The IRS prohibits tax-exempt organizations from engaging in activities that are illegal or contrary to public policy. Given the nature of the rally (an attempt to rally support to overturn the results of a presidential election) and its aftermath (an illegal and violent insurrection at the Capitol), some nonprofits that helped organize the rally could have their tax-exempt status revoked under the illegality and public policy doctrines. In this piece, I review the IRS’s rules, discuss how they might apply to the rally, and offer suggestions for nonprofits that want to avoid getting in trouble with IRS.

The Background
Under longstanding IRS rules, tax-exempt organizations must be organized and operated for exempt purposes. An organization is deemed to NOT be organized and operated for exempt purposes if its activities are illegal or contrary to public policy. (For a more detailed discussion of Illegality & Public Policy, see the IRS’s EO CPE Texts from 1985 and 1994). The illegality doctrine acts as a check to assure that the federal government does not support through tax exemption an organization engaged in behavior the government is charged with preventing. Similarly, the public policy doctrine ensures that the federal government isn’t supporting behavior that adds to government’s burdens. To determine whether a nonprofit might lose its exemption, the IRS looks to the nature and extent of the activities carried on by the organization.

The centrality of the improper activities to the nonprofit’s overall purpose is important. If the nonprofit is organized to accomplish an illegal purpose, it should never qualify for tax-exemption in the first place. In other words, if any of the nonprofits that sponsored the January 6 rally had as their central purpose “the armed overthrow of the U.S. government”, they would never have been recognized by IRS as tax-exempt in the first place.

Even if a nonprofit qualifies for tax-exemption, if its activities are illegal or contrary to public policy, the nonprofit may have its tax-exemption revoked. In determining whether illegal activity will lead to revocation of tax-exempt status, the IRS looks at whether the illegal activities were “substantial”, both in terms of how much time and attention were spent on the illegal activity, including the extent to which the illegal activity can be attributed to the organization by virtue of the involvement of its directors or officers or through clear ratification of the organization’s governing body (i.e., quantitatively substantial), as well as the seriousness of the illegality involved (qualitatively substantial). If a group is organized around a permissible exempt purpose, but engages in an isolated egregious illegal act, it could have its tax-exempt status revoked, notwithstanding the fact that a majority of its other activities are law-abiding.

The Seminal Case – Bob Jones University (461 U.S. 574 (1983))
The case that is often cited to explain the illegality doctrine is Bob Jones Univ. v. United States, a case from the 1970s and early 1980s, in which the Internal Revenue Service sought to revoke the University’s tax-exemption because it denied admission to applicants who were either “engaged in interracial marriage or known to advocate interracial marriage or dating.” The case was joined with another, involving the Goldsboro Christian Schools, which maintained “a racially discriminatory admissions policy based on its interpretation of the Bible, accepting… only Caucasian students.”

In the combined Bob Jones cases, the IRS had laid the groundwork by first telling all tax-exempt organizations in a Revenue Ruling that it could no longer justify tax-exempt status for any school that operated in a racially discriminatory manner. (Rev. Rul. 71-447). The IRS determined that to qualify under traditional understandings of the term “charity”, an organization must not act illegally or contrary to public policy. In the IRS’s opinion, the United States had a compelling interest in eradicating racial discrimination in schools.

Both Bob Jones University and Goldsboro Christian Schools claimed that their religious beliefs required the racially discriminatory policies. The Supreme Court nonetheless found that national policy was clearly in favor of racial nondiscrimination and, therefore, the IRS was justified in its requirement that schools operate without discriminatory policies. In other words, the Court determined that the government’s interest in overseeing racially nondiscriminatory schools was so compelling that it overrode the First Amendment interests asserted by the schools.

Holding Groups Responsible For Actions by Members
Next, we should look at whether and how the IRS would hold an organization responsible for the actions its members (or attendees) take. As a general matter, an organization is not responsible for the actions of its members except where the organization “authorizes, advocates for, or ratifies” the members’ acts. If an organization urges its members to commit illegal acts, the organization may find itself subject to consequences, either through revocation of its tax-exempt status or civil action. The standard used in at least one IRS ruling (Rev. Rul. 75-384) was that those illegal activities “which violate the minimum standards of acceptable conduct necessary to the preservation of an orderly society, are contrary to the common good and the general welfare of the people in a community” would disqualify an organization from exemption under 501(c)(4). Similarly, if an organization “induces or encourages the commission of criminal acts by planning or sponsoring” events and, through criminal acts committed by its members, increases the burden on government, the IRS may revoke exemption under 501(c)(3).

Much of the guidance on illegality and public policy revocations is dated, but a new case related to protest activity and liability is instructive to see how our modern courts view organizer liability for actions by attendees at a protest event. A civil case currently winding its way through the courts, McKesson v. Doe, deals with the bounds of First Amendment protection for organizers. In the McKesson case, a police officer was injured by a rock thrown by an unknown protestor at an event where the attendees illegally occupied a roadway. There was no allegation that the organizers intended or foresaw that a rock would be thrown at the protest, but the court recognized that a jury may find that blocking the roadway was authorized, directed, or ratified by the organizers. The Fifth Circuit determined that because rock throwing was a consequence of the illegal activity that the organizers “authorized, directed, or ratified” (blocking the roadway), the organizers could potentially be held liable.

