1

Tax Exemption:Core Concepts

&Management Strategies

Terry Miller

Terry@TerryMiller.biz

415-333-6320

www.terrymiller.biz

AICPA NFP10 Session 111

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Introductions

Who’s here?

Purpose Today / Framing

Order of Concepts Conceptual: Legal / Public Policy Purposes Specific: Reporting on Form 990 Management: Planning Strategies

Questions as we go: universal vs. fact specific

Disclaimer

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Objectives

Objectives

Issue spotting vs. memorize all

nobody knows everything

Know when to get help

don’t be penny-wise & pound-foolish

Context: the concept of “organized & operated”

general legal compliance required

“illegal” or in “contravention of public policy” ≠ exemption

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Session Overview

Context: organization types / regulators / a word on words Legal concepts: Tax Exemption (The “Big Four” + 2)

1. Commerciality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . [earned income]

2. Inurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . [insiders]

3. Public v. private benefit . . . . . . . . . . . . . . . . . . . . . . . . [insiders OR outsiders]

4. Public policy advocacy . . . . . . . . . . . . . . . . . . . [1. lobbying, 2. electioneering]

Public charity status / public support tests . . . . . . . . . . [for 501(c)(3) charities]

Charitable deductions: substantiation & disclosure . . . . [for (c)(3) charities]

Miscellaneous compliance issues

Reporting: Form 990 – ‘the rubber hits the road’ Management strategies: Planning Opportunities Resources:

Supplemental materials Related Sessions at NFP10

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Context / Organization Types

Types: Nonprofit Corps, Trusts, LLCs, L3Cs … [STATE law] Types of Nonprofit corporations (some states)

Public Benefit, Mutual Benefit & Religious Authority:

State Constitution & Statutes Articles of Incorporation Bylaws

Corporate formalities – liability protection (“piercing the veil”)

SOS: Registration

IRS: Income Tax Exemption & Charitable Tax Deductions

AG: Charitable Trust & Charitable Solicitation Registration Charitable Solicitation Registration cy pres

??: Sales & Property Tax Exemption, Charitable Gaming

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“ Taxation? But we’re a nonprofit ?! ”

Nonprofit = state corporation concept

Tax law: levels of benefit by type of Exempt Organization, known by Internal Revenue Code Section 501(c)(1) Created by Congress; (c)(2) Title Holding

501(c)(3) Charities Public Charities

Private Foundations

501(c)(4) Social Welfare / Civic Leagues

501(c)(5) Labor / Horticultural

501(c)(6) Biz League / Prof & Trade Assoc / Chamber Commerce

501(c)(7) Social Clubs

….up to 501(c)(27) and beyond…501(d,e,f,k,n), 527

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More complicated than taxable for-profits

The notion of “organized and operated” “exclusively”

Form 990 is mind-numbing Measure whether sufficient exempt function activity is

occurring to justify favorable tax treatment “Commensurate” test Tax Exempt (most net income not taxable) Tax Deductible (mostly 501(c)(3) organizations)

Form 990 as a Public Communication tool

Heightened public focus stoked by scandals

2008 Form 990 overhaul first in 30 years

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A word on words

“nonprofit”, “not-for-profit”

“charity”

“charitable trust”

“EO” “exempt organization” “[income] tax-exempt”

“tax deductible [as a charitable gift]” “tax deduction”

“c3” “c4” …

“PF” “PC”

“new” 990

“income” = “support” + “revenue”

“UBI” “UBTI” “UBIT”

“exclusive” “substantial” “primary”

“facts & circumstances”

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Legal Concepts

Legal Concepts:

the Big Four

(plus assorted details:

“the fine print” )

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Internal Revenue Code501(c) (3) (Complete! *)

“(3) 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.”

* (color, bold & underlines added)

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Internal Revenue Code501(c) (4),(5) & (6) (Complete*)

“(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.

(B) Subparagraph (A) shall not apply to an entity unless no part of the net

earnings of such entity inures to the benefit of any private shareholder or

individual.

