Nonprofit Organizations

General Principles Non-profits business association formed under state law, more lenient than fed law, but exempted from fed taxes under fed law. Non-distributional constraint hallmark of NPOs NPOs can make a profit, but cant distribute it to those in control of the organization. Any profits must be used for public rather than private purposes; all net profit after expenses go to fund orgs exempt public purposes. o No dividends in the non-profit sector o Profits cant be distributed to members/employees except as reasonable compensation or reimbursement for expenses Upon dissolution, remaining assets must go to a charitable purpose. Salaries have to be reasonable but comparable to those paid in the for-profit sector are fine. (In for profit sector, reasonable salaries also protect against irate shareholders). How salaries are set in non-profit sector is different though. NPOs can still charge fees and dont have to give discounted services as long as for exempt purpose (i.e. educational) then it is still charitable. o Can charge fair market value fees o Can compete directly with for-profit orgs does raise questions of unfair competition o The purpose not the method is the most important Tax exemption Primarily concerned with exemption from fed income taxes, under IRC. o Also a misnomer to some degree all NPOs subject to unrelated business income tax, also some excise taxes and penalties Parallel State exemptions property taxes, etc 501(a) Exemption from taxation: An organization described in subsection (c) or (d) or 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under 502 or 503. 501(c) List of exempt organizations: The following organizations are referred to in subsection (a): o 25 subparagraphs setting out categories of exemption Exempt Purposes NPO doesnt require stereotypical purpose dont need to support the poor or needy, dont have to give services away for free o Charitable means a lot more than this as construed by courts, IRS, states, legislatures o Not only benevolent or philanthropic o Keep definition flexible, evolve with society When creating an NPO, organizational documents should establish broad charitable purposes o Leave room for org to grown and expand, develop its mission o Much harder to change purposes once the charter is filed Org must be organized and operated exclusively for charitable purposes o Exclusively under 501(c)(3) really means primarily must operate primarily for exempt purposes o Can engage in non-exempt activities as long as they are not a substantial part of the organizations activities. Exempt purposes, according to 501.c.3 Defined as Religious, Charitable, Scientific, Testing for Public Safety, Literary, Educational, Amateur Sports (not including providing equipment/facilities), or Prevention of Cruelty to Animals There may be differences between state and fed definitions Who polices exempt purposes? o State AG or IRS both can reject articles/applications

IRS has to take more affirmative action in granting exemption (rather than just approving incorporation) so has to scrutinize purported exempt purposes more closely o Though challenging charities is never popular, and there are so many NPOs that they are hard to monitor closely Funding How do NPOs actually get funding? Fees for goods and services: Tuition, hospital fees, bookstore sales, etc. o Commercial activities, provided theyre related or only insubstantial if unrelated Membership fees and dues Government grants much larger % of total Donations/private philanthropy surprisingly small amount, about 19% of all funding Investment income/endowments Different sorts of NPOs have different funding structures, concentrations o Education funding Elementary/HS most from govt Higher education most from fees and sales, plus endowment and philanthropy. o Religion 95% from private philanthropy (which includes fees that people pay to religious organizations) Ways to categorize/analyze NPOs Public serving v. mutual benefit Funding concentrations Activities political v. nonpolitical, etc

501(c)(3) Organizations: Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

Benefits for 501(c)(3) Organizations Can receive tax deductible donations under 170 (fundraise more easily) State and local benefits - Real estate, sales, and local and state income tax deductions Right to issue tax exempt bonds hospitals, schools, investors dont get taxed on the interest they receive on the bonds, reduces the borrowing costs for some (c)(3)s. Postal rate reductions Exempt from unemployment taxes Limitations on 501(c)(3) Organizations Cannot use funds for political campaigns; limits on lobbying expenditures o Lobbying is permitted if not substantial insubstantial lobbying is fine o All campaign work is prohibited Net earnings cannot inure to the benefit of any private shareholder or individual Cannot engage in or promote activities that are illegal or against public policy (Bob Jones University and Revenue Ruling 75-384) Tied into reasons an org might not qualify for 501.c.3. status o Purposes might not fit definition of charitable o Assets may be used for private purposes o Org might participate in prohibited lobbying/political activities Other important 501(c) Organizations: 501(c)(4) organizations: (4) (A) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes. Public serving organizations Look a lot like c(3) orgs they can have similar purposes o Promoting social welfare qualifies as a generalized charitable purpose Major differences (c)(4) arent subjected to the political limitations, can be set up just for lobbying or campaigning activities Contributions to (c)(4)s arent tax deductible for the donor 501(c)(6) organizations: A lot of the membership, association organizations more mutual benefit than public (6) Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual. o Now includes all professional sports leagues o Business leagues 501(c)(7): Social clubs (7) Clubs organized for pleasure, recreation, and other nonprofitable purposes, substantially all of the activities of which are for such purposes and no part of the net earnings of which inures to the benefit of any private shareholder. Concerns about commingling of purposes, fees, earnings Purpose of exemption is for tax neutrality not really tax exemptions

Theories of Tax Exemption Public benefit or traditional subsidy theory Justifies charitable tax exemptions on the basis of public benefits conferred by the organizations, which relieve the burdens of govt by providing goods or services that society or govt is unable or unwilling to provide. Quid pro quo theory pay NPOs back for the societal benefit they provide Emphasizes the secondary community benefits offered by nonprofit orgs by their contributions to a robust and pluralistic American society and their role as innovators and efficient providers of public benefits. Capital Subsidy Theory - Hansmann Links contract failure theory to rationale for tax exemptions by arguing that income tax exemptions are a necessary tool to compensate nonprofits for the constraints they face in gaining access to capital markets by virtue of their inability to offer profit shares to private investors and their inadequate access to debt financing. NPOs face financing difficulties b/c they dont offer personal benefits to investors exemption counteracts the disincentive to donate Altruism Theory Atkinson Tax exemptions are justified as appropriate subsidy rewarding the altruistic decision by nonprofits founders to forego profits. Altruistic orgs = nonprofits other than mutual commercial nonprofits Types of Non-Profit Organizations Public Serving Formed to serve public/charitable purposes Includes 501(c)(3) orgs, private foundations, 501(c)(4) social welfare orgs, 527 orgs Members have no ownership interest in their corporation Assets held for public or charitable purposes, cant be distributed to members, directors or officers not even on dissolution. Restrictions on the type of corps with which they can merge and conditions of merger May be no private individual with an economic incentive to review decisions made by directors Revised Act seeks to fill this void by clarifying existing common law and statutory authority of AG authorizes AG to monitor and exercise oversight powers over public benefit corporations. Mutual Benefit (Member Serving) Formed primarily to further the common goals of their members rather than for profit or a public or religious purpose Typically narrow interests bonded by some sort of personal nexus o Ex: economic chambers of commerce, labor unions o Ex: social country clubs, fraternities Members may have an economic interest o May not receive distributions while a mutual benefit corp is operating, but membership interests may be sold or transferred to the corporation or third parties o And upon dissolution, members may receive distributions. Members have broad rights to vote on bylaw amendments May operate with a self-perpetuating board of directors indivs can be called members even if they dont have right to vote for directors (but not treated as members under Revised Act) Churches may be their own third category Religious organizations (like some others but more than many) are important compound orgs Generally considered to fall under public serving (allow non-members to worship, contribute to public charity causes) and yet they operate for the benefit of their members

