The opinion is instructive on how not to deal with the IRS in the exemption process.  Organizations seeking IRS recognition of tax exemption (which is required of almost all charities, except for churches) must file a 26-page Form 1023, which is explained in 38 pages of instructions.  The IRS also has extensive questions and answers further explaining Form 1023.

Notwithstanding the broad scope of the questions on the Form 1023, it is quite typical to receive further extensive questions from the IRS following its review of the Form 1023 submission package.  These questions usually seek elaboration on the current and proposed activities of the organization, compensation structure, information about the Board members, copies of documents referred to in the application (e.g., bond offering, leases, and employment agreements).  Some practitioners sometimes treat these supplemental IRS questions in a cavalier manner, considering them a nuisance.  This type of response is a mistake, as the petitioner in Ohio Disability Association v. Commissioner learned.  At a minimum, responding to IRS questions in this manner often leads to extensive delay in obtaining an IRS exemption letter.

1. In the numerous letters that were exchanged between the organization and the IRS, the organization’s answers were “often curt and, for the most part, referred [the IRS] back to prior letters and the initial application.”  (Interestingly, the court notes that, at times, the IRS inquiries “were not coherent.”)

2. The organization’s letters included conclusory statements that the requirements for tax exempt status were satisfied.

3. In response to a question on how the conflict of interest policy would be implemented, the organization said that it copied the policy from the instructions.

4. Most of the organization responses were general and conclusory.

5. The organization supplied a sample pooled trust agreement when requested to supply the actual agreement that would be used by the organization. 

The lesson of the case is to fully and timely respond to all questions, even if the organization or its representative believes that the IRS is asking questions that are unnecessary or repetitive. 

We have seen situations where playing games has resulted in inordinate delay and extensive additional legal fees.  If the IRS unduly delays in issuing a determination of exemption, try filing a Form 911, a form not commonly known among practitioners, with the National Taxpayer Advocate Office.  For an interesting annual report by that office, see the National Taxpayer Advocate's 2009 Annual Report to Congress, which discusses, among other things, how targeted research and increased collaboration are needed to meet the needs of exempt organizations.

About 90 years ago, Congress promulgated an exclusion from income for the rental value of the housing provided to a “minister of the gospel,” which includes priests, rabbis, imams and any other duly ordained, commissioned or licensed member of the clergy.  Alternatively, the minister can exclude the rental allowance paid as part of compensation, to the extent actually used as rent or other costs of home ownership.  Since 2002, the allowance is capped at fair rental value, including furnishings and appurtenances (such as a garage), plus the cost of utilities.

While there are IRS publications that explain the tax nuances of parsonage (e.g., Publication 517 and The Tax Guide for Churches and Religious Organizations), the unusual tax treatment of ministers can still be very confusing.

The following are some of the highlights of this unique status for the employer and the minister:

1. An employer need not withhold any taxes from a minister’s compensation.      

2. There is no withholding of FICA (Federal Insurance Contributions Act) taxes from a minister’s compensation.  This includes the parsonage portion and the non-parsonage portion.

3. A minister must pay SECA (Self-Employment Contributions Act) taxes on the entire compensation, including the parsonage payment.  For example, if the minister receives $50,000 of compensation and half of that amount ($25,000) is designated as parsonage, SECA taxes must be paid on the entire $50,000.

4. A minister must pay quarterly estimated taxes to cover income tax and SECA tax liability, unless he or she entered into a voluntary withholding agreement with the employers.

5. The IRS takes the position in Rev. Rul. 68-507 that if the employer pays the employer portion of FICA on behalf of a minister, that amount is treated as additional taxable income to the minister for both income and self-employment tax purposes.

6. The minister is given a Form W-2.  There is no need to set forth the parsonage amount on the W-2, but the IRS writes that you may include the parsonage allowance in Box 14.  Including this amount is probably a good idea.

For more information about parsonage and the treatment of unique tax benefits accorded ministers, please see the IRS Minister Audit Technique Guide.

An endowment fund is created when a person or entity donates money to a charity with the condition that the corporation cannot spend the money freely (commonly known as “permanently restricted”). The original donation is called the historic dollar value, that is, the aggregate fair value in dollars of (i) an endowment fund at the time it became an endowment fund; (ii) each subsequent donation to the fund at the time it is made, and (iii) each accumulation made pursuant to a direction in the applicable gift instrument at the time the accumulation is added to the fund. In New York, the governing board of an endowment fund operates under standards and guidelines from The New York Not for Profit Corporation Law (“NPC”), the New York Attorney General (“Attorney General”) and because New York has adopted it, principles of the Uniform Management of Institutional Funds Act (“UMIFA”).

