|Volunteer Legal Handbook, 9th Edition
Handbook > Law > Government Regulation
The federal government and, to a lesser extent, state governments, impose extensive regulations on nonprofit corporations and very extensive regulations on charitable corporations. This section of the Handbook addresses some of those regulations. But first, and because we are going to be dealing with the Internal Revenue Code pretty extensively here, we'll review some terminology.
NOTE: You can best understand these complex rules, and the tax rules in particular, by identifying the policies underlying them, and not thinking of them as revenue-generating statutes.
A nonprofit corporation is a corporation whose income is exempt from taxation in many cases. A charitable corporation is a special kind of nonprofit corporation, typically but not always operating under Internal Revenue Code Section 501(c)(3), as to whom donations are ordinarily deductible from income by the donors. According to the IRS, in 2003 there were more than 1.3 million charitable corporations listed in its database. Those charitable corporations raised some $195 billion in 2002, the last year for which I can find data. Obviously charitable corporations are a significant part of the economy and play a significant role in society.
Interestingly, while most of us think of large charitable corporations when we think about them at all, the IRS reports that 73% of all charitable corporations have budgets of $500,000 or less. Most charitable corporations are small businesses.
For a variety of reasons, charitable corporations are much more closely regulated by the Internal Revenue Code than simple nonprofit corporations. These regulations typically impact a charitable corporation in several ways, including:
- Restrictions on ways in which charitable corporations can raise monies.
- Restrictions on the way in which charitable corporations can spend monies.
- Reporting requirements and information returns charitable organizations are required to file.
Each of these topics will be briefly examined.
Caution: This is an extremely complicated area of the law, with literally hundreds of statutes and thousands of regulations. Many of the statutes are new, so there isn't a lot of precedent. Proceed with extreme caution, and only with the advice of a qualified accountant or attorney.
One last word by way of introduction: there are charitable corporations, and then there are foundations, which are different animals, and are subject to different rules. Foundations are discussed briefly later.
One way that governments regulate charitable corporations is by restricting the ways in which they can generate monies for themselves. Classically, charitable corporations raise monies in one of two ways: soliciting monies, in particular donations, or by engaging in business activities. Both forms of revenue generation are extensively regulated
Only donations to charitable organizations are deductible; a donation to a nonprofit corporation that is not a charitable organization does not give the donor a tax deduction. And not all transfers and payments to charitable corporations are deductible. A volunteer engaged in fund-raising can expose himself and the nonprofit corporation to considerable liability to the IRS and the donor by innocently misrepresenting the deductibility of any particular "gift." To understand the rules for deductible donations, we'll first have to look at what a "donation" is.
The first requirement for a deductible donation is that there be a donation. The IRS is pretty specific about this: there must not be something given in return for the donation, not even something as intangible as a chance to win a lottery, or a dinner, or a concert. To the extent there is something given in return, then the deductible donation is the difference between the value of the donation and the value of the thing received. If you received a concert ticket worth $10 in return for your $20 donation, then you have made a $10 donation.
Written Acknowledgement for Gifts of $250 or More. Since 1994, gifts of $250 or more must have a written receipt from the nonprofit corporation to be deductible to the donor. The receipt must be "contemporaneous," which in this context means received by the donor before the due date for the donor's tax return. The receipt may be for each gift or may be an annual statement. The donated property must be described in reasonable detail. If there was a "quid pro quo" (see next section) for the donation, the value of the exchange must be estimated in good faith.
Congress passed and the President has signed the Pension Protection Act of 2006 (H.R. 4), followed by technical amendments in 2007. The impact of the new law goes far beyond pensions; the new statute will impact charitable giving in several ways, one of them involving contributions of cash. No deduction will be allowed for any contribution of cash, check or other monetary gifts unless the donor can show a bank record or a written communication from the charity indicating the amount of the contribution, the date the contribution was made, and the name of the charity. The practical effect on charitable organizations who want the good will of their donors is to impose a requirement of a written receipt on each and every contribution of cash or cash equivalent. This requirement applies to contributions made in the tax year after enactment of the law. H.R. 4, §1217. The IRS has proposed regulations to implement this change.
The same law has made it more difficult for donors to give fractional interests in tangible personal property. For example, if a husband and wife own a valuable painting, and the husband gives half of his interest in the painting to a charity, the husband will not be able to take a deduction for that gift. The IRS is authorized to relax this rule by regulation, but, obviously, no such regulations are issued yet. H.R. 4, §1218.
Valuation of Gifts. In the last ten years, the IRS has taken a more aggressive position on the valuation of gifts (other than cash). Dozens of cases in the period 1992 - 1996 focused on disputes over the fair market value of donations. The IRS believed that there was significant abuse, with donors claiming unreasonably high valuations; donors believed that the IRS was claiming unreasonably low valuations.
In 1993, Congress directed the IRS to develop a procedure by which donors could elect a valuation by the IRS in advance of donation. The IRS's response to date has been limited to procedures for the valuation of art with a value of $50,000 or more.
Donations of vehicles (along with boats and airplanes) are a particular sore point for the IRS. If a vehicle has a value of more than $250.00, the value has to be substantiated. If it has a value in excess of $5,000.00, the IRS requires a written appraisal - not simply a Bluebook valuation - of the vehicle that includes fairly detailed requirements. See generally IRS Publication 1771, "Charitable Contributions - Substantiation and Disclosure Requirements."
Where non-cash, non-vehicle donations (other than stock with a known market price) exceed $500, there are increased documentation requirements called an "appraisal summary." Where the non-cash donations have a value of $5,000 or more, the IRS also imposes an appraisal requirement. Such a "qualified appraisal" must be prepared within 60 days of the donation, must be signed by a "qualified appraiser" and must meet fairly rigorous substantiation requirements.
The Pension Protection Act of 2006 toughened the requirements for appraisals, narrowing the allowable error in appraised value and increasing the penalties for over-appraisal. The penalties apply to both the appraisers and the donors who use the appraisals.
Where a charitable organization that has received non-cash donations sells those non-cash items, and the items are worth more than $500, it must report the sale. As to all non-cash donations, where the charitable organization simply sells the donations there are two risks: (1) for the donor, that the price realized on sale of the donated goods, if lower than the appraisal, will be used by the IRS and not the appraised value; and (2) for the donee, that there will be a sufficient number of sales that the IRS will regard the income as an unrelated business activity, triggering a tax liability (see page 36).
A charity that fails to provide donors with disclosure statements as required, or that makes a disclosure that is incomplete or inaccurate, is subject to a penalty of $10 per contribution, to a maximum of $5,000 per event. While a "reasonable cause" exception is available as a defense, if the IRS concludes the behavior is intentional or repeated, it can seek to revoke the nonprofit corporation’s §501(c)(3) status.
The IRS has long been concerned about non-cash donations. To gain more information on non-cash donations, the IRS created Schedule M to accompany the new Form 990 information return discussed in Section Three this Chapter. Schedule M requires tax-exempt organizations that receive over $25,000 in aggregate non-cash donations, along with certain other property regardless of value, to provide additional details about the donations. Schedule M requests information on seventeen specific categories of property plus “other” types of property. Art, books, clothing, household goods, and vehicles are among the specific categories.
Quid Pro Quo Gifts. There’s a lot of confusion about this. A "quid pro quo" donation is a payment or transfer made partly as a contribution and partly in consideration for goods or services provided by the donee to the donor. A charity that receives a quid pro quo contribution in excess of $75 must provide to the donor a written statement that contains:
Token Goods or Services. If the quid pro quo consists of token goods or services, then the donee is excused from the quid pro quo requirements. Two IRS determinations, Rev. Proc. 90-12 and Rev. Proc. 92-49, help a little in defining "token goods or services." If the charity intends the goods or services to qualify for this exception it should say so in writing. Suggested language: "Under IRS guidelines, the estimated value of the benefits you receive [describe the benefits] is not substantial. Therefore, the full amount of your payment is a deductible contribution."
There appear to be three different tests. Meeting any one of them is supposed to be a "safe harbor" from risk of sanction.
Lottery Tickets. It is absolutely clear that lottery tickets are always deemed to have a value equal to the amount paid to obtain them. That is, there is never a tax deduction for a purchase of lottery tickets. Lottery tickets can never qualify as a donation.
Newsletters. In return for the payment of "dues," many nonprofit corporations give their "members" a periodic newsletter. Be careful here; a newsletter can constitute a "quid pro quo" and is subject to complex rules and limitations.
Newsletters will not constitute transfers with measurable value if they meet the following tests:
Any of the following activities with regard to a newsletter will transform it into a "non-token" good or service for which the nonprofit corporation must make a good faith estimate of value and report to the donor.