Choice of Organizational Form Trust - which for 501(c)(3) purposes also includes fund or foundation A fiduciary relationship with respect to property arising as a result of the manifestation of an intention to create it. Charitable trusts differ from private trusts their object is to benefit the community rather than private individuals; the assets of a charitable trust must be irrevocably dedicated to the purposes of that trust. o Enforced by attorney general rather than by trusts beneficiaries o Can be of unlimited duration, exempt from rule against perpetuities. o Often used for private foundations that are engaged solely in making grants. Instrument: o Names the trustees, states the charitable purpose, establishes policies for administration, distribution of assets and dissolution, names successor trustees/method of selection, and states the duration of the trust. o Management rests in trustees may be selected by settler, court, and may be selfperpetuating if the trust instrument so provides. Pros: Great if there are no liability issues, just trying to give out money o Easier/quicker to set up no need for prior state approval, no requirement of identifiable beneficiaries o Administration with fewer formalities than the corporate form o Fewer housekeeping requirements o Perpetual or indefinite period of existence o Possibility of continuing control by grantor o May be less expensive to maintain than a for profit corporation Cons: Tax rates on unrelated business income higher than for corporations o Problems if money is going to be given overseas o UBIT trust rate gets higher a lot faster than corporate tax rates trust is bad for an org that will generate a lot of unrelated business income o Liability concerns higher standard of care imposed on trustees than corporate directors Unincorporated Association Many smaller non-profits, labor unions and political organizations Upon dissolution: o Members are entitled to their pro rata share of assets unless the articles of association provide otherwise. Pros: Informality and flexibility o No governmental approvals must be obtained to form or dissolve o No constitution or bylaws needed (unless seeking 501(c)(3) exemption) o Good for newly formed entities or those commencing incorporation process Those with uncertain prospects, limited expected duration, or founders who are unlikely to bring the activity or project to fruition. Cons: OUTWEIGH THE BENEFITS o Liability o No separate legal existence apart from the members though most jurisdictions have passed legislation treating the unincorporated association as an entity for legal purposes o Individual members have personal o Cannot receive or hold property or contract in the associations name o Banks, creditors and other vendors may be reluctant to conduct business with an unincorporated association. o Subject to agency laws more flexible but detracts from planning certainty

Non-profit corporation best form for NPO operating as a business Must conform to more formalities in creation or dissolution than unincorporated assoc. or charitable trust, but internal governance is more flexible, easier to react to changed circumstances such as the resignation or death of director. Artificial entity; can sue or be sued, hold property in own name, contract. Indefinite existence, centralized management (board of directors) who are held to lower standard of care than charitable trustees and enjoy limited liability. Best benefit limited liability, protected by same shields as for-profit corps AG can sue to prevent a diversion of property from the purposes for which it was given (even though the property has been conveyed to the charitable corporation) Pure Donation - Last ditch effort for a person who just wants to advance a cause and get a tax deduction donate to an established org, create a fund controlled by the other org and let them deal with it Wont work if donor cant find an org that fits her interests, or if she wants to retain control of the actual expenditure of the funds

Forming a Nonprofit Corporation

Make sure the purposes qualify under state and federal law; confirm that these are the founders true intentions, that they understand the purposes. When you apply as corporation, AG or Secretary of State can reject your application by saying purposes are not charitable. o Might be denied inc status at state level Or if you slip by the state process, when apply for 501(c)(3), IRS will take closer look at articles of incorporation, set a higher standard of charitable, more likely to care about enforcement of this. o More scrutiny on charitable issues at fed/IRS level o IRS sees all documents, issues a ruling to each org o State seen as more of a ministerial duty, might not see all documents. Inform the founders re: restrictions on 501(c)(3) organizations lobbying, campaign, distribution constraint. Select a state of incorporation and reserve a corporate name w/ secretary of state Typically jurisdiction in which organization intends to conduct activities Law of the state of incorporation governs internal organizational affairs If in a rush and it will be complicated, then set up in Delaware (if you are NY nonprofit) or Nevada (if CA nonprofit) Draft articles of incorporation (also called certificate of incorporation or charter) Eventually filed with the secretary of state Generally requires the certificate to contain: o Name of the organization o Statement and description of the purposes o Some categorization of the organization public serving or mutual benefit o Name of an agent for service of process o Names and addresses of the original incorporators or directors o If public benefit, must have provision stating that upon dissolution the assets will be distributed to other public benefit orgs!! o Best to quote actual language of IRC or state code as much as possible safe harbor Obtain certain consents for particular types of organizations Hospitals, educational orgs, etc. Create set of bylaws Procedures or internal rules governing the entity More detailed and more flexible than articles of incorporation o Notice requirements for meetings, definitions of members, quorum requirements, member tenure, election procedures, removal and filling of vacancies of directors,

number and responsibilities of officers, fiscal year, committees, indemnification provisions, procedures for amendment. Once filed and accepted by secretary of state, Corporation exists. Now hold organizational meeting. Initial board of directors is elected, officers appointed, bylaws approved, authorization to open bank account is granted. Apply for recognition of exemption with IRS for federal income tax File form 1023 problem, might not have the information the IRS is requesting, client might not be organized. If file within 27 months of the end of the month in which incorporated, then exempt status is retroactive to the date of incorporation o Have some time to organize application and still have it go into effect retroactively o If application is rejected, can even tax issues out afterwards If not, then status is prospective from date of determination letter. Apply for both 501(c)(3) and 170(c) so the organization can receive charitable contributions. If a church, dont have to file form 1023, but may want to in order to: o Make donors more comfortable about the tax deduction of their donations o Make sure of exemption if they conduct activities beyond those of a typical house of worship All fill out pages 1-9, Schools must also file Schedule B o Must not discriminate based on race {in addition to criteria in 170(b)(1)(A)(ii)} Also need to register for state tax-exemptions can re-file approval from IRS IRS is more of a policeman now o Can reject exemption application for violations of public policy (rarely would rather stretch definitional question) or b/c purported activities dont fit the definitions of the potential categories, or for failing advocacy rules Form 990 Annual filing, disclosure Once a 501.c.3 still need to follow rules and regulations esp disclosure Preserve transparency and promote public accountability

States role in governance: o Oversight by charity officials Enforcement of state nonprofit corp or trust statutes Charitable trust principles Charitable solicitation and fundraising registration o Audited financial statement requirements o Who governs the org Members or directors? Trustees? Allocation of duties among them Best judgment rule Duty of loyalty and duty of care Procedures and policies, and amendments to the governing instruments Requirements regarding minimum or maximum board sizes or qualifications of directors

Fiduciary Duties / "Norms of Behavior" Responsibilities of the Board of Directors and Trustees 1. Regular attendance of meetings o directors cannot designate another person as the directors proxy, to attend or vote at the board, in his place, because director was selected to perform a duty, not the grant of a transferable privilege, and the org may demand that director's expertise. 2. Exercise independent judgment o must judge what is in the corp's best interest, irrespective of other entities with which the director is affiliated or sympathetic, or to which the director owes his board appointment. o Cal. Corp. Code 5227 - 49% Rule for Interested Persons - no more than 49% of the board can be "interested persons" (= any person compensated by the corporation within the past 12 months and any member of such person's family.) 3. Adequate information o Assuring adequacy and clarity of information 4. Reliance limitations: director may act in reliance on information and reports received from regular sources that the director reasonably regards as trustworthy. o these rules do NOT apply if the director has any personal knowledge that would make reliance on the info unwarranted, and any info on reliability may have to be brought to the attention of other board members. 5. Delegation limitations: Directors oversee, but do not directly engage in corporation's day-to-day operations. Best Judgment Rule: Even when a corporate action has proven to be unwise or unsuccessful, a director will generally be protected from liability arising from it if he or she acted in good faith and in a manner reasonably believed to be in the corporation's best interest, and with independent and informed judgment. generally not available in basic breaches of duty by director, i.e. criminal activity, fraud, bad faith, willful and wanton misconduct. Queen of Angels Hospital o Rule: The AG can void a settlement agreement that was not a proper exercise of the Board's sound business judgment. o Facts / Issue: Because the Board accepted the validity of a legal claim (i.e., the payment of bonuses to charity volunteers) and entered into the settlement agreement without checking if there was evidence to support the claim, the Hospital ultimately had no legal obligation to pay the terms of the settlement. Limitations on Board Powers o NPO with members must give members all the rights outlined in the organizations bylaws. o Fitzgerald v. NRA o NRA Magazine must accept an advertisement about Fitzgeralds candidacy for the board, but the NRA does not have to allow his ad to solicit for contributions. o Where members seek to avail themselves of the right to communicate with other members in the context of disputed elections, the directors must facilitate those communications, consistent with the directors fiduciary duty to the associations membership to conduct the corporations affairs in the best interests of the association. 8

Duty of Care
- RULE: Directors must act in a reasonable and informed manner when participating in the board's decisions and its oversight of the corporation's management. 1. Must be informed. 2. Must discharge duties in good faith, with the care that a person in a like position would reasonably believe appropriate under similar circumstances. 1. the nature and extent of responsibilities will vary depending on the size, complexity, urgency and location of activities carried on by the particular nonprofit corporation 2. decisions must be made on this basis without the benefit of hindsight. 3. the special background and qualifications and responsibilities of a particular director may be relevant in evaluating compliance.

