobby a LOT • 501(c)(5) (Labor unions, Farm Bureau) lobby a LOT • 501(c)(6) (Trade associations, chambers of commerce, professional associations) lobby a LOT • 501(c)(7) social & recreational: not so much • Different definitions: legislation (other than local), plus certain executive branch policies • Business dues non-deductible as biz expense if used for lobbying, & must apply dues income first to Lobbying • Notify members of non-deductible portion, or • Pay 35% proxy tax

24. Public Policy Advocacy: Lobbying -3 • Remember: this has been about TAX law • Fed / State / (Local?) ethics & registration rules such as Congressional “Lobbying Disclosure Act” (LDA) • Trigger points ($ level) • Different definitions • Wining & dining & gifts & travel, money in politics, including by individuals from organization (!) • LDA allows public charities that have elected the expenditure test to use some of the tax definitions • Ballot measures may involve State election commissions and “PAC” regulation / registration / reporting • RESOURCE: Session 43 (elect & lobbying reporting: beyond tax)

25. Public Policy Advocacy: Candidate Electioneering -1 • IRC Section 527 & “527 Activities” = political = “electioneering” • True meaning: influence the election of candidates • “527” As used in the press: issue advocacy targeted at influencing election of candidates which escapes election commission jurisdiction by not being explicit • will Citizens United kill off such “issue 527’s” of this sort? • 501(c)(3) Charities (both PC & PF) • CANDIDATE ELECTIONEERING PROHIBITED • Revocation and/or penalties on charity AND on individuals (Board) • Non-partisan voter registration, voter education & get out the vote are all OK if done just right • (think: League of Women Voters)

26. Public Policy Advocacy: Candidate Electioneering -2 • 501(c)(4,5,6 …) organizations • Must be not primary purpose, conducted legally, and consistent with overall exempt purpose • Primary: 51/49%? No clear standard • EACH year, no rolling periods • Legal: jurisdiction of FEC or State/Local equivalents • Usually means hiring election law coun$el • Notion of Separate Segregated Fund • 527 Organizations • Not just “soft PACs / issue 527’s” – includes parties, candidate cttees • Risk if not political enough • (more than insubstantial “non-exempt purposes”)

27. Recap: The Big Four • Commerciality • Exempt Function Income • Unrelated Business Income • UBI but for Exclusion(s) • Inurement – insiders • Public v. Private Benefit – insiders or outsiders • Public Policy Advocacy • Lobbying v. Candidate Electioneering • Next: • Private Foundation v. Public Charity & the public support tests • Charitable Deduction Rules • Misc Compliance Issues

28. 501(c)(3): Public Charity or Private Foundation? • 501(c)(3) charities are private foundations (PF) by default, unless can qualify as a public charity (PC) • status tests (e.g. school) or public support tests • “Grandma’s Foundation” vs. Publicly-Supported Charity • PC is better; much less regulated than PF • better donor deductibility (% of AGI, FMV v. Basis) • more transactions with insiders allowed + safe harbor avail (for now) • no tax on investment income, fewer “excise tax” penalties • may MAKE grants to any entity (including foreign) for specific charitable purposes (if entity not a c3) • only practical way to get many PF grants is to be a PC • may lobby

29. PC or PF?Types of Public Charity • Qualify as Public Charity under IRC 509(a)(1)-(4) • 509(a)(1) says: 170(b)(1)(A)(i) - (vi) • 170(b)(1)(A)(i) Church status • 170(b)(1)(A)(ii) School status • 170(b)(1)(A)(iii) Hospital / medical research org status • 170(b)(1)(A)(iv) Support org to public college or univ status • 170(b)(1)(A)(v) Governmental unit status • 170(b)(1)(A)(vi) Publicly supported charity – gifts test • 509(a)(2) Publicly supported charity – fees test • 509(a)(3) Supporting Org (four sub-types ) mix • RESOURCE: Session 47 (supporting organizations) • 509(a)(4) Product Safety Testing Org status

30. PC or PF? Public Support Test(s) • Two Public Support Tests: • Both are complex – dynamic formula (mix of donors & revenues by size) • 5 year measurement period • Advance period for startup – don’t prove until Year 6 (2-3-4-5-6) • 509(a)(1) & 170(b)(1)(A)(vi): broad gift support • more forgiving and flexible than (a)(2) • some changes with New 990 • 509(a)(2): broad base of earned revenue from program services, plus very small gifts • extraordinarily complex math – 1 yr, 5 yr & data from inception • unforgiving, inflexible test • switching between is OK

