Earlier this week, Gregory Colvin and Rosemary Fei reported on the current scandal at the IRS concerning the Service’s improper review of certain tax-exemption applications, particularly those applications from conservative and Tea Party groups seeking recognition as 501(c)(4) social welfare organizations. Since the news came out, some commentators have proposed eliminating the 501(c)(4) social welfare category altogether. In a brief debate on Bloomberg News yesterday afternoon, Rosemary Fei argued against this approach, pointing to the beneficial role that Section 501(c)(4) groups play and stressing the need for better guidance about what these groups can and cannot do. To watch Rosemary debate with University of Illinois Law Professor John Colombo, click here.
Five of our attorneys, Rob Wexler, Ingrid Mittermaier, Susan Dawson, and the two of us, were in the audience at the American Bar Association Exempt Organizations Committee meeting in Washington, D.C., on May 10.
We heard the remarks from Lois Lerner, head of Exempt Organizations at the IRS, apologizing for how the exemption applications of some conservative groups had been targeted for extra scrutiny through word searches using “Tea Party,” “Patriot,” and other inappropriate terms.
Since then, the controversy has erupted in many directions. Given our firm’s practice area, we’ve had many requests to join the national conversation about what went wrong and what it means, and we hope our expertise can be helpful for what should happen next.
It is now apparent that the improper selection process was not limited to 501(c)(4) applications (social welfare organizations). According to the report of the Inspector General (TIGTA), the search terms were also used to select applications across the 501(c)(3), 501(c)(5), and 501(c)(6) categories (charities, unions, and trade associations). On May 15, the IRS posted answers to questions here and also released a list of 175 “advocacy” organizations that had been approved in the recent period here. The range of ideologies represented on the list stretches from conservative to liberal, and includes a good number of 501(c)(3) charities. There are hundreds of organizations that were selected for special review still in process at the IRS, and we don’t know their tax section or their viewpoints. We hope these cases will be resolved soon and the IRS will provide updated information on them, to the extent their obligation to keep individual taxpayers’ information confidential permits it.
What was the IRS looking for? Evidence of political intervention in the campaigns of candidates for public office, especially in the 2010 and 2012 elections. That’s a job the IRS must perform, because Congress has set prohibitions and limits in the Internal Revenue Code on the extent to which political campaign activities can be conducted by 501(c) organizations that receive tax-deductible and tax-exempt money.
The problem is that the IRS has no clear standards for determining what is and is not permitted election activity for exempt organizations, and how much is too much for the non-charitable 501(c) groups. The two of us have been working for several years with other tax-exempt attorneys on a “Bright Lines Project” to replace the vague, unpredictable “facts and circumstances” approach currently used by the IRS to judge political activity. We want to see a set of clear definitions and safe harbor exceptions that would apply across the board under the Internal Revenue Code. You will be hearing more about that in the coming months.
Meanwhile, here are some news items to which we have contributed:
“Room for Debate” Opinion Pages of the New York Times, describing the valuable purposes served by 501(c)(4) social welfare organizations
For our clients with exemption applications pending at the IRS: not to worry. We have had a few cases that experienced extra scrutiny for advocacy activities, but we received the IRS exemption letter in the end. Most of our IRS applications, we believe, will be unaffected by this controversy.
This is not over yet. Stay tuned.
Congratulations! Your startup is finally going public/being acquired/experiencing some other “liquidity event,” and those shares you have been earning are actually going to be worth something! Your taxable income is probably going to spike this year, and you may be thinking about offsetting it with a large donation to your favorite public charity. Your most valuable asset is your stock in the company, so the obvious thing to do is transfer some of it to charity, right?
Not so fast!
Even if the company is publicly-traded, your stock may be restricted under the securities laws and/or the terms of one or more shareholder agreements or lock-up agreements. If so, a host of issues may arise:
- Before you try to give the stock to the charity, you need to confirm that you have the right to transfer the stock at all. If a shareholders’ agreement is the only thing preventing transfer, you may be able to have the agreement amended or an exception made, depending on your position with the company and your “pull” with the other shareholders. If the restriction is based on securities laws or a lock-up agreement, you may be out of luck.
- You normally don’t recognize gain when donating appreciated stock to a public charity. But if the charity will be obligated to sell the stock as soon as the charity receives it — for example, if you already committed the stock to a buyer, and the charity will only hold it pending completion of the sale — the IRS will treat you as though you sold the stock yourself and then donated the cash to charity. That means you will pay tax on the gain from the sale, probably wiping out your tax benefit from the donation. This “pre-arranged sale” rule can also be an issue if you contribute your stock after a tender offer or redemption has been announced, even if you have not entered into any agreement yourself.