If you accept payment for advertising. Free advertising for related activities is probably all right.
In-Kind Donations. In-kind donations of services from donors are not ordinarily deductible. The lawyer who provides free legal services to a nonprofit corporation is not permitted to deduct the value of those services. (There are narrow exceptions for accrual-based donors; consult a good certified public accountant before relying on the deductibility of in-kind services based on an accrual-based donor.)
The Pension Protection Act of 2006 also impacts some types of in-kind gifts. Gifts of used clothing and household goods are no longer deductible unless the donated items are in “good used condition or better.” The term “household items” is defined to include furniture, furnishings, electronics, appliances, linens and “similar items.” It does not include food, paintings, antiques, jewelry, gems or objects of art. The term “good used condition or better” is not defined in the statute. This change applies to all in-kind donations made after the law is enacted. H.R. 4, §1216.
Donor Limits on Charitable Giving. It’s not usually a problem, but there are arcane limits on the total dollar amount of tax deductible donations some kinds of donors can make in a year. Consult a good certified public accountant if you need more information.
A second way in which governments regulate charitable and other nonprofit corporations is by imposing a tax on revenues earned by the organization which are attributable to a business activity that, in the judgment of the government, is too remote from the organization's exempt purpose. This is an extremely complicated, extremely important area of nonprofit corporation law. Important nonprofit corporations in Alaska have been brought to ruin by IRS audits which have resulted in tax and penalties associated with "unrelated business income." Here is a very simple overview of this complex area of the law. Please consult with a qualified certified public accountant in evaluating your own nonprofit corporation.
The general rule is that any nonprofit corporation may be subject to a tax on its "unrelated business income" if it regularly carries on a business that is "unrelated" to its exempt purpose. If the unrelated business activities are more than insubstantial, the nonprofit corporation may lose its tax exempt status.
An unrelated business is a trade or business that the nonprofit corporation regularly carries on which is not substantially related to the nonprofit corporation's exempt purposes. Note that an activity which generates income used by the nonprofit corporation for its purposes may still be an "unrelated trade or business;" it's the manner in which the monies are earned and not the use made of them that triggers the tax.
An activity will be deemed "regularly carried on" if the activity is conducted with the frequency and continuity comparable to the commercial activities of for-profit corporations.
An activity is "substantially related" - and therefore not "unrelated" - to the nonprofit corporation's exempt purpose if the activity contributes to the nonprofit corporation's exempt purposes other than through the production of income. The need for the funds generated by the activity does not of itself make the activity "substantially related."
Specific examples of "substantially related" activities include:
- An activity where substantially all of the work is carried on by volunteers.
- An activity that is carried on primarily for the benefit of members, students, patients, officers or employees.
- An activity that consists of selling merchandise, substantially all of which has been donated.
- An activity that relates to the distribution of low-cost articles.
- An activity where the business consists of a legal bingo game, in a state where bingo games "are not ordinarily conducted on a commercial basis."
NOTE: an activity may be "substantially related" and still fail other tests.
There is an ongoing dispute with the IRS about "pull-tabs" and the taxability to nonprofit corporations of income generated by charitable gaming "pull-tab" operations. You should obtain advice from a qualified certified public accountant regarding this issue.
Exclusions From Unrelated Business Income Tax. The IRS excludes certain kinds of unrelated business income from unrelated business income tax. That is, even though the monies may be "unrelated business income" they are still excluded from the tax imposed upon "unrelated business income." For the exclusion to operate, and for the unrelated business income to escape taxation, the income must not result from "debt financing." That is the activity generating the income cannot be financed in substantial part by borrowed money. For example, rental income is taxable as unrelated business income if your nonprofit corporation owes money under a mortgage secured in the rented property.
Assuming the income is not "debt financed," the following kinds of income are excluded from the unrelated business income tax:
- Dividends, interest, and payments with regard to certain securities, loans and annuities are excluded from the unrelated business income tax.
- Royalties paid for intellectual property rights - patents, trademarks, copyrights - are excluded from the unrelated business income tax. If a donor gave your nonprofit corporation a patent, the royalties generated by the patent wouldn't be taxable.
- Rental income from real property is in many cases excluded from the unrelated business income tax. Please note there is no similar exclusion for personal property.
- Gain from the sale of capital assets is excluded from the unrelated business income tax. If your nonprofit corporation sold a depreciated asset - a computer - for more than your nonprofit corporation's basis, your nonprofit corporation would not pay unrelated business income tax.
Nonprofit corporations are required to report unrelated business income. There are stiff penalties for a failure to do so, and ultimately the risk that the exemption will be lost. Use Form 990-T to report any unrelated business income.
State Fund-Raising Solicitation Issues
This section addresses an issue of Alaska law. In 1993, the Alaska Legislature adopted laws regulating charitable solicitations, AS 45.68.010-900. The Alaska Department of Law is charged with enforcing the statute, but if you call there you'll get mostly an awkward silence. Here's a brief summary.
A charitable organization must register with the Alaska Department of Law before soliciting monies. The Alaska Department of Law has issued a detailed four page Charitable Organization Registration Form. This form must be filled out by every fund-raising organization annually on September 1 before solicitation of contributions for the ensuring fiscal year. AS 45.68.010(a). The Department requires a $40 registration fee annually. The most recent registration forms are available online at http://www.law.state.ak.us/consumer. The state also accepts the Unified Registration Statement (“URS”) form, available at http://www.multistatefiling.org. The URS form is useful for regional or national nonprofit organizations or any charitable organization that seeks to register in more than one state.
If any of the information described in the registration form changes in the charitable corporation during the year it must be reported to the Department of Law. AS 45.68.010(e). A Charitable Organization Registration Form as filed, with any additions or changes, is a public record available for inspection and copying under AS 09.25.110. AS 45.68.060.
Organizations Excused. There are some significant exceptions from the Alaska registration requirement:
- A church or religious organization that is exempt from filing with the IRS under 26 U.S.C. Section 6033(a)(2)(A) is similarly exempt from these registration requirements.
- A few kinds of political organizations can qualify as charitable corporations. If a political organization files reports under state or federal elections laws it is exempt from the registration requirements.
- Small charitable organizations which will conduct fund-raising activities involving $5,000 or less during its fiscal year or do not intend to receive monies from more than ten (10) persons are exempt, if no one is paid to solicit the money and no monies go to salaries. AS 45.68.120(a)(3). If despite your intentions one or the other contingency occurs, you must register within thirty (30) days. AS 45.68.120(c).
- A person or municipality with a registered gaming permit under AS 05.15.100.
Organizations required to register or exempted as small are required to retain their records for five (5) years in auditable form. AS 45.68.070(b) and AS 45.68.120(b).
Paid Solicitors. A "paid solicitor" is defined as a person who solicits charitable contributions in return for compensation. The definition includes persons who are employed by a paid solicitor. The term does not include attorneys or bona fide salaried officers, employees or volunteers of a charitable organization. Presumably, the compensation need not be based upon funds raised.
These laws are very tough on paid solicitors. They are required to complete a detailed application form and to post a bond before making charitable solicitations. They are required to have a written contract with the charitable corporation for whom they are raising funds, a copy of which must be filed with the Department of Law.
There is a long list of mandatory disclosures a paid solicitor is required to make, including the true name of the individual making the solicitation, the true name of the charity, the true name of the paid solicitor, the form and amount of compensation the paid solicitor receives, and that a financial statement is available for the charity upon request. There are other mandatory disclosures. The paid solicitor is also required to mail written confirmation of a pledge within five (5) days of the date it is received. The written confirmation must set out the mandatory disclosures as well.
It is a Class A misdemeanor for a paid solicitor to seek contributions without complying with the registration requirement of AS 45.68.010. A Class A misdemeanor is a serious crime, punishable by a fine of up to $1,000 and a sentence of up to one (1) year in jail. There is a right of private enforcement for a violation of these laws. Either another charitable organization or an unhappy donor can bring an action for damages and actual cost and attorney's fees. A violation of AS 45.68 is probably also a violation of the consumer protection laws, AS 45.50.05-900.
The practical effect of AS 45.68 is to make it difficult to impossible for paid solicitors to lawfully engage in fund-raising activities in Alaska. Boards of directors of nonprofit corporations will need to be extremely careful about their fund-raising activities to avoid becoming ensnarled in the "paid solicitor" rules.
REMEMBER: Any non-exempt organization that actively solicits donations at any significant level in Alaska MUST register under AS 45.68.
This section also addresses issues of Alaska law only. Nonprofit corporations in other states do not need to worry about this section.