(5) Labor, agricultural, or horticultural organizations.

(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.”

* (color, bold & underlines added)

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Legal Concepts: The “Big Four”

Commerciality How much can we operate like a business and still be tax exempt? Can we charge for services?

Private Inurement - Insiders How much can we pay the boss? Can we rent from the Chairperson?

Public vs. Private Benefit Who really benefits from our work, on balance?

Politics & Lobbying Can we support candidates for office? Can we join a coalition to oppose legislation?

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Commerciality -1

History destination test, until

NYU / Mueller Macaroni, circa 1950

Pizza parlor example: “operated for” charitable (not

commercial) purpose

“Exempt function income” / program service revenue income as a by-product of program activity

The concept of Unrelated Business Income (Tax)1) trade or business

2) regularly carried on

3) unrelated to the exempt purpose

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Commerciality -2

Common problem / error: technical assistance substantially below cost

Useful exclusions from UBI follow from definition passive – not “carried on” at all

interest, rents & royalties (watch out for debt-financed property) gains & losses

not regularly carried on substantially by volunteers – not “trade or business” sale of donated merchandise – not “trade or business” convenience of patrons – “related”

All revenues are one of these three: Related Exempt Function Income (a/k/a “program svc revenue”) UBTI UBI but for exclusion

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Commerciality -3

Qualified Sponsorship Payments (v. advertising) no price & item, inducement to buy, comparative messaging

watch out for web links!

RESOURCE: Session 19 (qualified sponsorships)

Dual types For-Profit & Nonprofit/EO: (e.g. hospitals) usually means there will be specific guidance frustrating issue: evolutionary enterprises (e.g. schools): poachingRESOURCE – Session 55 (hospitals & community benefit)

Commercial sub-activities when UBI activity becomes jeopardizing: substantial (?)

for-profit subsidiary

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Private Inurement -1

about INSIDERS (power to exercise major influence) History: William Aramony

(resigned 1992, convicted 1995, released 2001)

Need for “Intermediate Sanctions” – IRC 4958

Continued concern driven by juicy scandals: Smithsonian, American University, Irvine Foundation, etc etc etc

Excess compensation most common issue

“Excess Benefit Transactions” includes loans & other (buy/sell/rent)

T. Pattara says Grassley on a tear about this (recent news about Grassley & Boys & Girls Clubs) – Congress as a wild card

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Private Inurement -2

Conflicts of Interest / Conflict of Interest Policies Definition?

IRS: concerned about self-dealing Confidential information? “Settling scores”?

Who covered? IRS: directors & officers (they define officer to include CEO & CFO)

All employees? Volunteers?

What relationships to report? IRS: close family & business

Domestic partners? Best friends?

How declared? IRS: at least annually – report all relationships that could give rise

Duty of loyalty – develop sensitivities to disclosure & openness

How monitored & enforced? Disclosure & recusal is usually enough

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Private Inurement -3

Section 4958 Overview: (c)(3) pub charities & (c)(4) orgs Penalties doubled by Pension Protection Act

Severe – on individuals notion of “intermediate sanctions” scrambled up by Caracci case

4958 “rebuttable presumption” basics – re: “disqualified persons”

1. Written comparables, saved with minutes2. Disinterested majority of board, with interested party/parties out of room3. Good faith determination best interest of the organization4. Prior to transaction Some in Congress want safe harbor steps required IRS considers it best practice; pressure to report IRS concerned about quality of “comparables”

Risks: notion of “Automatic” Excess Benefit Transactions / Listed Property

RESOURCES: Session 48 (intermediate sanctions)

Session 53 (comparability audits)

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Public v. Private Benefit -1

501(c)(3)’s & 501(c)(4)’s

Subtle / requires step back & ask: “who really benefits?” NOT about insiders, necessarily

avoid: “more than incidental private benefit”

“the presence of private benefit, if substantial in nature, will destroy tax-

exempt status regardless of an organization’s other charitable purposes or

activities” – Marcus Owens on Better Business Bureau case (Resources)

Charitable class – how big? Public?