Cases: different standards by different courts o George Pepperdine Foundation v. Pepperdine o "absence of a standard of care" o Plaintiff was the org, suing the Former Directors for damages. Pepperdine could not be sued by his own foundation for mismanagement of funds, because he could not be sued in his individual capacity for mismanaging his own funds intended for use by charity. o Lynch v. Redfield Foundation o Trust standard o AG sued directors for not putting $$ into an interest bearing account. o Standard of Care here was the prudent man investment rule: Directors are liable for own neglect, i.e. the trust standard o Stern v. Lucy Webb I o The corporate standard o Hospital sued the Hospital Board of Trustees for conspiring to enrich themselves 2 Members had dominated the board and made decision without convening a board. o RULE: Standard of Care for mismanagement = Gross Negligence (whereas for trustee it is simple negligence o HOLDING: Breach only if, when on a particular committee, the director failed to use due diligence in supervising; or self-dealing without informing board members of a conflict of interest; actively participating in choosing his own business to transact with the organization; lack of good faith. o Cal. Corp. Code 7237

Duty of Loyalty and Duty of Obedience (163-202)

Rule: Directors must exercise their powers in good faith and in the best interests of the corporation, rather than in their own interests or the interests of another entity or person. 1. Interested Transactions 1. Rule: whenever a director has a material financial interest in a proposed transaction to which the corporation may be a party. 5233(a) 1. Can be Direct or Indirect, i.e., personally involved or other relationship with the other party, or having a family member who is 2. Director must be conscious of the potential for conflicts of interest, and act with candor and care in dealing with such situations. 3. Penalties: voiding the transaction or liability for breach of duty of loyalty Remedies for Violations of Duty of Loyalty: o Liability can be big $$ o D&O Coverage generally does NOT cover breaches of Duty of Loyalty o Settlement of Adelphi cost trustees $1.23 million in personal funds. Duty of Obedience RULE: Directors must be faithful to purpose and goals of nonprofit org. Matter of the Manhattan Eye, Ear and Throat Hospital Facts: Court refused to approve sale of hospital's real estate assets because it did not promote the purposes of the corporation. An outpatient clinic is NOT THE SAME as a hospital. CA: Even if the org had amended its articles before the sale, this would not be permitted because the assets must go to another charitable organization.

10

Self-dealing law - Cal. Corp. Code 5233 Law requires that certain procedures be followed in order for the Board to approve any specific transaction that involves self-dealing on the part of a director. Self-dealing = a transaction in which the corporation is a party, and a director has a material financial interest. No penalty if the following facts are established: ( 5233d) a) The organization is entering into a transaction for its own benefit, b) The transaction is fair and reasonable to the organization, at the time the corporation entered into it, c) Prior to consummating the transaction, the Board authorized or approved it in good faith by a vote of the majority of directors then in office (without counting the vote of the interested director), and the Board had knowledge of the material facts of the deal and the directors interest in the deal, d) The organization (in fact, or in a good faith determination by the Board) could not have obtained a more advantageous arrangement with reasonable effort under the circumstances OR: if it was not reasonable practicable to get approval of the Board prior to entering into the transaction, then the Board can ratify the deal at its next meeting by a vote of majority of directors (less the interested directors), after finding determining in good faith that it was not reasonably practicable to get approval in advance, and that the deal was approved in standards set forth above. Exceptions: 1. an action fixing Board or officer compensation 2. a charitable program approved in good faith and without unjustified favoritism if a director or member of their family are within the intended class of charitable beneficiaries 3. transaction involving less than $100k/year where the interested director has no actual knowledge of the transaction. Remedies: The court will provide an equitable and fair remedy to the corp, taking into account any benefit received by the corp and whether the interested dir acted in good faith and with the intent to further the best interests of the corp. 1. Director may have to account for any profits made from the deal, and pay back to the org 2. Director may have to pay corp the value of the use of any of its property used in the deal 3. Return or replace property lost to the org in the deal, together with income or appreciation lost, or proceeds of sale. Self-Dealing Cases: Nixon v. Lichtenstein o Holding: Gross Negligence standard for trustees of a trust? o Removal of directors by board if: 1) Director acted in gross negligence, and 2) Removal is in best interests of the corp. o Court favors appointing new members over dissolution because law favors 11

continuing unless it isnt able to carry out its purpose. Lucy Webb School for Deaconesses o Rule: Members should disclose potential conflicts of interest and then refrain from voting on that issue. A bank is only liable if it had actual or constructive knowledge that a trustee was in breach of a fiduciary duty. o Holding: Court uses its equitable powers to order accounting procedures, to require disclosure of affiliations, and each new trustee must sign a compliance agreement. Committee to Save Adelphi o Facts: Key incidents of self dealing / conflicts of interest: Trustee with insurance expertise is appointed by a committee to explore options, and the committee ultimately appoints a firm wholly owned by her. The Board believed it was retaining this firms services for free rather than for a fee. Trustee presents her own firms proposal for new ad campaign without considering other proposals. The Creative work was free, but they were being compensated for production and placement of the ads. o Rule: Because the Board failed to act after learning of the potential conflict of interest, then the Board as a whole is in breach.

12

Conflict of Interest Policy

Rule: IRS Form 990 asks whether org has a written conflict of interest policy. If yes, then IRS asks whether board members, officers, and key employees are asked annually to disclose potential conflicts, as well as whether the organization regularly and consistently monitors and enforces compliance with the policy. (Part VI, Section B, Form 990). IRSs job is to assess whether an org has complied with tax laws. In some cases, this means looking at whether a particular organization managers participated in decisions that resulted in EBT or other noncompliance. In other cases, it means look at whether the org took certain steps to assure the fairness of the arrangement to the exempt org (i.e., taking steps to establish reasonableness of compensation). IT is not the IRSs job to determine the orgs governance structure, etc.

NPO should have a conflict of interest policy, i.e., procedural requirements for authorizing an Interested Party Transaction, and must document that it was followed in its authorization. 1. that the Corp is entering into the transaction for its own benefit 2. that it is fair and reasonable to the corporation 3. that it was voted on without the consent of the interested directors 4. that after reasonable investigation it could not have gotten a better deal 5. describing a "material financial interest" 6. terms for making loans to Directors or Officers (unless required for personal residence) 1. loans must be approved by the AG. 2. limited exceptions: advancement of exceptions, life insurance premiums, or secured loan to help director or officer finance the purchase of a principal residence. documentation of procedures -- board should document that it followed appropriate procedure, consistent with its policies, to assure that the decision made was in the best interest of the nonprofit and not based on any influence from the conflict holder. directors should disclose affiliations with other NPO's Corp must inform IRS whether it has adopted a "conflict of interest policy" similar to the one included in Form 1023, and explain if it has not. California Endowment Conflict of Interest Policy: o Primary Purpose: o To assist Dirs and staff in the performance of their duties o State clear guidelines to be followed in identifying and resolving conflict of interest and self-dealing issues o Broad disclosure because Directors and staff members may have been selected in part for their strong involvement with underserved communities that make up the organizations charitable class. o Sources of Rules COMPARING STATE LAW WITH FEDERAL TAX CODE: o IRC prohibition on self-dealing for private foundations (4941) and private inurement (EBT, 4951) o Cal Corp Code 5233 Cal requires special steps in approving transactions in which Directors have a material financial interest CA requires adherence to a specific process in order to approve selfdealing transactions. (The IRC, by contrast, prohibits self-dealing transactions). o Additional limitations adopted by the Board of the Endowment 13

Public Counsel Conflict of Interest Policy Evaluation of Potential Conflicts: 1. Duty of self-disclosure 2. If the potential conflict is disclosed during a Board or Committee meeting at which the Interested Person with the potential conflict is in attendance, the Interested Person shall leave the meeting while the determination of whether a conflict of interest exists is either discussed or voted on 3. Factors: a. Proximity of Interested Person to the decision-making authority of the other entity involved in the transaction b. Whether the amount of the financial interest or investment is de minimis relative to the overall financial situation of the corporation c. Degree to which the Interested Person might benefit personally if a particular transaction were approved AG Report on the Getty Trust, Key findings: No enforcement action. (Surprising. Criticism that the AG did not handle this as a fundamental governance issue, but about trivial things) o Improper use of charitable funds in paying for travel expenses of former presidents wife o Flying first class and dining in expensive restaurants? AG said this was inappropriate, especially when trips were not overseas or transcontinental. But this did not violate any clear rule. o Improper use of funds to buy gifts of artwork for retiring trustees o Improper use of funds in using trust employees to run personal errands for him o Improper use of funds in paying consulting fees to graduate art student

