Prepared for Stetson 2018 National Conference on Special Needs Planning and Special Needs Trusts Pre-Conference Pooled Trusts Intensive St. Petersburg, Florida Wednesday, October 17, 2018 Presented by: James M. McCarten Partner Burr & Forman LLP Atlanta, Georgia Nashville, Tennessee jim.mccarten@burr.com 404/532-7236 (Atlanta, GA) 615/724-3236 (Nashville, TN)
Our Agenda 1. Section 501(c)(3) Exemption Requirements. 2. Public Charity vs. Private Foundation. 3. No Substantial Lobbying. 4. Private Benefit, Private Inurement. 5. Intermediate Sanctions. 6. Miscellaneous Current Non-Profit Tax. 7. Non-Profit Changes in the Tax Cuts and Jobs Act 2
Introduction: Becoming & Staying Exempt Have a public purpose. Do not violate private benefit & private inurement rules (the organized & operated exclusively requirements). Do not engage in excessive lobbying. Do not engage in any political activities. Do not engage in an excessive amount of unrelated trade or business activity. Meet IRS filing requirements (ask for exempt status). Meet State law requirements. Do not violate public policy. 3
501(c)(3) Requirements: Serve a Public Exempt Purpose A 501(c)(3) nonprofit (a Charitable Organization) must have a mission which is charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children, as described in the statute and again in Form 1023. A Charitable Organization which makes significant changes to its mission, it must disclose the change to the IRS on its Form 990 or Form 990-EX. It may need to file another Form 1023. A significant change involves changing from one activity to another or adding an activity; e.g., a job training entity adds free day care services for clients. Most report any significant activities that are discontinued. 4
The Organized For Test The Organizational test looks at the exempt organization s stated: Purposes and activities; Legislative and political activities; and Distribution of assets upon dissolution. The organizational test is usually satisfied by having the proper language in the entity s organizational documents. See, e.g., Dumaine Farms v. Comr., 73 T.C. 650, 659 (1980). 5
The Operated Exclusively Test The operated exclusively test requires that the organization be operated exclusively for exempt purposes. In reality, the organization is only required to primarily engage in activities. See Treas. Reg. 1.501(c)(3)-1(c)(1). Stated differently, an organization may only engage in an insubstantial amount of activities that do not further its exempt purpose. Id. 6
What is Insubstantial? Factors for determining insubstantial : Compare the income derived from the nonexempt activity(ies) to the organization s total income Compare the expenditures related to the nonexempt activity to the organization s total expenditures Compare the time the organization s employees on the non-exempt activity compared to their total hours worked. 7
More on Insubstantial? There is no bright line test to determine whether and when an activity becomes so substantial that it is no longer insubstantial/incidental. However, if 30% or more of an organization s gross income is derived from a non-exempt purpose, the organization has likely failed to comply with the operational test. See, e.g., Orange County Agricultural Society, Inc. v. Comr., 893 F.2d 647 (2d Cir. 1990) 8
What Type of Section 501(c)(3) Are You? The question is determined under Code Section 509. An organization is presumed a private foundation unless it can prove otherwise. Other type is a public charity. Statutory public charities. Code 509(a)(1) Satisfy 1 of 3 public support tests. 9
Why Not Be A Private Foundation? The Private Foundation prohibitions, separate excise taxes, and other requirements. Net Investment Income excise tax. Code 4940. Prohibition on self-dealing. Code 4941. Requirement of annual distributions. Code 4942. Prohibition on excess business holdings. Code 4943. Prohibition on jeopardizing investments. Code 4944. Prohibition against taxable expenditures. Code 4943. 10
The Public Support Tests There are 3; two (2) Donative tests and a Service Provider test. Testing applies on an aggregate 5-year basis; the current year and the immediately preceding 4 years. The first 5 years are free as long as the nonprofit has a good faith belief that it will meet the test in year 6. IRC Section 509(a)(3) supporting organizations must support a public charity, and are not required to meet the public support test. 11
The Donative Tests The 1/3 test. At least 1/3 of financial support must be contributions or membership fees from the general public, government, or other charitable organizations. The facts and circumstances test. If at least 10% of total support is from public sources and the entity operates in a way which represents, serves and is accountable to the public (in order to attract public or government support). Gifts from donors other than government grants or publicly funded public charities are subject to a 2% limitation. Such donations only count toward the 1/3 public support requirement if the donation does not exceed 2% of the organization s overall support. 12