While McKesson v. Doe is far from finished and rests heavily on Louisiana civil law, the discussion by the Fifth Circuit and Supreme Court is instructive for the organizers of the March to Save America who may try to invoke the First Amendment as a shield from being held responsible for their attendees’ actions, whether in a civil case or for possible action by the IRS. If the violence that erupted at the March was more foreseeable than the rock throwing in the McKesson case – if the March’s organizers had notice that violence was a likely consequence of their event and if the March’s organizers invited speakers who they knew, or should have known, would increase the risk of violence – the McKesson case suggests that the First Amendment may not shield the March’s organizers from liability.

The March To Save America
Organized and supported by tax-exempt 501(c)(3) and 501(c)(4) organizations, among others, much of the content of the speeches at the March was a continuation of what those speakers and the nonprofits’ leaders had been saying since the November election – that the election result was somehow invalid (despite no evidence), should be overturned (despite numerous failed attempts in court to do just that), and that supporters of the outgoing President should “fight” to make sure the electoral college votes were tallied appropriately. This history is important under the IRS’s tests to determine whether the attendees’ violent and illegal insurrection at the Capitol is attributable to the organizers (discussed above). If the attendees’ behavior was “authorized, advocated for, or ratified by” the organizers, the IRS may try to attribute the violence in the Capitol to the organizing groups as it assesses whether to revoke their exemption. This might also be the case if a civil litigant injured in the melee and seeks recompense.

The nonprofits involved in the March might argue that the attendees’ later violent behavior should not be attributed to them.  As discussed earlier, the default rule is that organizations are not held accountable for unauthorized activities of their members. Should the IRS pursue any action against the groups, some important considerations will be whether the March’s nonprofit organizers can demonstrate that they did not authorize, advocate for, or ratify the violent actions of their attendees. How they must show this is less clear; they may try to show that they took steps to consider and minimize the likelihood of violence when they invited certain speakers, to try to avoid inflammatory rhetoric at the event, or simply miscalculated the levels of security and other precautions typically required of an event of this size.  Because many of the groups and their leaders have condemned the violence at the Capitol, it could undercut IRS’s argument that the groups condoned or ratified the resultant violence.  Whether that is sufficient to avoid liability or a revocation by IRS remains to be seen.

It’s important to note that the illegality and public policy doctrines are related, but separate.  Consider, then, whether the nonprofits’ peaceful and intentional activities at the March, namely a rally to protest a free and fair election, could be sufficient reason for a revocation as a violation of public policy. The Bob Jones case established that a nonprofit’s exemption can be revoked where no illegality is alleged but because the nonprofit’s activities are so contrary to public policy that they should not be condoned by the federal government with tax exemption. Challenging the tallying of the electoral votes without any real basis, even without illegality and acts of violence, may amount to a violation of the public policy doctrine – it is hard to think of a more central public policy in a democracy than the peaceful transfer of power. The IRS would never provide tax-exemption to an applicant whose stated purpose was to “challenge federal elections and undermine public faith in our democratic institutions, regardless of whether there is any basis to do so.” Yet that appears to be what those groups did, notwithstanding that they would argue they were simply ensuring all “legal” votes were counted.

Lessons to Be Learned
A nonprofit that plans to organize an event that deals with a topic likely to inflame the passions of its supporters must carefully consider how they will manage the risk of aggressive behavior by participants.  The goal is not only to avoid violence, but also to avoid any attribution of it to the organization.  The following are suggested steps to ensure both the protection of the public and the nonprofit organization.

1. Carefully vet the speakers

It may be tempting to invite a popular figure who is supportive of the cause.  If that person has a history of advocating violence, illegal behavior, or is prone to fiery language, it will likely creates a greater risk of inciting the crowd to dangerous behavior. Researching potential speakers before invitation is crucial, including a review of news coverage, social media accounts and other speaking engagements.

2. Develop written guidelines for the speakers

This is useful in many contexts (for instance, many nonprofits want to ensure their events don’t stray into politics, which is strictly prohibited for 501(c)(3) organizations). The guidelines will differ based on the nature of the event, but in general make should sure that speakers specify whether they are speaking on behalf of any organization and that they avoid topics or statements that could get the nonprofit in trouble (or are otherwise contrary to the views or interests of the organization).

3. Monitor the speech and have a plan to pull the plug on any speakers who violates the guidelines.

This step is a last resort in case the speaker makes statements that are inflammatory, advocate illegal activity, or otherwise overstep the guidelines the nonprofit has established. The organizers must monitor the speakers’ statements and be prepared to step in the immediately. If improper statements are made, the nonprofit should swiftly disavow any language considered improper if it were spoken by the nonprofit or its executives.

4. Make sure other safeguards are in place.

Large events require infrastructure.  A reliable vendor can help assess how best to safeguard participants and the public.  However, the organization that sponsors the event bears the ultimate responsibility for ensuring that basic issues are taken care of – the safety and security of the attendees, speakers, and surrounding community being the foremost concern. The organizers should give ample notice to potential attendees that certain guidelines must be followed – for instance, no weapons. And the organizers should coordinate with local authorities not just to secure any necessary license but also to ensure that adequate manpower is available to oversee and support the event.