14

Corporate Opportunity Doctrine

Rule: 1) A person who, because of his position with the org, learns of a business opp that would be attractive to the dir apart from his role as a dir, and 2) The deal would plausibly fall within the corp's present or future activities. Corp must first be offered the deal before the director can take advantage of it outside of his role as a corporate director", and disclose any conflicts of interest. (ALI Test in Northeast Harbor Golf Club, see below) Cases: Northeast Harbor Golf Club v. Nancy Harris o D breached fid duty by purchasing and developing property next to the Golf Club o Facts: The owners of land contacted Harris, as President, and thought the club would buy property. Harris instead bought the property with her own money and in her own name and did not disclose to the Board at first. o Issues/Rules: It did not matter if it did not look like the club could afford to buy the property (they could have raised funds). o ALI Test: can take advantage if offer to corp and disclose conflict of interest. The court emphasizes the importance of disclosure and the rejection of the offer. If opportunity is a corporate opportunity, then the NPO must show that it was not offered the deal or that it did not reject the deal. If the NPO shows that it did not reject by a vote of disinterested directors after full disclosure, then the board members can show that taking the opportunity was fair to the NPO. Lynch v. Spillman Holt v. College of Osteopath Physicians and Surgeons o Minority trustees/directors may sue for breach of charitable trust, in this case, for changing purposes.

15

Basic Requirements for Charitable Tax Exemption:

1. Choice of form 3 are primarily acceptable Corporations Trusts Unincorporated associations 2. Charitable Purpose: Charitable in the broad sense. Not just for relief of the poor. Sources of Charitable Restatement (Third) of Trusts (controversial because it includes other purposes beneficial to the Community and that might be too broad) Preamble to Statute of Uses (not broad enough, does not include Religion) Categories of Exemption under 501c3: 1. religious 2. charitable 3. scientific 4. testing for public safety

5. literary 6. educational purposes 7. prevention of cruelty to children or animals

Other Definitions of Charity: a. relief of the poor b. promotion of health c. promotion of social welfare (combating prejudice, neighoborhood tensions, community deterioration, and juvenile delinquency, and defending human/civil rights d. advancement of religion, education and science e. erection of public buildings f. lessening of governments burdens g. cultural organizations h. providing goods at less than cost (simply providing goods or services at cost is not charitable) Rule: Organizational and Operational Tests: To be tax exempt, a 501c3 must be "organized and operated" exclusively for exempt purposes. Organizational Test: focuses on the language in the charter o Cannot be authorized for purposes broader than those stated in c3 o Purpose statement may be narrow or broad o Must have a proper dissolution / distribution provision Operational Test: focuses on the activities to achieve its ends - Operated "Exclusively" means "Primarily," and Primarily means anything else cannot be substantial (we do not know what substantial means) - Activities cannot violate public policy - Cannot distribute net earnings to its members or others - Cannot be an "action" org, i.e. influence legislation

3. Charitable class: 16

The beneficiaries must constitute a sufficiently large or indefinite class, that the community as a whole, rather than a pre-selected group of people, benefits when a charity provides assistance. Sufficiently large so the beneficiaries cannot be individually identified, such that it benefits the community as a whole, or Sufficiently indefinite If the group of eligible beneficiaries is more limited. i.e. disasters: the relief program must be open-ended and include employees affected by the current disaster, and those who may be affected by a future disaster. If the facts and circumstances indicate that the newly established disaster relief program is intended to benefit only victims of a current disaster without any intention to provide for victims of future disasters, the organization would not be considered to be benefiting a charitable class.

4. Prohibition on private inurement no portion of the organizations net earnings may inure to a private individual 5. Restrictions on lobbying no substantial part of the organizations activities may be certain forms of political lobbying Cant be a substantial lobbying org, but can do some 6. Prohibition on political campaign activities absolute prohibition on political campaign activities Though those activities are carefully defined 7. Fundamental public policy requirement no part of an orgs purposes or activities may be illegal or violate establish public policy Stems from the common law definition of charitable, as it has been interpreted by the IRS and the courts. Advantages of being 501c3 1. Exemption from most federal income taxes 2. Contributions are tax-deductible by contributors, up to limits imposed in 170(b) 3. Some 501c3s may finance their exempt activities by issuing tax exempt bonds, enabling them to lower their borrowing costs 4. Exemption from state real property tax, sales, and use taxes 5. Reduced postal rates for mailings

Limitations on Unrelated Business Activities: Rule: "Primary Purpose Test": Unrelated business activities may not disqualify an otherwise exempt 501c3, if the unrelated activities do not constitute the org's primary purpose. Conduit Theory: When an org distributes funds to non-exempt, but insures use of funds for c3 purposes by limiting distributions to specific projects that are in furtherance of its own exempt purposes. o Key: Org must retain control and discretion that funds are used for c3 purposes. 17

o Example: A 501c3 org subsidizes lawyers to establish practices in economically depressed communities; the lawyers are not the charitable class, but they are instruments through which the charitable purposes are accomplished.

Commercial Purposes: will not automatically threaten exemption. o Sinai Temple: o Rule: cemetery discount for members of a synagogue is not a per se payment of a dividend, gain, or profit, and so does not threaten their exemption. o Issue: religious corporation was operating its cemetery for profit, in competition with other for profit cemeteries, and using the profits to pay off the purchase price of the cemetery. o Holding: here, because the Charter authorized the maintenance of a cemetery, it was within the Religious Corporations power to operate it at a profit, and the discount was not the same as a distribution to the synagogues members from net profits

OTHER REQUIREMENTS: Annual Information Return (Form 990) Most c3's must also file Form 990 Disclosure (Form 1023): Included in application for exemption Can file within 27 months of organization; if later, then exemption begins on the date the form was substantially complete. Form 990, Part VI - Governance, Management and Disclosure

18

Public Policy Limitation

RULE: 501c3 orgs cant engage in / promote activities that are illegal or against public policy. Issue: Whether a racist organization can be tax exempt? o They may get state level status, but not IRS exemption. Issue: Whether an organization promoting the legalization of drug use can be tax exempt? o This type of org can be educational, be promoting health care, science, etc. o If they are only advocating a change of the laws, and not advocating breaking the law, then they canbe exempt. o But an organization that promotes illegal actions is not going to qualify. o Further issues: o Substantial lobbying such an org must comply with the lobbying restrictions and political campaigning restrictions o Civil disobedience is illegal and not charitable. Bob Jones University: Being educational or religious is not enough to pass the operational tests. The organization must also not violate a fundamental public policy. o Analysis: SCOTUS reasoned that Congress intended to incorporate the common law concept of charity into 501c3, that the common law concept of charity excludes purposes and activities that violate fundamental public policy, and that racial discrimination in education is clearly counter to strong public values and policies that had evolved in the 20th century. Therefore, Congress intended that the 501c3 exemption not be available to schools that discriminated on the basis of race. o Criticism: o 1. Bad statutory interpretation? Rehnquist dissent argued Congress could condition exempt status on racial nondiscrimination, and it has not. o 2. SCOTUS handed off to the IRS the authority to deny exemption on the basis of inconsistency with some fundamental public policy, i.e., that the IRS is vested with the authority to decide which public policies are sufficiently fundamental to require denial of tax exemption o 3. Powell argued the important role tax exemptions play in encouraging diverse or conflicting viewpoints, and was disturbed by the Majoritys view that a racially discriminative university does not confer some public benefit. o Outcome: o Bob Jones has not been tested o IRS tends not to disqualify from exemption for fundamental public policy reasons. o IRS has applied Bob Jones outside of education (Private letter ruling 8910001) (1988) -- privately administered trust that otherwise qualifies for exemption under 501c3 will not be recognized as exempt if its governing instrument restricts beneficiaries to white people. Open Issues: 1. Is the Bob Jones principle applicable to discrimination on grounds other than race? How about gender? 2. What is the framework for identifying those public policies that are sufficiently established and sufficiently fundamental? 3. Is the Bob Jones principle applicable to public policies other than discrimination? What about a needle-exchange program? 19

