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Archives
December 2002
A Reason to Give: Private Letter Ruling on Corporate Charitable Giving Programs A recent IRS private letter ruling illustrates how some donations to nonprofit organizations may be deductible as business expenses of the donor, rather than as charitable contributions. By characterizing donations as business expenses, some companies may be able to make larger donations, as a corporation's charitable donations are tax deductible only up to 10% of the company's taxable income. Deductions for business expenses are not subject to these types of limitations.
The company requesting the private letter ruling was a small insurance provider that had come under increasing competitive pressure from larger companies. The company established a charitable giving program under which it would donate 1% of the face value of an insurance policy to a charitable organization designated by the policy holder. The company believed that the proposed charitable giving program would appeal to buyers and would give it a significant marketing advantage.
The ruling allowed the company's donations to qualify as tax-deductible business expenses, rather than as charitable contributions. The IRS emphasized that the donations were part of a strategy designed to increase business by attracting more customers to purchase the company's insurance policies. As such, the donations qualified as ordinary and necessary business expenses under section 162(a) of the Code. In particular, the IRS indicated that donations under the company's charitable giving program were in effect "advertising and other selling expenses" that are deductible under Section 1.162-1(a) of IRS Regulations. The IRS also noted that IRS regulations explicitly allow donations to non-charitable organizations to be deducted as business expenses if they bear a direct relationship to the donor's business and are made with the reasonable expectation of a financial return commensurate with the amount of the donation.
On the other hand, the IRS also emphasized that donations for lobbying and political purposes are not deductible as business expenses under IRC section 162(e). Under the insurance company's giving program, purchasers were not permitted to designate political or lobbying organizations as recipients.
While IRS private letter rulings cannot be applied wholesale to the operations of other nonprofit organizations, the ruling sheds light on the agency's thinking about charitable donations and business expenses. Charities should be aware that in some cases, donations from businesses need not be limited by the cap on corporate charitable contributions. Organizations should consider this option when negotiating licensing agreements and other transactions resulting in payments from business corporations.
By Amy Licht
The Ins and Outs of Intermediate Sanctions
The IRS has recently released the first intermediate sanctions rulings since it finalized the regulations in February 2002. These rulings provide an early glimpse into how the IRS will implement intermediate sanctions and offer lessons about financial practices charities should use- and avoid- to steer clear of penalty taxes.
The purpose behind intermediate sanctions is to impose an excise tax on individuals who receive excess benefit from a nonprofit, without revoking the organization's tax-exempt status altogether [see NN 02/01 and 02/02]. The rules apply only to individuals or entities with substantial influence over a nonprofit. Termed "disqualified persons," this category includes senior employees, directors and officers and their families, as well large donors and individuals with a close relationship to a charity's financial operations. Managers who knowingly participate in an excess benefit transaction are also subject to intermediate sanctions.
The recent cases highlight the procedure a nonprofit must follow when evaluating a financial transaction, either compensation or asset transfers, to avoid creating excess benefit [see NN 02/01]. If an organization follows these steps a transaction is presumed to be proper, unless particular facts and circumstances prove otherwise. The elements of this rebuttable presumption are:
Lesson #1: Maintain accurate records of all financial transactions, particularly those involving a disqualified person and use comparability data to determine salary level of officers and key employees.
In Technical Advice Memorandum 2002-4-3057, the IRS imposed intermediate sanctions on the owner of a used-car business who is also the founder and president of a related 501(c)(3) nonprofit through which individuals can donate cars to charity. The IRS determined that the charity's payment to the founder constituted an excess benefit transaction because the organization lacked documentation regarding the hours he worked or the services he provided. The organization's repayment of several undocumented loans to the founder also resulted in excess benefit. Under the intermediate sanctions provisions, the founder was taxed more than $1,000,000 for an original benefit of less than $300,000.
Lesson #2: Do research and pay a "fair market value" for property, particularly when the transaction involves a related for-profit entity or disqualified persons.
In Carraci et. ux., et. al. v. Commissioner of Internal Revenue, the U. S. Tax Court determined an excess benefit transaction occurred in an asset transfer between related nonprofit and for-profit entities. The organizations, a 501(c)(3) healthcare charity and for-profit subchapter S corporation both known as Sta-Home Home Health Agencies, were controlled by three members of the Carraci family. Based on an accountant's negative-value assessment of the charity, the Sta-Home for-profit entity assumed the assets and liabilities of its nonprofit predecessor. However, the court found that the price the Sta-Home for-profit paid was far below the charity's fair market value, which the IRS estimated at over $5 million. As a result, the transfer provided direct benefit to the Sta-Home for-profit entity as well as indirect- and excess- benefit to its shareholders, the Carraci family.