Conclusion
We don’t know yet whether there will be any consequences for the organizations involved in the January 6 March for America. If IRS chooses to enforce its illegality and public policy doctrines, the nonprofits may have left themselves vulnerable. Nonprofit professionals can use the episode as a learning experience to avoid such catastrophe in the future and protect their organizations.

The views expressed here are those of the author which, do not necessarily represent the views of the Firm.

The post Nonprofits and the “March to Save America”– Lessons for Responsible Nonprofits first appeared on Perlman Sandbox.

That means that organizations and companies that choose to take this payroll tax deferral would then withhold additional amounts from those affected employees’ paychecks from January 1, 2021 through April 30, 2021 to repay that deferred tax obligation.  The payroll tax deferral would not excuse the requirement of payment of such taxes. Additionally, the deferral is not retroactive meaning that an employer may only defer payment of taxes prospectively through December 31, 2020 (it may not include deferral of taxes or reimbursement of taxes to employees that were already withheld starting September 1).

There remain questions about the legality of President Trump’s memorandum in the absence of approval from Congress which constitutionally holds the power over the federal “purse strings”— to tax and spend public money for the national government. Although the Internal Revenue Service (IRS) issued guidance on August 28, 2020 (Notice 2020-65), employers are still awaiting further IRS guidance regarding how the deferral would be implemented, including whether (or how) an employee’s obligation to pay those deferred taxes or an employer’s obligation to withhold will be forgiven in the absence of Congressional approval, written confirmation that the choice of whether to implement deferrals rests with the employer, not the employee, and employer obligations with respect to such taxes if an employee is no longer employed with that employer at the time that repayment is due.

The payroll tax deferral is simply a deferral, not a forgiveness of taxes.  If an employer does not pay the deferred payroll tax to the IRS by April 30, 2021, it could potentially be liable for penalties, interest and late fees.

Organizations should confer with their legal counsel and accountant before deciding to defer payroll tax withholding and to discuss structuring any agreements with affected employees concerning repayment if those organizations do decide to defer payroll tax withholdings.

The post Employee Payroll Tax Deferral Causes Confusion and Uncertainty for Employers first appeared on Perlman Sandbox.

I. Federal Tax Code Limitations on Public Charity Lobbying and Political Campaign Activities

Advocacy
A public charity can engage in an unlimited amount of advocacy in furtherance of its exempt purposes as long as that advocacy does not constitute lobbying or political campaign activity. This type of unrestricted advocacy may take many forms, including public education, nonpartisan research, and nonpartisan voter education, and can lay the groundwork for future lobbying activity.

Lobbying
What is Lobbying?
The Code recognizes two types of lobbying – direct lobbying and grassroots lobbying. In order for advocacy to be considered direct or grassroots lobbying, the communication must reflect the organization’s view on specific legislation.  “Legislation,” in this context, includes action by Congress, a state legislature, local council or similar governing body, and the general public in a referendum, initiative, constitutional amendment, or similar procedure. It generally does not include action by an executive branch of government or independent regulatory agencies.

Direct lobbying refers to attempts to influence specific legislation through communication with a member or employee of a legislative body or a government official who participates in the formulation of legislation.  A “member of a legislative body” generally includes members of Congress, state legislators, county supervisors and commissioners, city council members, members of international bodies with legislative power, legislative staffers, and the general public when voting on a ballot measure. Communication with other government employees, such as executive or administrative officials and staff, will be considered lobbying if those officials participate in the formulation of legislation and the purpose of the communication is to influence legislation. However, in general, communication with judges, executive branch officials, school board members, members of other similar local special purpose bodies, and members of the public when not voting on ballot measures do not qualify as communication with a member of a legislative body, and are therefore excluded from  the definition of “direct lobbying.”

Grassroots lobbying refers to attempts to influence specific legislation by urging the public to take action with respect to the legislation. Common actions that constitute grassroots lobbying include: (1) directing the public to contact a legislator for the purpose of influencing legislation, (2) providing the contact information for a legislator, (3) providing a means to contact the legislator (e.g., a petition or postcard), or (4) publicly identifying a legislator as being opposed to or undecided about the organization’s view on the legislation.

Public Charity Lobbying Limits
A section 501(c)(3) public charity may engage in direct or grassroots lobbying as long as it does not devote a substantial part of its overall activities to lobbying activities (the “substantial part test”). There is no bright line rule stating what constitutes a “substantial” amount of lobbying activity. Whether an organization has devoted a substantial part of its activities to lobbying depends on all facts and circumstances, including the time of both compensated and volunteer workers devoted to lobbying activity and lobbying expenditures. If a public charity engages in a substantial amount of lobbying activity in any one year, the Internal Revenue Service (IRS) can revoke its tax-exempt status causing all of the organization’s income to be subject to tax. In addition, the IRS may impose a tax equal to 5% of lobbying expenditures on the organization and, separately, on any manager who agreed to make the expenditures knowing the organization would likely lose its tax-exempt status.