Health Care Organizations

Generally: o Largest category of c3s in terms of assets and revenue o Change from care for indigents to community benefit after Medicare added government health care assistance to those in need. o Must have an ER open to entire community, whether someone can pay or not. (IHC) HMOs are hard to qualify as c3 because they will only treat their members. IRS Factors for evaluating hospitals: o Independent governing board no more than 20% of the board can be hospital insiders practicing physicians "affiliated" with a hospital (such as medical staff members) are NOT considered "independent" based on their "close and continuing connection" to the hospital, without regard whether the nonprofit hospital compensates the physicians in any amount o If the hospital is part of a multi-entity system, is there corporate separateness? Each entity needs to be independent and separate Presumption this prong is satisfied, absent evidence that its some kind of sham o Is admission to the medical staff relatively open? Must be objective standards for admissions o Is there an ER open to all 24/7? Guarantees the community benefit is satisfied o Does hospital provide non-emergency care to all in community who can pay? o If specialty hospital, then no ER required; But must have some PLUS benefit. o Nonprofit pharmacy is not exempt unless some of the drugs are sold below cost or free to those who cannot afford them. Community Benefit Standard (Rev. Ruling 69-545) o Good: 250 bed community hospital, independent civic leaders on board, ER open to all o Bad: 60 bed hospital, originally owned by 5 doctors who are now on the board, only patients of the docs holding privileges may be admitted. o ERs are important BUT: SPECIALTY HOSPITALS do not need ERs, in which case, the IRS will look for some other indicia of community benefit IHC Health Plans o IRS said HMOs did not qualify for exemption because they were not providing community benefit. They looked too much like an insurance company. o IRS says not activity that promotes health is charitable. NEED A PLUS. Hospitals must provide a service that would not likely be provided within the community but for the added subsidy of tax exemption CA can deny property tax exemption to hospitals that dont provide enough indigent care. Obamacare Issues: o Will Schedule H lead to more consistent reporting of community benefit? o Will requirement of PPAC of community needs assessment per facility help. o Often find Private Inurement here.

20

Educational Organizations
Summary: o Educational organizations are per se charitable. No plus community benefit is required. o Includes: schools, museums, symphonies, day care, etc. o Schools defined: (170(b)(1)(A)(ii) Regular faculty Curriculum Regularly enrolled body of pupils/students o Educational = the instruction or training of the individual for the purpose of improving or developing his or her capabilities, or the instruction of the public on subjects useful to the individual and beneficial to the community. o Advocacy Orgs vs. Educational: o An advocacy org may be educational, even if it advocates a particular viewpoint, as long as: sufficiently full and fair exposition of the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion (501c3-1d3) (Big Mama Rag) Must be more than the presentation of an unsupported opinion Methodology Test: determined by the how the views are expressed rather than of the views themselves. o Not Educational (Rev. Ruling 75-384) civil disobedience An organization that informs on principles of civil disobedience Primary activity is sponsoring protest demonstrations, which are violations are local ordinances o Educational (Rev. Ruling 78-305) - homosexuality Org that educates about homosexuality to promote tolerance of homosexuals Seminars, forums, and groups qualify as educational under the regs. Useful/beneficial to the community o Big Mama Rag v. US - Definition of Educational in the regs was unconstitutionally vague and violated the First Amendment. Facts: Radical feminist org conducts lectures, panels, and other educational activities, but they constituted a considerable minority of the orgs activitieis. The majority was the publication of BIG MAMA RAG, its feminist newspaper. IRS viewed the newspaper as the mere presentation of unsupported opinion, and therefore not within 501c3. Analysis: BMR argued that educational orgs presenting their views to the public are held to a stricter full and fair standard than noneducational 501c3 orgs. Without an objective standard, then the orgs had no notice, and so they did not know if they were subject to the full and fair exposition standard. o Rev Proc. 86-43 IRS responds to BMR with a Methodology Test National Alliance case methodology: Look to the method used by the org in advocating its position, not the position itself. Method will NOT be considered educational if: o Fails to provide a factual foundation for the viewpoint or position being advocated, or o Fails to provide the relevant facts that would aid a listener or reader in a learning process 21

Religious Organizations
General Principles: 501c3 includes an exemption for religious purposes, but it does not really define what religious is o Inordinately difficult definitional task. o Common religious purposes: Religious publishers, broadcasters Burial societies Geneological research o Churches: Automatically regarded as tax exempt Presumed not to be private foundations No 1023 required or 990 required Audits are infrequent o Possible Factors (Rev Proc 59-129(1959)) (1) distinct legal existence, (2) recognized creed and form of worship, (3) a definite and distinct ecclesiastical government, (4) formal code of doctrine and discipline, (5) a distinct religious history, (6) a membership not associated with any church or denomination, (7) a complete organization of ordained ministers ministering to their congregations, (8) ordained ministers selected after completing prescribed courses of study, (9) a literature of it own, (10) established places of worship, (11) regular congregations, (12) regular religious services, (13) Sunday Schools for religious instruction, (14) schools for preparation of ministers o Holy Spirit Association v. Tax Commission: Are the Moonies religious or political? Illustrates the problem of denying a govt benefit to a religious org. 2 prong test: Does the religious org assert that the challenged purposes and activities are religious? Is the assertion bona fide? o General Counsel Memorandum 36993 Witchs cousin qualifies as religious org since its beliefs are claimed to be religion and are sincerely held (though the public policy principle will prohibit illegal activities)

22

Inurement and Private Benefit

Inurement and PB doctrines regulate the quintessential characteristics of charities: that they operate for public benefit, and do not permit their assets or activities to profit persons other than their intended beneficiaries. Inurement: o Stems from the code. o Applies to Insiders o Prohibits any benefit by an insider, no matter how trivial, is prohibited o Penalty used to be loss of exemption, but this has evolved into Intermediate Sanctions Private Benefit: o Stems from Treasury regulations o Prohibits organizations from providing substantial economic benefit to individuals who do not exercise any control over the organization. o Incidental benefits OK (i.e., not excess benefits)

Insiders ONLY Insiders + Outsiders o Per se insiders: Anyone who does not exercise substantial o founders, directors, officers, and control over the corporation. people in a position to influence the financial affairs of the organization o entities or partnership with more than 35% of the voting power or influence over the org o insider test from EBT: Any person who was.. in a position to exercise substantial influence over the affairs of the organization. 4958(f)(1)(A) Examples: 1. Payment for goods/services for more than FMV. 2. Transfer of org's assets for less than fair consideration. 3. Unreasonable compensation or compensation based on a percentage of the tax-exempt org's net income. 4. Anything not included in the compensation package, i.e., discounts, below market loans, etc. Example: United Cancer Council o Facts: In that case, the charitys outsider fund-raiser received $26.5 million as compensation out of a gross amount of $28.8 million raised for the charity. o Holding: The fundraiser did not, by reasons of being able to drive a hard bargain, become an insider

Church of Scientology v. Commissioner: Rule: IRS revoked tax organization's exemption based on a finding that net earnings had inured to the benefit of its founder. - Facts: Church was being operated for a substantial commercial purpose, with royalties inuring to benefit of the founder; also, its unreported overseas earnings violated public policy. 23

Excess Benefit Transaction and Intermediate Sanctions

Rule: A significant excise tax is imposed on (a) any insider who receives an excess benefit from a public charity, and (b) any organization manager who knowingly participates in the transaction. Excess benefit = where the value of the benefit > value of the consideration received by the org. 2 important scenarios: 1. excess compensation for insider 2. transactions between org and insider that unduly benefits the insider, probably at the expense of the organization o EXCEPTIONS: 1) Reimbursements for reasonable expenses for attending board meetings (but luxury expenses or spousal travel can be EBT) 2) Benefits provided to DQP solely as a member of or volunteer for the exempt org, if the same benefit is available to the public in exchange for a membership fee of no more than $75/year 3) Economic benefits provided to a DQP solely as a member of the charitable class that the org intends to benefit in connection with the accomplishment of its exempt purposes. 4) Does not apply to Private Foundations or State Universities that are government instrumentalities, i.e., receive exemption under 115 not 501c3. (ONLY applies to 501c3 or 501c4)

DQP Statutory DQP: exercises substantial influence over the organization at any time during the 5-year period ending on the date of the transaction; o or their family members; o or an entity in which the DQP in the aggregate controls 35% of voting interests. Deemed DQP Factors: o Founders o Substantial donors o Revenue based compensation o Significant financial control (i.e., over capital expenditures, operating budget, and employee compensation) o Manages discreet segment or activity that represents a substantial portion of the activities, assets, income or expenses of the org as compared to the org as a whole.

