Total compensation must be reasonable under federal law such that the organization complies with the private inurement doctrine. 
A 501(c)(3) organization must be organized and operated so that no part of its net earnings inures to the benefit of any private shareholder or individual.  It has long been held by the federal courts that “the payment of reasonable salaries by an allegedly tax-exempt organization does not result in the inurement of net earnings to the benefit of private individuals.”[1]

Assessing the reasonableness of compensation is largely a market driven analysis. 
An executive’s compensation is properly compared to individuals in similar positions at organizations of a similar size, in the same or a comparable geographical area, performing similar services.  The experience, expertise, and accomplishments of the individual are also taken into consideration.  It is appropriate to hire a qualified independent consultant to conduct a market analysis to ensure that compensation is reasonable.

The total compensation of an executive, and not merely the base salary or cash compensation, must be considered in determining whether compensation is reasonable. 
All compensation and benefits, including bonuses, deferred compensation, pension payments, and other perks not provided for legitimate business purposes are to be considered in calculating the total compensation at issue.

In the event that an executive is paid severance upon termination, any severance payments must be reasonable to assure compliance with applicable laws. 
The payment of excessive severance can itself be deemed excess compensation in violation of state and federal laws. An exception, for example, might be in connection with the reasonable settlement of a claim against the organization for improper termination.

Entering into a formal written contract with a senior executive can be advantageous for both the organization and the executive to ensure compliance with the laws governing executive compensation. 
Such a contract should set forth the duties and responsibilities of the executive, and thereby set standards for evaluating the executive.  It should also establish appropriate severance in the event of termination without cause.

Board members of charitable organizations in the various states have a fiduciary duty to preserve the organizations’ charitable assets, to supervise and oversee the administration of the organization’s’ assets, and to establish mechanisms designed to protect against the squandering or misuse of such assets.
This includes the authorization and payment of reasonable compensation and benefits to executives, and establishing mechanisms and internal controls to protect the organization’s expenditures.  Some states have specific laws requiring that compensation be reasonable.

The federal “intermediate sanctions” law, enacted by Congress in 1996, permits the IRS to impose excise tax penalties on charities executives who receive excess compensation (an “excess benefit transaction”) and on an organization manager or other person who is in a position to exercise substantial influence over the affairs of the organization.[2] 
In addition to paying a 25% excise tax on any excess compensation received, the executive must also make a correction and return the excess amount to the organization or face a confiscatory second tier tax.  The executive can be assessed the tax even if he or she acted in good faith and without knowledge that the compensation was excessive.

An organization manager can be assessed an excise tax only when he or she participated in an excess benefit transaction “knowing that it is such a transaction, … unless such participation is not willful and is due to reasonable cause.” 
If a board member or other organization manager has relied in good faith on professional advice that the compensation paid is reasonable, this would provide a strong defense against any IRS claim that excise taxes should be imposed.

It is significant to note that, under formal IRS rules, an executive is entitled to a rebuttable presumption that his or her compensation is reasonable if a three-step test has been satisfied.  

First Requirement: Compensation Fixed by An Independent Board
Board members must act independently and at arm’s length, and relatives and business associates of an executive should be excluded from any participation in fixing such individual’s compensation and benefits.

Second Requirement: Reliance on Appropriate Data as to Comparability
The IRS Regulations specify that the relevant information upon which the authorized body may rely “includes, but is not limited to, compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-exempt organization; current compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the services of the disqualified person.”

Third Requirement: Adequately Document Basis for Determination of Compensation
The board of a charity should, through formal board minutes, a written employment contract, an independent compensation survey, and/or other relevant documentation demonstrate the basis for the compensation paid.

Improper excess benefits can be quite varied. 
Areas which might be scrutinized by government regulators could include: purchases or leases of automobiles; payments of country-club dues; use of apartments, interest-free loans; travel expenses; use of charity credit cards without documentation; and blanket amounts to spend on expenses.

Summary: General Considerations in Fixing Compensation

• Decisions should be made by an independent board of directors at arm’s length.
• There should be Board minutes and/or other documents reflecting the criteria and basis for fixing compensation.
• Total compensation should reflect the fair market value of the executive’s services.
• Where appropriate, there should be reliance on an independent compensation survey.