There is little guidance about what constitutes “substantial” lobbying activity and the consequences resulting from a violation of the substantial part test are severe. As a result, many organizations desire a more definite set of rules. Fortunately, Congress responded in 1976 when it enacted Code Sections 501(h) and 4911 setting forth the “expenditure test” as an alternative to the substantial part test. Charities seeking clearer limitations for their lobbying activities may elect to be subject to the “expenditure test” instead of the substantial part test by filing Form 5768 with the IRS (also known as making “a 501(h) election”).

While the substantial part test takes into consideration all facts and circumstances, including time spent by volunteers on lobbying activity, the expenditure test is concerned only with an organization’s lobbying expenditures. Under the expenditure test, lobbying will not jeopardize a charity’s tax-exempt status unless the organization’s lobbying expenditures exceed 150% of the lobbying expenditure allowance set by the Code taking into account the current year and the previous three years. For the first three years of its first election an organization need only take into consideration the years in which the election has been in effect as long as its lobbying expenditures do not exceed 150% of the lobbying expenditure allowance for those years . A public charity that has made a 501(h) election can spend up to twenty-five percent (25%) of its lobbying expenditure allowance on grassroots lobbying or up to the entire amount on direct lobbying. Lobbying expenditures in excess of this allowance will be subject to a 25% tax. Also, for electing charities, the Code exempts certain activities from the definition of lobbying including nonpartisan analysis or research, discussions of broad social, economic, and similar problems, requests for technical advice, and certain “self-defense” communications made by the organization to a legislative body or its representatives.

Political Campaign Activity
In addition to placing limits on lobbying activity, the Code prohibits a public charity from engaging in political campaign activity. An organization engages in political campaign activity when it participates or intervenes, directly or indirectly, in any political campaign on behalf of or in opposition to any candidate for public office. Whether an organization is participating or intervening in a political campaign depends on all of the facts and circumstances of each case. The IRS often looks for whether the communication, in content, structure, or distribution, evidences a bias or preference with respect to the views of any candidate or group of candidates. A “candidate for public office” is anyone who offers himself or herself, or is proposed by others, as a contestant for an elective office at the federal, state or local level. Participation in a political campaign might include actions such as endorsing or supporting financially a candidate for public office, a political party or a political action group or making statements in favor of or in opposition to a candidate. Certain voter education activities, such as releasing voter guides or legislative scorecards can, if structured appropriately, be conducted in a non-partisan manner and not constitute political campaign activity. A public charity that engages in any political campaign activity will lose its tax-exempt status.

II. Creating an Affiliated 501(c)(4) Organization

The limitations placed on public charity lobbying and political campaign activity may not allow a charity to engage in the level of advocacy necessary to achieve a desired policy outcome.  One option in this instance is to establish a 501(c)(4) social welfare organization. Contributions to a 501(c)(4) are not deductible as charitable contributions, but 501(c)(4)s may engage in an unlimited amount of lobbying as long as the issues relate to the exempt purpose of the organization. In addition, 501(c)(4) organizations may engage in limited political campaign activities, subject to campaign finance laws, as long as these activities are not its primary activity. Charities should consider the operational and strategic implications of this decision, including:

• if there is a sufficient donor base to support a new 501(c)(4) organization;
• if additional advocacy tools will complement the 501(c)(3)’s advocacy efforts;
• whether the organization’s policy issue has been politicized in a way that makes it difficult to discuss in a non-partisan manner; and
• the effect of establishing an affiliated 501(c)(4) on the organization’s reputation.

Below are a few more considerations for public charities that plan to establish an affiliated 501(c)(4) organization.

Legal Separation
The 501(c)(4) must be a separate legal entity from the 501(c)(3). Usually, 501(c)(4) organizations are established as corporations under state law and, as such, are required to observe corporate formalities. The two organizations should maintain their own books and records, bank accounts, mailing addresses, and file their own tax returns and applications for tax-exempt status.

The board of directors of the 501(c)(4) organization must operate independently from the 501(c)(3), including holding distinct meetings. The 501(c)(3) and 501(c)(4) may have board members in common. If the boards completely overlap, careful attention must be paid to keep meetings and decisions separate so that it is clear which board is acting at a given moment. Even with careful recordkeeping, there are reasons to keep board overlap to a minority of the board. Minority overlap will allow the disinterested majority of the board of each entity to approve financial transactions (e.g., grants or loans) between the entities and protect the interests and separate existence of both entities. Further, if the 501(c)(4) will engage in any political campaign activity, it is often advisable to increase the separation between the two entities to reduce the risk that any political activity of the (c)(4) may be attributed to the 501(c)(3).

Financial Separation
A 501(c)(3) must not subsidize the day-to-day operations of an affiliated 501(c)(4). If the two entities will share office space, equipment, and/or staff, the (c)(4) must pay its share of the cost. Typically, this arrangement is memorialized in a written cost-sharing agreement.

Shared employees should keep written time records in order to support allocation of salary between the two organizations. This is critical if the (c)(4) will engage in political campaign activity since the (c)(3) may not directly or indirectly support the political activity of the (c)(4).

