Nonprofit Law Matters

Doing Right by the Projects: Fiscal Sponsorship after IHC

By Gregory L. Colvin on Posted in IRS, FTB & Attorney General Controversies, Nonprofit Governance & Ethics, Public Charities

Recent news in the nonprofit press about the reported collapse of International Humanities Center (IHC), a fiscal sponsor organization based in California, has raised real concerns in the philanthropic world.  Projects sponsored by IHC received correspondence from IHC indicating that it was unable to make disbursements in response to their check requests for money to cover current project expenses.  Donations made to IHC, restricted to the purposes of certain charitable projects, were not available when needed by the projects. 

The most extensive coverage has appeared in a two-part article by Rick Cohen, published in Nonprofit Quarterly earlier this month.  The story also ran in the Los Angeles Times. 

This is not the first time such a thing has happened.  In my book, Fiscal Sponsorship:  6 Ways To Do It Right, at page 73, I cite the case of Media Network, a documentary film sponsor that collapsed in 1997 in similar fashion. 

While the full story and the future of IHC may not be clear right now, many are asking:  What can be done to prevent this from happening? 

I suggest that sponsors take these precautions—and that projects watch to make sure they do: 

1.    Make it clear everywhere—in the fiscal sponsorship agreement, in writing to donors, and on Form 990—that the sponsor treats funds received for the purposes of a project as restricted under the charitable trust doctrine.  The sponsor can obtain unrestricted funds by charging administrative fees, but otherwise the funds dedicated to the purposes of one project may not be used to pay the expenses of another, or to pay the sponsor’s general overhead. 

To be clear:  a fiscal sponsor is not a bank.  Each restricted fund belongs to the sponsor, not the project.  However, each project fund is impressed with a trust commitment “for the charitable purposes of” the project, and the sponsor has the legal duty to honor that trust.  Within the limits of those purposes, the sponsor has discretion and control over spending decisions.  But if the sponsor breaches that duty, the state attorney general can intervene to enforce the charitable trust in the public interest. 

2.    The sponsor’s board should set a reserve policy to maintain a strong minimum of general, unrestricted funds, so that the sponsor can meet its overhead expenses even if administrative fees from projects were to take a sudden drop. 

3.    The sponsor should have internal financial controls that would discourage any one person from invading project funds.  Since many fiscal sponsors centralize check-writing authority for all projects in a few top managers, major disbursements should require a second signature or a second pair of eyes.  Where required by law, the sponsor must have a board-level audit committee and an annual independent audit by a CPA firm.  The accounting firm can issue a management letter to the board to address defects in internal controls. 

4.    The sponsor’s board of directors needs to pay attention and oversee the program.  Among other things, the Board should receive frequent financial statements showing the condition of the fiscal sponsor’s unrestricted general fund, to make sure that reserve requirements are met and that there is no improper “borrowing” from project funds.

5.    Strive for transparency.  Project directors should receive frequent (or have immediate online access to) internal financial statements showing the condition of their project fund.  The project’s fund accounting should always show cash on hand in excess of incurred expenses.  A positive balance that relies on a “receivable” from the sponsor’s general fund is a danger sign; the project director should jump on that immediately. 

6.    The sponsor cannot afford to be too soft-hearted.  General funds should not be advanced to projects.  If the cash in the project fund isn’t sufficient to meet payroll or other costs, employees will need to be laid off and project expenses curtailed.  Reliance on grants receivable, loans, and pledges is risky business.  And some sponsors may need to revisit their administrative fee structure if not enough unrestricted money is being generated to meet the costs of audits, controversies, full insurance coverage, and other elements of risk management. 

7.    Some fiscal sponsors, in the public health field, for instance, must rely heavily on government grants that are paid on a reimbursement basis.  In those cases, projects may need to incur or pay expenses before receiving grant funding.  Operating such a fiscal sponsorship system successfully requires very careful, professional planning by experienced grants managers, but it can be done.