[1] Founding Church of Scientology v. U.S., 412 F.2d 1197, 1200 (Ct. Claims, 1969), cert. denied, 397 U.S. 1099 (1970).

[2] The intermediate sanctions rules apply to both 501(c)(3) and 501(c)(4) organizations.  They do not apply to private foundations, as the well-established self-dealing rules in the Internal Revenue Code already barred payment of excessive compensation to executives of private foundations.

The post What Can They Be Paid? Advising Charitable Organizations on Executive Compensation first appeared on Perlman Sandbox.

Colleges/Universities
State regulators discussed issues faced by colleges and universities in 2020. Jim Sheehan, Chief of the New York Attorney General’s Charities Bureau, stated that financial hardship faced especially by small liberal arts colleges outside metro areas has led to an increase interest in mergers as a possible solution. He mentioned that his office has witnessed situations where a merger is the only way to save the mission of a financially distressed nonprofit college or university and, in this and similar circumstances where a merger is lawful, his office is generally supportive of this activity.

In addition, regulators are reviewing how colleges or universities forced to close due to the financial strain caused by COVID-19 might implement a teach-out plan for current students (a teach-out plan is an arrangement whereby a college or university provides current students with the opportunity to complete their course of study when the institution closes). Other common issues faced by colleges/universities in 2020 of interest to state regulators include (1) determining the circumstances when it may be appropriate to utilize a larger percentage of a college or university’s endowment fund; (2) whether a financially distressed college or university should borrow from a third party or liquidate otherwise illiquid assets; and (3) under what circumstances a college or university can remove donor-imposed restrictions on charitable contributions.

The NY Charities Bureau plans to issue guidance on the use of endowment funds for institutions facing financial challenges during COVID-19. Massachusetts has already released similar guidance.

Tanya Ibanez, Senior Assistant Attorney General in the California Attorney General’s Office of Charitable Trusts, mentioned that the California Attorney General is looking closely at for-profit schools converting to non-profit organizations.

Crowdfunding
State regulators are still considering carefully how to regulate crowdfunding platforms. Ms. Ibanez briefly discussed the California Attorney General’s support of California Assembly Bill 2208, which recently died in committee. Generally, the bill required charitable fundraising platforms to register and file annual reports with the California Attorney General’s Registry of Charitable Trusts before soliciting, permitting, or enabling solicitations in California. Ms. Ibanez said that she anticipates that a similar bill will be introduced in the California legislature’s next legislative session.

In the context of discussing regulation of crowdfunding, Leslie Friedlander, Assistant Attorney General in the Texas Attorney General’s Office, reminded listeners of the recent PayPal Giving Fund settlement entered into between PayPal Giving Fund and twenty-two (22) state attorneys general. A summary of that settlement and its implications, PayPal Giving Fund Enters Multi-State Settlement, was written by my colleague Karen Wu.  Ms. Friedlander also teased upcoming donor-facing guidance on crowdfunding to be released by NAAG/NASCO in the near future. The FTC has released guidance for donors on giving through an online giving portal.

Form 990 Reporting
State charity regulators are taking advantage of the increased availability and searchability of data about charitable organizations, particularly data filed with the IRS on Form 990, to find organizations that may warrant closer is scrutiny.

Mr. Sheehan explained that organizations which disclose governance weaknesses on Form 990, Part VI, are more likely to have other governance problems such as weak internal controls that can lead to serious problems of interest to regulators. He recommended that, in addition to Part VI, tax practitioners should pay particular attention to Form 990 Schedules J (Compensation Information), L (Transactions with Interested Persons) and O (Supplemental Information). Organizations should ensure information on these schedules is complete, correct, and that an organization does not simply copy and paste information on these schedules from year to year.

Ms. Ibanez added that two additional areas of interest to regulators are the percentage of total contributions received as gifts-in-kind and joint cost allocations. She mentioned that if, for example, an organization receives 70%-80% of total contributions as gifts-in-kind then that organization is likely on the California Attorney General’s radar for a potential audit to determine whether those gifts are being properly valued.

Donor-Advised Funds
Speakers also discussed issues that regulators are grappling with when it comes to contributions made to and from donor advised funds.