- If you have held the stock for one year or less (i.e., its sale would not generate long-term capital gain), your deduction will be limited to your cost basis — probably zero or close to it — making the stock a poor choice for your contribution. If you earned the stock as compensation and did not make a “Section 83(b)” election at the time you received it, the one-year clock did not start ticking until the stock vested.
- Unless the stock is completely unrestricted (i.e., there are “market quotations readily available on an established securities market”), you will probably need an IRS-qualified appraisal before you take your deduction. Qualified appraisals of nonpublic stock can be costly and difficult to obtain.
- If you are donating stock in a company you founded, maintaining control of the company is probably important to you. Talk to your tax counsel about this issue — simply donating the stock while retaining the right to vote the shares can kill your deduction, because the IRS may treat it as a donation of less than your entire interest in the stock.
- The charitable deduction is available in the tax year that the contribution is “actually paid.” If the stock transfer is conducted through the issuing corporation, the donation is not complete until the corporation enters the transfer on its books — not when you authorize the transfer. This distinction can be crucial if the transfer will be completed near the end of the year. Transfers of restricted stock can be complex and may involve approval from multiple parties, often taking longer than donors anticipate.
- There may be implications for your other holdings of the same security. For example, if you are subject to a volume limitation on sales under securities laws or a shareholders’ agreement, you may be required to aggregate sales by the charity with your own sales.
If you have stock options rather than actual stock, things are more complicated. See Erik Dryburgh’s excellent article on this topic here.
And if all you have are “restricted stock units” (RSUs), well, forget it — you can’t transfer them at all. RSUs are not really an asset that you own; they are more like a bonus that you may receive at some point in the future. Once your RSUs vest and you receive actual stock, you may be able to donate that, depending on what restrictions apply to it.
Social impact bonds (“SIBs”), sometimes referred to as “pay-for-success” financing, may arrive in California. A bill introduced in the legislature, SB9, would establish the Office of Social Innovation and Entrepreneurship Development. The purpose of this governor’s office would be “to establish partnerships with government agencies, private investors, nonprofit organizations, and for-profit service providers to facilitate the use of social impact bonds to address social services needs.”
A “social impact bond” is an investment arrangement in which private funding sources finance a social program administered by a nonprofit organization or a for-profit service provider on behalf of a government agency. The government agency enters into a performance-based contract with the provider, pursuant to which the government only pays if the provider accomplishes specific social outcomes that the government wants achieved. Unlike conventional bonds, which generally involve an unconditional return of capital plus interest, payment on an SIB is contingent on the accomplishment of the specified social outcomes.
Performance-based contracts are typically used in areas where results can be measured quantitatively and producing the results can save the government money. For instance, creating additional housing for the homeless may be a measurable goal, and accomplishing this goal may reduce government expenditures on social services in the long run. The government then pays back investors from the anticipated savings. If the provider’s approach does not achieve the desired outcome, the government is not out any money. The risk instead is taken on by the SIB investors.
Great Britain pioneered the concept of SIBs a few years ago with financing for a program to reduce recidivism rates for prisoners at Peterborough prison. By helping parolees find housing and other support, the program aims to reduce the recidivism rate by 7.5 percent. The assessment period is not yet up, and investors are waiting to see if the program will succeed. More information about the Peterborough experiment and SIBs in general is available here.
SIBs may be a good candidate for program-related investments (“PRIs”). A PRI very generally is an investment in which the primary purpose is to accomplish a charitable goal rather than to generate income. Private foundations and other charities may be willing to accept the risks involved with an SIB in order to facilitate new approaches to addressing pressing social concerns. You can find more information on PRIs here.
Yesterday, the IRS released its final report on its compliance project on colleges and universities. (For those who don’t remember, this started in 2008 with questionnaires sent to 400 randomly-selected exempt colleges and universities, followed by 34 not-at-all-randomly-selected audits.) While there were other interesting findings, I’d like to focus on the widespread and substantial underreporting of (and corresponding underpayment of taxes on) unrelated business taxable income: you can see the error rates and dollars involved in the final report.
While the study was limited to institutions of higher learning, there is a cautionary tale here for much of the charitable sector. The major problems cited by the IRS in the unrelated business area were:
- improperly claiming expenses to offset taxable income where expenses related to activities were not conducted with a profit motive. You can’t get business expense deductions if you’re not running a business for profit, and the IRS decided you can’t be running a business for profit if you consistently lack profits.
- improperly allocating costs associated with assets that are used for both exempt purposes and in unrelated business activities. You can’t over-allocate the expense of dual-use assets to offset your taxable income.
- errors in calculating net operating losses, and unsubstantiated net operating losses.
- misclassifying unrelated business activities as related to and substantially furthering exempt purposes, and therefore not subject to tax.