8.    The sponsor’s annual IRS Form 990, accessible to the public via Guidestar, can reveal that a fiscal sponsor is in trouble.  Look at Part X, the Balance Sheet, Lines 27, 28, and 33.  If unrestricted net assets are negative, and total assets are less than temporarily restricted (project) assets, it can mean that the sponsor has borrowed from or misspent funds held in charitable trust for the projects’ purposes.  The sponsor may not have the cash to cover all the projects’ check requests.  The Form 990 might not be filed until almost two years after the sponsor goes in the hole to its project funds, so projects should demand more frequent balance sheets.  IHC’s unrestricted net assets went negative back in 2008; its projects could have transferred to another sponsor or taken other protective action in 2009. 

9.    The sponsor needs to be adequately insured.  When I was on the board of Community Initiatives in San Francisco with Jan Masaoka and John Kreidler, our motto was “buy insurance by the truckload.”  Besides general liability and directors’ and officers’ insurance, consider employee dishonesty and theft, non-owned auto, special event coverage, discrimination, harassment, molestation, and employee claims.

10.    The National Network of Fiscal Sponsors has published guidelines for best practices.  These are a valuable resource for all concerned to determine whether a sponsor’s program is up to the industry standard. 

Are fiscal sponsors inherently weak?  Not at all.  By sponsoring a range of projects, the whole can be stronger than the sum of its parts.  But just like any other charity—a hospital, college, museum, church, or social service group—it may fall into a deficit position for any number of reasons, pulling down all of its  departments, scholarship funds, and special programs. 

For more tips on doing fiscal sponsorship right, see www.fiscalsponsorship.com.

 

 

Could Your Nonprofit Chapter Network Be a Franchise System?

By Steven R. Chiodini on Posted in Nonprofit Network Affiliations

Charities have many legal issues on their radars, but franchise law typically isn’t one of them.  Consequently, a Wisconsin case applying franchise law to a nonprofit surprised many in the sector.  Should you worry? 

As described in the opinion, the local Girl Scouts chapter in Manitou, Wisconsin, like more than 300 other local Girl Scouts “councils,” held a license from the national 501(c)(3) organization to sell Girl Scouts cookies and other merchandise.  This naturally brought significant revenue to the chapter.  When the national organization attempted to consolidate the chapter with other local councils, effectively revoking its license as a separate council, the chapter sued, claiming that it was a “dealer” (i.e., a franchisee) under the Wisconsin Fair Dealership Law and that its franchise could not be terminated without good cause, regardless of what any contract with the national group provided.  The appellate court agreed, at one point comparing the Girl Scouts to Dunkin’ Donuts, and the national Girl Scouts’ effort to consolidate the chapter was stopped. 

How important is this case to other charity networks with a less commercial hue?  It’s not clear.  While the cookie sales are definitely a distinguishing factor, it’s not that hard to fall under the definition of a franchise under the laws of many states (see, for example, the California Franchise Relations Act).  It typically involves a three-part test, although statutes do contain exceptions: 

  • The putative franchisor (the national organization) grants the chapter a right to offer or sell goods or services to the public under a marketing plan;
  • The marketing plan is substantially associated with the franchisor’s mark; and
  • The franchisor charges a fee for using its mark. 

For example, a charity that licenses an educational program to local chapters and receives a percentage of resulting tuition in return might very well meet all three prongs.  (Of course, the details of this test and how they’re applied vary from state to state—e.g., New York requires only two of these prongs—so it’s important to consult local counsel.) 

The results of an “accidental franchise” can be dire—disclosure and registration requirements may apply, and franchisee protections may limit the parent’s ability to enforce its affiliation agreement if the chapter goes rogue.  Of course, the franchise laws were intended to protect the public from unscrupulous franchisors, and most parent-chapter affiliations in the charitable sector probably don’t trigger this sort of concern.  But there is unlikely to be any case law or regulatory guidance to give much comfort on this point.   

Fortunately, an accidental franchise can usually be avoided, by structuring the relationship to fail at least one prong.  The first prong—selling goods/services to the public—often is inapplicable to nonprofit parent-chapter affiliations, although offering goods or services to the public might technically be enough.  (Note, however, that the federal Franchise Rule, enforced by the Federal Trade Commission, does not apply to relationships unless they are entered into with the expectation of profit.  See FTC staff opinions on this matter here and here.)  Where the first prong is met, the second—using the parent’s brand—will usually be met too.  In that case, the third prong can be avoided by charging no fee to chapters, or working with counsel to structure the fee so that it doesn’t resemble a typical franchise fee. 

