Operating Agreement 11/17/2016. Legal Considerations For Tax-Exempt Entities. Lumsden McCormick Exempt Organizations Conference 1

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1 LEGAL CONSIDERATIONS FOR TAX EXEMPT ENTITIES: A Primer on Tax Issues for Joint Ventures & Recent Changes to the New York Nonprofit Revitalization Act of 2013 Marla Waiss mwaiss@hodgsonruss.com Patricia Sandison psandiso@hodgsonruss.com Hodgson Russ The Guaranty Building 140 Pearl Street, Suite 100 Buffalo, New York Hodgson Russ Joint Ventures with For Profit Entities Activities of partnership/llc are considered activities of partners/members. Consider: Private benefit/inurement and unrelated trade or business income (UBIT). Must serve public, rather than private interest. Protective language in Operating Agreement. No bright line test what are activities of LLC? Will non profit control LLC? 2 Operating Agreement Protective language may include that the forprofit entity will use its best efforts to ensure the company does not take any action or fail to take any action that would adversely affect the tax exempt status of the tax exempt partner/member within the meaning of Code Section 501(c)(3). Minimize potential for private benefit/private inurement. Private Benefit or Inurement; Insider Transactions Code Section 501(c)(3): no part of an organization s net earnings may inure to the benefit of a private shareholder or individual. Private inurement: Insider receives a benefit in excess of FMV of goods or services provided. Inurement to insiders (e.g., board members, officers, key employees, etc.): absolutely prohibited! Private benefit applies to outsiders and must be incidental. 3 4 Unrelated Business Income (UBI or UBIT) Tax is imposed at corporate income tax rates on net income from an activity that is an unrelated business. A trade or business Regularly carried on Not substantially related to organization s exempt purpose If UBI is substantial, it may jeopardize tax exemption. Unrelated Trade or Business Exceptions Activities deemed to not be unrelated trades or businesses: Activities conducted substantially by volunteers Activities conducted for the convenience of members, students, patients, employees, e.g., hospital gift shop Sale of donated merchandise Qualified sponsorship income 5 6 Exempt Organizations Conference 1

2 Unrelated Business Income Exclusions Exclusions: Interest and dividends Royalty income Rental income subject to certain exceptions Gains and losses from sale of property Excess Benefit Transactions IRC Section 4958 penalizes insiders and organization managers involved in Excess Benefit Transactions. An economic benefit is provided directly or indirectly to or for the use of an Insider if the value of the benefit exceeds the value of the consideration received. Insiders: Disqualified Persons Directors, officers Other persons with substantial influence over affairs of organization at any time in previous 5 years Their family members 7 8 Excess Benefit Transactions 3 prong rebuttable presumption of reasonableness : established if, in approving a transaction with insider: Advance approval by board (interested parties are recused from voting on transaction) Board or committee relies on appropriate data of comparability (e.g., salary survey, appraisal) Adequate contemporaneous documentation by Board or committee Excess Benefit Transaction Penalties Insiders: Repayment of excess, plus interest Tax = 25% of excess amount, or 200% if not corrected Organization Managers: Persons who approved, knowing it was an excess benefit. Tax = 10% of excess amount 9 10 Managing Insider Transactions Establish and enforce policies: Conflicts of interest policy Require disclosure of interests that could give rise to conflicts Compensation determination policy Use rebuttable presumption of reasonableness procedure Joint Venture Policy There is no one size fits all model template, but the IRS Form 990 does ask whether the nonprofit has a JV policy NY Nonprofit Revitalization Act of 2013 The Act is the most comprehensive revision of the New York Not for Profit Corporation Law ( NPCL ) in over 40 years. Prior to the Act, non profits have faced: Antiquated requirements Unnecessary costs and delays Insufficient guidance on fiduciary responsibility Exempt Organizations Conference 2

3 Who is subject to the Act? The law applies to New York not for profit corporations, including New York education corporations and New York religious corporations. Certain provisions also apply to New York charitable trusts. Certain provisions also apply specifically to non New York corporations and trusts registered with the AG to solicit charitable contributions in New York. Purposes The purposes and legislative objectives of the Non Profit Revitalization Act are: to reduce unnecessary and outdated burdens on nonprofits; and to increase public trust in the nonprofit sector to enhance nonprofit Board governance And to enhance AG enforcement powers and other internal Board oversight to prevent fraud and insider self dealing Revitalization Act is born Passed by NY Legislature June 21, 2013 Signed by Gov. Dec. 18, 2013 December 2015 Amendment Changed certain key definitions Further clarifications to COI and WB reqs Endless tweaks? Modernization Highlights Highlights of the Act relating to streamlined and modernized procedures include: 2013 July 2014 Most provisions of Revitalization Act went into effect December 2015 June 2017? Pending Amendments Definition & roles of Independent Directors Related Party Txn exceptions Clarifications for committees *Not yet signed into law* Future? Electronic Communications Modernized and simplified procedures Reclassification of Board Committees 16 Board Governance Highlights Highlights of the Act relating to Board Governance practices include: Independent director rules Related Party Transaction rules Conflict of Interest policy Whistleblower policy Audit oversight rules Board governance provisions Best practices are now mandatory Aspects of the Revitalization Act that impact Joint Ventures (a form of conflict of interest) Conflicts of Interest Independent Directors Exempt Organizations Conference 3