Charitable gaming is highly controversial on several levels. While some believe that it represents a benign, voluntary tax; others view it as taking advantage of the statistically impaired at best and government-facilitated addictive behavior at worst. These moral issues are beyond the scope of this manual, but you should be aware they exist. We address this issue because the IRS from time to time has regarded charitable gaming proceeds as unrelated business income, and therefore subject to unrelated business income tax.
Gambling is generally illegal in Alaska. AS 11.66.200. However, certain kinds of gambling are legal, including pull-tabs, bingo and lotteries under certain narrow circumstances. Playing cards, dice, roulette wheels, coin-operated machines and the like remain illegal. This section discusses when and how legal gambling may be conducted, and the idea of "charitable gaming" in general. Charitable gaming is regulated by the Tax Division of in the Alaska Department of Revenue, and is referred to in this section as "the Division."
Alaska law allows "authorized games of chance" to be conducted by persons holding permits ("permittees") or by "operators" or "vendors" on behalf of persons holding permits with the requirement that "net proceeds" be payable to "qualified organizations." See generally AS 05.15.010 et seq.
The Alaska Department of Revenue overhauled its regulations governing charitable gaming in 2003 and it continues to refine those regulations. The Department’s most recent amendments became effective June 22, 2008. The regulations can be found in the Alaska Administrative Code at 15 AAC 160.010 - 160.995. The regulations contain the nuts and bolts of how to legally operate a charitable gaming activity. A charitable organization should consult these regulations, along with a qualified attorney, before engaging in any charitable gaming activity. Significant changes that took effect in 2008 include:
Charitable gaming is a pretty misleading term, it refers to gambling that is lawful because the proceeds go to a municipality (a city or borough) or to a "qualified organization." A municipality is not a charity, and a "qualified organization" need not be a charity, as discussed below.
Basically, "authorized games of chance" legal gambling are pull-tabs, bingo and lotteries. The lotteries may be disguised: ice classics (guess the date and time the ice goes out on a river or lake), rain classics (guess the total amount of rain that will fall in a certain length of time), salmon classics (guess when the first salmon will return to a given spot), fishing derbies (catch the biggest fish), goose classics (guess when the first migrating goose will return to a given locale) and many other variations. Certain kinds of pure lotteries and raffles are also authorized.
NOTE: so-called "Monte Carlo" gaming is not authorized. In an Attorney General’s Opinion issued November 15, 1995, the Department of Law stated that such events were illegal gambling, and not permitted under the charitable gaming statutes.
Qualified Organizations. Qualified organizations, according to AS 05.15.690(38), include bona fide civic or service organizations or bona fide religious, charitable, fraternal, veterans, labor, or educational organizations, police or fire departments and companies, dog mushers’ associations, outboard motor associations, or fishing derby, or nonprofit trade associations in the state that operate without profits to their members and that have been in existence continually for a period of three (3) years immediately before applying for a license; the organization may be a firm, corporation, company, association, or partnership. Note that since January 1, 1997, "political organizations" have been generally ineligible to be "qualified organizations."
Plainly, some "qualified organizations" are a long ways from charitable organizations. A "qualified organization" may be a charitable corporation but it doesn’t have to be. Qualified organizations can include: (1) an organization or club organized under or formally affiliated with a political party as defined at AS 15.60.010; (2) an organization, not for pecuniary profit, constituted wholly or partly to bargain collectively or deal with employers, including the state or its political subdivisions, concerning grievances, terms or conditions of employment or other mutual aid or protection in connection with employees; and (3) other organizations described at AS 05.15.690(1)-(44).
Permittee. A "permittee" is a municipality or qualified organization that has obtained a permit to conduct charitable gaming. This is the person intended by the Alaska Legislature to benefit from the "profits" of the authorized games of chance. To obtain a permit the municipality or qualified organization must submit an application and the appropriate filing fee. The amount of the fee is based upon gross revenues in the previous year. Two to six beneficiaries may apply for a multiple-beneficiary permit; effectively, they may share in a permit.
A municipality may conduct a "local option" election to determine whether or not charitable gaming will be permitted in the municipality. The election results are binding and prevent the Tax Division from issuing charitable gaming permits in or within five miles of the boundaries of the municipality.
A municipality may protest the issuance of a specific charitable gaming permit, but the grounds for the protest are limited to the restrictions imposed by law, and a permit may be issued despite the municipal protest.
A permittee is required to designate a "member in charge" and an "alternate member in charge." There are modest testing requirements imposed upon these persons. The member in charge (or the alternate) is responsible for the performance by the permittee and, if there is one, the operator, of the various duties imposed upon those persons by the law.
Operator. An "operator" is a person who conducts charitable gambling on behalf of a permittee. That is, the permittee doesn’t run the pull-tab, bingo or lottery, but instead hires someone to do it for them. Operators are regulated to a greater extent than are the permittees themselves. An operator can operate permits for more than one permittee. However, a permittee cannot contract with more than one operator for the same kind of activity.
A municipality may prohibit an operator or a vendor (see below) from conducting activities within the municipality.
An operator is required to obtain a license from the Division. The license process is controlled by regulations found at 15 AAC 160.030. The license application must be accompanied by an annual fee of $500.
An operator must post a bond for $25,000 for each permit under which the operator conducts business to a maximum of $100,000. The bond has to have a term that extends two (2) years beyond termination of the operator’s permit. 15 AAC 160.030. The regulations effective in 2008 provide for putting up lienable property in lieu of a bond if certain requirements are met,
The operator is required to show proof of liability insurance in the minimum amounts of $100,000 per incident and $300,000 aggregate. 15 AAC 160.210.
The form of the written contract between the permittee and the operator is prescribed by statute at AS 05.15.115 and by regulation at 15 AAC 160.220.
There are a few restrictions imposed upon operators under AS 05.15.165(f). An operator may not:
There are modest accounting requirements imposed upon an operator. They are required to make payments by checks, AS 05.15.165(a), and the records must be reviewed annually by a certified public accountant, AS 05.15.165 and 15 AAC 160.310, and submitted to the Division by February 28 of the next year. Records must be kept on an accrual basis.
Vendors. A "vendor" is a person permitted to sell pull-tabs for a permittee. Vendors are required to register with the Division. Approval of the registration operates as an endorsement on the permittee’s permit, and a separate endorsement is required for each vendor location. There is a $50 fee for a vendor endorsement.
Charitable Gaming Proceeds. To understand what must be done with proceeds you have to understand some of the terms used. Then you must look at the activity involved and then who is conducting the operation to determine how much money must be paid to the "qualified organization." (It’s not as bad as the Internal Revenue Code, but it’s close.)
Operators are required to pay to the permittee not less than 30% of the adjusted gross income from pull-tabs annually. Operators are required to pay to the permittee not less than 10% of the adjusted gross income from other gambling activities annually. AS 05.15.128(a)(2).
A vendor is required to pay to the permittee not less than 70% of the ideal net. This payment is required to be made at time of delivery of the pull-tabs. Vendors may exert pressure on permittees to pay afterwards, or to grant credits for return of pull-tab sets where the big prizes paid early. Those concessions are illegal.
Many charitable gaming organizations offer door prizes - another form of lottery - as an additional inducement to participation. The total value of door prizes offered by a qualified organization is capped at $20,000 per month and $240,000 per year. AS 05.15.180(d) and (e).
A permittee may distribute a maximum of $1,000,000 in prizes in a year. If the permittee conducts its activities through an operator, it may distribute a maximum of $500,000 in prizes in a year. Multiple-beneficiary permits are permitted to multiply these amounts by the number of beneficiaries operating under the permit. AS 05.15.180(g). Bingo games are not subject to these limitations.
Uses of Charitable Gaming Proceeds. Although the kinds of "qualified organizations" are very broad, the uses that those "qualified organizations" may make of net proceeds is a little more limited. AS 05.15.150 provides limits on the uses that may be made of net proceeds.
The authority to conduct the activity authorized by this chapter is contingent upon the dedication of the net proceeds of the charitable gaming activity to the awarding of prizes to contestants or participants and to political, educational, civic, public, charitable, patriotic, or religious uses in the state. "Political, educational, civic, public, charitable, patriotic, or religious uses" means uses benefiting persons either by bringing them under the influence of education or religion or relieving them from disease, suffering, or constraint, or by assisting them in establishing themselves in life, or by providing for the promotion of the welfare and well-being of the membership of the organization within their own community, or through aiding candidates for public office or groups that support candidates for public office, or by erecting or maintaining public buildings or works, or lessening the burden on government. Permitted uses of charitable gaming proceeds do not include,
- to aid candidates for public office or groups that support or oppose candidates for public office;
- to a political party or to an organization affiliated with a political party; or
- to a group, as that term is defined in AS 15.13.400, or a political group, as that term is defined in AS 15.60, that seeks to influence the outcome of an election.