Private Benefit: IRS’ new all-purpose hammer? “commensurate” test “efficiency & effectiveness”

dovetails with public skepticism

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Public v. Private Benefit -2

Famous cases American Campaign Academy Consumer Credit Counseling current: Seller-financed Down Payment Assistance

Governance as indicator of risk: audit flag v. denial of exemption application unpredictable good governance policies & controls; Owens’ paper (Pg 111-64), e.g.:

broad Board clear records on achievements conflict of interest & whistleblower policies commitment to proper arm’s length outside auditor & if big enough, internal auditor greater disclosure than required accountable plan for reimbursements compensation process use rebuttable presumption

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Public Policy Advocacy:Lobbying v. Politics

Key distinction: Lobbying v. Candidate Electioneering big danger in jumbling them !!

[C3 Public Charity] Lobbying = legislation including work on referenda even though elections involved

[C456] Lobbying = legislation

plus certain executive branch decision making

Electioneering = candidates for elected office some targeted lobbying IS electioneering

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Public Policy Advocacy: Lobbying -1

501(c)(3) Public Charities History: 1930, 1934, 1955, 1970, 1990

Expenditure Test v. Substantial Part Test Expenditure Test: more objective (IRC 501(h), Regs 4911)

Direct v. Grassroots lobbying “Specific legislative proposal”

Substantial Part Test: “facts & circumstances”

501(c)(3) Private Foundations No explicit lobbying (earmarked / restricted) Some wiggle room (general support, or project support less than the

non-lobbying portion of the project) mostly they just don’t want to hear about it

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501(c)(non-3) Exempt Organizations Unlimited if related to exempt purpose

501(c)(4)’s (NRA, Sierra Club, etc) lobby a LOT

501(c)(5) (Labor unions, Farm Bureau) lobby a LOT

501(c)(6) (Trade associations, chambers of commerce, professional associations) lobby a LOT

501(c)(7) social & recreational: not so much

Different definitions: legislation (other than local), plus certain executive branch policies

Business dues non-deductible as biz expense if used for lobbying, & must apply dues income first to Lobbying

Notify members of non-deductible portion, or Pay 35% proxy tax

Public Policy Advocacy: Lobbying -2

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Public Policy Advocacy: Lobbying -3

Remember: this has been about TAX law

Fed / State / (Local?) ethics & registration rules such as Congressional “Lobbying Disclosure Act” (LDA) Trigger points ($ level) Different definitions Wining & dining & gifts & travel, money in politics, including by individuals

from organization (!)

LDA allows public charities that have elected the expenditure test to use some of the tax definitions

Ballot measures may involve State election commissions and “PAC” regulation / registration / reporting

RESOURCE: Session 43 (elect & lobbying reporting: beyond tax)

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Public Policy Advocacy: Candidate Electioneering -1

IRC Section 527 & “527 Activities” = political = “electioneering” True meaning: influence the election of candidates

“527” As used in the press: issue advocacy targeted at influencing election of

candidates which escapes election commission jurisdiction by not being explicit will Citizens United kill off such “issue 527’s” of this sort?

501(c)(3) Charities (both PC & PF) CANDIDATE ELECTIONEERING PROHIBITED

Revocation and/or penalties on charity AND on individuals (Board)

Non-partisan voter registration, voter education & get out the vote are all OK if

done just right (think: League of Women Voters)

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Public Policy Advocacy: Candidate Electioneering -2

501(c)(4,5,6 …) organizations Must be not primary purpose, conducted legally, and consistent with overall

exempt purpose

Primary: 51/49%? No clear standard EACH year, no rolling periods

Legal: jurisdiction of FEC or State/Local equivalents Usually means hiring election law coun$el

Notion of Separate Segregated Fund

527 Organizations Not just “soft PACs / issue 527’s” – includes parties, candidate cttees

Risk if not political enough (more than insubstantial “non-exempt purposes”)

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Recap: The Big Four

1. Commerciality Exempt Function Income Unrelated Business Income UBI but for Exclusion(s)

2. Inurement – insiders

3. Public v. Private Benefit – insiders or outsiders

4. Public Policy Advocacy Lobbying v. Candidate Electioneering

Next: Private Foundation v. Public Charity & the public support tests Charitable Deduction Rules Misc Compliance Issues

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501(c)(3): Public Charity or Private Foundation?