As in the case with employee time, the (c)(4) should pay its fair share for any office space or equipment used so that the (c)(3) is not subsidizing the (c)(4)’s activities. The (c)(4) might sublease office space from the (c)(3) at fair market value, pay its share of the rent to the landlord directly, or even pay the full amount of rent and allow the (c)(3) to occupy the space free of charge.

Operational Separation
The charity may not control or give the appearance that it controls the everyday activities of the (c)(4). The (c)(3)’s and (c)(4)’s purposes may align, but each organization should maintain and document its own levels of authority and responsibility in day-to-day operations. Set up good legal compliance systems from the beginning and train staff so they know these systems and can make sure they function effectively.

There are a number of other considerations when establishing an affiliated 501(c)(4) organization, including issues related to applying for tax-exempt status, startup costs, joint fundraising, grants or loans between the organizations, and whether the two entities can share other resources, such as donor lists or a website.  To navigate these issues, it is helpful to seek qualified counsel.

The post Public Charities, Lobbying Limits, and Affiliated 501(c)(4)s first appeared on Perlman Sandbox.

An IRA allows an individual to save for retirement using pre-tax money. Generally speaking, the earnings and gains in an IRA aren’t taxed until distribution. Once the individual reaches 70½, they must to begin taking distributions from their IRA. Failure to do so may subject them to penalties from the IRS.  Distributions from the IRA are taxable in the year they’re received.

Alternatively, there is a happy exception that benefits both charities and donors! The individual can make a “qualified charitable distribution” to a charity, which is not taxable, up to a maximum amount of $100,000 per year. If the donor exceeds the $100,000 cap, the excess distribution is taxable. Sadly, this option is not available for ongoing SEPs (wherein contributions continue to be made) or SIMPLE IRAs.

There are a few restrictions – the donation can’t go to a supporting organization, nor can it go into a donor-advised fund. The charity needs to treat the donation like any other, by issuing an acknowledgement. Most importantly, the donor (and the IRA trustee) should confirm that the recipient organization is a tax-exempt public charity.

The post Qualified Charitable Distributions from an IRA – It’s not too late! first appeared on Perlman Sandbox.

Some donor advisors request the DAF to purchase a ticket to a charitable event, such as a gala, in order to support a charity of their choice. Typically, such tickets cost more than the fair market value of what the purchaser receives in return, such that when purchased directly (not through a DAF), the purchaser enjoys a tax deduction on the price of the ticket exceeding the fair market value.

The charitable community sought guidance on a DAF’s purchase of tickets, specifically regarding whether DAFs could pay the charitable portion of the ticket cost (i.e., the part above fair market value). According to the proposed regulation, however, the prohibition would be absolute. The DAF cannot pay for any portion of the ticket, regardless of the fact that if a person bought the ticket directly, he or she would receive a charitable deduction for the portion of the ticket over and above fair market value.

The proposed IRS regulations place the primary burden of compliance on the donor advisor, who would be fined if the funds in the DAF were used for ticket purchases. Potential excise taxes may also be imposed on any fund manager of the sponsoring organization who authorizes such a payment knowing it would confer a prohibited benefit. Charities and DAFs should take note and bar these types of payments, as donors may unwittingly advise DAFs to pay for tickets and in so doing, putting the donor advisor and the sponsoring organization at risk of being fined. This might sour relations between the donor and the sponsoring organization. Charities and DAFs are therefore advised to take affirmative steps to ensure that any donations made by DAFs are prohibited from being used to purchase event tickets.

The post Stop! Purchase of an Event Ticket with DAF Dollars Could Land You in Hot Water with the IRS first appeared on Perlman Sandbox.

On July 16, 2018, the IRS issued Revenue Procedure 2018-38. Under the pending rule modification, many nonprofits, including 501(c)(4), (5), and (6) organizations, that  must include the donor information  on Schedule B  will no longer be required to do so. (Other organizations formed under Section 501(c)(3) or Section 527 will still need to provide it on Schedule B.) The change takes effect for tax years ending on or after December 31, 2018. The move by IRS to limit its collection of contributor information has been met with both cheers and jeers, which I summarize below.

Cheers

In the eyes of those supporting the change to the reporting requirements, the collection of contributor information represents a chilling of free speech and a donor’s right of association and privacy. The supporters also point to the IRS’ occasional inadvertent disclosure of donor information, making the case that removing the requirement to submit it will further insure protection of the contributors’ speech and privacy rights. The argument is also made that the IRS has no need for the information except in the case of an audit. For its part, the IRS reasons that the reporting and redacting of donor information is a waste of time and resources for both the agency and nonprofits.

Jeers

Critics of the move argue that the IRS is inviting additional improper funding into so called “dark money” groups (such as 501(c)(4) organizations) which have become increasingly active in American elections since the Citizens United Supreme Court decision in 2010. Since donors to these groups already avoid much of the public disclosure required of traditional political organizations, the fear is that the new rule invites abuse of existing campaign finance laws, including foreign contributions. Critics are also quick to point out that the IRS’ change came on the same day news outlets reported an arrest of a Russian national accused of attempting to improperly influence American politics through, among other things, the influence of U.S. nonprofit organizations.