The net proceeds derived from the activity must be devoted within one (1) year to one or more of the uses stated in this section. A municipality or qualified organization desiring to hold the net proceeds for a period longer than one (1) year must apply to the department for special permission and upon good cause shown the department may grant the request. It’s not clear when the year starts. It’s not clear whether creating a "permanent fund" and drawing the interest operates as a disbursement. AS 05.15.150(b).
NOTE: Political uses of charitable gaming proceeds were sharply reduced effective January 1, 1997. Lobbying is forbidden, and using funds in support of or against candidate elections is prohibited. However, so-called "grass-roots" lobbying, things like paying the expenses of citizens to travel to Juneau to lobby without pay for or against legislation, isn’t addressed and may still be permitted.
There is a trap here for the unwary. While charitable gaming proceeds may be used without limit for "grass roots" lobbying, the IRS as opposed to the Alaska Department of Revenue sets some significantly different limits on those uses. To the extent Alaska law still permits use of charitable gaming proceeds for "grass roots" lobbying, it is still strictly regulated by the IRS.
For purchase of real property or construction or repair of improvements to real property to qualify as a use of net proceeds the real property and improvements have to be dedicated exclusively to "political, educational, civic, public, charitable, patriotic, or religious uses." Over the life of a building, that could present some challenges. A similar issue has arisen repeatedly in the context of property tax levies against charitable properties. See, for example, City of Nome v. Catholic Bishop of Northern Alaska, 707 P.2d 870 (Alaska 1985).
Use of the U.S. Postal Service for charitable gaming activities. In 2000, the U.S. Postal Service amended its Domestic Mail Manual (“DMM”) C031.3.2 to incorporate a decision by the Department of Justice to no longer enforce the criminal lottery statute (18 U.S.C. § 1302) against gambling advertisement mailers, so long as the activity advertised is legal and the mailing does not provide any entry materials. Customer Support Ruling PS-307, dated March 2002, clarified somewhat the rules on the use of mails in charitable gaming. Provided the lottery is otherwise lawful, charitable organizations may use the mails for advertising lotteries or to forward bona fide winning lottery prizes. However, the use of the mails to transmit material for entering lotteries is still prohibited.
The Customer Support Ruling does recognize, however, that when one of the three elements that defines a lottery (prize, chance, and consideration) is missing, the activity is no longer a “lottery” for postal purposes and use of the mails is permitted. For example, if “consideration” is omitted and a person does not have to pay a fee to enter the lottery, and it is clear that a donation is not required to enter the lottery, the nonprofit organization may use the mails to distribute tickets for that lottery.
The most current version of the DMM addresses use of the mails for charitable gaming in section 601.12.3.1. You should consult the DMM and your local postmaster for more information on the use of the U.S. mails for charitable gaming.
A second major way in which the government regulates nonprofit corporations is by restricting the uses they can make of their funds. There are a lot of restrictions; we'll examine three of the more important ones.
1. Charitable Purposes.
Every charitable corporation exists for specific purposes as a part of its Section 501(c)(3) status. It's a short list of allowable purposes, and changing them means amending your Section 501(c)(3) application.
Every charitable corporation must be "organized and operated exclusively" for an exempt purpose. Some of those exempt purposes include:
Religious. Because of the requirements of the First Amendment of the U.S. Constitution, this purpose is very broadly defined." Religious purposes" have been found for charitable corporations ranging from construction of a church building, to inspection of food products for compliance with religious dietary requirements, to genealogical research. The IRS has issued a "Tax Guide for Churches and Other Religious Institutions," Publication 1828, which describes its position on these issues in more detail. Available on-line at:
If a charitable corporation with a Section 501(c)(3) exemption for religious purposes expends monies for something other than its exempt purpose it is less likely to encounter problems with the IRS than other charitable corporations, again because of deference under the First Amendment. It's probably accurate to say that religious organizations are less rigorously scrutinized by the IRS for proof that the activities of the organization fit to its religious purpose. However, the prohibitions on political and legislative activities below are pretty rigorously enforced.
Charitable. This is probably the broadest category. Originally, "charitable" may have meant "relief of the poor," but case law and, reluctantly perhaps, the IRS have acknowledged that it is much broader than that. There is no longer any requirement of a nexus between the charitable corporation and "relief of the poor."
Scientific. Scientific purposes include both sponsorship of research and facilities for research and the dissemination of the results of that research.
Educational. Advancement of education includes creation of nonprofit educational institutions, financing of scholarships, dissemination of knowledge by publication, support of libraries and similar uses.
Fiscal Sponsorship. A relatively new role for charitable organizations comes in the form of “fiscal sponsorship,” where the charitable organization chooses to support non-exempt projects. This situation usually arises were a project seeks support from a private foundation or government entity, or tax deductible contribution. The project seeks a tax-exempt sponsor to receive the funding. The IRS has a strict policy against conduit arrangements, however. To be deductible, the charitable organization must have complete control and discretion over the funds it receives and is legally responsible for ensuring that the funds are used to further its charitably purpose. Any entity considering fiscal sponsorship should consult with appropriate tax and legal advisors.
2. Political and Legislative Activities.
One of the most famous and most important limitations on the activities of Section 501(c)(3) nonprofit corporations is the very serious limitation placed on their political and legislative activities. Section 501(c)(3) provides, in part, that with regard to a charitable corporation "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."
This is an extremely complex, politically volatile and legally dangerous area of law. The easiest rule to follow is to not engage in political activities. If your Section 501(c)(3) nonprofit corporation decides it must, exercise great care. What follows is only an introduction; you will need specific legal and accounting advice to find your way through this maze.
Basically, there are two sorts of regulated activities, which are explained below. The kinds of activities, the limits imposed, and the sanctions for violating the limits, are quite different.
Political Campaign Activities Prohibition.
"It should be noted that exemption is lost . . . by participation in any political campaign on behalf of any candidate for public office." United States v. Dykema, 666 F.2d 1096, 1101 (7th Cir. 1981) (cert. den., 456 U.S. 983 (1982).
The IRS position is simple: your Section 501(c)(3) organization can't engage in political campaign activities. If you do, you are ineligible for Section 501(c)(3) status. Period. As we will see below, in the case of "legislative activities," there is a test of substantiality. In the case of political campaigning activities, there is no requirement of substantiality. The IRS position is that any amount at all is fatal. A few cases have held that there is a certain minimum threshold before the political activities are noticeable, as it were. But the IRS has not agreed with that position. Don't rely on it.
There are four (4) requirements, all of which must be present, for action to be a prohibited "political campaign activity." None of the elements is particularly well-defined.
1. A 501(c)(3) organization may not "participate" or "intervene" in a political campaign.
2. The political activity must be a "political campaign."
3. The campaign must be with respect to an individual who is a "candidate."
4. The individual must be a candidate for a "public office."
Candidate. An individual who offers himself, or who is proposed by others, as a contestant for an elective public office, whether such office be national, state, or local. IRS Reg. Section 1.501(c)(3)-1(c)(3)(iii).
Political Campaign. A campaign for public office in a public election merely and simply means running for office, or candidacy for office, as the word is used in common parlance, and as it is understood by the man on the street. Norris v. United States, 86 F.2d 379, 382, (8th Cir. 1936), rev'd on other grounds, 300 U.S. 564 (1937).
Participate or Intervene. The most obvious way for a charitable organization to participate or intervene in a political campaign is to make a contribution to the political campaign of a candidate. However, this is clearly forbidden as a condition of tax exemption. New Faith, Inc. v. Commissioner, 64 T.C.M. 1050 (1992).
Public Office. Elective public office (at least in the context of private foundations). IRC Section 4946(c)(1).
There is no exception for legislative activity related to the Section 501(c)(3) nonprofit corporation's purpose. There is a pervasive and myth that legislative activities are "okay" if they relate to your organization's purpose. The myth is false. The same rules apply whether the legislative activities are closely or only remotely related to your Section 501(c)(3) purpose or the purposes set out in your other organizational or planning documents.
There are key concepts here. You need to understand what constitutes "legislation," what amounts to "legislative activities," "grass roots" versus "direct" lobbying, and the "substantial part" versus the "expenditure" test. We'll try them in that order.
Legislation. Generally, "legislation" is action by an elected body. The legislative body could be Congress or a local school board. It could be voters themselves, if the issue involves an initiative or referendum. The subject could be Constitutional amendments to simple, non-binding resolutions.
Legislative Activities. It can take two (2) forms: "direct" lobbying and "grass roots" lobbying. The rules are a little different for each type, and the spending limits depending on whether your Section 501(c)(3) nonprofit corporation has elected the "substantial part" test or the "expenditure" test.