So, in the end, even though your charity network may not look much like Dunkin’ Donuts, it may still be wise to consider precautions to avoid franchise hang-ups.

CRT Disclosure

By Erik Dryburgh on Posted in Charitable Gift Planning

We have good news and bad news.  

The IRS Form 990 (filed by tax-exempt organizations) includes a number of schedules, including Schedule R: “Related Organizations and Unrelated Partnerships,”  which was rolled out for tax years beginning in 2008.  The 2010 instructions for Schedule R clarified that charities should report charitable remainder trusts (CRTs) that are “related” to the charity in Schedule R, Part IV, including the name and address of the CRT, its taxpayer ID number, and the value of the charity’s interest in the CRT.  This disclosure obligation met with a fair bit of resistance from the tax community, who noted that CRT donors do not expect their information to become public—especially as the names of individual donors to public charities are not subject to public disclosure.  The IRS responded to this resistance, revised the 2011 Schedule R instructions, and reported at the recent Western Conference on Tax Exempt Organizations that charities will not have to disclose the names and other identifying information of their “related” CRTs, but will only have to report the type of the trust. 

That’s the good news.  

The bad news is that the cat is mostly out of the bag anyhow.  The name, address, taxpayer ID number, and asset balance of all CRTs are now available online!  Just log onto Guidestar.org and search for the name of the trust.  (Many donors include their name in the name of their CRT—such as “The John Smith Charitable Remainder Trust,” so you can search for many CRTs via the donor name.)  You can even search for “Section 4947(a)(2)” entities (which include CRTs) by zip code—so search your zip code and see if any of your neighbors has a CRT!

Model C Fiscal Sponsorship: The More Formal, the Better

By Steven R. Chiodini on Posted in Public Charities

Model C fiscal sponsorships, where a public charity enters into a pre-approved grant relationship with an unrelated individual or organization, may be less common than Model A direct-program sponsorships, but they do offer some advantages, including the possibility of limiting a sponsor’s liability for project activities.    

Unfortunately, they also pose a number of traps for the unwary, and a recent private letter ruling by the IRS provides a cautionary example. 

In PLR 201138050 (June 21, 2011), the IRS determined that an organization formed as a “friends of” charity did not qualify for exemption under Section 501(c)(3).   Although in fact the charity was intended to benefit a specific foreign school, the exemption application said that the organization would make pre-grant inquiries on all grantees and would establish procedures to ensure that grant funds were used in furtherance of its exempt purposes, among other things.  The problem, however, was that the organization never actually did what it promised:  it failed to document any pre-grant inquiries into the sole grantee, its board never met, outsiders had check-signing authority on bank accounts, and there were no records showing that it monitored the grantee’s activities.  Consequently, there was little evidence that the “friends of” charity was anything more than a conduit for contributions to the foreign school. 

So what does this PLR have to do with Model C fiscal sponsorships?  Unlike the more standard grant situation—for example, where a foundation solicits grant proposals, investigates candidates, and awards grants—a “friends of” charity and a Model C sponsor usually have a much closer and informal connection to the grantee.  In this situation, any number of things can go wrong: 

  • Donors may be told to write checks directly to the project organization.
  • Project staff might be given authority to sign checks directly on the sponsor’s accounts.  
  • Fundraising material may neglect to disclose the fiscal sponsorship.
  • The sponsor may fail to obtain periodic written reports from the project. 

After all, why bother reviewing quarterly activity reports when you can simply walk down the hall and talk to project staff in the space they rent from you?  And isn’t it easier to tell donors to write their checks to the project they’re familiar with and want to support? 

While it’s true that the situation considered in PLR 201138050 was extremely egregious, it does underline something crucial:  in both a “friends of” arrangement and a Model C fiscal sponsorship, the charity must have meaningful discretion and control over the funds it receives in support of the grantee.  If the charity doesn’t observe the cumbersome but essential grantor-grantee formalities that are necessary for maintaining this discretion and control and for avoiding public confusion, the charity runs the risk of becoming a mere conduit for donations from the public to the grantee. When this happens, charitable deductions for contributions could be disallowed, and private foundations could find that their grants to support the project were not made to a proper public charity.  