Contrary to the IRS recommendation, the court did not revoke the Sta-Home charity's tax-exempt status. The court stated that since the charitable organization was dormant, it was unnecessary to investigate if it was functioning for tax-exempt purposes and or to explore revocation. Importantly, the court's decision not to rescind the charity's tax-exempt status underscores the point that revocation may be used only for the worst or most pervasive cases of abuse.
Lesson #3: Apply the rules when creating and amending contracts.
In Technical Advice Memorandum 2002-4-4028 the IRS addressed the question of reasonable compensation to a disqualified person and his spouse. The IRS focused on the amending of a consulting agreement between a nonprofit healthcare organization and its former executive director and his wife.
In the memorandum, the IRS stated that the organization's Board of Directors did not examine a study about comparable compensation levels until nine months after determining the couple's compensation rate, at which point the data was five years old. As a result, the Service found that the review was not meaningful and the organization did not meet the requirements of a rebuttable presumption.
The IRS also determined that as the spouse of disqualified person, the executive director's wife fit the definition of a disqualified person. The intermediate sanctions tax was imposed because the Board of Director failed to consider relevant facts and circumstances, such as her education or experience, when determining her compensation rate. Most egregiously, the contract provided that the wife would receive payment for two people in the event of the husband's disability or death.
Since the regulations are only in their infancy, much remains to be seen about their implementation and effectiveness. However, the best way for charities to avoid intermediate sanctions is to institute proper financial procedures.
By Amy Licht
Charities should be aware that certain safe harbors exist for small organizations (defined as those with less than $1 million in annual gross receipts) and for managers who unknowingly participate in an excess benefit transaction.
Increased Protections for Donors Listed on Schedule B
The Service will implement three new measures to increase protection of contributor identity. First, the Service will not include Schedule B on CD sets or any other form of media made available to the public. Second, people who request Schedule B from the IRS will be told that redacted versions of the form will be made available upon request. Third, the Service will review requests for Schedule B on a case-by-case basis to determine whether the information can be reasonably expected to identify the contributor.
Currently the information on Schedule B is publicly available, with donors' names and addresses redacted to protect their privacy. However, critics claim that contributors can still be identified by piecing together information that remains on the form, including size of contribution and description of donated property. As a result, critics say, some donors may fear their contributions will be public and therefore be hesitant to donate to the charity of their choice.
While these steps will not end public access to Schedule B, they may help to protect individuals who prefer their contributions be confidential or anonymous.
By Amy Licht
Update: Revised Filing Requirements for 527 Political Organizations Available Online The details of the new law that exempts many state and local political organizations from filing certain IRS forms may now be found online [see NN 11/02]. The IRS has added both an informational news release and a fact sheet to its website.
The news release may be found online at: http://www.irs.gov/pub/irs-news/ir02-123.pdf, and the fact sheet may be found at: http://www.irs.gov/pub/irs-news/fs-02-13.pdf. Because these pages are in PDF format, you will need Adobe Acrobat to view these documents.
For those interested, the text of the legislation may be found at http://thomas.loc.gov by searching for "H.R. 5596."
By Miguel de Baca
The bill, as originally drafted, proposed that the recording industry collect per-song, per-listener amounts for current broadcasts, and for broadcasts retroactive to 1998. Many small and noncommercial webcasters raised concern that this per-performance system, compounded with retroactivity, would put them out of business. These webcasters would have been subject to royalty rates similar to those of large Internet broadcasters (e.g., AOL or Microsoft).
The signed law replaces the per-performance system for small webcasters. Instead, it allows SoundExchange, the royalties-collection arm of the recording industry, to enter into negotiations that will set a percentage-of-revenue amount to be paid. Although a percentage-of-revenue fee likely will be high, it at least allows small and noncommercial webcasters an option if they cannot afford the per-song, per-listener amount. The law also specifically imposes a six-month moratorium on royalties collection from noncommercial webcasters to allow for negotiations to take place.
Additionally, the signed law authorizes SoundExchange to postpone collecting retroactive royalty payments from small and noncommercial webcasters. Instead, these webcasters may pay in installments over the course of one year.