31. Donor Deductibility -1 • Donor Substantiation (Receipting) • Publication 1771 & Deeper: Pub 526 • Cash (& Un-reimbursed Volunteer Participation) Gifts >= $250 • donor must have receipt with required language if audited • Cash v. Non-Cash gifts • valuation: internal estimate (books) v. donor receipt (no value estimate!) • for charitable use vs. for resale: key issue • Quid pro Quo gifts > $75 • FMV, not cost, stated in Solicitation or Receipt • TIP: fundraising events need TWO income lines each • exception: low cost logo items (“coffee mug”) for certain gifts • Common Errors • Donated services (+ whole concept of confusion about “a write-off”) • Earmarked for individual beneficiaries • Non-cash valuations estimated on receipt (donor pressure!) earned donated

32. Donor Deductibility -2 • Intangible Membership & Religious Benefits • best to read Pub 1771 • rules are pretty common-sense • Penalties • Failure to disclose non-deductibility (attn C4s!) • Failure to provide quid-pro-quo information • Vehicles, Boats & Planes: Pub 526 • general direction of law • Other high-value non-cash items • 8282 / 8283 • RESOURCE: Session 24 (charitable contribution compliance)

33. Other Compliance Issues • 990 Disclosure (Guidestar does not count) • 1023/1024 Disclosure • “Complete & Accurate” Return: statute of limitations, penalties if severe • Late Filing: Penalties • 3 years Non-Filing: Revocation • Donor Advised Funds & certain “fiscal sponsorships” • Abuses: 1) parking place, 2) self-serving grants, 3) self-serving investments • RESOURCE: Session 59 (working with community fdns) • Foreign Activity: PATRIOT Act / know your customer • RESOURCE: Session 36 (foreign operations)

34. Reporting: Form 990 Reporting: Form 990 (the rubber hits the road)

35. Key Parts of the New 990:Core Form PART ISummary(dashboard for the public) IIIProgram Service Accomplishments (commensurate test) IVChecklist of Required Schedules(trigger questions) VOther Filings & Tax Compliance(various compliance) VIGovernance, Mgt & Disclosure (private benefit / inurement) VIICompensation(inurement) VIIIRevenue(commerciality; UBI analysis) IXFunctional Expenses(commensurate test) XBalance Sheet(inurement)

36. New 990:The 16 Schedules -1 SCHEDULE (Which schedules to file? Based on “trigger question” – thresholds) A Public Support Tests / Pub Char Status (public charity status) B Contributors (no change from “old” 990) (deductibility) CCampaign & Lobbying Activity (public policy advocacy) D Supplemental Financial Statement Detail (various) E Private Schools [Education] (no substantive change) (special) F Foreign Activities & Grants (special: PATRIOT Act / terrorism) GGaming (& Fundraising) (commerciality; private benefit) HHospitals (commensurate test; public benefit)

37. New 990:The 16 Schedules -2 I Grants (Domestic - Inside U.S.) (public benefit) J (Justify) Compensation (inurement) K Bonds (public benefit; compliance) LLoans (inurement) M Non-Cash Contributions (deductibility; excess benefit) N Termination / Disposition of Assets (inurement / public benefit) OOpen for Narrative Responses (various) RRelated Organizations (various / public benefit)

38. 990: Core Form Pg 1 see Full-Size Form in Supplemental Materials ! (Page 23) • Core Form Page 1 Parts I and II • Dashboard / Overview

39. 990: Core Form Pg 2 • Core Form Page 2 Part III • Program Accomplishments • Commensurate Test • Key Communication Tool

40. 990: Core Form Pg 3 • Core Form Page 3 Part IV • “Trigger Questions” • threshold(s) where IRS has concern

41. 990: Core Form Pg 4 • Core Form Page 4 Part IVcontinued

42. 990: Core Form Pg 5 • Core Form Page 5 Part V • Other Filings & Compliance

43. 990: Core Form Pg 6 • Core Form Page 6 Part VI • “Governance, Management & Disclosure” • IRS Theory: Public v. Private Benefit risk assessment: audit flags • BIG emphasis

44. 990: Core Form Pg 7 • Core Form Page 7 Part VII • Compensation of: • Officers • Directors (Trustees) • Key employees • Highest comped ees • Former ODKE’s • Inurement • IRS Focus: audit flags: more BIG emphasis

45. 990: Core Form Pg 8 • Core Form Page 8 Part VII continued Trigger Questions

46. 990: Core Form Pg 9 • Core Form Page 9 Part VIII • Income (“Revenue”) • Support v. revenue • Classify revenues • Related • UBTI • UBI but for exclusion

47. 990: Core Form Pg 10 • Core Form Page 10 Part IX • Functional expenses • Program • Mgt & Gen (Admin) • Fundraising

48. 990: Core Form Pg 11 • Core Form Page 11 Part X • Balance Sheet • Inurement

49. 990: Core Form Pg 12 • Core Form Page 12 Part XI • Accounting methods, auditors, etc

50. Schedule Highlights:Schedule J Pg 1 • Schedule J Page 1 • Inurement • compensation setting basis & practices • compensation-like reimbursements