This doesn’t necessarily mean that every Model C sponsor needs to demand extensive reports from its projects, or suppress any mention of a project’s name in public fundraising appeals.  It does mean, however, that sponsors should be wary of having a too-informal arrangement with their Model C projects.  In particular, donation checks should always be written to the sponsor, not to the project, and all fundraising materials should clearly identify the sponsored status of the project. 

Ultimately, Model C fiscal sponsorships can be extremely useful, but not at the risk of jeopardizing the sponsor’s tax-exempt status.

Extension of 990 Filing Deadline for Certain Exempt Organizations

By Martha Lackritz on Posted in IRS, FTB & Attorney General Controversies, Private Foundations, Public Charities

Most exempt organizations whose tax years end on August 31 or September 30, and which would ordinarily have January or February filing deadlines for Forms 990, 990-EZ, 990-PF, and 1120-POL, have received an unexpected reprieve from the IRS.  Due to system maintenance, these organizations will have until March 30, 2012, to complete their filings electronically, or by paper.  The IRS will still accept paper filings during this period, including from those organizations normally required to file electronically.  The only organizations that are not eligible for this extended deadline are those which file Form 990-N, the “e-postcard.”  Because the system will still operate for the 990-N, such organizations must still file electronically by the regular deadline.  

Who is affected?

  • Organizations (other than those that file Form 990-N) with filing due dates of January 17, 2012, or February 15, 2012
  • Organizations that have already obtained an extended filing deadline that falls on either January 17, 2012, or February 15, 2012 

If you’re already on extension… Organizations that have already obtained one three-month extension of time to file, with a due date that falls between January 1 and February 29, 2012, will automatically be granted a second extension as long as they file a Form 8868, Application for Extension of Time to File an Exempt Organizations Return, by March 30, 2012.  Those organizations that have already been granted two three-month extensions will not be permitted to file a third application for extension of time. However, they will have until March 30, 2012, to file their returns.  In order to avoid receiving a system-generated penalty notice for late filing, these organizations are encouraged to attach a brief Reasonable Cause Statement to their returns, referencing Notice 2012-4.  (Appendix A to Notice 2012-4 provides a sample of a Reasonable Cause Statement, which may be copied verbatim for this purpose.) 

For more information, visit http://www.irs.gov/newsroom/article/0,,id=251322,00.html for a description of the Notice, and a link to the Notice itself.

Form 8940 Requests and Other Recent Dealings with the IRS

By Ingrid Mittermaier on Posted in Private Foundations, Public Charities, Religious Institutions

For several months now, the new IRS Form 8940 has been available for use by Section 501(c)(3) charities (and nonexempt charitable trusts) in filing a variety of requests with the IRS.  The form can be used to request (a) advance approval of certain set-asides described in Section 4942(g)(2) of the Internal Revenue Code, (b) advance approval of voter registration activities described in Section 4945(f), (c) advance approval of scholarship procedures described in Section 4945(g), (d) exemption from Form 990 filing requirements, (e) advance approval that a potential grant or contribution constitutes an “unusual grant,” (f) a change in Type (or initial determination of Type) of a Section 509(a)(3) supporting organization, (g) reclassification of foundation status, (h) an advance ruling for termination of private foundation status, and (i) termination of private foundation status at the end of a 60-month termination period.   

Some of the request types have been issues for Section 501(c)(3) charities for years, such as needing to request advance approval for scholarships or requesting an advance ruling for termination of private foundation status.  Other types of requests reflect more recent legal developments, such as the request for change in Type of or initial determination of Type of supporting organization status, an important issue post Pension Protection Act.  Whether for requests that we have filed repeatedly in the past, or for these newer and less familiar request types, we appreciate the effort of the IRS to provide a more uniform and clear procedure. 

