Assume Pat Patron, a lover of the arts,

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1 THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 THE PPC NONPROFIT UPDATE What Are Programmatic Investments? Assume Pat Patron, a lover of the arts, makes a gift to City Symphony of $250,000. The donor specifies the gift be used to make instrument loans to the musician employees at an interest rate of two percent less than the prime rate. Principal repayments on the loans must be used to make future loans, but the interest earned can be used by City Symphony to offset the costs of running the instrument loan program. Although those loans will earn a financial return, should they be classified as investments? Common sense would tell us a typical lender wouldn t make an unsecured low-interest rate loan to a talented but financially struggling musician although, programmatically, there are very good reasons for the symphony to make the loan. A new chapter in the AICPA Audit and Accounting Guide, Not-for-Profit Entities (Audit Guide), discusses that and other questions about investments that are motivated by the nonprofit organization s desire to achieve programmatic goals. Types of Programmatic Investments Chapter 8 of the Audit Guide discusses three types of investments made by nonprofit organizations for a program purpose: loans, guarantees, and equity investments. A programmatic investment has to meet both of the following criteria: The primary purpose is to further the mission of the nonprofit organization. The production of income or the appreciation of the investment isn t a significant purpose. In other words, an investor seeking a market return wouldn t enter into this type of investment. Although the term programmatic investment may be new, it is comparable to the term program-related investment defined by the IRS. That definition was developed to exclude certain investments from the excise taxes imposed on a private foundation for investments that jeopardize the carrying out of the foundation s exempt purposes. In this Issue: What Are Programmatic Investments? Overvalued Facade Easements Result in Appraiser s Suspension Veterans Organizations Special Rules Tax Briefs This newsletter is also available online. Please call (800) , or order online at

2 2 THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 Programmatic Loans The remainder of this article discusses the most common type of programmatic investment programmatic loans. A future article will discuss guarantees and equity investments. Loan terms vary widely based on the needs of the borrower, the type of project, the expectations of the nonprofit lender, and, if the resources used to make the investments were contributed, the donors restrictions. But regardless of the terms, the loan is intended to advance the mission of the organization. Ways in which a programmatic loan differs from commercial lending include the following: The stated interest rate on a programmatic loan may be much lower than the rate that would be offered to a borrower of similar credit risk, or perhaps the loan is interest free. The borrower may not be creditworthy, or the nonprofit lender may not check the borrower s credit as part of its loan origination procedures. The loan agreement may include forgiveness of a portion, or all, of the principal upon the occurrence of a programmatic goal. A nonprofit organization is willing to lend under those conditions because of the borrower s ability to help the lender achieve its programmatic goals. Additionally, by using loans instead of grants, a nonprofit organization can use any loan payments to fund new loans or other programs, thus achieving a greater program impact. Practical Consideration: The guidance in Chapter 8 of the Audit Guide is only intended for the nonprofit organization lender. Other guidance in the Audit Guide helps borrowers under programmatic investments account for their obligation. Chapter 5 of the Audit Guide has guidance for an organization benefiting from a loan bearing no interest or a below-marketinterest rate, and Chapter 10 of the Audit Guide has guidance for reporting debt. Accounting for Programmatic Loans The Audit Guide explains there are two ways to look at a programmatic loan, which leads to some diversity in accounting practice. Two Approaches. Some accountants look to the standards for loan accounting; the Audit Guide calls this approach the effective interest rate approach. Other accountants look to the definition of an inherent contribution; the Audit Guide calls this approach the inherent contribution approach. A nonprofit organization should determine which approach is most appropriate for the loans it makes, and apply that approach to all programmatic loans, reporting consistently from period to period. The choice is an accounting policy decision disclosed in the notes to financial statements. Both methods initially recognize the loan at fair value and, if the loan has a contribution element, both approaches recognize a contribution expense when the loan is made. The main difference between the two approaches is the rate used to impute interest in future periods. The effective interest rate approach uses the contractual cash flows specified in the loan agreement and imputes an interest rate on the loan that fully incorporates the risk the borrower may be unable to make the contractual payments when due. The inherent contribution approach uses the cash flows the organization is most likely to collect and, because much of the uncertainty of collection is reflected in the cash flow estimates, results in a much lower interest rate. A second difference between the two approaches is that as a result of the difference in the cash flows and discount rates used by the two methods, the effective interest rate approach will result in an impairment loss at the end of the fiscal year whenever the most likely cash flows are less than the contractual cash flows (that