Non-DQP

Deemed Non-DQP o Not highly compensated indexed capped at about $90k

Factors: o Vow of poverty, like a monk o Independent contractor whose sole relationship is providing professional advice, without having any substantial decision-making authority (i.e., lawyers, accountants who are being paid a fee for their advice, but do not affect major transactions) o If the direct supervisor is a DQP

24

Revocation vs. Intermediate Sanctions: Factors o size/scope of orgs regular and ongoing activities that further the orgs purpose both before and after the transaction o size/scope of the EBT o whether the org has implemented safeguards reasonably tailored to prevent future problems o whether the involved transactions have been corrected or whether the organization has made other good faith efforts to address the granted benefit PENALTIES INITIAL PENALTY = 25% of the excess benefit on the DQP (not the Org) 2nd TIER PENALTY = 200% imposed on DQP if the violation is not corrected within specified period of time (amount = EBT + additional $ needed to compensate for loss of the use of the money or other property during the period beginning the date of the EBT and ending on date of correction. PENALTY on MANAGERS w/ KNOWLEDGE, INTENT = 10% of EBT capped at $10,000 per transaction - Does not apply to independent contractors or middle managers who must consult with superiors - If 2 or more managers share responsibility, they are jointly and severally liable, and the max per transaction is aggregated. ABATEMENT if violation was due to reasonable cause and was corrected (4962)

Rebuttable Presumption of Reasonableness o transaction approved by the board of directors or a committee, o approving body composed entirely of independent individuals, o approval relied on appropriate comparability data, (i.e., hire comparability consultants; orgs with less than $1m in gross receipts can rely on data from just 3 organizations) o the approval is adequately and contemporaneously documented

o Policy Issues: o What kind of comparability data can be used when assessing reasonable compensation? Three areas of comparison: Job (responsibilities, level of supervision) Person (candidates prior experience, education) Particular organization (hospital, can compare to other hospitals whether profit or nonprofit) Include all forms of cash and non-cash payments, including bonuses, deferred compensation and fringe benefits, whether or not taxable Need detailed record keeping, labeling compensation as compensation 25

Initial Contract Exception: (Posner) one bite at the apple a person is not a DQP w/r/t his initial contract, but would be for renewal k (see 4958) exception does not apply if person was already a DQP when entering the K Revenue Sharing or Performance Based Compensation OK as long as its a Fixed Payment You can have performance-based comp that is Non-Discrectionary, and then it qualifies as fixed. o Up to 20% is discretionary. o But Up to 20% up to $x qualifies as a fixed payment

Note: An excess benefit transaction involving a director is an example of self-dealing and a breach of fiduciary duty.

26

Lobbying and Political Campaign Activities

Summary: A 501c3 cannot devote a "substantial part" of its activities to lobbying, propaganda, or attempting to influence legislation. Rule of Thumb (BUT NOT LAW): "not substantial" = < 5% of its overall activities - rule: if its main or primary objective can only be attained by legislation, and it advocates for that objective (as opposed to engaging in nonpartisan analysis, study, research and making the results available to the public. Exception: actions by executive, judicial, or administrative bodies What is NOT "influencing legislation"? IRC 4911(d) "Legislation" = acts, bills, resolutions, etc. a) nonpartisan analysis, study, or research; making results available to the public. b) providing technical advice or assistance in response to a written request by a governmental body. c) appearances before, or communications to, any legislative body with respect to a possible decision of the body which might affect the existence of the organization, its powers and duties, its tax-exempt status, or the deduction of contributions to it. d) communications between the organization and its bona fide members unless the communications directly encourage the members to influence legislation or directly encourage the members to urge nonmembers to influence legislation. e) routine communications with government officials and employees. No Substantial Part Test: No substantial part of the activities may constitute attempting to influence legislation. Christian Echoes National Ministry v. United States o Rule: Religious organizations that engage in lobbying (substantial legislative activity) are disqualified from tax exemption regardless of the motivation or purpose of that activity. o Tax exemption is a matter of grace rather than a right therefore, withholding exemption does not deprive the religious org of its guaranteed right of free speech. o Also see: Regan v. Taxation With Representation Washington (lobbying restrictions do not violate the First Amendment) 501(h): elective provisions permit "grass roots" lobbying and direct lobbying subject to dollar and percentage limitations. Politicking Rule: a 501c3 cannot intervene in any political campaign on behalf of a political candidate. - Cannot use questions designed to indicate bias on certain issues - cannot restrict consideration to only one candidate or that candidate's voting records. Exceptions: - the annual preparation and dissemination of Congressional voting records without comment or other indication of approval or disapproval - Surveying all candidates on a wide range of issues and publishing candidate's responses.

27

UBIT
An exempt organization generally must pay tax on its unrelated business taxable income, i.e., the gross income the organization receives from an unrelated trade or business (513) regularly carried on by the organization, less any permitted deductions which are directly connected with the carrying on of such trade or business, and subject to certain exclusions. Analytical Framework: 1. Whether the exempt organization is subject to unrelated business rules a. Virtually all orgs exempt through 501(a) are covered: charities, private and public, including pension funds, profit-sharing plans, state colleges and universities b. Does not apply to government entities (other than colleges/universities) 2. Whether the activity involves constitutes a trade or business a. Trade or business = any activity which is carried on for the production of income from the sale of goods or the performance of services. b. Fragmentation Rule: IRS will look at each activity separately, and characterize activity as it chooses. Consider, for instance, the sale of certain goods from the gift shop. If the product being sold is related to its exempt purpose, then it is not UBIT. 3. Whether the business is regularly carried on a. Frequency and Continuity -- must be infrequent, and pose no threat of unfair competition b. If activity is seasonal and occurs for a significant part of the season, then it qualifies as regularly carried on. c. NCAA v. Commissioner: i. advertising in NCAA program is not UBIT (yes, this is ridiculous) 1. not an unfair competitor 2. not regularly carried on a. regularly carried on depends on frequency and continuity in light of the goal of making sure they are taxed on the same basis as nonexempt business endeavors. b. Use the amount of time of the tournament, and not the time spent selling advertising, as the measured time span. (This is ridiculous). ii. Note: sale of broadcast rights for annual intercollegiate athletic event was not subject to UBIT, because it was related to the educational purpose of athletic competition (Revenue Ruling 80-296) d. Musem Gift Shops: i. Revenue Ruling 73-104: greeting cards made by a museum and sold commercially nation-wide in magazines is not UBIT because it promotes the exempt purpose by reaching more of the public and getting them interested in the museum. ii. Revenue Ruling 73-105: gift shop revenue from museum is not UBIT for stuff related to the museum (i.e., art, books, reproductions); but it is UBIT for touristy stuff (fragment sales to tax) 4. Whether the regularly carried on business is substantially related to the purpose of the exempt organization 28

a. Elements: (1.513-1(d)(2)) To be substantially related, must be: i. Causally related to the exempt function ii. Contribute importantly to exempt purposes iii. On a scale that is reasonably necessary b. based on facts and circumstances i. Size/extent of the activity ii. Scope of activity if beyond, then UBIT (i.e., an agricultural school selling way more milk than is produced by its students 1. If processing/work necessary after its exempt purpose is fulfilled, then UBIT (i.e., agricultural school sells ice cream or cheese) the product should be substantially the same form as it was during exempt purpose. 2. Example: Blood banks: selling blood is fine, but selling plasma or other byproducts = UBIT iii. United States v. American College of Physicians: Ad revenue from professional journal was UBIT because running an advertising business was not substantially related to the journals educational efforts iv. Hi-Plains Hospital v. United States: pharmacy sales in conjunction with a hospital may be UBIT when sales are made to the general public 1. Analysis: sales to private patients of the hospitals doctors were substantially related to the provision of hospital services, and therefore not UBIT. (Fragmentation). But sale of drugs to the general public was UBIT because sale of drugs is not exempt activity. c. Qualified Sponsorship Payments i. RULE: no substantial return benefit -- any payment, whether in the form of money, transfer of property or performance of services, made by a sponsor to an exempt organization without an arrangement or expectation that the sponsor will receive any substantial return benefit from the organization. 1. Irrelevant whether the sponsored activity is related or unrelated to the organizations exempt purpose, or whether it is temporary or permanent. ii. Substantial Return Benefit = any benefit other than: 1. use or acknowledgement of the name, logo, or product lines of the sponsors trade or business 2. any goods that have an insubstantial value and qualify as disregarded benefits (i.e., Tickets to an event, not more than worth 2% of the sponsorship payment) iii. No qualitative or comparative language of the sponsor iv. No exclusive sponsorships: There is a substantial return benefit when the organization agrees to limit the sale, distribution, availability or use of competing products in connection with a sponsored activity constitutes an exclusive-provider arrangement. 5. Does one or more of the activity exceptions apply?: a. Substantially all labor by volunteers (85%+) b. Trade or business is conducted for the convenience of its members, students, patients, officers. c. Selling of donated goods/ d. Bingo. 29