In direct lobbying, your organization, through its agents, is expending resources - staff time, volunteer time, money - to contact and directly influence one or more of the people who vote on legislation. Generally, this is an elected official, although it can be voters in the case of initiatives and referenda.
Grass roots lobbying is attempting to influence legislation by urging people to contact their elected officials. You are approaching voters, asking them to influence elected officials, instead of directly influencing the elected officials yourself.
Substantial Part Test. In the "Substantial Part Test" there don't seem to be any hard and fast rules. There are a few cases which show just how vague this standard is.
"The legislative activities of an organization must be balanced in the context of the objectives and circumstances of the organization to determine whether a substantial part of its activities was to influence or attempt to influence legislation." Christian Echoes National Ministry, Inc. v. United States, 470 F.2d 849, 855 (10th Cir. 1972), cert. den., 414 U.S. 864 (1973).
In a different context, "Whether an activity is substantial is a facts-and-circumstances inquiry not always dependent upon time and percentage expenditures." The Nationalist Movement v. Commissioner, 102 T.C. 558, 589 (1994), aff'd 37 F.3d 216 (5th Cir. 1994).
NOTE: this test can only be applied "after the fact" - it's a post hoc test to use the legal phrase.
Extremely vague tests like this sometimes invite selective enforcement. The expenditure test, defined below, was adopted in part because of perceived selective enforcement.
Expenditure Test. If your Section 501(c)(3) nonprofit corporation elects the "expenditure" test, then the following rules apply. Note the exceptions to the "expenditure" test described above, and note the catches described below.
The basic concept is that you are permitted without imposition of penalty or jeopardy of your tax-exempt status to spend a sliding percentage of the total of certain categories of expenses on legislative activities. Not all expenses your Section 501(c)(3) nonprofit corporation incurs are eligible for the sliding scale percentage.
The term "exempt purpose expenditures" means, with respect to any organization for any taxable year, the total of the amounts paid or incurred by such organization to accomplish purposes described in IRC Section 170(c)(2)(B) (relating to religious, charitable, educational, etc., purposes). See IRC Section 4911.
The IRS Regulations set out what is essentially an itemized list of what it deems are expenses sufficiently related to your charitable purposes to qualify as "exempt purpose expenditures" under this test. Not all expenses will qualify. The detailed list can be found at 26 CFR Section 56-4911.
There are five (5) exceptions for the "Expenditure Test" - IRC Section 4911(d)(2). If your Section 501(c)(3) nonprofit corporation has elected the "expenditure" test, described below, then there are five (5) kinds of "expenditures" which do not constitute "legislative activities." Note these exceptions are available only if your Section 501(c)(3) nonprofit corporation has elected the "expenditure" rule described below. The following are expenditures that are not legislative activities:
- Making available results of nonpartisan research. What constitutes "nonpartisan" is pretty constrained. If the IRS thinks it advocates one side of an issue, it will not qualify for the exception.
- Providing technical assistance in response to a written request. If the elected officials ask you to testify, to address technical issues, then it is not an "expenditure." Testifying before a legislative committee explaining why child abuse is bad, in response to a written request from the committee, would likely qualify.
- Self-defense exception. Your Section 501(c)(3) nonprofit corporation may engage in legislative activities without being subject to the expenditure test limits if the legislative activities are "self-defense;" your Section 501(c)(3) nonprofit corporation is lobbying to preserve its existence or the reason for its existence, as defined in its corporate purpose and Section 501(c)(3) application.
- Communications between the Section 501(c)(3) nonprofit corporation and its bona fide members. It's not legislative activity if you are only lobbying your bona fide members.
- Routine communications with government officials. If your Section 501(c)(3) nonprofit corporation is required by the terms of its grant agreement, for example, to make reports to elected officials, it's not lobbying under this exception.
This is an extremely complicated and dangerous area. The structure of the statutes resembles a kind of "mini-income tax," with deductions much like regular income tax. Expenses you might expect to qualify as "exempt purpose expenditures" - fund raising expenses, for example - may not qualify under the regulations. Please obtain legal and tax advice before venturing into this area.
If your Section 501(c)(3) nonprofit corporation has elected the "expenditure" test described above and subject to the qualifications and limits set out below, then your Section 501(c)(3) nonprofit corporation may expend up to the following amounts on "legislative activities" without incurring tax penalties or jeopardy to your tax exempt status:
20% of the first $500,000 in exempt expenditures
15% of the next $500,000 in exempt expenditures
10% of the next $500,000 in exempt expenditures
5% of any remaining exempt expenditures
As always, numerous restrictions, catches and limitations apply. Here are a few of them.
- It doesn't matter what the sliding scale permits; under no circumstances may your Section 501(c)(3) nonprofit corporation expend more than $1 million on legislative activities in any twelve (12) month period.
- Only 25% of the total authorized sliding scale percentage may be expended on "grass roots" lobbying.
- If you exceed the maximum permitted percentage of allowed expenditures, the excess expenditures are subject to a special excise tax of 25% of those expenditures.
- If on a four (4) year moving average you exceed 150% of the limitation, your Section 501(c)(3) nonprofit corporation will lose its tax-exempt status.
- Churches, church organizations, or private foundations and some other types of Section 501(c)(3) nonprofit corporations are not permitted to elect the "expenditure" test.
- There are detailed record-keeping requirements, as you would expect if the IRS is to be able to verify compliance with these requirements.
3. Excess Benefits Transactions.
A third major constraint on charitable corporations is imposed by Section 501(c)(3): "No part of the net earnings of which inures to the benefit of any private shareholder or individual."
Congress recently re-worked these requirements and adopted something called the "excess benefits rule," in part to accomplish the prohibition on benefits to any private shareholder or individual, so-called "private inurement." The idea was to create a class of "intermediate sanctions" so that in the event of improper distributions the IRS would have some lesser sanction than revoking a charitable corporation's exemption. The "intermediate sanctions" are pretty serious, however, and apply to both Section 501(c)(3) and 501(c)(4) entities. I will refer to charitable corporations in discussing these sanctions, but note they apply to nonprofit corporations that are Section 501(c)(4) organizations as well. These laws were adopted in 1996. Temporary regulations were issued January 10, 2001 and became effective on that date. See Federal Register at Volume 66, Page 2144. Final regulations were issues on January 23, 2002. See Federal Register at Volume 67, Page 3076.
Some commentators predict that the new "excess benefits transactions" rules are the most dramatic and important package of rules concerning charitable corporations since Congress established the basic nonprofit tax structure in 1969. If the new laws are targeted at nonprofit corporations who simply pay too much to employees or to the children of their principal donors, then the impact may be much less significant.
The Basic Rule: tax sanctions in the form of a penalty excise tax are imposed upon "disqualified persons" who receive an improper benefit from a transaction with a charitable corporation. A penalty excise tax is also imposed upon the "organization managers" who authorized the transaction knowing that it was improper. And the excess benefit transaction must be "undone" or an additional round of penalties will be imposed and, ultimately, the exempt status may be lost. There are a lot of concepts buried in this general rule that need to be examined with care.
When courts and, for that matter, lawyers, try to interpret and understand legislation they turn to the legislative history. In the case of the new excess benefits laws, the legislative history is scant, except for a House of Representatives committee report. The glosses put on the statute by that committee report pretty dramatically change the meaning of the parts of the law. For example, the committee report directs the IRS to write a series of "safe harbors" - standards charitable corporations can use to make certain they aren't violating the new rules - into the regulations the IRS issues, but the statute is completely silent as to any such rules.
NOTE: Because there is a "reach back" under 26 U.S.C. Section 4958 to September 14, 1995; the regulations apply to transactions you have already undertaken and are taking today.
The final regulations and commentary are thirty (30) pages long and fairly complex. A few of the more important issues are incorporated and addressed here.
There are also final regulations establishing the procedures for reporting excess benefit transactions. Those final regulations direct the use of IRS Form 4270 to report excess benefits transactions and the applicable excise taxes.
Disqualified Persons. The first special concept is the idea of a "disqualified person," the person who will pay one part of the penalty excise tax. There are a lot of ways one can be classed as a "disqualified person" for the purposes of this rule and a wide variety of persons are identified as "disqualified persons" under the regulations:
- Family members, all the way out to great-grandchildren and spouses of children.
- Persons controlling, directly or indirectly, 35% or more of the ownership or profit interests in the entity.
- Persons having substantial influence. This category has a number of subcategories, including:
- Individuals serving on the governing body who are entitled to vote.
- Presidents, CEOs, COOs, treasurers, CFOs who actually have influence of control.
- Persons with a material financial interest in a provider-sponsored organization in which a hospital that is an applicable tax-exempt organization participates.