Further, the adversaries note that inadvertent disclosures made by the IRS of protected information have been rare and do not appear to have chilled the free speech activity of those organizations. As to the IRS’ rationale that its rule change protects limited resources, they counter that the Schedule B change will increase initial investigatory costs as the request for donor information will have to be assessed and handled on a case-by-case basis. When the IRS needs to audit an organization’s financials, it will create even more work for IRS agents and nonprofits and could result in more frequent and invasive audits.

States Seek to Shine a Light on Dark Money

The new rules by the IRS may be made less relevant by state legislatures. New York, as an example, recently enacted a statute requiring both 501(c)(3) organizations (public charities and private foundations) who provide support to 501(c)(4) organizations (advocacy organizations) in excess of $2,500 in any six  month period, regardless of the purpose and the form of that support, to reveal its major donors on a public website established by the Attorney General’s office. In addition,  the new law requires that 501(c)(4)s that expend more than $10,000 in any one year on broadly communicated lobbying type activities also report their donors on the Attorney General’s  public website. (For a more in-depth discussion see:  Shining a Light on Dark Money: Floodlight or Flashlight ).  Although they are unlikely bedfellows, Citizen’s United and the ACLU have each challenged the new statute, resulting in a stay of its implementation.

Practical Effect

One thing the supporters and critics agree on is that IRS rarely uses the contributor information it currently collects, and nonprofits will still be required to keep records of their donations. The rules regulating the nonprofit sector are under-enforced at the federal level.  State charities regulators tend to be on the front lines of enforcement. The IRS’s change may have the effect of encouraging proactive states, as New York has done, to begin requiring contributor information as part of state filing and disclosure requirements. Regardless of how the states react to the decreased disclosure and transparency, the clear message to the nonprofit sector is that the current administration places less of an emphasis on transparency than its predecessors.

Just In

In late breaking news, the Governor of Montana, Steve Bullock (D), sued the Trump administration to void the new rules stating that it would  undermine the state’s ability to regulate nonprofits and make it harder to police illegal spending in political campaigns. It should be noted that Montana has some of the least rigorous oversight of charitable activities of any state in the country and as a result they depend heavily on the information filed with the IRS.  Undoubtedly, other states are likely to follow Montana’s lead as well.

The post Left In the Dark, IRS Moves to Limit Donor Transparency first appeared on Perlman Sandbox.

Newman’s Own Foundation needed the new law to avoid a requirement that it divest itself of at least 80% of No Limit under the “excess business holdings rule” of Internal Revenue Code Section 4943. The excess business holdings rule generally prohibits a private foundation from owning more than 20% of a for-profit company. It imposes extreme penalties on a foundation that are equal to twice the value of the holdings above the 20% limitation. In most cases, this will completely destroy the value of the “excess” holdings to the foundation. The new law creates an exception to the excess business holdings rule for foundations that own 100% of a business and devote all profits to charity.

Foundations that acquire more than 20% of a company normally have a five-year deadline to sell their excess holdings before the penalties apply. Newman’s Own originally faced that deadline in 2013 but was able to get a five-year extension that would have expired this year. The passage of the new law relieves Newman’s Own from the requirement that it divest itself of No Limit, meaning it can continue operating as it always has without interruption.

New law, new rules
The new law, Section 4943(g) of the Internal Revenue Code, permits a private foundation to own 100% of a company under the following conditions:

1. The foundation must own 100% of the shares. There cannot be any other shareholders, and the shares must have been donated to the foundation or acquired in some manner other than by purchase.
2. All profits must go to charity. The company has to distribute 100% of its net operating income to the foundation within 120 days of the end of each fiscal quarter. Net operating income is defined as gross income minus taxes, deductions directly attributable to the production of income, and an amount for a reasonable reserve.
3. The for-profit company is operated independently of the foundation. First, no substantial donor to the foundation can be a director, officer, or employee of the company. A substantial donor is someone who donates more than 2% of the foundation’s total contributions in a given year, and it includes these who donated shares or anything else of value to the foundation, if their donations exceed 2% of contributions to the foundation for the year. Second, a majority of the company’s directors have to be persons who are not also on the foundation’s board. Finally, the company may not make loans to substantial donors of the foundation.
4. Donor-advised funds and some supporting organizations cannot take advantage of the new law. Donor-advised funds and non-functionally integrated Type III supporting organizations are specifically excluded from the new law, thus are still subject to the 20% rule.

The new law, which took effect December 31, 2017, opens a world of possibilities for founders of companies that want to devote all profits from their businesses to charity, allowing them to place their companies under the ownership of a private foundation and permanently devote all profits to charity.

One way to adopt this model is to have the founder or the shareholders donate their shares to a foundation. They get a tax deduction for the value of their shares, but no buy-out. Since this is a gift, not a purchase, donating the shares satisfies the requirements of the new rule. The donations can happen anytime or even over time, but the new rule does not apply until 100% of the shares have been transferred to the foundation.

Under the new law, a total separation of the two entities is not required. The for-profit company will continue to be governed by its own board and managed by its own managers, with appropriate separation from the foundation. The new law permits the foundation, as the sole shareholder, to appoint the board, and the foundation may also hold other rights, depending on the jurisdiction where it was formed. For example, in many states, a sole shareholder has the right to inspect the books and records of the company and to sue the directors for breach of fiduciary duty (including the duty to pursue a social mission, if the company is a benefit corporation.) The shareholder may also reserve to itself the right to approve mergers, sales of assets, dissolutions, and to veto other fundamental decisions.