The Service Provider Test A Minimum Test. At least 1/3 of financial support must be from contributions from the general public, government, or other charitable organizations, membership fees, and gross receipts from activities which are not an unrelated trade or business; and Not-to-Exceed Test. No more than 1/3 of financial support can be from investment income. Amounts received from disqualified persons (defined in Code 4946) are excluded from the numerator. Gross receipts from admissions, sales, etc. from any person in excess of the greater of $5,000 or 1% are excluded from the numerator. 13
Identifying Disqualified Persons Substantial contributors. Those whose annual contribution is >$5,000 and exceeds 2% of total contributions. Owners of more than 20% of a corporation, partnership, trust or unincorporated enterprise which is a substantial contributor to the foundation. Foundation manager. Any officer, director, or trustee, or a person having responsibility similar to such individuals. Family member of anyone listed above. Related Businesses. A corporation, partnership, trust, or estate in which a person above owns > 35% of the total voting power. The 10 year rule. Once a substantial contributor, he/she/it continues to be one until 10 years have expired since any related party made a contribution. 14
Other Bad Support: Unrelated Trade or Business Income (UBTI) Net taxable income from an activity is UBTI if the activity is: A trade or business, Regularly carried on, Not substantially related to the exempt purpose. However, for-profit activity does not alone give rise to UBTI or jeopardize tax exemption. An exempt organization qualifies under 501(c)(3) even though it operates a trade or business (even if the trade or business is substantial) if: a. The trade or business is in furtherance of the exempt purpose, and b. The organization is organized or operated for the primary purpose of carrying on an unrelated trade or business. 15
To Be UBTI The activity must be a trade or business. Same definition as used under Code 162. Must be carried on for production of income from sale of merchandise or performance of services. Focus is on commerciality. The activity must be regularly carried on. Not isolated or occasional activities. Must be conducted with sufficient consistency to indicate a continuing purpose to derive income even though infrequent or seasonable. Treas. Reg. 1.513-1(c)(1)(c). If only occurs annually, a quasi-presumption is that the activity is not regularly carried on. Treas. Reg. 1.513-1(c)(2). Not Substantially Related. A substantial causal relationship to exempt purpose. 16
Dangerous Activities: Lobbying & Advocacy Advocacy by a 501(c)(3) is never okay. A Political Expenditure Excise Tax; Code 4955 A 10% tax on the amount of each political expenditure unless not willful and flagrant. A 100% tax if not corrected within the taxable period (which is open until IRS comes knocking). Managers are subject to a 50% penalty unless relying on a reasonable legal opinion. 17
Lobbying & Advocacy 501(c)(3) non-profits may not engage in substantial activities to influence legislation. If the organization conducts substantial legislative activities, it is considered an action organization and will not qualify as exempt. Two types of action organizations: A substantial part of the organization s activities is attempting to influence legislation. Regulations create a presumption that an organization is an action organization if it has two characteristics: Its primary objective(s) can only be accomplished through the enactment or defeat of proposed legislation; and It advocates/campaigns to bring those objectives to reality. Treas. Reg. 1.501(c)(3)-1(c)(3)(iv). 18
Substantial Lobbying A facts and circumstances test. Compare time and expenses of lobbying to total time and expenses. What is lobbying for substantiality test? Attempts to influence legislation by Congress, state legislatures, local councils or general public in issues put to a vote. Attempts to influence executive or administrative actions is generally not lobbying, unless discussing pending legislation. Organizations should always worry about substantial. It s a I know it when I see it test. Too much lobbying = loss of exemption. 19
The 501(h) Lobbying Election A mathematical, objective calculation. The election sets caps on lobbying expenditures. An absolute cap of $1M Total Exempt Purpose Expenditures Allowable Lobbying Expenditures Not over $500,000 Over $500,000 but not over $1,000,000 Over $1,000,000 but less than $1,500,000 Over $1,500,000 20% of exempt expenditures $100,000 plus 15% of the amount over $500,000 $175,000 plus 10% of the amounts exceeding $1,000,000 $225,000 plus 5% of all exempt expenditures which exceed $1,500,000 20