e. Distribution of low-cost items for fundraising (i.e., mugs, notepads, etc.) f. Exempt function revenue, i.e. ticket sales to the symphony g. Certain research income 6. Does one or more of the income exceptions apply?: a. Passive Income is exempted from UBIT, because passive income does not trigger the unfair competition rationale behind UBIT. i. Dividends, interests, annuities, capital gains is exempt from UBIT. ii. Certain rents are exempt from UBIT: 1. Rent must be paid out of lessees gross receipts 2. When personal property is leased together with real property: a. if rent attributable to the personal property is < 10% of total rent all the rent qualifies for the rental exclusion. b. If rent attributable to the personal property is 10-50% of total rent the amount that is attributable to the real property qualifies for the rental exclusion. c. If rent attributable to personal property is 50%+ of total rent none of the rent qualifies for the rental exclusion. 3. No exclusion applies if: a. rent depends in whole or part on the net income or profits of any person from operating the property. b. If the organization provides services to the lessee other than those normally provided by a landlord, such as heat, light, trash. iii. Royalties: Payment for the right to use University name, logo, CR, patents, etc. will be taxed if the University provides more than minimal services.

7. What available expenses can be deducted in computing UBIT a. Formula: GI from regularly carried on trade or business less directly related deductions i. Directly Related = proximate and primary relationship to the unrelated business are deductible from UBIT 1. Examples: a. Expenses attributed solely to the unrelated business are deductible from UBIT b. Expenses attributed to dual use facilities or personnel, requiring an allocation between exempt and nonexempt functions on a reasonable basis. i. Use time as a reference. Depreciation can be allocated by reference to space used for various activities. ii. Rensaelear Polytechnic University v. Commisioner: Rule: Indirect expenses attributable to dual use facilities are by definition proximately and causally related to the business and therefore they are related. Thus, the organizations allocation of fixed expenses must be reasonable. 30

1. Holding: Here, RPI computed by faction of total hours used for nonexempt purposes divided by total number of hours the field house was used for all activities and events combined. Court held this was reasonable. 2. Counterargument: Commissioner argued that the calculation must be based on the total time available for use, not the total time actually used. Argued that a strict application of directly connected with was necessary to prevent abuse of the tax exemption privilege. 3. Takeaway: Red Herring that RPIs allocation method will promote tax abuse; the use of educational facilities to produce unrelated business income is not tax abuse. ii. Exploitation of Exempt Functions expenses allocated to exempt activity may be deducted from UBIT only after first being deducted from income derived from that function 1. Limited to the extent that: a. Expenses exceed exempt activity income b. The allocation of the excess expenses to UBIT does not result in a loss from the unrelated trade or business. 2. Examples: a. Cost of developing a membership list and selling it to an ad agency not deductible from UBIT because that activity is not one that is usually conducted by for-profit org. b. Income from selling ads in an exempt organizations journal is deductible against UBIT because producing the journal is one normally conducted by taxable orgs, so the expenses attributable to the production may be deducted against UBIT. 8. Whether the unrelated activity poses a threat to the organizations exempt status

31

Private Foundations
Generally o Definition: a fund of private wealth established for charitable purposes, usually in perpetuity o Every charity is deemed to be a private foundation (it is the default classification) unless it satisfies the IRS that it meets one of the definitions of a public charity under 509(a) o Most are supported from a single individual, corporate source, or family o Principal function is to make grants, but they can be organized as operating foundations o Types of Private Foundations:
Independent -largest & most varied, established by contributions from individual donor or family who usually participate actively in foundations direction, most are endowedhave a principal fund and make grants from investment income o Corporate -established by business corporations as a means of carrying out systematic programs of charitable giving, focus on educational, cultural and social welfare needs of communities where they have facilities and employees, few have large endowments o Community -multiple sources of funding and a local or regional focus in their giving, usually classified as public charities under Tax Reform Act so are subject to fewer and different regs than private foundations, gifts to them qualify for highest income tax deductibility o Operating -private foundation that primarily conducts programs of its own, expending its funds directly for the conduct of its own charitable activities rather than making grants to others Disadvantages of Private Foundation Status o Not the best 170 deduction o Excise taxes if the org fails to: Refrain from acts of self-dealing 4941 Meet minimum distribution requirements 4942 Abstain from excess business holdings and jeopardizing investments 494344 Refrain from making certain charitable expenditures o 2% excise tax on net investment income, including capital gains, which can be reduced to 1% if charitable contributions are increased to a specified amount (4940) o Much tougher restriction on self-dealing No intermediate sanctions on inurement o Tougher reporting and disclosure requirements Private foundation is really the 501c3 default option, unless it qualifies as a public charity under 509 o 509a1 generally covers churches, schools, hospitals, support orgs for state colleges and universities, and government units, as well as other orgs that receive their public support through gifts, grants, and contributions from a broad group of people mechanical test: more than 33.33% is public support facts and circumstances test: org must have at least 10% public support and be organized and operated to attract new and additional public / govt support on a continual basis, i.e. active fundraising program and membership. The closer to 10% public support, these factors apply: o Support from broad number of persons, not just members / single family o Governing body representative of broad public or community interests, such as a public official, or those elected by a broadbased membership. o Availability of public facilities, such as a museum, library, symphony, etc. o

32

Catch-all category: Substantial # of dues paying members Whether dues have been set at rates that make membership available to a broad cross-section of the public; whether activities appeal to some broad common interest.

o 509a2 generally covers orgs that receive their support from a combination of membership dues or activities related to their tax-exempt purpose o 509a3 generally covers supporting orgs that support public charities, that receive public charity status because of the relationship, without regard to the source of their income. General rules: o Fraction of the sum of orgs public support during 5-year period, over the sum of the orgs total support. Normally, under 509a1, the org must have 33.33% public support to qualify as publicly supported, but it may qualify with as little as 10% public support by submitting a narrative facts and circumstances description of how it is organized and operated to attract public support. o Public Support the funding should come from a broad cross-section of society, but 509a1 and 509a2 account for public support differently. For example, 509a2 can include exempt function income while 5019a1 must exclude exempt function income from both the numerator (public support) and the denominator (total support). o 509a1 Test: Mechanical Test: Public Support / Total Support must be greater or equal to 33.33%

Calculating Public Support numerator Includes o Gifts, bequests, grants, government grants, membership fees. o private funds subject to the 2% limitation. (2% of total support); o gifts from family members are aggregated for purposes of the 2% test. o Qualifies sponsorship payments (up to 2%) Does not Include o Amounts passed through a public charity or govt unit by a donor who has expressly earmarked them for the benefit of the recipient org. o Exempt function Income o Fees paid in exchange for a benefit o Unusual grants: (unexpected windfalls that could adversely affect public charity status)

Calculating Total Support - denominator Includes o o o o Monetary gifts, grants, and contributions from all kinds of donors Government grants Net income from unrelated business Gross investment income (except capital gains) Does not Include o o o o Related income (to the orgs exempt purpose); tuition, admission fees Capital gains The value of donated services Unusual grants substantial contributions or bequests from disinterested parties that are unexpected, and would adversely affect the orgs status as publicly supported. They are considered to be attracted by the orgs publicly-supported nature.