Profits of the business will be up-streamed to the foundation in the form of after-tax corporate dividends or, in the case of a pass-through LLC, as partnership distributions, in which case the tax on unrelated business income may apply.

We are sure to see a growing number of private foundations take ownership of profitable businesses as a result of this new law. It also offers another option for founders of mission-oriented companies who want a philanthropic exit that locks mission into the company on a permanent basis.

If you are a social entrepreneur or impact investor and want to know more about this new law and how it might affect you, contact Allen Bromberger, allen@perlmanandperlman.com

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In the latest denial, the charity applicant was formed to promote local agricultural products within the restaurant and hospitality industry by establishing and operating food hubs across the state. Its clientele consisted primarily of farmers, restaurants, and retailers. In its ruling, the IRS said the applicant did not qualify for exemption under Section 501(c)(3) of the Internal Revenue Code because it was not operating exclusively for charitable purposes. Quoting a revenue ruling from 1972, the IRS said that “an organization is not exempt merely because its operations are not conducted for the purpose of producing a profit.” Stating that the services, in this case, were provided at cost and solely for exempt organizations “is not sufficient to characterize this activity as charitable within the meaning of Section 501(c)(3).” The IRS concluded that more than an insubstantial part of the applicant’s activities was devoted to a non-exempt (i.e., commercial) purpose, and was therefore not organized exclusively for charitable, educational or religious activities within the meaning of Section 501(c)(3) of the Code.

In other words, according to the IRS, you can be charitable, or commercial, but not both. However, there is a growing segment of the charitable sector actively engaged in revenue-generating activities without any problems.

The primary conflict resides in how the IRS defines “commercial” and how the commercial facets of the organization are utilized. Whether the activity is a “trade or business ordinarily carried on for profit” dictates its status (B.S.W. Group, Inc. v. Commissioner, 70 T.C. 352 (1978). Another factor is whether the activity competes with other for-profit businesses and if it does, is it distinguishable from those other commercial entities?

In Denial 201641027, another tax-exemption denial based on the presence of too much commercial activity by a charity, the IRS decided that a group organized to assist community residents to gain access to quality patient care was commercial, not charitable. This despite the fact that such efforts have generally been granted exemption in the past, and there is a series of revenue rulings upholding such exemption. The IRS did not explain why they thought this case was different.

The IRS’s hostility to nonprofit commercial activity inhibits charities that want to deliver good works using a commercial model. In the last year alone, the IRS has handed down denials to groups that operated a public market (to ensure the availability of fresh, healthy food in the community); a record label (to provide at-risk youth the resources to intern in the entertainment industry); a farmer’s market (to contribute to the sustainability and development of markets that make fresh and healthy foods available to all people); and selling laptop computers (above cost but below market) to students to further educational objectives. These rulings have been based primarily on a determination that the charities were using commercial means to accomplish admittedly charitable and educational ends.

In issuing these rulings, the IRS appears to be resurrecting the obsolete, discredited “commerciality doctrine,” which says that a nonprofit cannot be charitable if it engages in activities which are primarily commercial, even if the activity benefits only the general public or a charitable class. The commerciality doctrine was abandoned years ago because it stifled innovation and did not reflect changes that were happening in the philanthropic sector. If unchecked, the doctrine would threaten the exemption of community health centers, university bookstores, the NCAA, technical assistance groups, and any other charity that competes with private business or relies primarily on earned income to sustain itself. Quite simply, the doctrine is outmoded and is bad tax policy, hence its abandonment.

There are ways to avoid the clash between commercial and charitable facets of these organizations. One option is separating highly commercial activities into subsidiaries or affiliated service organizations. And in many other cases, charities can conduct the commercial activity in-house, so long as they have a substantial amount of other activity. There may be other reasons to perform commercial activity outside of the charity entity, but jeopardizing the charity’s tax status does not have to be one of them.

We’ll be writing more about private benefit and commerciality for nonprofits and hybrids in the next few months. Stay tuned as the story develops.

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Efficiency. The IRS’s goal for efficiency is mostly driven by its limited resources: the staff size and the budget for oversight have continued to decline, even as the number of exempt organizations continues to grow.  In response, the IRS’ imperative is to implement strategies which maximize efficiency in oversight of tax-exempt compliance. This is largely accomplished by the use of data analytics, particularly through mining data from filed Form 990s to identify returns with a likelihood of non-compliance.  To achieve efficiency, and where appropriate, the IRS is doing more compliance checks and correspondence exams in place of more labor intensive in-person field exams.