The 501(h) Lobbying Election Expenditures over the cap are taxed at 25%. Lobbying is a defined term under 501(h). Direct lobbying. Grassroots lobbying, which has a separate limitation (25% of the 501(h) cap). Certain actions are excluded. 21
Private Benefit Private benefit is larger than private inurement which is limited to insiders. Private benefit, though, applies when any person receives more than an incidental benefit. Private benefit occurs when a non-profit serves a private rather than a public purpose. An incidental private benefit is when a benefit to a private person accompanies public benefit; e.g., hospitals primarily benefit the public, and incidentally individual patients. 22
Private Inurement A non-profit organization must not allow the use of its assets for the benefit of insiders. E.g., a 501(c)(3) organization cannot overpay for services or goods from an insider (FMV standard). Insiders include founders, officers, directors, CEOs, COOs, and other top officers. It also includes spouses and parents as well as siblings, children, grandparents, grandchildren and their spouses. Focus is a functional analysis, does the individual have sufficient influence over control or management. 23
Intermediate Sanctions Enacted in 1996, the intermediate sanctions exist to provide a penalty between the options of taking no action and the extreme of revoking an organization s tax exemption. These sanctions apply to public charities (Section 501(c)(3) charitable organizations, but not private foundations) and social welfare organizations (Section 501(c)(4)). The Affordable Care Act added qualified nonprofit health insurance issuers to the organizations subject to these rules. 24
What is an excess benefit transaction? Excess Benefit Transactions Any transaction that provides an economic benefit in excess of FMV, directly or indirectly, to or for the use of any disqualified person by non-profit. Examples of typically occurring excess benefit transactions : Compensation Purchase of goods and services Sale of goods and services Leases 25
Who Are Section 4958 Disqualified Persons? Any individual who was, at any time during the 5- year period ending on the date of the transaction, in a position to exercise substantial influence over the affairs of the organization (whether by virtue of being an organization manager or otherwise). A member of the family of an individual described above, and An entity in which persons described in the preceding categories own more than a 35% interest. 26
The Penalty Amounts A disqualified person receiving an excess benefit is subject to an initial tax equal to 25% of the amount of the excess benefit. An organization manager who participates in an excess benefit transaction, knowing it confers an excess benefit, is personally subject to a penalty of 10% of the excess benefit (subject to a per transaction maximum of $20,000). An additional tax of 200% is due if the excess benefit transaction is not corrected within a specified time period. 27
A Presumption of Reasonableness A rebuttable presumption of reasonableness arises when a compensation arrangement with a disqualified person is approved by an independent board (or an independent committee authorized by the board): Composed entirely of individuals unrelated to and not subject to the control of the disqualified person(s), Obtained and relied upon appropriate data as to comparability (usually third party data), and Adequately documents the basis for its determination. 28
A Presumption of Reasonableness If the criteria above is satisfied, intermediate sanctions can only be imposed if the IRS develops sufficient contrary evidence to rebut the probative value of the evidence from the parties to the transaction. Be sure to clearly reflect intent to treat amount as compensation. From a practical standpoint, these same best practices do not just protect in compensation transactions. 29
Intermediate Sanctions: Procedural Issues Excess benefit transactions are to be selfreported on Form 990 which means the tax is self-assessed. If properly reported on the Form 990, IRS has 3 years to assess the tax against the disqualified person. If the excess benefit is underreported by more than 25%, the statute of limitation is 6 years. 30
Miscellaneous Current Issues The impact of South Dakota v. Wayfair, Inc., et al. (S. Ct. June 21, 2018). Enforcement by the States Required Tax Filings Oversight by States Attorney Generals. 31
Tax Reform s Impact on The Reduction of the Individual Tax Rate Non-Profits The Increase in the Estate/Gift Tax Exclusion The Change in Corporate Tax Rates Separate Reporting for each unrelated trade or business. The New Charitable Deduction Substantiation Rules 32
Tax Reform s Impact on Non-Profits A New Excise Tax for Certain Educational Institutions New Executive Compensation Rules ($1M) Excise Tax on Severance Payments Other Tax Reform Changes Which Might Impact a Non-Profit 33
THE END. Thank you for your kind attention. James M. McCarten (404) 532-7236 jim.mccarten@burr.com sought for specific 30631376_1 situations.