Activities conducted by colleges and universities most often associated with unrelated business reporting problems were fitness centers and sports camps, advertising, facilities rentals, arenas, and golf. While very few charities have a golf course, income from advertising and facilities rentals is common. The unrelated business income tax has been described, only half jokingly, as an “optional” tax in light of the many exceptions and avoidance techniques available, but the results of this compliance project may be a warning that could be changing. Concerned charities may want to get ahead of the IRS by conducting their own internal unrelated business income tax compliance audit. The new report tells them what to look for.
I had the honor this week of testifying in Washington, D.C., before the Senate Judiciary Subcommittee on Crime and Terrorism. The topic was political campaign activity by 501(c)(4) social welfare organizations that signed IRS tax filings stating that they would not intervene, or had not intervened, in candidate elections.
The point of the hearing was to see whether the (c)(4) officers had made false statements under penalty of perjury on tax returns and could be criminally prosecuted. I explained how difficult this would be under the IRS multi-factor “issue advocacy” rules and its vague “facts and circumstances” approach to judging cases of political intervention. The Chairman, Senator Whitehouse (D-RI), and I discussed whether the “less than primary” amount of political activity permitted for (c)(4) organizations should be reduced to “insubstantial.” Although precise percentages have never been officially set for those concepts, this could lower the limit from 49% to 10%.
My oral testimony appears in the webcast of the hearing on the Senate Judiciary website, along with my full written statement, here.
As part of a compliance check initiative, this week the IRS sent out letters to more than 1,300 section 501(c)(4), (c)(5), and (c)(6) “self-declared” exempt organizations, requesting the completion of a nine-page online questionnaire (Form 14449) regarding their activities, revenue, and expenditures. Unlike section 501(c)(3) charitable organizations, which are required to obtain an IRS determination of their exempt status, most other 501(c) entities can either apply for IRS determination or “self-declare” by being organized, operating, and filing regular Form 990 tax information returns in a manner consistent with their claimed exempt status.
The questionnaire gives us some clues as to the IRS’s concerns with respect to self-declared tax-exempt entities, but it will be some time before we know how the IRS will use the information it collects. Unsurprisingly, there are many questions that probe organizational expenditures for political activity, but related (“tandem”) organizations, unrelated business income, and compensation are three other key focuses. Some questions require financial data for the calendar year 2012 even though the organization may have a different fiscal year. All respondents should be mindful about consistency between questionnaire responses and Form 990 reporting.
The questionnaire may be answered only by organizations who received IRS letters requesting their input. Although completion of the form is voluntary, organizations whom the IRS asks to fill out the form, and who choose not to do so, may be referred for an audit.
In the wake of new private foundation regulations, I had previously written about the concept of foreign public charity equivalence repositories. Our client TechSoup announced yesterday that their repository, built in collaboration with Council on Foundations, is now up and running.
It is always exciting to see a client’s hard work come to fruition.
On December 28, 2012, the Treasury Department issued final, temporary, and proposed regulations regarding Type III supporting organizations (“Type III SOs”), effective that day. The final and temporary regulations, including the substantial preamble, are here. The temporary and proposed portions of the new regulations, available here, address the calculation of the annual payout requirement for non-functionally integrated Type III SOs, which differs from that in the 2009 proposed regulations. Treasury will accept public comment on the new proposed regulations through March 28, 2013.
Type III Supporting Organizations and the New Regulations: Background. All Internal Revenue Code (“IRC”) section 509(a)(3) supporting organizations derive public charity status from their relationship with one or more IRC section 509(a)(1) or (2) public charities:
- Type I SOs are operated, supervised, or controlled by their supported organization(s) (“parent/subsidiary” relationship);
- Type II SOs are under common control with their supported organization(s) (“sibling” relationship);
- Type III SOs are “operated in connection with” one or more of their supported organizations.
In the 2006 Pension Protection Act, in response to perceived abuses of Type III SO status, Congress established two sub-categories: “functionally integrated” Type III SOs, which carry out the functions of their supported organizations, and “non-functionally integrated” Type III SOs, which most typically make grants to their supported organizations. Believing that non-functionally integrated Type III SOs would otherwise remain vulnerable to abuse, Congress imposed significant additional requirements on this new sub-category of SOs and on private foundations and donor-advised funds making grants to them. The 2009 proposed regulations interpreted these new requirements and restrictions.
Effect of New Regulations on Functionally Integrated Type III SOs: Few Surprises. For most functionally integrated Type III SOs, the 2009 proposed regulations accurately presaged the 2012 final regulations; deviations were minor and anticipated. However, the 2012 final regulations eliminated the provision of the 2009 proposed regulations regarding functional integration with a government entity, reserving this discussion for future proposed regulations.
