On the Record: Charity Laws Face Changes

In June, the Senate Finance committee — which oversees the Internal Revenue Service’s regulation of tax-exempt organizations — released a draft staff report suggesting many drastic changes in the law that governs charities. Sen. Charles Grassley (R-Iowa), the chairman of the committee, announced at press time that he intended to introduce bipartisan legislation this fall to incorporate some of these changes. Here is a condensed look at some of the more wide-ranging, proposed changes.

1. Five-year review of tax-exempt status
The staff report proposes that every five years a tax-exempt organization must submit detailed information justifying its exempt status. This information would include conflicts of interest policies; management policies regarding best practices; financial statements; and a detailed narrative about all the organization’s policies and practices. This information would be made available to the public, and failure to file would result in loss of exempt status. Currently, exempt organizations have no such requirement, and many in the nonprofit community believe this will place an undue burden on organizations.

2. Apply private foundation, self-dealing rules to public charities
Under existing law, private foundations are subject to greater restrictions on transactions with “disqualified persons,” or insiders, than public charities. For public charities, disqualified persons are those who have substantial influence over the charity during a five-year period that ends on the date of the transaction in question and includes officers and voting members of the governing body, family members of these persons and entities in which these persons have a 35 percent or greater interest. For private foundations, disqualified persons include substantial contributors, trustees, directors, family members of these persons and, again, entities in which these persons have a 35 percent or greater interest.

For example, an insider is subject to excise taxes upon the sale of property to a private foundation, even if the sale price is below market value and thus benefits the foundation.

Public charities, however, can engage in such a transaction with an insider as long as the sale price is fair-market value. Self-dealing transactions generally include the following transaction between an insider and a private foundation: the sale, exchange or leasing of property; the lending of money or other extension of credit; the furnishing of goods, services or facilities; the payment of unreasonable compensation by a private foundation; and the transfer to or use by an insider of a private foundation’s income or assets.

The staff report extends these self-dealing rules to public charities, and would modify the intermediate sanction rules that currently are applicable to public charities. In addition, the excise taxes on the self-dealer and foundation officers who approve self-dealing would be increased to an unspecified amount.

3. Limit compensation for private foundation trustees and foundations
The staff report prohibits the payment of any compensation to trustees of a private foundation, or in the alternative, limits it to a statutorily prescribed de minimis amount. In addition, compensation paid by non-operating private foundations to “disqualified persons” (substantial contributors, trustees and directors or family members of these persons) would be limited to the comparable federal government rates for similar work.

Compensation or severance payments to any person whose salary is over $200,000 would require the filing of additional supporting material with the IRS, and the payment of a processing fee for the IRS’s review. This information would be made available to the public.

4. Limit amounts paid for travel, meals and accommodation
Charities would be subject to the applicable U.S. government rate for expenses pertaining to travel, meals and accommodation, and would be subject to a penalty for failure to comply. Public charities would not be subject to these limits if the board of directors approves each expense above the limit or if such approval is disclosed on Form 990.

5. Form 990 changes
Numerous concept changes to Form 990 have been proposed, many of which are borrowed from the Sarbanes-Oxley Act. Changes include requiring the CEO to sign and certify the Form 990; increasing penalties for failing to file or for filing an inaccurate and/or late Form 990; requiring increased disclosure about affiliated organizations and insider deals; requiring organizations with more than $250,000 in gross receipts to have independent audit financial statements; requiring a public charity to publicly disclose investments; requiring an attachment to Form 990 listing all partnership interests and the charity’s role in the partnership; and requiring an attachment to Form 990 showing all legal options involving agreements with insiders and conflicts of interest.

6. Treatment of private foundation administrative expenses
Under the proposal, private foundations that have administrative expenses — defined in the staff report as all expenses other than grants to charities, above 10 percent of the foundation’s total expenses — would be required to file additional supporting materials with the IRS.

7. Required changes to governance
The board of directors would be required to have at least three members, but no more than 15. At least one-fifth of the board must be independent. Any person not allowed to serve on the board of a publicly traded company due to federal or state law could not serve on the board of an exempt organization. The IRS would be given the authority to remove any board member, officer or employee of an exempt organization who violates any rules relating to self-dealing, charitable solicitation or private inurement.

8. Accreditation
The IRS would sponsor an accreditation program for charities and could base charitable status or authority to accept charitable donations on accreditation.

9. Additional public disclosure
The staff report also proposes changes in public-disclosure requirements. Financial statements, final determinations, audit results and unrelated business-income returns would be made public and posted on the organization’s Web site.

10. Federal oversight of exempt organizations
The staff report proposes to extend federal control over nearly all aspects of tax-exempt organizations. The IRS and Tax Court would have the same powers as presently exercised by the states over exempt organizations’ operational decisions, boards of directors and finances. For example, the IRS could seek the removal of directors via the Tax Court. The Tax Court would have broad equity powers to remedy any detriment to an exempt organization resulting from any violation of the substantive rules.

11. Elimination of supporting organizations
One method for an organization to qualify as a public charity is for it to constitute a “supporting organization” — any 501(c)(3) organization that is so closely aligned with a public charity that the supporting organization itself is treated as a public charity.

The staff report states that supporting organizations have been an area of significant abuse and consequently should be eliminated. It suggests that Donor-Advised Funds be used instead.

12. Restrictions on donor-advised funds
DAFs accept gifts from many different donors and take into account the donors’ suggestions on how grants of the funds should be made. DAF’s are, in effect, collections of private foundations, but they are treated like public charities — thus avoiding the private foundation limitations — because they receive funds from enough donors to meet the public-charity support tests.

The staff report suggests imposing many restrictions on DAFs, including the following: contributions other than cash or publicly traded securities to a DAF would have to be sold within one year of the contribution; DAFs would be prohibited from making grants to a non-operating private foundation or to individuals; DAFs would be required to meet an annual payout requirement similar to that applicable to private foundations; and DAFs would be required to obtain an acknowledgement from the grantee that the grant will not convey a private benefit to the donor.

These proposals represent significant changes in how exempt organizations operate and are regulated. It is too early to tell, however, if any or all of the proposed changes will make it into law. But nonprofits would be well served to be on high alert.

Kathleen Stephenson is of counsel with the Philadelphia office of Pepper Hamilton LLP. Lisa Petkun is a partner in the tax department of Pepper Hamilton. On the Record keeps readers up to date on the latest tax and planning issues pertaining to fundraising endeavors and charitable organizations.