4 December 2015 Amendments In December 2015, the Act was amended to modify certain key definitions and further clarify certain other provisions Key Definitions affected: independent director affiliate entire board relative related party key employee * Pending Amendments An Amendment to the Act was passed in June 2016, which IF signed into law by the Governor, would provide significant relief for some nonprofits under the Act. Governor has until the end of the year to sign the 2016 Amendment into law would go into effect 180 days after the bill is signed (~June 2017) *Bylaws & COI policies and related analyses should be updated accordingly A Related Party Transaction is defined as any transaction, agreement or any other arrangement in which a related party has a financial interest and in which the non profit (or an affiliate) is a participant. Related Party Transaction Nonprofit or affiliate Related Party Transaction Pending Amendment: UPDATE: The June 2016 Amendment, IF signed into law by the Governor, would create three exceptions to the definition of related party transaction: 1. an exception for a de minimis transaction or where the related party s interest is de minimis; 2. an exception for a transaction not customarily reviewed by the board in the ordinary course of business if the transaction is available to others on similar terms; or 3. an exception for a transaction that provides a charitable benefit to a related party as a member of a class of persons that the corporation assists as part of its mission where the benefit is available to others on similar terms. A Related Party is: 1. any director, trustee, officer, or key employee* of the nonprofit corporation or charitable trust (or any affiliate) or any other person who exercises the powers of directors, officers or key employees over the affairs of the corporation or any affiliate of the corporation; 2. any relative of any individual described in #1; or 3. any entity in which any individual described in #1 or #2 above has a 35% or greater ownership or beneficial interest, or, in the case of a partnership or professional corporation, a direct or indirect ownership interest in excess of 5% Exempt Organizations Conference 4

5 No non profit corporation or charitable trust shall enter into any related party transaction unless the transaction is determined by the Board to be fair, reasonable and in the nonprofit s best interest at the time of such determination. Any director, officer or key employee who has an interest in a related party transaction shall disclose in good faith to the Board or Board committee the material facts concerning such interest. Enhanced review is required of charitable corporations and trusts if a related party has a substantial financial interest in the transaction. The Board or Board committee must: consider alternative transactions to the extent available; approve the transaction by at least a majority vote; and contemporaneously document in writing the basis for its approval including consideration of alternative transactions Substantial financial interest is not defined. *Designed to be consistent with, or at least not inconsistent with, the federal excess benefit txn approval process* Related Parties are not permitted to participate in deliberations or voting on Related Party Transaction matters. BUT, any director, officer, or key employee who has an interest in a Related Party Transaction must disclose the material facts concerning such interest in good faith to the Board or committee. A Related Party may provide information concerning a Related Party Transaction prior to the commencement of deliberations or voting on the Related Party Transaction upon request., cont. Authority of the Attorney General The Act clarifies that the AG may begin an action to enjoin, void or rescind any related party transaction or proposed related party transaction that: violates any provision of the NPCL; or was otherwise not reasonable or in the best interests of the non profit corporation or charitable trust at the time the transaction was approved , cont. Authority of the Attorney General The AG may also seek other relief, including, for example, restitution, removal of directors, trustees, or officers, or, in the case of willful and intentional conduct, payment of an amount up to double the amount of any benefit improperly obtained. Typically, related party transactions (self dealing ) and lack of financial oversight are areas most likely to provoke AG action The Act requires all nonprofits to adopt a written conflict of interest policy The policy must cover directors, officers, and key employees * A ʺKEY EMPLOYEE means any person who is in a position to exercise substantial influence over the affairs of the corporation, as referenced in the IRS rules on excess benefit transactions with disqualified persons to the extent applicable. It includes a CFO, for example, but not a low level employee. *UPDATE: The June 2016 Amendment, IF signed into law by the Governor, would replace Key Employee definition with Key Person definition Exempt Organizations Conference 5

6 Is there a distinction between a related party transaction and a conflict of interest? While the Act defines the circumstances that constitute a related party transaction, the Act does not define the circumstances that constitute a conflict of interest. Under the Act, a nonprofit must define conflict of interest, which must at least include related party transactions and can include more. According to the IRS, A conflict of interest arises when a person in a position of authority over an organization, such as a director, officer, or manager, may benefit personally from a decision he or she could make must: Define circumstances constituting a conflict of interest (COI) Establish procedures for disclosing, addressing and documenting COI and Prohibit the conflicted person from being present at, participating in, or improperly influencing the vote Require documentation of existence and resolution of COI Require compliance with related party rules Require annual COI statement be signed by all Directors COI Policy must also cover: Prohibition against attempts to influence deliberation and vote on conflict Procedures for disclosing, addressing and documenting related party transactions Pending Amendment: Conflicts of Interest Currently, the Revitalization Act requires all nonprofits to adopt a, which must include certain procedures. UPDATE: The June 2016 Amendment, IF signed into law by the Governor, would expand these requirements to require nonprofits to include: procedures to disclose possible conflicts of interest and procedures for the board or committee to determine whether a conflict exists. The current law requires only procedures for disclosing an actual conflict of interest. Independent Directors The act currently requires non profits to assign certain votes and responsibilities to independent directors conflict of interest matters whistleblower policy matters certain audit matters Exempt Organizations Conference 6