Effectiveness. The IRS is also using a data-driven approach to do more strategic case selection.  It has created (and is continually refining) specific queries of Form 990 data fields, often using combinations of data fields to identify potential non-compliance.  Although not explicitly noted in the 2018 Work Plan, during a recent webinar hosted by Ernst & Young, TE/GE Commissioner Sunita Lough explained that the five strategic issue areas for tax-exempt compliance outlined in the 2017 Work Plan — (1) Exemption; (2) Protection of Assets; (3) Tax Gap; (4) International; and (5) Emerging Issues — continue to be the foundation of the IRS’s compliance efforts. The 2018 Work Plan particularly highlights the following issues in its compliance strategies for the year:

• Supporting organizations filing 990-Ns
• Organizations seeking 501(c)(3) status that previously operated as for-profit entities
• Private inurement/benefit: based on unspecified “indicators”
• Employment tax non-compliance

Transparency. One new strategy, Knowledge Management, fulfills all three themes: efficiency, effectiveness, and transparency. The IRS has created informational tools for its agents to more efficiently and effectively carry out their enforcement responsibilities. This is especially critical now as longtime staff with significant knowledge have been departing the agency. Toward achieving greater transparency, these tools are being made available to the public. Two of these Knowledge Management tools are called Issue Snapshots and Audit Technique Guides (ATGs).

Issue Snapshots provide analysis and resources for a given technical tax issue. Planned topics include issues involving gaming, unrelated business income (and related exemption issues), IRC section 501(r), organizational test requirements, and employment tax. Each snapshot includes “issue indicators” and “audit tips.” Examples of published Issue Snapshots are “Advertising or Corporate Sponsorship Payments?” and “Identification and Treatment of Income from Mailing Lists.” New Issue Snapshots will continue to be added and posted here.

Audit Technique Guides (ATGs) recommend specific examination techniques, explain specialized business practices and terminology, and explore issues common to certain types of exempt organizations.[1] The 44-page ATG for public charities, for example, outlines the procedures for determining the proper foundation status for organizations described in IRC Section 501(c)(3); provides guidance on determining and addressing the presence of inurement, private benefit, and excess benefit transactions; and discusses political and legislative activities, how to determine if they are present, and their effect on charities.

[1] The IRS website states that the material in the ATGs is drawn from former Internal Revenue Manual (IRM) 4.76, Exempt Organizations Examination Guidelines, which was removed from the IRM in September 2017. For uniformity and consistency with other parts of the IRM, the IRS moved the technical guidance information formerly found in this IRM to ATGs.

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The IRS inquiries focus on the dual factors of private benefit and commerciality. The private benefit question seeks to determine if private individuals (including insiders) are getting a substantial benefit from the enterprise, which is not permitted under the regulations. The commerciality question seeks to determine if the organization is a “business” or a “charity” based on its relatively subjective criteria. As in all such matters, the difference between approval and denial seems to rest on the way in which the application is prepared.

The private benefit objection confirms our observation that the IRS has increasingly become distrustful of the use of nonprofits and charities as vehicles to operate a commercial business. The IRS presumes that operating a profitable business is likely to result in the charity being used to further the private interest of individuals, unless the applicant can refute that presupposition.  One way to do this is to demonstrate that the primary objectives of the organization are purposes and activities that fit precisely within the parameters of Section 501(c)(3) as explained in the Exempt Organizations Determinations Manual.

The IRS also looks to see whether or not certain safeguards have been adopted, including policies on compensation and conflicts of interest, procedures that ensure that the board has timely and accurate information, that the terms of these arrangements are clearly understood, and that the organization’s treasurer, bookkeeper and auditors are independent and have no conflicts of interest. Transactions with private individuals must be done at arm’s length, and on terms that are fair and reasonable (even concessionary) to the charity.

To the extent that the commercial venture will benefit individuals, the IRS wants the applicant to establish that those benefits are merely “incidental”. An incidental benefit is one which is not “substantial.” There is a qualitative test and a quantitative test, summarized on the IRS website.

The IRS also wants applicants to show that the benefits of the activity flow primarily to the public, not to private individuals, and that the majority of the organization’s governing board does not personally benefit from the organization’s activity (except if they are members of the charitable class to be served.) There is no absolute ban on interested directors, but a majority of the board must be independent and disinterested. If a small number of people control the venture and receive benefits, either directly or through an intermediary, it will be problematic in the view of the IRS. In the final analysis, any benefits to private individuals must be a “mere byproduct” of the activity, and must be no greater than is necessary to accomplish the charitable mission.

The current commerciality issue is a remnant of the “Commerciality Doctrine,” a discredited guideline used back in the 60s, 70s and 80s. Under this guideline, the IRS denied exemption to organizations which were operating businesses, even if the business was run in such a way as to accomplish charitable or educational goals and did not benefit private individuals. The IRS simply declared (and many authorities agreed) that you had to be either a business or a charity – there was no middle ground. Fortunately, over time, the growth of commercial activity in the sector has required the IRS to develop a more nuanced approach. To some extent, the expansion of private benefit discussed above reflects that approach.  But it seems when the IRS wants to deny an application but cannot articulate other grounds, it will default back to the doctrine of commerciality.

Nonprofit commercial activity is good for the sector – it helps organizations to be more self-reliant, resilient, and enhances their opportunities to expand programs. That why it is crucial to craft the tax exemption application to get around any objection of private benefit or commerciality.  The organization then has the option of adjusting its governance or commercial arrangements if necessary to make them acceptable to IRS. The extra effort to get it right could make the difference between an organization that merely functions and one that flourishes.

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