- Persons meeting the "facts and circumstances" test, which applies "in all other cases." The test requires examination of "all facts and circumstances." Here is a partial list of criteria tending to show the person has "substantial influence" and therefore is a "disqualified person."
- The person founded the organization.
- The person is a "substantial contributor" under Section 507(d)(2).
- The person's compensation is based primarily on revenues derived from activities of the organization that person controls.
- The person controls expenditures to a significant degree.
- The person has managerial authority, shown by authority to control a substantial portion of the organization's budget or control of a discrete segment of the organization's activities.
- The person owns a controlling interest in a corporation, partnership, or trust that is a disqualified person.
Any person who during the five (5) year period ending at the date of the scrutinized transaction was in a position to "exercise substantial influence over the affairs" of the nonprofit corporation, whether by reason of being a manager, director or officer or otherwise, is a disqualified person.
There is a similar list of facts and circumstances tending to show the person does not have "substantial influence" and is therefore not a "disqualified person." Note this is distinct from persons officially deemed not to have "substantial influence."
Facts and circumstances tending to show the person does not have "substantial influence" include:
- Persons who have taken a vow of poverty.
- Persons who are independent contractors, including attorneys, accountants and investment advisors.
- If the person is under review because they were a large contributor who received preferential treatment, evidence that other persons made similarly large contributions and received similar preferential treatment.
And there's a list of persons officially deemed not to have substantial influence. Note this is distinct from persons who under facts and circumstances might have "substantial influence."
- Applicable tax-exempt organizations under IRC Section 501(c)(3).
- Certain persons who are not "highly compensated employees" under IRC Section 414(q)(1)(B)(i).
In light of the "initial contract exception" arising under United Cancer Council v. Commissioner of Internal Revenue, 165 F.3d 1173 (7th Cir. 1999) (discussed below), there can be no excess benefit in a first-time, fixed-payment contract with an independent contractor with no prior relationship with the charitable corporation.
NOTE: Many of these criteria are subjective and not objective, so that it can be extremely difficult to determine at the time if the person involved is a "disqualified person." The final regulations offer some improvement in this regard over the earlier proposed regulations but it's still a muddle.
In addition, many of the criteria involve information or issues that may be incapable of determination at the time the board of directors of a nonprofit corporation is acting. For example, it might be impossible to determine in January whether in December a person involved in a transaction that is under scrutiny is a "substantial contributor" under Section 507(d)(2).
These examples from the regulations demonstrate just how difficult the determination of whether a person is a "disqualified person" can be.
Example 10. U is a large acute-care hospital that is an applicable tax-exempt organization for purposes of section 4958. U employs X as a radiologist. X gives instructions to staff with respect to the radiology work X conducts, but X does not supervise other U employees or manage any substantial part of U's operations. X's compensation is primarily in the form of a fixed salary. In addition, X is eligible to receive an incentive award based on revenues of the radiology department. X's compensation is greater than the amount referenced for a highly compensated employee in section 414(q)(1)(B)(i) in the year benefits are provided. X is not related to any other disqualified person of U. X does not serve on U's governing body or as an officer of U. Although U participates in a provider-sponsored organization (as defined in section 1855(e) of the Social Security Act), X does not have a material financial interest in that organization. X does not receive compensation primarily based on revenues derived from activities of U that X controls. X does not participate in any management decisions affecting either U as a whole or a discrete segment of U that represents a substantial portion of its activities, assets, income, or expenses. Under these facts and circumstances, X does not have substantial influence over the affairs of U, and therefore X is not a disqualified person with respect to U.
Example 11. W is a cardiologist and head of the cardiology department of the same hospital U described in Example 10. The cardiology department is a major source of patients admitted to U and consequently represents a substantial portion of U's income, as compared to U as a whole. W does not serve on U's governing board or as an officer of U. W does not have a material financial interest in the provider-sponsored organization (as defined in section 1855(e) of the Social Security Act) in which U participates. W receives a salary and retirement and welfare benefits fixed by a three-year renewable employment contract with U. W's compensation is greater than the amount referenced for a highly compensated employee in section 414(q)(1)(B)(i) in the year benefits are provided. As department head, W manages the cardiology department and has authority to allocate the budget for that department, which includes authority to distribute incentive bonuses among cardiologists according to criteria that W has authority to set. W's management of a discrete segment of U that represents a substantial portion of its income and activities (as compared to U as a whole) places W in a position to exercise substantial influence over the affairs of U. Under these facts and circumstances, W is a disqualified person with respect to U.
It may prove to be extremely difficult to contemporaneously determine whether a party to a transaction is a "disqualified person" in a specific case.
The IRS says that officers, directors, and trustees of nonprofit corporations are not automatically "disqualified persons" by reason of their status, but it's hard to see how an officer, director or trustee could claim otherwise. It's not clear that even the rigorous abstention and conflict of interest procedures discussed below would protect an officer, director or trustee in these circumstances. The "safe harbor" regulations from the IRS don't really describe how a person could avoid "disqualified person" status.
The definition of "disqualified person" is intended by Congress to test by status and not by technical definition; that is, it looks like the IRS will determine on a case-by-case basis whether or not a person has or had at the time of the scrutinized transaction the ability to exercise substantial influence over the affairs of the nonprofit corporation. For example, a major donor to a organization, while not an officer, director, or member, may nonetheless be characterized as a person in a position to exercise substantial influence and thereby be a disqualified person.
Organization Managers. The second special concept is the idea of "organization managers," the person who will pay another part of the penalty excise tax. It includes trustees, directors, or officers of the charitable corporation, however denominated. If authority has been granted to an executive committee or management committee, the members of such a committee are "organization managers" with regard to the decisions delegated to them. The title doesn't matter. Rather, a person is considered an organization manager whether they are named to it or whether they "regularly exercise general authority to make administrative or policy decisions on behalf of the organization." A person who has authority merely to make recommendations but not to implement them without approval of a superior is not an organization manager.
Independent contractors acting in a capacity as attorneys, accountants, investment managers and advisors are not "organization managers." Section 53.4958-1(d)(2)(B)
Excess Benefits. An "excess benefit" transaction is any transaction in which an economic benefit is provided by a charitable corporation directly or indirectly to or for the benefit of a disqualified person and the economic benefit received by that disqualified person exceeds the value received by the charitable corporation.
For example, suppose a charitable corporation owns a recreational camp that is only uses in the summer, and lets its executive director use that camp in the fall and winter as a "perk" at no charge. Suppose the rental value of the camp is $250/day. If the executive director uses it for two months, that might be 60 days x $250/day = $15,000 in "excess benefits" paid to the executive director. Presumably, the executive director's salary is the base benefit, the executive director is certainly a "disqualified person," and hence the use of the recreational facility might be an "excess benefit."
As another example, suppose your charitable corporation has a volunteer and member of the board of directors who has given twenty years of selfless volunteering to your charitable corporation. The charitable corporation decides to give the volunteer and his wife a two week, all expenses paid trip to Hawaii. That vacation might be an "excess benefit." The volunteer, as a member of the board of directors, is a "disqualified person," and a volunteer, by definition, serves without expectation of compensation. Any payment from the charitable corporation to the volunteer might be "excess benefits."
The regulations also provide some guidance in identifying what is or is not an "excess benefit," although as in the case of a "disqualified person" those standards are distressingly subjective. While broadly an "excess benefit" occurs "when the value of the economic benefit provided exceeds the value of the consideration," Section 53.4958-4(a), it's a test that can be exceptionally difficult to apply. Consider the protracted hearings and trials that arise in a well-settled area of the law like property condemnation, where the fair market value is an issue. The task is made more complex still because the determination of the economic benefit given includes both direct and indirect benefits.
There is a reported Tax Court decision on the issue of calculation of "excess benefits." In Caracci v. Commissioner, 118 TC No. 25 (2002), the issue was the fair market value of the assets of a nonprofit corporation. The Caracci family controlled three charitable corporations that provided home health care services. On the advice of their accountants, they created a for profit corporation, and in return for assuming all of the debts of the charitable corporations, received all of the assets of the charitable corporations. The IRS challenged the valuation of the charitable corporations’ assets, arguing the assets were worth far more than the debts assumed. It came to a battle of appraisers, and the Tax Court sided with the IRS’s appraisers, and found that the Caraccis had received excess benefits of about $5.1 million.
As if the 25% penalty and the 200% penalty on the $5.1 million weren't bad enough, the IRS also imposed the IRC §6662(a) penalty of 100% for intentionally under-reporting taxes, resulting in a total liability of some $37 million. The §6662(a) penalty isn’t really a surprise; the IRS training materials had made clear that in these situations it would seek the penalty on the excise taxes.