is, the nonprofit lender doesn t expect to collect all amounts due according to the contractual terms of the loan agreement). Impairment is less likely under the inherent contribution approach because that approach uses the most likely cash flows. Over the complete life of the loan, the difference in the effect on net assets of the two approaches is zero because the first-year impairment loss of the effective interest rate approach is offset by higher interest income recognized in each year thereafter until collection. Choosing Which Approach to Use. The best approach depends in large part on the organization s reasons for making the loans and its expectations at origination for collection of the loan payments. For example, some organizations make loans with the expectation that the borrower will make the contractual payments. (The organization doesn t have to expect to collect all of the payments; its expectations would be similar to that of a market lender.) Most student loans and low income housing loans fall into this category. Microfinance loans small dollar loans to small businesses and individuals in poverty often fit in this category as well. Loans of this type often accomplish their programmatic goals by offering the borrower a lower

3 THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 3 interest rate, no interest at all, or forgiveness of part or the entire loan principal upon the achievement of programmatic goals. For loans originated under those conditions, the effective interest rate approach and the inherent contribution approach might work equally well. Other organizations make loans even though they have little or no expectation of repayment. Those organizations may believe a loan format is more effective than a grant in helping the borrower succeed and become self-reliant. When the objective is social change, the nonprofit lender often doesn t consider the borrower s creditworthiness when determining whether to make the loan, and often doesn t intend to pursue collection if the loan becomes past due. Many start-up loans to businesses owned by members of economically disadvantaged groups or located in deteriorated urban areas are examples of this type of loan. When loans are made under those circumstances, the inherent contribution approach might be preferable because the loan is, in substance, a contribution to the borrower. At the origination date, the value of the cash (or other assets) transferred to the borrower is reported as a contribution made, and the organization doesn t recognize interest income or impairment losses in future years. If payments are collected, they are recognized as a gain. Still, other organizations make loans to borrowers of marginal creditworthiness with the expectation that some, but not most, of the payments will be collected. There is a lot of risk inherent in the cash flows, and it is reasonably possible the borrower will default or be slow-paying. Typical market sources, such as banks or mortgage lenders, won t lend to those borrowers or will lend only at rates that aren t affordable for the borrower. Short-term loans from community foundations to local nonprofit organizations for their operating needs and bridge loans to the community for rebuilding in the aftermath of a disaster that are repayable from insurance recoveries are examples of those types of loans. The inherent contribution approach might be preferable for that type of loan because the impairment losses and higher interest rate recognized under the effective interest rate approach are inconsistent with the fact that, from their origination, those loans are expected to be only partially collectible. Forgiving Programmatic Loans The preceding discussion has focused on loans that have a contribution element because they have belowmarket interest rates or because they are made to borrowers of marginal creditworthiness. Another way nonprofit organizations use loans to achieve program goals is to make a loan to a creditworthy borrower, but to agree to forgive all or a portion of the loan if the borrower achieves a programmatic goal. Loans that will be forgiven if a student completes a specified amount of community service after graduation are an example of that type of loan. Because the forgiveness of the loan is dependent upon a future and uncertain event, the contribution element of those loans is a conditional promise. At origination, the loan typically is recognized as though the portion that might be forgiven will be collected. At the future date when the programmatic goal is achieved (that is, when the conditional promise becomes unconditional), the loan s carrying amount is reduced and a contribution made is recognized. In other cases, the terms of a programmatic loan don t include forgiveness, but the nonprofit lender decides to forgive all or a portion of the loan. The Audit Guide discusses how to distinguish between a loan that is forgiven (a contribution made) and a loan that is impaired (a loan loss). Accounting after Initial Recognition and Measurement and Disclosures for Certain Organizations In most ways, after the initial recognition and measurement, programmatic loans are similar to loans without a programmatic element. In addition, if making programmatic loans is one of the organization s major programs, paragraph 8.52 of the Audit Guide recommends the organization disclose the following additional information in its financial statements: The number of loans outstanding. The average face amount and average carrying amount of the loans at origination, and the reason for the difference. The program purpose being accomplished by the loan activity. The amount of impairment losses in total and by program expense line item(s). Practical Consideration: More information on programmatic investments can be found in the 2014 edition of PPC's Guide to Preparing Nonprofit Financial Statements. To order, visit tax.thomsonreuters.com/products/brands/ checkpoint/ppc.