501(c)(3) charities are private foundations (PF) by default, unless can qualify as a public charity (PC) status tests (e.g. school) or public support tests

“Grandma’s Foundation” vs. Publicly-Supported Charity

PC is better; much less regulated than PF better donor deductibility (% of AGI, FMV v. Basis)

more transactions with insiders allowed + safe harbor avail (for now)

no tax on investment income, fewer “excise tax” penalties

may MAKE grants to any entity (including foreign) for specific charitable purposes (if entity not a c3)

only practical way to get many PF grants is to be a PC

may lobby

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PC or PF?Types of Public Charity

Qualify as Public Charity under IRC 509(a)(1)-(4)

509(a)(1) says: 170(b)(1)(A)(i) - (vi)1. 170(b)(1)(A)(i) Church status

2. 170(b)(1)(A)(ii) School status

3. 170(b)(1)(A)(iii) Hospital / medical research org status

4. 170(b)(1)(A)(iv) Support org to public college or univ status

5. 170(b)(1)(A)(v) Governmental unit status

6. 170(b)(1)(A)(vi) Publicly supported charity – gifts test

7. 509(a)(2) Publicly supported charity – fees test

8. 509(a)(3) Supporting Org (four sub-types ) mix

RESOURCE: Session 47 (supporting organizations)

9. 509(a)(4) Product Safety Testing Org status

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PC or PF? Public Support Test(s)

Two Public Support Tests: Both are complex – dynamic formula (mix of donors & revenues by size)

5 year measurement period Advance period for startup – don’t prove until Year 6 (2-3-4-5-6)

509(a)(1) & 170(b)(1)(A)(vi): broad gift support more forgiving and flexible than (a)(2) some changes with New 990

509(a)(2): broad base of earned revenue from program services, plus very small gifts

extraordinarily complex math – 1 yr, 5 yr & data from inception unforgiving, inflexible test

switching between is OK

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Donor Deductibility -1

Donor Substantiation (Receipting) Publication 1771 & Deeper: Pub 526 Cash (& Un-reimbursed Volunteer Participation) Gifts >= $250

donor must have receipt with required language if audited

Cash v. Non-Cash gifts valuation: internal estimate (books) v. donor receipt (no value estimate!) for charitable use vs. for resale: key issue

Quid pro Quo gifts > $75 FMV, not cost, stated in Solicitation or Receipt TIP: fundraising events need TWO income lines each exception: low cost logo items (“coffee mug”) for certain gifts

Common Errors Donated services (+ whole concept of confusion about “a write-off”) Earmarked for individual beneficiaries Non-cash valuations estimated on receipt (donor pressure!)

earneddonated

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Donor Deductibility -2

Intangible Membership & Religious Benefits best to read Pub 1771 rules are pretty common-sense

Penalties Failure to disclose non-deductibility (attn C4s!) Failure to provide quid-pro-quo information

Vehicles, Boats & Planes: Pub 526 general direction of law

Other high-value non-cash items 8282 / 8283

RESOURCE: Session 24 (charitable contribution compliance)

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Other Compliance Issues

990 Disclosure (Guidestar does not count)

1023/1024 Disclosure

“Complete & Accurate” Return: statute of limitations, penalties if severe

Late Filing: Penalties

3 years Non-Filing: Revocation

Donor Advised Funds & certain “fiscal sponsorships” Abuses: 1) parking place, 2) self-serving grants, 3) self-serving investments