The full text of the Act is available online at http://www.soundexchange.com/HR5469.pdf
By Miguel de Baca
Under existing tax law, U.S. charities are responsible for reviewing and approving the use of grant funds by foreign organizations (that are not recognized by the IRS as tax-exempt under Section 501(c)(3)), to ensure that the use furthers the U.S. organization's exempt purposes. The IRS has not provided specific guidelines regarding the extent to which U.S. organizations must investigate foreign grant recipients, however. This raises the concern that the IRS may look to the new Guidelines in evaluating charities' foreign grant-making procedures.
In addition to specifying standards for U.S. organizations' internal governance and accounting, as well as expansive public disclosure procedures, the Guidelines recommend detailed fact-finding by U.S. charities making grants to foreign organizations, including obtaining the following information:
Furthermore, the Treasury recommends that a charity review the financial operations of the foreign recipient, including checking its financial institution's sound banking practices. The Treasury also suggests that the charity do on-site audits of the recipient organization whenever possible.
Critics of the Treasury's guidelines say that the lengthy and detailed information is too tall of an order for most charities. For example, gathering the names and addresses of the foreign recipient organization's employees and subcontractors is an administrative burden on both the grantor and the foreign grantee. Evaluating the foreign organization's banking institutions would be practically impossible. In most cases, U.S. charities generally lack the expertise and resources to investigate money laundering schemes. Some also note that the "public lists" of terrorist organizations enumerated by the Treasury are not readily available.
While the Treasury guidelines are voluntary, U.S. charities should keep an eye on how the guidelines may be applied by the IRS or whether mandatory measures will be implemented by Congress. Congressional representatives have suggested a "white list" of charities who comply with the Treasury guidelines, and possible expansion of the PATRIOT Act to include mandatory disclosure and oversight by charities making foreign grants. There is also a bill pending in the Senate that would suspend the tax-exempt status of any organizations designated by Executive Order as supporting terrorist activity.
While it is too early to know whether the interest in preventing terrorist funding will have any binding legal ramifications for tax-exempt organizations, it is clear that it is increasingly important for organizations to exercise supervision over foreign grants. U.S. charities working with organizations abroad should seriously consider implementing the Treasury guidelines to the extent feasible and to think about exercising additional measures to evaluate foreign grant programs. An international grant-making charity should have practices in place to ensure that the foreign organization operates consistently with the purposes of the domestic charity, obtain available documents describing the foreign organization's activities, and conduct other research regarding grantees as is feasible.
The full text of the Treasury guidelines is available online at http://www.treasury.gov/press/releases/docs/tocc.pdf.
By Miguel de Baca
A Victory for Small Webcasters: The Small Webcaster Settlement Act of 2002
The Small Webcaster Settlement Act of 2002, signed by President Bush earlier this month, allows small webcasters to negotiate the amount of royalties paid to record companies and artists. It may also serve as a reminder that even nonprofit Internet broadcasters have an obligation to pay royalties to the recording industry for the use of copyrighted material, such as music.
How Not To Fund Terrorist Organizations Abroad
Over the past few years, U.S. charities have increasingly made grants to foreign nonprofits to fund charitable work abroad. The Department of the Treasury's Office of Foreign Assets Control has now stepped in to caution U.S. charities against unknowingly donating to terrorist organizations. Recently published guidelines, "U.S. Department of the Treasury Anti-Terrorist Financing Guidelines: Voluntary Best Practices for U.S.-Based Charities," furnish U.S.-based charities with a set of recommended practices intended to reduce the chance that charitable funds leaving the United States will finance terrorism. After release, the Guidelines sparked controversy in the nonprofit sector over their practicality. The Guidelines and the objections raised remind charities to have procedures in place to know grantee organizations and to monitor the use of funds granted to foreign organizations.
The Treasury recommends that a charity seeking to fund foreign organizations use resources such as the Internet and certain "public lists" compiled by the U.S. Department of Treasury, the U.S. Department of Justice, the United Nations, and the European Union to screen potential grant recipients for terrorism or money laundering.
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To RSVP, or for more information, please call Miguel de Baca, (202) 328-3500.
This publication is designed to provide accurate and authoritative information about the subject matter covered. It is not distributed with the intent to render legal, accounting, or other professional advice. The services of a competent professional should be sought if legal advice or other expert assistance is required.
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