4 4 THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 Overvalued Facade Easements Result in Appraiser s Suspension Background The conduct of CPAs, attorneys, appraisers, and enrolled agents in their practice before the IRS is strictly governed by Treasury Department Circular 230. The consequences of violating Circular 230 can be severe and include (1) disbarment or suspension from practice before the IRS, (2) monetary penalties, and (3) disqualification from presenting evidence or testimony in any administrative proceeding before the Treasury or the IRS. Practice Defined Practice before the IRS is much broader than many practitioners realize and includes all matters connected with a presentation to the IRS relating to a taxpayer s rights, privileges, or liabilities under any IRS-administered law or regulation. This includes, but is not limited to, preparing or filing federal tax returns and other documents; corresponding and communicating with the IRS; representing a client at conferences, hearings, and meetings; and determining the correctness of oral and written representations made to clients and the IRS [Circular 230, Sec. 10.2(a)(4)]. Since Circular 230 applies to any law or regulation administered by the IRS, it encompasses areas that are not part of the Internal Revenue Code. Most notably, these include issues pertaining to foreign financial account reporting and the Affordable Health Care Act of The Underlying Issue The underlying issue in all Circular 230 cases is the tax professional s (or appraiser s) fitness to practice before the IRS. Circular 230 embodies the rules of engagement for tax practice to ensure requisite character, reputation, qualifications, and competency to represent clients in interaction with the IRS. Due Diligence Is Critical Exercising due diligence in all matters involving the IRS is the key to avoiding becoming intimately familiar with Circular 230 enforcement. Unfortunately, Circular 230 does not define due diligence, which has contributed to controversy between the IRS and various professional organizations. Due diligence is presumed exercised if the practitioner relies on the work product of another person and uses reasonable care in engaging, supervising, training, and evaluating the person, taking into account the nature of the relationship with the other person [Circular 230, Sec (b)]. However, the practitioner cannot ignore the implications of information furnished or actually known and must make reasonable inquiries if the information appears to be incorrect, inconsistent, or incomplete [Circular 230, Sec (d)]. Therefore, a tax professional can rely in good faith without verification upon information furnished by a taxpayer, another advisor, another tax return preparer, or other third parties (FAQs posted to IRS website). However, where the Code or regulations attach a condition to a credit or deduction (e.g., proper substantiation of charitable deductions), preparers must make appropriate inquiries to ensure the condition has been satisfied. Current Enforcement Activities The enforcement of Circular 230 is the responsibility of the Office of Professional Responsibility (OPR). In recent public comments, the director of OPR observed that there were 11 disbarments of tax professionals in 2013, as opposed to only two in In addition, OPR heard almost as many cases involving alleged violations of Circular 230 in February of this year as in all of IRS Announcement , IRB 620, describes the recent OPR disciplinary sanctions imposed on certain professionals. OPR has also recently imposed Circular 230 sanctions on a group of appraisers from the same firm that suspends them from performing appraisals in federal tax matters for five years (IRS News Release ). The suspension is a result of the appraisers acknowledged failure to exercise due diligence in preparing documents relating to facade easement valuations for charitable contributions, and for failure to determine the correctness of written representations made to the Treasury Department. Practical Consideration: Exercising due diligence is not a new concept; however, the IRS s focus on ensuring that tax professionals and appraisers are adhering to it has significantly increased.

5 Veterans Organizations Special Rules Veterans organizations (VOs) occupy a special place in the world of exempt organizations. Not only are most VOs tax-exempt, contributions to them may be deductible, and some are permitted to set aside amounts to provide insurance benefits for members. This combination of tax-exempt status, deductibility of contributions, and the ability to pay benefits to members is relatively rare. When coupled with the ability to engage in both lobbying activities and political activities, it is fair to say that VOs are unique in the taxexempt sector. In a recent phone forum, the IRS reviewed and discussed several key topics applicable to VOs, including exemption requirements, exempt activities, unrelated business income (including gaming), and recordkeeping. Depending upon their organization and purposes, VOs may qualify for tax exemption under IRC Secs. 501(c)(2), (c)(4), (c)(7), (c)(8), (c)(10), (c)(19), or (c)(23). The following discussion relates to the rules for exemption under IRC Sec. 501(c)(19). Section 501(c)(19) Exemption Requirements A post or organization whose members are past or present members of the U.S. Armed Forces (USAF) qualifies for tax-exemption under IRC Sec. 501(c)(19) if (1) it is organized in the U.S. or its possessions, (2) no part of the net earnings inures to the benefit of any private shareholder or individual, and (3) certain membership tests are satisfied. Membership Test. At least 75% of its members must be past or present members of the USAF. Substantially all (22.5%) of its other members must be individuals who are cadets or are spouses, widows, widowers, ancestors, or lineal descendants of past or present USAF members or of