RESOURCE: Session 59 (working with community fdns)

Foreign Activity: PATRIOT Act / know your customer

RESOURCE: Session 36 (foreign operations)

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Reporting: Form 990

Reporting:

Form 990

(the rubber hits the road)

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Key Parts of the New 990:Core Form

I Summary (dashboard for the public)

III Program Service Accomplishments (commensurate test)

IV Checklist of Required Schedules (trigger questions)

V Other Filings & Tax Compliance (various compliance)

VI Governance, Mgt & Disclosure (private benefit / inurement)

VII Compensation (inurement)

VIII Revenue (commerciality; UBI analysis)

IX Functional Expenses (commensurate test)

X Balance Sheet (inurement)

PART

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New 990:The 16 Schedules -1

(Which schedules to file? Based on “trigger question” – thresholds)

A Public Support Tests / Pub Char Status (public charity status)

B Contributors (no change from “old” 990) (deductibility)

C Campaign & Lobbying Activity (public policy advocacy)

D Supplemental Financial Statement Detail (various)

E Private Schools [Education] (no substantive change) (special)

F Foreign Activities & Grants (special: PATRIOT Act / terrorism)

G Gaming (& Fundraising) (commerciality; private benefit)

H Hospitals (commensurate test; public benefit)

SCHEDULE

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I Grants (Domestic - Inside U.S.) (public benefit)

J (Justify) Compensation (inurement)

K Bonds (public benefit; compliance)

L Loans (inurement)

M Non-Cash Contributions (deductibility; excess benefit)

N Termination / Disposition of Assets (inurement / public benefit)

O Open for Narrative Responses (various)

R Related Organizations (various / public benefit)

New 990:The 16 Schedules -2

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990: Core Form Pg 1

see Full-Size Form

in

Supplemental Materials !

(Page 23)

Core Form Page 1

Parts I and II

Dashboard / Overview

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990: Core Form Pg 2

Core Form Page 2

Part III

Program

Accomplishments

Commensurate Test

Key Communication

Tool

40

990: Core Form Pg 3

Core Form Page 3

Part IV

“Trigger Questions”

threshold(s) where IRS

has concern

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990: Core Form Pg 4

Core Form Page 4

Part IV continued

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990: Core Form Pg 5

Core Form Page 5

Part V

Other Filings &

Compliance

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990: Core Form Pg 6

Core Form Page 6

Part VI

“Governance,

Management &

Disclosure”

IRS Theory: Public v.

Private Benefit risk

assessment: audit flags

BIG emphasis

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990: Core Form Pg 7

Core Form Page 7

Part VII

Compensation of: Officers Directors (Trustees) Key employees Highest comped ees Former ODKE’s

Inurement

IRS Focus: audit flags:

more BIG emphasis

45

990: Core Form Pg 8

Core Form Page 8

Part VII continued

Trigger

Questions

46

990: Core Form Pg 9

Core Form Page 9

Part VIII

Income (“Revenue”) Support v. revenue

Classify revenues

Related

UBTI

UBI but for exclusion

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990: Core Form Pg 10

Core Form Page 10

Part IX

Functional expenses Program

Mgt & Gen (Admin)

Fundraising

48

990: Core Form Pg 11

Core Form Page 11

Part X

Balance Sheet Inurement

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990: Core Form Pg 12

Core Form Page 12

Part XI

Accounting methods,

auditors, etc

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Schedule Highlights:Schedule J Pg 1

Schedule J Page 1

Inurement compensation setting

basis & practices

compensation-like reimbursements

51

Schedule Highlights:Schedule L

Schedule L

Inurement: Loans &

other transactions with

insiders

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Schedule Highlights:Schedule M Pg 1

Schedule M, Page 1

Deductibility: non-cash

gifts

Private benefit / excess

benefit: certain hard-to-

value noncash gifts

Governance Type

Questions

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Planning Strategies

Management:

Planning Strategies

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Planning Strategies -1

General Fads & fashions in tax law enforcement

Unfortunate but true

Australia: the “tall poppy” syndrome

Read trade publications Congress – official & individual

Sen. Grassley, but earlier was J.J. Pickle

Subscribe to IRS’ free “EO Update” newsletter

Read Chronicle of Philanthropy

Retain counsel

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Planning Strategies -2

Commerciality Broaden exempt purposes – amend articles, review 1023 Master exclusions Logo wear vs. message wear Sponsorship deals if UBTI: calculate expenses with consistent methodology if UBTI approaching substantial activity: for-profit subsidiary

Inurement Benchmarking – not everyone is above average / 75th %ile Audit committees – value squeaky wheels – avoid groupthink Compensation committee – do regular review; document Learn to spot compensatory reasoning and handle it correctly

watch out for listed property Managing [even the appearance of] Conflicts of Interest

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Planning Strategies -3

Public v. Private Benefit Commensurate test – think critically Mission & (re)-evaluation regularly New blood Take governance seriously

Public Policy Advocacy Master the lobbying rules

Find one person or committee to really master it Train train train

C3’s: Watch out for Election Years Consider tandem c3/c4 or triad c3/c4/527

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Planning Strategies -4

Public Support the notion of “tipping”

run a test at Year 3

don’t panic about 10% + facts & circumstances

if tipping, consider alternates:

509(a)(3)

501(c)(4)

private foundation

private operating foundation

sponsored project

merger into / with another public charity

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Resources: Supplemental Materials

Supplemental Materials1. Form 990 markups: Core Form, Schedules J (Pg 1), L, M (Pg 1) 33

2. Types of Tax Exempt Organizations (from IRS.gov) 48

3. “Nonprofit Governance, and Effectiveness and Efficiency of Operations,” speech by former IRS EO Commissioner Steven T. Miller, April 2008 50

4. “Current Climate for Charities,” speech by Miller, October 2007 58

5. “More Scrutiny of Charities Expected, Regulators Told,” article about IRS EO Director Lois Lerner speech to NASCO 63

6. UBTI exclusion codes – good short reference (from 2007 990 instructions) 66

7. “Private vs. Public Benefit,” Marcus Owens, 2007, AICPA NFP conference 67

8. IRS Pub 1771: “Charitable Contributions: Substantiation & Disclosure” 76

9. Bibliography: Public Policy Advocacy 84

10. Additional Resources 93

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Resources: Directly Related Sessions at NFP10

19 Qualified Sponsorship Payments (commerciality)

22 2009-2010 Tax Year Update (repeats in 49) (general)

24 Charitable Contribution Compliance (donor deductions)

36 Foreign Operations / Schedule F (anti-terrorism)

42 New 990: Lessons & Ambiguities (general)

43 Election & Lobbying Reporting: Beyond Tax (policy advocacy)

47 Supporting Organizations (public charity status)

48 Compliance w/ Intermediate Sanctions Rules [4958] (inurement)

49 (repeat) 2009-2010 Tax Year Update (general)

53 Managing Comparability & Compensation Audits (inurement)

55 Hospitals & Community Benefit (special)

58 Ask the Experts Panel: Tax (varies)

59 Working with Community Fdns – Planning Opptys (public support)

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Resources: Other EO Tax Sessions at NFP10

202 Form 990-T: What’s New? (commerciality-UBIT / general)

205 Reporting 403(b) Plans on Form 5500 (inurement)

6 View from the IRS (general)

13 Issues With Related & Affiliated Orgs (varies)

18 Tax Exempt Bond Compliance (varies)

25 Tax Ethics / Practitioners (varies)

30 Private Foundations: Current Developments (PF / advanced)

35 Form 990 Part IX / Functional Accounting (commensurate test)

54 Alternative Investments (charitable trust)

60 Advanced Non-Qualified Deferred Comp (inurement)

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End

Questions?