Carol Washington, Manager of the Minnesota Attorney General Charities Division, shared how her office recently engaged with the Minnesota Council of Nonprofits to discuss areas of mutual public policy focus with respect to donor advised funds. The Minnesota Council of Nonprofits prepared an extensive white paper on the operation of donor advised funds, including policy recommendations on how the state might regulate donor advised funds to improve transparency and ensure that the original donor’s intent is respected.

Board Engagement During COVID-19
In answer to a question about the need for increased board engagement during COVID-19, Eunice Nakamura, General Counsel, Susan G. Komen, emphasized the importance of the board meeting early and often and encouraging board members to be proactive in discussing strategies that can be implemented and actions that can be taken now that will help the organization to weather this crisis now and into the future. Courtney Aladro, Chief of the Non-Profit Organizations Division of the Massachusetts Attorney General’s Office, mentioned that another way boards have increased engagement during COVID-19 is to create specific committees focused on issues raised by the pandemic.

Incentive-Based Executive Compensation
Ms. Aladro was asked for her thoughts on organizations that approve incentive-based compensation in order to reward nonprofit executives for staying with the organization through the difficult circumstances presented by the COVID-19 pandemic. She explained that, even assuming the compensation was reasonable, a regulator might still raise questions about such an arrangement if, for example, the organization has offered such incentive-based compensation but at the same time has made the decision to lay-off lower paid workers in order to keep the organization afloat.

Virtual/Online Events
Sara Hall, Chief Legal Officer at St. Jude Children’s Research Hospital, discussed some very practical lessons her team has learned switching from in-person to virtual fundraising events. These include: (1) obtaining all trademark clearances (for event names, hashtags, etc.) and music licenses for the event; (2) vetting and engaging a vendor with experience facilitating multi-channel, multi-platform content; (3) projecting attendance (Ms. Hall mentioned that this is particularly difficult with virtual events since there is generally no translation from in-person events); and (4) being aware of that spammers and fake websites may pop-up prior and during the event. It is important to be ready to address these issues during the event in real time.

With respect to digital engagement, Ms. Hall reminded listeners not to forget about required disclosures when engaging an influencer as part of a virtual fundraising event. For more on that subject read Influencer Philanthropy and Social Media – What are the Rules, What are Best Practices? by my colleague Jeremy Coffey.

Online Fundraising – Charleston Principles
Brian Armstrong, Deputy Attorney General at the California Department of Justice, discussed regulation of online fundraising. He pointed listeners to the Charleston Principles (which he said is generally consistent with personal jurisdiction case law) to determine when registration may be required due to online activity. For more on this topic, please see Karen Wu’s excellent article recently published in The Nonprofit Quarterly.

The post The 2020 NAAG/NASCO Virtual Conference – Noteworthy Issues for Nonprofits first appeared on Perlman Sandbox.

Clients new to the world of private foundations (including clients who suddenly find themselves at the helm of family foundations) are often unsure of how to compensate directors, and if it is even legally permissible.  This is not surprising, since, at first glance, the law in this area is puzzling, and several different pieces of the law must be fit together to reveal the full picture.

Among the many peculiar and non-intuitive features of the tax rules for private foundations is that, in the first instance, compensation by a foundation to a “disqualified person” is categorized as an impermissible act of “self-dealing.”  (Foundation directors, their spouses, and their family members – among others – all fall within the law’s definition of a “disqualified person.”)  However, as with many areas of tax-exempt organizations law, this blanket prohibition is followed by a list of exceptions.  The key exception regarding compensation provides that payment of compensation by a private foundation to a disqualified person will not be considered impermissible self-dealing as long as the compensation is not excessive and the compensation is for “personal services which are reasonable and necessary to carrying out the exempt purpose of the private foundation.”