One request that we needed to take a closer look at was the option of requesting exemption from Form 990 filing requirements (see 2010 Instructions for Form 990, p. 6).  While certainly an issue in the past, the fact that tax-exempt entities with Form 990 filing requirements will lose exempt status for failure to file three annual returns in a row has put a premium on clarifying with the IRS when a charity does not have a filing requirement.  Unfortunately, due to a variety of data glitches, it does not appear to be uncommon for charities to incorrectly have their exemption revoked because the IRS thought they had a Form 990 filing obligation that was not met.  What we confirmed for one such client, a church, is that once the entity has received such a revocation letter, the Form 8940 is not the appropriate form to use to correct the problem.  Rather, if the organization has documentation showing it met the filing requirement, or an IRS letter showing it did not have a filing requirement, it can submit that information to the IRS with a cover letter (see http://www.irs.gov/charities/article/0,,id=221600,00.html, Questions 10 and 11).  For organizations without such documentation, it appears that they need to submit a full new exemption application (http://www.irs.gov/charities/article/0,,id=221600,00.html, Questions 5 and 6).  However, the IRS website also lists special options for churches.  

Revised CGA Rates

By Erik Dryburgh on Posted in Charitable Gift Planning

The American Council on Gift Annuities (ACGA) held its semi-annual meeting on November 7, 2011. The board reviewed the current assumptions that underlie the gift annuity rate schedules and, recognizing the significant changes in the economic environment, approved a new schedule of suggested rates.  These new rates will become effective January 1, 2012.  

As you would expect given the drop in interest rates, the suggested rates are slightly lower ― for example, one-life rates will decline by 0.5% to 0.8% for ages older than 60. 

You can find more information about the assumptions underlying the new rate tables, as well as the full gift annuity rate schedules, at the ACGA web site:  www.acga-web.org.

Fiscal Sponsorship of Occupy Wall Street . . . and Other Locations

By Gregory L. Colvin on Posted in Public Charities

Last week, I received a call from a reporter at the Chronicle of Philanthropy asking whether it was true that people could donate in support of Occupy Wall Street and receive a charitable tax deduction. 

Here’s how I answered: 

The Alliance for Global Justice is listed with the IRS as a 501(c)(3) public charity and so contributions to the Alliance are tax-deductible as charitable gifts. 

I read Chuck Kaufman’s explanation of the Alliance’s fiscal sponsorship of Occupy Wall Street and found it fairly well-reasoned and appropriate.  The Alliance can receive donations designated for the support of the Occupy Wall Street movement and hold those assets restricted for that specific cause.  The Alliance seems to know that it must exercise discretion and control over all expenditures, to ensure that they are charitable.  The Alliance cannot act as a conduit for another group: donations are restricted to support of the purposes of Occupy Wall Street, but the Alliance retains the right to decide who gets the money to further those purposes. 

I also read The Blaze critique of the relationship between the Alliance and Occupy Wall Street.  While it is clear that the writer differs ideologically with these progressive endeavors, he didn’t seem to find anything legally improper.  In between the lines, I almost detected some respect for how it was set up. 

It can take 3 to 6 months or more for a new organization to apply to the IRS and receive approval of its 501(c)(3) tax exemption.  Fiscal sponsorships are often used to provide a charitable fundraising facility for an emerging community need, whether it is a natural disaster like Hurricane Katrina or a sudden upsurge among people seeking reforms or protesting events.

I’m sure that the Alliance is finding it a big challenge to handle these financial affairs for the movement, and no doubt it will need to make improvements as it goes along. 

Note: Alliance for Global Justice is not a client of Adler & Colvin. 

The Chronicle of Philanthropy story appeared online here. 

Other Cities? 

Next, I was asked about other cities where there may not be a proper fiscal sponsorship in place, and here’s how I answered: 

About the financial status of the Occupy groups, there’s more to worry about than just the tax deduction.  Before supporters open a bank account, decisions must be made: 

1.    Who does the money belong to?  The bank will want a tax ID number, either a person’s social security number or an entity’s federal employer identification number (FEIN).  As far as the IRS is concerned, that is the owner of the account.  If it is an individual person, he or she has legal control over the funds and deposits to the account may be taxable income to him or her, personally. 

2.    If the bank account is held by a new entity with a new FEIN, its tax life will begin.  Sooner or later, it will need to file papers with the IRS and declare what it is. 

3.    If the entity doesn’t qualify for some kind of tax-exempt status, the IRS will likely view it as a taxable organization, like a business. 