Rules Governing Endowment Funds

New York law requires a governing board of a non-profit corporation to use all assets received for the purposes specified by the donor, including payment of reasonable and proper expenses. The board must also account for the endowment fund separate from other accounts. Further, the treasurer of the non-profit corporation must provide members of the board with annual reports of the fund’s assets and income, unless the donor states otherwise. 

The Prudence Standard

Directors and officers of a non-profit corporation must discharge the duties of their positions in good faith and with the degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances, according to the NPC and UMIFA. Before deciding whether to appropriate appreciation from endowment funds, the board must consider factors, such as the long and short term needs of the corporation in carrying out its purposes, its present and anticipated financial needs, expected return on total investments, price level trends and general economic conditions. 

1. Income

A governing board cannot expend the historic dollar value of its endowment fund. Instead, it must invest the fund’s assets and then use the resulting income for spending. Importantly, it may decide to spend the income generated even if the fund’s principal value drops below the historic dollar value (commonly known as an “underwater endowment”) unless the gift instrument says otherwise.

Although not required, the New York Attorney General suggests that a governing board should upwardly adjust the historic dollar value of the endowment fund for inflation to maintain its buying power. Another viable option is to create a spending rate policy. This policy, based on assumed rates of inflation, sets spending rates at levels that over time that are sufficiently below the fund’s expected long term investment return. This policy is likely to preserve a fund’s purchasing power as well as its historic dollar value. Regarding deflation, however, UMIFA takes a different view.  According to UMIFA, a fund’s historic value is not revised downward if market losses reduce the principal below that value.   

2. Appreciation  

If prudent, a governing board may appropriate an amount of the net appreciation for expenditure in the fair value of the assets of an endowment fund over the historic dollar value of the fund. According to New York law, this includes realized appreciation with respect to all assets, and unrealized appreciation with respect to readily available marketable assets. Still, the law makes it clear that this limitation is not meant to forestall the governing board from expending funds in accordance with other law, terms of the gift instrument or the corporation’s certificate of incorporation. According to the NPC, “this section is not intended to restrict the authority of the governing board to expend funds as permitted under other law, the terms of the applicable gift instrument or the certificate of incorporation of the corporation.”   So, if the terms of the donation allow for expenditure of endowment fund appreciation, the board may spend such appreciation where prudent.

Spending Rate and Historic Dollar Value Restoration

According to the NPC, a governing board cannot appropriate net appreciation through application of its spending rate policy if the value of an endowment fund is at or below historic dollar value. The New York Attorney General believes that to comply with the law and its responsibility, the corporation has an affirmative duty to restore to the fund any appropriation that occurs when the fund is already below the historic dollar value. If the decrease in the historic dollar value was due to an appropriation, the governing board must restore to the fund an amount equal to the difference between the historic dollar value and the post appropriation value of the fund regardless of whether the loss of historic dollar value was a result of a spending rate policy. According to the Attorney General, failure to restore a fund to historic dollar value may subject directors and officers to liability for breach of their duty of care. Nevertheless, a governing board can expend the net appreciation even if at the time of expenditure the endowment fund value drops below historic dollar value so long as the board prudently appropriated the appreciation. If the board requires funds in excess of the income and appreciation over historic value, the board may seek the donor’s consent or ask the court to, apply the cy pres doctrine.

Aggregation for Purposes of Appropriation

According to the New York Attorney General, the NPC does not authorize aggregation of endowment funds for purposes of appropriation for expenditure. A review of the NPC also does not appear to allow aggregation. The NPC discussion of appropriation of appreciation refers to a single endowment fund and discusses appropriation on a fund by fund basis. Practically, the prohibition on aggregation means that where there is a general decline in market values, the application of a total return spending policy could conflict with a board’s obligation to preserve the historic dollar value of each endowment fund. If so, the governing board should be subject to the appropriation and expenditure limitations discussed above.

NOTE: New York currently follows UMIFA and has not yet adopted the Uniform Prudent Management of Institutional Funds Act ("UPMIFA").  UPMIFA legislation has been introduced this year in New York, however.  It is believed that UPMIFA would help to address the issue of "underwater endowments" because the Act would remove the focus on the historic dollar value of a fund and place it instead on seven prudent investment criteria.  For more information on UPMIFA's adoption in New York, please visit the New York State Assembly's site.

Despite guidelines and standards enunciated by the NPC, UMIFA and the New York Attorney General, there are still questions regarding income expenditure when an endowment is below its historic dollar value and whether a board should restore the historic dollar value of an endowment. These are complex decisions that require a governing body to act prudently and consult with its counsel.