33

509a2 Gross Receipts Test: 2 steps:

o PUBLIC SUPPORT: 1 - Must receive more than 1/3 of total support from gifts, grants, contributions, membership fees, admission charges, and fees from the performance of exempt function, and from anyone who is not a DQP o Exclude: gifts from substantial contributor or other DQP gross receipts from exempt function that exceed the greater of 5k or 1% of support for that year. 2 - Negative 33.33% support test an org will not qualify as publicly supported if it normally receives 33.33% of its total support from o gross investment income o income from unrelated taxable activities, minus the tax imposed on the income TOTAL SUPPORT o Gifts, grants, contributions, net income from unrelated activities and investment income (except capital gains), gross receipts from admission, sales of merch, performance or services or furnishing of activity that is not unrelated. o Investment Test: no more than 1/3 of total support may consist of interest, dividends, rents, royalties, payments with respect to securities loans, and net after tax UBIT

509a3 Supporting Org 2 tests

Purpose test supporting org has to benefit or carry out the purpose of the supported org Control test supported org has to control the supporting org in some way, vote for a majority of board directors

34

PRIVATE FOUNDATION EXCISE TAXES: Name of Tax Sec. 4941 Self-Dealing Sec. 4942 Charitable Distribution 5% of FMV of all assets over acquisition indebtedness with some adjustments** N/A Sec. 4943 Excess Business Holdings 20% limit on PF and DQP holdings, with 35% in some cases and 2% de minimis okay N/A Sec. 4944 Jeopardy Investments Tax on risky portfolio investments; close scrutiny to options and straddles, for example** N/A 10% up to max of $10,000 if knowing* 10% on amount so invested N/A 5% up to max of $20,000 if knowing 25% on amount so invested Sec. 4945 Taxable Expenditures Forbidden activities - e.g. grants to individuals or non-PC's , unless meet conditions** N/A 5% up to $10,000 if knowing* 20% of amount expended N/A 50% up to $20,000 if knowing 100% of amount expended

Brief Description

Sales, leases, compensation use of assets, and other dealings between PF and DQP 10% of Amount Involved 5 % if knowing up to max of $20,000* N/A 200%

Initial tax on DQP (other than Manger) Initial tax on Foundation Manager Initial tax on PF Second-tier tax on DQP

N/A 30% of undistributed amount N/A N/A 100% of undistributed amount

N/A 10% on value of excess N/A N/A 200% on value of excess

Second-tier tax 50% if knowing on Manager Second-tier tax on PF N/A

* **

Reliance on advice of counsel helps to avoid. Special rules for program-related investments.

35

DISSOLUTION and DISTRIBUTION OF ASSETS o General Concepts: o Rule: non-distribution constrain applies on dissolution Must be considered at the organizational phase and accounted for in the organizing documents: plan for it at the beginning Assets will go to another charity, or will be distributed according to the bylaws to members of a mutual benefit org. o 501c3: Organizational Test: Articles must require that on dissolution assets must be distributed for an exempt purpose, or would be distributed by a court to another org to be used in a manner that would best accomplish the general purpose for which the dissolved org was organized (Treas. Reg. 1.501(c)(3)-1(b)(4))
o State laws: stricter. The AG will usually require that the subsequent charitable purposes are actually as close to initial charitable purpose as possible. Involuntary Dissolution o Abandonment of activity o Insufficient assets to discharge liabilities o Board deadlock o Internal dissension by members o Fraudulent mismanagement or abuse of corporate privilege o Failure to carry out corporate purpose o Waste of assets o Failure to pay creditors as liabilities become due o Violation of statutes, corporate privileges or powers o Failure to pay appropriate taxes or adhere to filing or record-keeping requirements o Cant be forced into involuntary liquidation under federal bankruptcy code

Voluntary Dissolution o Bankruptcy o Disposition of all corporate assets o Failure to conduct an activity for statutorily defined period of time o Loss of all corporations members o Loss or surrender of a corporate charter by a subordinate chapter to its head corp o Duration in the charter was limited by a specific event or date which occurred o Statutorily specified number of members, directors, or the AG can petition for voluntary dissolution

Trusts o Rule: establish broadest purposes possible so that if specific purpose disappears, money can be diverted elsewhere Instead of Save the Llamas make it about saving animals o Dissolution clause: permits the trustee to dissolve when she wants o Variance clause: allows trustee to change the purpose without going to court Either of these clauses must be in the organizing instrument o Upon dissolution, funds must go to an entity whose purpose is sufficiently similar to the original purpose. Put any details in the bylaws, not the instrument itself Public Benefit Corporation o Rule: assets must be distributed to other public benefit corporations according to the rules of the jurisdiction, i.e. the Attorney General o Checklist: California Procedures for Voluntary Dissolution

The board of directors, members, or both, as appropriate, adopt resolutions electing to wind up and dissolve file a certificate of election to wind up and dissolve with the Secretary of State Not necessary if the vote is by all members of a corporation with
members or by all directors of a corporation without members, and

36

o Cases Matter of MS Service: Issue: how much flexibility should be permitted to modify an orgs charitable purposes upon dissolution? Rule: Assets held by corp must be distributed to an org engaged in activities substantially similar to the dissolved corp. Factors o Source of funds to be distributed (public subscription, trust, investment) o Purposes and powers of the corporation as enumerated in the charter o Activities in fact carried out and services actually provided by corp o Relationship of the activities and purpose of the proposed distributes to those of the dissolving corp. Mutual Benefit o Cases: In re Los Angeles County Pioneer Society: Public benefit orgs must transfer their assets on dissolution to charitable or similar uses, while mutual benefit orgs may distribute assets to members or in accordance with such other plan provided for in the certificate

if a statement to that effect is added to the certificate of dissolution. Notify the Attorney General and, if holding assets in charitable trust, it requests a waiver of objections to any proposed distribution of assets. Notice of the dissolution and winding up to members and creditors as necessary. Wind up operations, pay or adequately provide for payment of liabilities, and distribute assets File a certificate of dissolution with the Secretary of State Notify the Registrar of Charitable Trusts. File informational returns (Form 990)

37

Cy Pres: Modification of NPO Purposes and Deviation for Charitable Trusts o o Courts use equitable powers to save a trust from failure or to reform it so as to accomplish its general purposes. Cy Pres: modification of trusts fundamental purpose, overall objectives, or beneficiaries: o Rule: When the satisfaction of a charitable purpose becomes impossible, inexpedient or impracticable, or has already been accomplished, equity will permit the trustee to substitute another charitable object, which approaches the original purpose as closely as possible. Degree of Frustration must be relatively great Degree of change must be relatively small Will also be applied when purpose violates constitutional or statutory norms (ie racial discrimination) o Test: 3 parts A valid charitable trust exists Settlors specific charitable obligation is frustrated, necessitating cy pres modification to carry out the settlors wishes Settlors general charitable intent is not restricted to the precise purpose identified in the trust instrument Cases: o In re Estate of Buck Facts: Buck left a large estate to the care for the needy of Marin County, and for other nonprofit charitable, religious, or educational pruposes in that county. Trust assets had grown enormously after Bucks death. The Trustee (SFO Foundation) petitioned to modify the trust under an expansive interpretation of cy pres, and sought to expand the geographical limits to enable the trust to make grants outside of Marin County, arguing out of equity and charitable efficiency Issue: whether cy pres doctrine would permit a change in charitable purpose for reasons of equity and charitable efficiency? Holding: No, court denied petition for modification. Analysis: Cy pres was inapplicable because ineffective philanthropy, inefficiency do not constitute impracticability under cy pres. Cy pres cannot be invoked on grounds that it would be more fair and more equitable to spend the trust funds in a manner different from that specified by the testator.

Deviation modification of trusts administration o Rule: A court may alter the administrative or procedural provisions of a trust when compliance becomes impossible or illegal, or that due to circumstances not known or foreseen by the settlor, compliance would defeat or substantially impair the accomplishment of the purposes of the trust. o This does not alter the trusts fundamental purpose, just the way the objective is administered and carried out. o Often used to change investment issues, administrative options, trust property, etc. o Example: o When a trust established a school for locally-born girls ran out of money to continue operating, the administrators wanted to admit non-local girls, but keep trust money for only for the local girls. The Court applied deviation and allowed for admission of nonQuincy girls. Cy Pres NOT applicable because the gift had not yet failed entirely or become impossible. Trustees proposals were secondary to the intent of establishing the school. Testamentary clause stated that the school was for the education of native-born girls referred only to the use of his gift, was a subordinate detail, and could be disregarded if changed circumstances rendered it obstructive or inappropriate to the accomplishment of the primary charitable purpose.

38