The Fifth Circuit reversed the Tax Court in Caracci v. Commissioner of Internal Revenue, 456 F.3d 444 (5th Cir. 2006). The court cited numerous factual and legal errors most conceded by the Commissioner and the Tax Court in the deficiency notices and the valuation analysis. The Tax Court made numerous errors of law and fact, and the appellate court outright reversed the decision without remanding it for further proceedings. The Court of Appeals determined that, as a matter of law, that the taxpayer did not receive a “net excess benefit.” This decision demonstrates that the courts will provide a check on the IRS’s enforcement of the net excess benefit rules. However, the IRS and the Tax Court made significant errors; absent these errors, the appellate court may well have affirmed the Tax Court.
Exceptions. Certain kinds of economic benefits are never treated as "excess benefits" as a matter of regulation and law:
- Reimbursement for reasonable expenses of attending meetings of the board of directors, excluding luxury travel and spousal travel. The standards under IRC Section Section 162 and 274 are used to determine "reasonableness."
- Economic benefits provided to a member of or volunteer for the nonprofit corporation for a membership fee, provided all persons paying that level of membership fee enjoy the same kind of benefits.
- Economic benefits provided to the person as a member of the charitable class targeted by the nonprofit corporation.
- Liability insurance for excise taxes imposed is not an "excess benefit" if the premium paid is treated as compensation to the disqualified person and the total compensation to the person is reasonable.
"Safe Harbor" for Certain Kinds of Transactions. The regulations implement at least part of the expressed intent of Congress to create a kind of limited "safe harbor" for certain kinds of transactions that might otherwise be impermissible excess benefits transactions. While the requirement of a "safe harbor" was described in the legislative history, it was not described in the statute itself. A "safe harbor" means that the transaction involved does not constitute an "excess benefits transaction" unless the IRS provides information to the contrary; a rebuttable presumption is created in favor of the nonprofit corporation that the transaction does not constitute an improper, excess benefits transaction.
A "rebuttable presumption" is a rule of evidence. In this case, if the requirements for the "safe harbor" are met, it means the IRS must come forward with evidence to establish that there was an excess benefit, rather than your organization being required to prove there was no such thing.
Your nonprofit corporation should attempt to satisfy the "safe harbor" requirements in every material transaction, whether it is a salary for a management employee or a transaction involving something other than a routine, minimal purchase. Because it can be impossible to tell with certainty in advance whether the transaction involves an "excess benefit" or whether it was paid to a "disqualified person," you should assume you may need the rebuttable presumption created by the "safe harbor." To qualify for the "safe harbor," the nonprofit corporation must meet the following requirements:
- The compensation arrangement or terms of transfer are approved in advance by the nonprofit corporation's governing body or a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the transaction ( Section 53.4958-6(a)(1));
- The governing body or committee obtained and relied upon appropriate data as to comparability prior to making its determination ( Section 53.4958-6(a)(2)); and
- The governing body or committee adequately documented the basis for its determination concurrently with making that determination ( Section 53.4958-6(a)(3)).
The requirements for each element are moderately detailed. For example, a person who has a conflict of interest with regard to the transaction in question may be present when the transaction is under consideration, but only to answer questions; that person must recuse themselves from the meeting during both debate and voting on the transaction. For example, if you are considering the salary for your nonprofit corporation's executive director, the executive director cannot participate in the salary evaluation, and can appear before the board of directors or committee only to answer questions, and then must leave the room during debate and voting. The minutes of the board of directors or committee must reflect these things.
Perhaps the most troubling issue presented is the requirement that the decision-maker must have "obtained and relied upon appropriate data" as to comparability. In the case of "small organizations" - nonprofit corporations with annual gross receipts of less than $1 million, based on a rolling average over the last three (3) years - you can get by if you have "data on compensation paid by three comparable organizations in the same or similar communities for similar services." For many nonprofit corporations, this requirement will impose a very significant burden.
The requirements for nonprofit corporations with annual receipts in excess of $1 million are much more burdensome, requiring information sufficient to determine whether under the standards at Section 53.4958-4(b) a compensation arrangement will result in the payment of reasonable compensation or a transaction will be for fair market value. Note in many situations that is a very vague guideline. To meet those requirements, a nonprofit corporation must have "relevant information," which may include:
- Compensation levels paid by at least three (3) similar organizations, both taxable and tax-exempt.
- Independent compensation surveys compiled by independent firms.
- Actual written offers from similar institutions competing for the services of the disqualified person.
In the case of property, independent appraisals of the value of the property.
It's not at all clear that nonprofit corporations in Alaska, for example, can get the information required of them. While information services will likely meet the needs in larger metropolitan areas, the proof requirements are likely to present grave problems, particularly for mid-sized nonprofit corporations.
Despite the requests of commentators, the Regulations did not relax the requirements as to mid-managers; however, the commentary to the "safe harbor" regulations suggests that the scope of disqualified persons has been relaxed sufficiently that far fewer mid-level managers will be "disqualified persons" subject to scrutiny. Given the difficulty in contemporaneously identifying who is or is not a "disqualified person" I'm not sure that reassurance really means much. Prudent managers will seek the "safe harbor" for all managers who do or may exercise significant control.
Implicit in gaining the "safe harbor" is knowing what total compensation can be at the time the evaluation of compensation takes place. In the case of deferred compensation, the Regulations provide some guidelines. Bonuses, however, can be very difficult. The employment contract for a disqualified person must set a limit on a total bonus if the evaluation is to qualify for the "safe harbor." A simple recitation in the employment contract of "a bonus in an amount set by the Board of Directors" is not likely to pass muster. It's not required that the total compensation to be paid must be known at the time of approval, but the maximum possible compensation must be known and, if the compensation is not fixed, then the maximum possible compensation must be used as the basis of evaluation.
And finally, the regulations plainly demonstrate the importance for nonprofits of keeping accurate and comprehensive minutes and records. The requirement is to have "adequately documented" the basis for its determination concurrently with making that determination. The regulations require not only "adequate documentation," they also require the minutes be "concurrent."
There are pretty detailed requirements for the requirement of "adequate documentation." Those requirements include:
- The terms of the transaction that was approved and the date it was approved.
- The members of the board of directors or committee who were present during debate and those who voted on it (I understand this to require a roll-call vote).
- The comparability data relied upon and how the data was obtained.
- The actions taken by those who had conflicts of interest.
- The documentation (classically, minutes) must be prepared by the next meeting and must be reviewed and approved by the board or committee by the later of the next meeting or sixty (60) days after final approval.
Records may be written or electronic. The IRS Exempt Organizations Director has developed a Rebuttable Presumption Checklist to aid in documentation. A recent version is at the back of this Handbook, and the most recent version may be found at:
Liability for Excess Benefits Transactions. Remember, two sorts of persons are liable for the excise tax imposed under these rules, as described earlier: the person receiving the "excess benefit" and the person(s) conferring the "excess benefit." The extent of liability and the analysis to determine liability are entirely different for the two kinds of persons.
A disqualified person who receives an excess benefit is subject to an initial tax of 25% of the excess benefit conferred. If more than one person received the excess benefit, the liability is joint and several.
If a disqualified person "corrects" the excess benefit by putting the nonprofit corporation into the financial condition it would have been in but for the excess benefit, and does so within the "correction period," then any further tax is abated in the same manner as is the case under private foundation rules Section Section 4961(a) and 4962(a). "Correction" is defined as
[U]ndoing the excess benefit to the extent possible, and taking any additional measures necessary to place the applicable tax-exempt organization involved in the excess benefit transaction in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards.
Reg. Section 53.4958-7(a).
The "correction period" is the interval between the time of the excess benefits transaction and the earlier of mailing a notice of deficiency as to the initial tax or date of assessment of the initial tax. It is IRS practice to send a "first letter of proposed deficiency" thirty (30) days before the notice of deficiency is issued. 66 F.R. 2144, "Explanation of Provisions." While the IRS uses the same Notice of Deficiency for both the initial 25% penalty and the second 200% penalty, the IRS states the abatement rules under IRC Section 4961 abate the 200% penalty if the excess benefit is "corrected" within ninety (90) days after the IRS has mailed the Notice of Deficiency.
An "organization manager" may be liable for an excise tax amounting to 10% of the excess benefit paid to the disqualified person. If more than one person was an "organization manager" with regard to the transaction, then the liability is joint and several. The maximum aggregate liability for any one transaction is $10,000.
Organization managers may be liable if they:
[K]nowingly participated in the excess benefit transaction, unless such participation was not willful and was due to reasonable cause.
Section 53.4958-1(d)(1). There are at least four key concepts in that statement of liability: "knowingly," "participated," "willful" and "reasonable cause." Viewed the other way, if you are an organization manager and the IRS comes to call, these are your defenses to liability for the excise tax imposed on organization managers.