4.    Tax exemption as a 501(c)(3) charity is the most beneficial.  If the Occupy group is educating the public and advocating for social change, with no more than an insubstantial amount of lobbying and absolutely no political candidate campaign activity, it could qualify.  But it must not conduct or encourage any illegal activity, such as civil disobedience.  Social welfare tax status is also available under 501(c)(4) if the group wants to do more lobbying and some political activity.

5.    Most groups wanting to declare a tax-exempt status will want to file state papers as a nonprofit corporation, and may have state tax forms to file as well. 

6.    On top of that, the very act of soliciting funds for charitable or public-spirited purposes will likely trigger charitable solicitation registration laws in all the states where the group is soliciting funds.  The state attorney general may enforce those laws and require donated funds to be spent in accord with those specific purposes. 

7.    For all these reasons, use of a local, reputable, experienced, tax-exempt fiscal sponsor can be a great advantage for a new project that is just getting on its financial legs.  If the sponsor is convinced the Occupy group is conducting a truly charitable program, the sponsor can adopt the group as a direct project and take full responsibility for its financial, tax, and legal affairs. 

8.    With a fiscal sponsor in place for now, the decision about creating an independent, separate, new tax-exempt organization can be postponed until the group’s structure, mission, and base of support have fully taken shape. 

9.    None of this is easy to do.  Cutting corners can be disastrous.  Those responsible for handling Occupy finances must understand the system under which they are operating, not misrepresent it, and pay faithful attention to the details. 

Based on this additional commentary, a follow-up article will appear in the November 17 print edition of the Chronicle of Philanthropy.  Stay tuned.

 

Social Enterprise Update: California Governor Signs Bills Creating Flexible Purpose Corporations and Benefit Corporations

By Robert A. Wexler on Posted in Social Enterprise

Nearing the midnight hour on Sunday October 9, 2011, Governor Brown signed into law two bills that will both take effect on January 1, 2012.  Both of these bills will provide an opportunity to form for-profit corporations in California that also promote a social or charitable purpose. 

Senate Bill 201 adds the Flexible Purpose Corporation as an option to the California Corporations Code.  Flexible Purpose Corporations are going to be ideal for social entrepreneurs who want to set up businesses that can also spend resources on charitable causes, socially beneficial causes, labor, and the environment, without having to worry about maximizing profits for shareholders. 

A Flexible Purpose Corporation can fashion Articles of Incorporation to provide for both a business purpose PLUS (i) one or more enumerated charitable or public purpose activities that could be carried out by a nonprofit public benefit corporation and / or (ii) the purpose of promoting positive short-term or long-term effects or minimizing adverse short-term or long-term effects upon any of the following:  employees, suppliers, customers, creditors, the community, or the environment. 

Assembly Bill 361 adds the Benefit Corporation as an option to the California Corporations Code.  While the Flexible Purpose Corporation is an entirely new form of legal entity, the Benefit Corporation already exists in several states, although some of the provisions differ from state to state.  The Benefit Corporation is ideal for those entities seeking “B Corporation” certification because it was sponsored by B Labs, the owner of the “B Corporation” trademark and because it requires that Benefit Corporations satisfy an objective, outside third-party standard, such as the one offered by B Labs. 

Although in most cases I favor the Flexible Purpose Corporation, having been one of its drafters, I believe that both forms will be highly valuable for California moving forward.

Fiscal Sponsorship Handouts Available from COF Community Foundations Conference in San Francisco, September 20, 2011

By Gregory L. Colvin on Posted in Public Charities

Over 100 attended our fiscal sponsorship presentation at the Community Foundations Conference sponsored by the Council on Foundations – attendees from Delaware, Iowa, Alaska, the Outer Banks, San Diego, everywhere.  Even the Ocean (Foundation). 

With the large unexpected audience, we ran out of handouts.  But they are available now at www.fiscalsponsorship.com: 

(1)       the basic PowerPoint on fiscal sponsorship, especially Models A and C, 

(2)       6 Ways That Community Foundations Can Relate to Fiscal Sponsorship, PLUS 

(3)       lessons learned and posted by Jessica Janssen, executive director of Fremont Area Community Foundation.