7 Definition of INDEPENDENT DIRECTOR was expanded by the December Amendments to be a director who: i. is not, and has not been within the last three years, an employee of the corporation or an affiliate, and does not have a relative who is, or has been within the last three years, a key employee of the corporation or an affiliate; ii. has not received, and does not have a relative who has received, in any of the last three fiscal years, more than $10,000 in direct compensation from the corporation or an affiliate (other than reimbursement for expenses reasonably incurred as a director or reasonable compensation for service as a director); iii. is not a current employee of or does not have a substantial financial interest in, and does not have a relative who is a current officer of or has a substantial financial interest in, any entity that has made payments to, or received payments from, the corporation or an affiliate for property or services in an amount which, in any of the last three fiscal years, exceeds the lesser of $25,000 or 2% of such entity s consolidated gross revenues; or iv. is not and does not have a relative who is a current owner, whether wholly or partially, director, officer or employee of the corporation s outside auditor or who has worked on the corporation s audit at any time during the past three years. Pending Amendment: as affects Independent Director Rules The act currently requires non profits to assign certain votes and responsibilities to independent directors : conflict of interest matters whistleblower policy matters certain audit oversight matters *UPDATE: The June 2016 Amendment, IF signed into law by the Governor, would require an organization have independent directors only for those certain audit oversight matters Audit Oversight Requirements Audit Oversight Requirements Sliding Scale of Revenue Thresholds for Financial Reporting Audit oversight requirements apply to New York (and possibly foreign) non profits that solicit contributions in New York State AND which are required to file an independent CPA audit report with the New York State Charities Bureau. Only independent directors may deliberate or vote on audit matters. Good news for smaller charities. Annual Gross Revenue and Support Levels Unaudited Financial Report on Form Prescribed by the AG Current Less than $100,000 Effective July 1, 2014 Less than $250,000 Effective July 1, 2017 Less than $250,000 Effective July 1, 2021 Less than $250,000 File Annual Financial Report with Independent CPA Review Report At least $100,000, but not more than $250,000 At least $250,000, but not more than $500,000 At least $250,000, but not more than $750,000 File Annual Financial Report with Independent CPA Audit Report Greater than $250,000 Greater than $500,000 Greater than $750,000 At least $250,000, but Greater than $1,000,000 not more than $1,000, New Audit Requirements The Act requires audited charities to use independent directors or an Audit Committee (of all independent directors) to: Oversee accounting and financial reporting processes Oversee audit of non profit s financial statements Retain an auditor annually Review audit results with auditor For audited charities with more than $1 million revenue, there are additional steps and procedures: Review scope and planning with auditor prior to audit Following audit, review material weaknesses, restrictions on scope, significant disagreements, and adequacy of audit processes Annually consider auditor s performance and independence Whistleblower Policy Nonprofits with 20 or more employees and annual gross revenues of $1 million+ must adopt a whistleblower policy A copy of the policy will be distributed to all directors, officers, employees and to volunteers who provide substantial services UPDATE: December 2015 amendment allows dissemination of policy by posting it on the nonprofit s website or at the nonprofit s offices (at a conspicuous location accessible by employees and volunteers) to satisfy the distribution requirement Exempt Organizations Conference 7

8 SUMMARY OF TAKEAWAY LESSONS 1. Review and update Bylaws and conflict of interest policy and ensure new definitions and concepts from December 2015 Amendment are reflected 2. Determine and continuously monitor which directors are independent (using current definition!) 3. Ensure the non profit has enough independent directors and that they handle the appropriate matters conflict of interest, audit oversight and whistleblower matters (at least until the law changes in June 2017 IF it does!) 4. New York non profits, including charitable trusts, need to: Approve all related party transactions and document that each is determined to be fair, reasonable and in the corporation s best interest; and if there is a substantial financial interest, document the consideration of alternatives 5. New York (and possibly foreign) charities required to register with the Charities Bureau to solicit contributions and which meet the gross revenue thresholds should: be aware of the new thresholds where an audit is required, follow the new audit oversight rules and procedures. have independent directors (or an audit committee comprised of independent D s) handle audit oversight issues Look out for Hodgson Russ Client Alert regarding whether latest Amendments have been passed (likely to be effective in June 2017) For More Information, Please Contact: Marla Waiss mwaiss@hodgsonruss.com (716) Patricia Sandison psandison@hodgsonruss.com (518) Please contact us if you would like to be added to our list to receive Client Alerts on nonprofit legal updates Exempt Organizations Conference 8