"Knowingly," includes, in addition to what you would expect, a negligent failure to make reasonable attempts to find out whether the transaction involves an excess benefit. It does not include simply having reason to know, but having reason to know is evidence of "knowingly." [ Section 53.4958-1(d)(4)(ii)]. That's a difficult distinction.
"Participated" includes silence or inaction where the organization manager is under a duty to speak or act. An organization manager must oppose the transaction in a manner that is consistent with the fulfillment of the manager's responsibilities. A special note for this defense: you must be able to prove your opposition to the action. Simply voting against it may not be enough, even with a roll call vote, since as a fiduciary you may very well have a duty to disclose the knowledge you have. If you actually knew of the risk that the transaction might confer an "excess benefit," and didn't tell the other directors, you might be breaching the duty to act consistent with the fulfillment of your duties. And you must be certain the minutes reflect these issues and actions.
"Willful" means voluntary, conscious, and intentional. It does not require that you have the motive of avoiding the restrictions on excess benefits. However, apparently actual knowledge that you are violating the excess benefits rules is not required. I interpret this requirement to mean that ignorance of the excess benefit transaction laws is not a defense, but that, after some level of due diligence, ignorance that the transaction under scrutiny confers an excess benefit is a defense. Section 53.4958-1(d)(5).
"Reasonable cause" is the "prudent person" standard; i.e., you have exercised your responsibility on behalf of the nonprofit corporation with ordinary business care and prudence. Section 53.4958-1(d)(6).
There is a kind of "mini-safe harbor" to the elements of "willful" and "reasonable cause" available where you rely upon the advice of qualified professionals. However, to qualify, the "advice of a qualified professional" must meet pretty rigorous standards:
- There must have been full disclosure of the fact situation to the qualified professional, who may include in-house counsel.
- The opinion must be expressed in a written opinion, the opinion must address itself to the facts and the applicable law.
- The opinion must apply the facts at hand to the law. An opinion that merely recites the facts and that expresses a conclusion without addressing the application of the law to the facts will be insufficient.
The "qualified professional" may be an attorney, a qualified CPA or, in some circumstances, a qualified appraiser. No negative inference may be drawn from the absence of a written opinion of a qualified professional by the IRS. Section 53.4958-1(d)(4)(iii).
Statute of Limitations. The statutes of limitations for IRS claims against the recipients and against organization managers are the general excise tax statutes of limitations at IRC Section 6501. Section 53.4958-1(e). Under Section 6501(e)(3), the statute of limitations for IRS claims is six (6) years where the tax return has been filed. However, as is the case with other excise taxes, where no return has been filed there may be no statute of limitations. Section 6501(c)(3).
There is a myth that nonprofit corporations do not have to file federal income tax forms. Don't confuse taxability of income with tax reporting. All nonprofit corporations must file income tax returns. They are information returns. The failure to file such a return exposes the nonprofit corporation, and its officers, directors, and management to penalties, and can jeopardize a charitable corporation's Section 501(c)(3) status.
There are a discouraging number of tax returns that can be required of nonprofit corporations in general and charitable corporations in particular. The list is too long to set out in full, but here are a few of the more common requirements.
Annual Information Return - Form 990.
Form 990 is the basic information return for nonprofit corporations (except private foundations). If your nonprofit corporation’s gross receipts in a year were less than $25,000, you need not file a return, unless you received one in the mail. Effective for the 2010 tax year, this threshold increases to $50,000. Generally, these small organizations are required to file a Form 990-N, also known as the e-postcard. The IRS is working on creating a means to file these returns electronically. Note that the laws of some states (not Alaska) require all nonprofit corporations to file information returns.
The Short Form 990-EZ is a simplified Form 990. It’s available for exempt organizations, except private foundations, whose total assets and gross receipts fall under certain thresholds. For the 2008 tax year (returns filed in 2009), organizations with gross receipts of more than $1 million or total assets greater than $2.5 million are required to file the full Form 990. For the 2009 tax year (returns filed in 2010), the threshold decreases to $500,000 and $1.25 million, respectively. The threshold again decreases for the 2010 tax year to $200,000 and $500,000, respectively. The IRS is basically requiring a much broader range of nonprofit charitable corporations to file the full Form 990.
Both the kind of nonprofits required to file an annual information return and the content of the information return are changing rapidly. You should consult a tax adviser for recent changes in this area. In particular, the IRS created an entirely new Form 990 for the 2008 tax year. According to the IRS, the goal of the revised form is to enhance transparency, encourage compliance, and minimize the burden on filing organizations. The new form contains numerous questions on governance policies and procedures, many of which are based on the IRS good governance principles that are not required by statute or regulation.
|The revised Form 990, which became effective for the 2008 tax year, is complex and the IRS is still developing instructions to go with the form as well as new regulations. The Form 990 is likely to evolve substantially over the next several years. Any organization required to file the Form 990 should seek advice from a qualified accountant, attorney, or both.|
If your nonprofit corporation is required to file a Form 990 or 990-EZ, then it is also required to make a copy of that form available for inspection and copying by interested persons, along with your Form 1023 (Application for Exempt Status). Copies of the forms must be furnished to interested persons upon request, at cost. IRC §6104. See the discussion at page 71 below.
There are also numerous special returns that must be filed, including:
Public Disclosure Requirements
New disclosure requirements were imposed by the IRS under IRC Section 6104 and regulations at Regs. Section 301.6104, effective June 8, 1999. Under the new rules, an exempt organization is required to make most of its tax records available to the general public.
General Rules. An exempt organization must make its application for an exemption, its determination letter, and all of its Form 990s, including the Special Returns discussed in the preceding section, available for inspection and copying. The requirement includes all schedules and supplementary materials. These materials must be made available for a period of three (3) years, beginning on the date the return was due or the date it was filed, whichever is later. Generally, the names and addresses of donors need not be disclosed, except that Private Foundations are required to disclose that information as well.
Inspection of Records. The records must be available for inspection during regular business hours at the principal, regional, and district offices of the exempt organization. The inspection must be without charge and, except in narrow exceptions described below, there simply is no right to refuse to produce records.
Copies of Records. An exempt organization generally must provide copies of documents requested in-person on the day they are requested. In certain kinds of unusual circumstances, the exempt organization can have an additional day or, if special duties exist that truly prevent staff from providing copies, then the delay interval may be as many as five (5) days. But the general rule is same day service.
If the request is made in writing, then the exempt organization has thirty (30) days from the date of receipt of the request to comply. Facsimile and electronic mail requests are treated as written requests.
An exempt organization can charge for the reasonable costs of the copies and postage. The "reasonable costs" can't exceed the rate the IRS itself charges for copies. That can work true hardship in rural Alaska.
The exempt organization may require payment in advance. If so, then the time to respond to a written request does not begin to run until the organization receives that payment.
Failure to Provide Records; Penalties. A person who fails to allow inspection or who fails to allow copying of records without reasonable cause faces a penalty of $20 per day for each day with a maximum penalty of $10,000. A willful failure to comply subjects a person to a fine of $5,000 with respect to each return or application. Note these penalties are imposed on the individual who refuses to comply, not the exempt organization.
Compliance by Posting to the Web. An exempt organization is not required to comply with a copy request if it has made the information described above "widely available" by posting it to the organization's web site or by linking to a site maintained by a third party for that purpose. Web availability does not excuse an organization from compliance with inspection requirements. The rules for availability on the Web are fairly stringent.
The Web page through which the information is made available must clearly describe what is available and provide instructions for accessing and downloading it. The organization must take steps to assure the information posted at the web site is reliable and accurate, and must have reasonable procedures in place to prevent that information from being altered or destroyed.
Perhaps unreasonably, the documents must be posted in a format which, when downloaded and printed, exactly reproduces the image of the original, except for deletions permitted by the IRS.
Any individual with access to the Internet must be able to access, download and print the document without special hardware or software. The commentary to the regulations strongly suggests that PDF is acceptable. Note, however, you will have to scan the returns and post them as graphic images to meet the "reproduce exactly" requirement.
Harassment Campaign Exception. There are procedures by which an organization can complain to the IRS if it believes it is the subject of a campaign of harassment by which someone is attempting to disrupt its operations by repeated requests for documents. There's also a limited self-help right, by which an exempt organization may ignore any request for copies beyond the first two (2) received in a thirty (30) day period or the first four (4) received in a one (1) year that come from the same individual or the same address.
Although we require that payment not exceed operating costs, that requirement should not disqualify property owned by successful fundraisers. We hold that an operating surplus will not preclude an otherwise valid tax exemption so long as revenue is not generated out of a dominant profit motive and revenue is allocated only to support exempt purposes.
|Volunteer Legal Handbook, 9th Edition
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