“Personal services” is not a defined term in the statute, but the Treasury Regulations include as examples of personal services: legal services, investment management services, and general banking services.  Further, the term is generally understood to include professional and managerial services rendered by a disqualified person in her capacity as an officer, director, trustee, or executive director of the private foundation.   Much ink has been spilled by others attempting to define “personal services,” and there is a hefty pile of private letter rulings devoted to the topic.  This is understandable since all self-dealing transactions, including impermissible compensation to a director, can result in excise taxes imposed on the self-dealer (e.g. an improperly compensated director), and in certain circumstances, on the other foundation managers and on the foundation itself.  One reason for this onoing uncertainty is that, in the leading case on this issue, Madden v. Commissioner of Internal Revenue, T.C. Memo 1997-395, 74 T.C.M. 440 (1997), the tax court held that the term “personal services” should be construed narrowly and that personal services are “essentially professional and managerial in nature.”  This of course begs the question:  what counts as “professional and managerial?”   That is a question for another day.  For current purposes, however, it is clear that non-excessive compensation to a director for her duties as a director falls squarely within the exception, and is therefore not “self-dealing.”

This background helps illuminate the odd way in which Form 990-PF is structured with respect to reporting on director compensation.  If a private foundation does compensate, or reimburse expenses of, a director or other disqualified person, the organization must answer “Yes” to question 1a(4) of Part VII-B on its Form 990-PF.  That question is straight-forward enough.  It simply asks:  did the foundation “pay compensation to, or pay or reimburse the expenses of, a disqualified person?”

Unfortunately, the crucial follow-up question “1b” is not nearly as straight-forward.  In my practice, I have seen that even experienced preparers will sometimes answer it incorrectly or simply leave it blank.   The awkwardly worded question, which cries out for an English teacher’s red pen, asks:  “If any answer is “Yes” to 1a(1)-(6), did any of the acts fail to qualify under the exceptions described in Regulations…?”  Unless a foundation is intentionally disclosing impermissible activity and including a check to the IRS for excise taxes, the correct answer to this question should be “no”.   By answering “no,” a foundation informs the IRS that “yes” – the compensation (or other transaction) is within the exceptions to self-dealing described in the Treasury Regulations, and therefore is permissible and not subject to excise taxes.

Perhaps what trips up preparers and foundation officials is the section heading for Part VII-B:  “Statements Regarding Activities for Which Form 4720 May Be Required.”   As most informed foundation managers know, Form 4720 is not a form you want to file.  Form 4720 is used to calculate and pay excise taxes for activities that are disallowed under the Internal Revenue Code, and private foundations almost never have a reason to file them voluntarily.  Since Part VII-B, Question 1b refers to the “exceptions” to “self-dealing,” preparers and managers may be eager to answer this question “yes” with the hope that doing so signals “yes, these activities were exceptions to self-dealing.”  However, because of the clunky wording of the question, the answer should almost always be “no.”   A private foundation intending to answer this question “yes” likely has bigger problems than bad grammar.

The post Form 990-PF Filers Beware! The Tricky Double Negative of Part VII-B first appeared on Perlman Sandbox.

As with most reactionary legislation and regulations, this ill-conceived proclamation fails to fully comprehend the collateral impact as it was guided by political expediency and the myth that high overhead cost equates with poor performance.

The Executive Order sets limits on administrative expenses and executive compensation to any entity regulated by a list of thirteen specified state agencies if those entities receive more than $500,000 in annual state support and at least 30% of their annual funding from the State (or from New York City or other local jurisdictions through State funded programs). EO #38 became effective as of July 1^st, 2013. (10 NYCCR Part 1002)

The regulations require that “covered entities” shall not use State funds to pay Executive Compensation (10 NYCCR Part 1002.5) in amounts greater than $199,000 a year unless (i) the entity obtains a waiver from the state; (ii) the compensation is paid from other sources; or (iii) the compensation is for direct services, and

• the compensation, regardless of its source, is not greater than the 75^th percentile of compensation paid to comparable executives as established by state recognized compensation surveys; and
• the Executive compensation is approved by the entity’s board of directors or compensation committee after reviewing the comparability data and surveys.

EO #38 also limits Administrative Expenses (10 NYCCR 1002.2a), calculated as a percentage of total operating expenses, to no more  than 15% of the funds provided by the State or from State authorized funds. (This limit started at 25% in 2013 and was reduced to 15% in 2015.)