cadets. Consequently, there is a 97.5% test in addition to the 75% test. For these membership tests, cadets include only students in college or university ROTC programs or at Armed Services academies. THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 5 As long as the membership tests are met, an organization can have any number of social nonmembers who participate in the organization s restaurant and gaming activities. Example 1: Post A has 1,200 members, all of whom are USAF veterans. There are 300 social nonmembers who participate in the Post s gaming activities. Since all members are past or present USAF members, Post A satisfies the Section 501(c)(19) membership requirements. Example 2: Post B has 1,500 members who participate in its gaming activities; 1,200 of the members are past or present USAF members. The remaining 300 are social members who are not cadets and are not related to past or present USAF members. Post B cannot qualify for exemption under IRC Sec. 501(c)(19) because social members exceed 2.5% of the Post s total membership. Exempt Activities Section 501(c)(19) organizations are permitted to have one or more of eight purposes that generally pertain to social welfare, civic or patriotic activities, and member programs [Reg (c)(19)-1(c)]. Social and Recreational Activities. The permissible activities most often conducted by a VO are social and recreational activities for members. These can include operating a bar/restaurant, gaming activity, and dinners/dances. Participation in these activities should be limited to organization members and their guests. A person is a guest only if invited by a member and only if all of his or her expenses are paid by a member. Opening activities and facilities to the public (i.e., persons other than members and their bona fide guests) can result in unrelated business income and jeopardize an organization s exemption. Member Insurance. Section 501(c)(19) organizations are permitted to provide life, accident, or health benefits for their members and their members dependents. These benefits may be provided directly or indirectly through public insurance companies. Unrelated Business Income The unrelated business income (UBI) of a VO depends upon the code section under which it is exempt. Activities that are specifically excluded from the definition of UBI for most exempt organizations are also excluded for VOs. In addition, as discussed previously, a Section 501(c)(19) VO can operate a bar/restaurant for members and bona fide guests as one of its exempt purposes and can also conduct gaming activities open to members and bona fide guests.

6 6 THE PPC NONPROFIT UPDATE, MAY 2014, VOLUME 21, NO. 5 The PPC Nonprofit Update is published monthly by Thomson Reuters/Tax & Accounting, P.O. Box , Carrollton, Texas , (800) Thomson Reuters/Tax & Accouning. All Rights Reserved. Reproduction is prohibited without written permission of the publisher. Not assignable without consent. This publication is designed to provide accurate information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, investment, or other professional advice. If such assistance is required, the services of a competent professional should be sought. Reports on products or services are intended to be informative and educational; no advertising or promotional fees are accepted. Tax & Accounting Research and Guidance P.O. Box Carrollton, Texas PRSRT STD U.S. POSTAGE PAID Thomson However, the income from the following seemingly related activities is UBI: Income from the sale of liquor and food for offpremises consumption. Income received under reciprocal agreements allowing members of unrelated veterans groups to use a VO s facilities. Income from nonmembers, including active duty military personnel. Recordkeeping Every VO, regardless of the basis for its exempt status, must maintain adequate records to establish that its activities further exempt purposes and to establish its liability for, or exemption from, taxes. Section 501(c)(19) organizations must also maintain a list of members and the category of membership (veteran, degree of relation, nonveteran, or nonrelative). If a VO receives deductible charitable contributions, it must maintain even more specific membership data. Know the Rules Securing and retaining tax-exempt status by a VO requires an understanding of the applicable rules and adherence to those rules. IRS Pub. 3386, Tax Guide Veterans Organizations, is an excellent summary of the rules applicable to each potential exemption category for VOs. Another useful resource is IRS Pub. 3079, Tax- Exempt Organizations and Gaming, which discusses the rules for gaming activities (including bingo). Tax Briefs REMEMBER THE HEALTH CARE TAX CREDIT. As discussed in the July 2013 issue of The PPC Nonprofit Update, a tax-exempt organization (EO) may be eligible to claim the small business health care tax credit, provided it (1) paid health care premiums under a qualifying arrangement, (2) had fewer than 25 full-time equivalent employees (FTEs) for the tax year, and (3) paid average annual wages for the tax year of less than $50,000 per FTE. The credit for 2013 can be up to 25% of an eligible EO s share of the health insurance premiums it paid. For years beginning in 2014, the maximum credit for EOs is 35%. The credit is refundable, so even if an EO has no unrelated business income, it can receive the credit as a refund, provided the amount does not exceed the EO s income tax withholding and Medicare tax liability for a calendar year. An EO calculates the credit on Form 8941 and claims it on Form 990-T, line 44f. BETTER LATE THAN NEVER. Under Rev. Proc. 79-6, CB 485, exempt organizations were allowed to use U.S. Department of Labor forms in lieu of specified portions of Form 990. However, Form 990 and the instructions were changed to preclude the use of these substitute forms for tax years beginning in Rev. Proc , IRB 646, formally revokes Rev. Proc