Effect of New Regulations on Non-functionally Integrated Type III SOs: New Payout Calculation. Similarly, the 2009 proposed regulations provided non-functionally integrated Type III SOs with fair warning of most of the new requirements and restrictions to be imposed on them, with at least one critical exception. Before the promulgation of the new regulations, any Type III SO that did not meet the definition of “functionally integrated” was required annually to distribute substantially all (at least 85%) of its income to one or more of its supported organizations. The 2009 regulations replaced this 85% income-based test with a proposed 5% asset-based annual payout similar to that required of private foundations. In the new regulations, in response to substantial concerns from the public, Treasury replaced the proposed 5% payout requirement with an alternative test:
Each year, a non-functionally integrated Type III SO must distribute the greater of:
(1) 85% of its adjusted net income (which generally excludes long-term capital gains) and
(2) 3.5% of the fair market value of its non-exempt-use assets.
This payout requirement and the valuation rules used to determine fair market value for this purpose compose the temporary and proposed regulations that remain open for public comment until March 28, 2013.
Other Guidance Forthcoming. All Type III SOs should be aware that Treasury intends to issue additional proposed regulations that will address other matters, which include:
- Clarification of the responsiveness test to require a Type III SO to be responsive to all of its supported organizations;
- Request for additional examples of responsiveness;
- Definition of “parent” to determine when a Type III SO qualifies as the functionally integrated parent of a supported organization;
- Definition of “control” for purposes of the prohibition on contributions from a donor that “controls” a supported organization;
- Clarification regarding what will count towards the payout requirement, including whether expenditures meeting the definition of program-related investments are counted.
“Names are not always what they seem. The common Welsh name BZJXXLLWCP is pronounced Jackson.” — Samuel Clemens (“dba” Mark Twain)
Nonprofits use alternate names for many reasons, from making a name shorter to representing a particular project. A nonprofit considering a name change can either legally change its name by amending its articles of incorporation (or comparable founding document), or it can use a “fictitious business name,” often called a “doing business as” name or a “DBA.”
Generally, an organization must register its DBA in each state (or, depending on the state, in each county) where it plans to use its DBA. In some states, nonprofits are exempt from DBA registration requirements (e.g., California), but this is not so elsewhere (e.g., New Jersey). DBA registrations are straightforward and inexpensive, so a nonprofit operating nationally may wish to register in multiple states. Consult with counsel if in doubt. Whether or not your nonprofit is legally required to register its DBA, the following tips may be useful.
Contracts (Use Legal Name, dba Fictitious Name). A nonprofit may enter into contracts using a DBA, but in some states it cannot enforce such contracts until it has complied with the DBA registration requirements. If a nonprofit registers its DBA after it decides to enforce a contract, it could owe a penalty. To avoid this, just use the legal name plus the DBA in all contracts. Conversely, don’t worry if your counterparty uses a DBA. Organizations using a DBA may still have contracts enforced against them. Nevertheless, knowing the legal name of a counterparty can help in locating information about the organization, such as public filings.
Checks (Either Name Is Probably Fine). When writing checks, you may use either name, depending on what the recipient will accept (the name on the check should probably match the name on the underlying contract, but this is not required). When accepting and depositing checks, you may use either name, provided the bank will deposit the checks. Banks set their own rules, so it is worth inquiring.
Regulatory Filings and Policies (Use Both Legal Name and Fictitious Name). The IRS requires organizations to list both a legal name and any DBAs on tax filings. Corporate policies should likewise use the legal name (plus DBA, if desired), since these are part of the corporate record. Furthermore, many of these policies must now be attached to Form 990.
Promotional Materials (Probably Fine to Use Fictitious Name). There is no legal impediment to using DBAs on promotional materials. However, be careful if your DBA bears no resemblance to your legal name, since this can cause confusion. For instance, imagine that an organization legally named “Zebra Inc.” uses the DBA “Tiger” in its promotional material. If a benefactor leaves a bequest to “Tiger,” the executor and probate court may be confused about which organization is entitled to the funds. Similarly, an organization considering a DBA should research whether other organizations are already using confusingly similar names.
Project Materials (Use Fictitious Name, a Project of Legal Name). Organizations using a DBA for a particular project may have letterhead, etc., in the name of the project. To avoid confusion about whether the project is a separate entity or part of the existing organization, we recommend clarifying this (e.g., if the letterhead provides “Global Scholarships, a project of World Charity,” readers understand that Global Scholarships is part of World Charity, not a separate entity).
Can’t remember your nonprofit’s legal name? Check the articles of incorporation (or comparable founding document). Can’t find a recent copy? Order a certified copy of the articles from the Secretary of State (for California’s, click here). You can also search the Secretary of State business registry, available online in most states (California’s is available here).