To complicate matters, the covered entity may obtain a waiver of the compensation and administrative expense limits if the entity can demonstrate “good cause” by showing that the availability and quality of the program services will be negatively impacted due to the nature, size, and complexity of the programs funded. If the covered entity fails to comply with these rules or obtain the appropriate waivers from one of the thirteen State Agencies (each of which appear to have their own process for obtaining a waiver), the entity is subject to suspension, modification or termination of its State funded service contracts and/or its Office of Mental Health (OMH) or Department of Health (DOH) license. Non-compliance can potentially be cured through a corrective action plan approved by the State. The entity can also file an administrative appeal of the sanctions.

The Conflict:

From the start, the proclamation has been controversial with state funded nonprofits and exceptionally difficult to administer. In response to an outcry from major health care providers a waiver system was enacted. In addition, further changes to the implementing regulations stirred additional controversy (10 NYCRR sub-part 69-4). The Department of Health (DOH) adopted amendments to address potential conflicts of interest involving early intervention program evaluators. This change in the conflict of interest rule in conjunction with the burden of the other limitations appears to have stimulated covered providers to challenge EO # 38 in court.

Tale of Two Cases:

Case 1  In an April 2014 decision, the Nassau County Supreme Court agreed with the challenging agency’s theory alleged in its suit (Agencies for Children’s Therapy Services, Inc. v. NYS Department of Health et al), which challenged the validity of the Governor’s action as a violation of the separation of powers doctrine. The suit claimed that the state legislature, not the Governor, had the power to enact rules governing state funded executive compensation, administrative expense limitations and conflict of interest rules at private facilities and that the legislature in its 2012 budget evinced no legislative intent to do so.

The Court held that the DOH “usurped the role of the legislature in making public policy assessments” and that DOH lacks “the authority to determine how much a for-profit entity may pay executives and how much to expend on administrative expenses.”

Case 2   In a very similar case brought in the Suffolk County Supreme Court (Concerned Home Care Providers, Inc. v. NYS Department of Health, et al.) the Court ruled that EO #38 and its implementing regulations were a constitutional exercise of Executive power. This decision was completely contrary to the holding in Agencies for Children’s Therapy Services, Inc. Suffolk County Supreme Court Justice Pines concluded that the regulations “are well within the legislatively mandated policy and “that inherent in such authority is the power to determine the terms of such contract so long as they do not deviate from other legal authority.”

The Appeal:

Emboldened by the decision of Judge Pines in Concerned Home Care Providers, the DOH appealed the adverse decision in Agencies for Children’s Therapy Services. On December 30^th, 2015 the Appellate Division 2^nd Department (New York’s intermediate Appeals Court) issued a surprising decision. It reversed the holding in Agencies for Children’s Therapy Services and found that the DOH had not violated the standards enunciated in the precedent setting Court of Appeals decision Boreali v. Axelrod.

 The Appellate Court ruled that the DOH is statutorily required to award service contract “on the basis of best value  . . . in a manner that optimizes quality, cost and efficiency.” The Court went on to state that “ the administrative cost and executive compensation limits contained in the use-of-funds rule are not inconsistent with the above statutory provisions or the underlying purpose of obtaining high quality services with limited available funds.” In what appears to be a stretch by the Court, it went on to determine that high quality services are made available “by ensuring that the DOH awards service contracts to agencies that will use most of the tax dollars they receive directly on the provisions of services rather than upon administrative overhead and executive compensation.”

Clearly, the Court bought into the often challenged and widely discredited theory that lower overhead and executive compensation expenses ensure optimized quality, lower costs and better efficiency. From where and how the Court formed this notion is not clear. —I suspect they simply believe it is common knowledge.  Unfortunately for New York service agencies and the philanthropic sector at large, there is nothing common or empirical about this equivalence. This decision illustrates the uphill battle that the charitable sector faces in convincing the public and our public servants that broad restrictions on the ability of charities to use their funds to appropriately scale and attract much needed talent is counter-productive and ultimately handicaps service providers’ ability to impact and solve difficult social problems.

The New York State Court of Appeals (New York’s top Appellate Court) has issued a stay of the decision in the Agencies for Children’s Services decision pending the outcome of its decision on the appeal of the lower Court’s decision. We shall see if these justices fall prey to the same misguided notion of charitable efficiency and impact which guided the decision of the lower Court.

The post New York Court Upholds Governor Cuomo’s Arbitrary Restrictions on Executive Compensation first appeared on Perlman Sandbox.