The Seminar discussed:

• Corporate Governance for Not-for-Profit/Exempt Organizations
• Maintaining Tax-Exempt Status During Election Season
• Investment Management under UPMIFA: What’s Required, What’s Good Practice
• Executive Compensation & Employee Benefits Developments

In her introductory remarks, Amanda H. Nussbaum , Partner, highlighted the Congressional hearings on proposals to modify the structure of tax breaks for charitable donations. In addition, she also discussed recent state legislation adopting flexible purpose corporations - - new companies that are part social benefit and part low-profit entities such as the L3C - - and whether these types of companies were really necessary or whether they would just fade away. She also mentioned the IRS monthly updates of the list of the names of organizations whose tax-exempt status has been automatically revoked due to the failure to file a Form 990 for three consecutive years and some of the IRS's recent projects such as its college and university compensation and unrelated business income study and its governance check sheet.

Here are some take-away points from each presentation:

Maintaining Tax-Exempt Status During Election Season. Stuart L. Rosow, Partner, reminded attendees that Section 501(c)(3) organizations are absolutely prohibited from engaging in any political campaign activity and violation of the prohibition can lead to revocation of tax-exempt status.  This prohibition does not preclude Section 501(c)(3) organizations from advocating a specific viewpoint on particular issues (though not legislation) related to an organization's exempt purpose.  Mr. Rosow emphasized that issue advocacy is permitted when the organization focuses expressly on issues and indicates no bias towards any particular political candidate.  Many tax-exempt organizations have officers and directors who engage in political campaign activities in their capacities as individuals and not as representatives of the organization.  Mr. Rosow provided certain guidelines to ensure such activities are not attributable to the organization and would not jeopardize the organization's tax-exempt status.  In addition, Mr. Rosow discussed that lobbying activities for Section 501(c)(3) organizations must be limited so as not to constitute a "substantial" activity and he explained the different methods for measuring whether an activity is "substantial."  Finally, Mr. Rosow also noted that the restrictions on lobbying and political campaign activity vary depending on the basis for the organization's tax exemption.  Section 501(c)(4), Section 501(c)(5) and Section 501(c)(6) organizations may engage in political campaign activity as long as it does not constitute the organization’s primary activity.  Section 501(c)(4), Section 501(c)(5) and 501(c)(6) organizations may engage in lobbying (even exclusively), provided that the lobbying activity is in furtherance of the organization’s exempt purpose.

Investment Management under UPMIFA: What’s Required, What’s Good Practice. Elizabeth M. Mills, Senior Counsel, described the investment provisions of the new Uniform Prudent Management of Institutional Funds Act (UPMIFA) and investment best practices for exempt organizations. The UPMIFA provisions concerning endowment spending and modification of gift restrictions have received the most attention. This is especially true in New York, where special provisions require contacting endowment donors to ask permission to operate under the new spending rules. However, UPMIFA also lays out specific fiduciary duties for boards and committees in managing investments. These include the duty of care (including the duty to use the special skills of the persons involved), the duty to minimize investment costs, the duty to investigate, the duty to diversify, and the duty to dispose of unsuitable assets. UPMIFA elaborates on the duty to invest with the care a prudent person would exercise by listing eight "prudence" factors a board or committee should consider, including, for example, the expected tax consequences of investment decisions. An exempt organization can delegate investment management functions to a professional or firm outside the organization so long as the organization exercises care in selecting and overseeing the agent and reviewing the agent's performance. Best practices include having a dedicated investment committee with a detailed charter outlining its duties and responsibilities, a written investment policy describing the investment goals and risk tolerance of the organization as well as such matters as asset allocation (required in New York), and regular oversight of investment advisors. 

Executive Compensation & Employee Benefits Developments.  Peter Marathas, Partner, reminded attendees that the IRS will soon release guidance on Code Section 457(f) "ineligible plans" that is intended to "synchronize" the rules for these plans with the rules under Code Section 409A. These rules will, among other things, establish strict standards for so-called severance plans under Code Section 457(f). In addition, Mr. Marathas discussed the enhanced fee disclosure rules applicable to ERISA-governed 403(b) arrangements and also explained the IRS's new guidance on the rules for terminating 403(b) plans. He reviewed some of the requirements of the Patient and Protection and Affordable Care Act (PPACA) for 2012, noting that the cost of coverage will be required to be reflected on Form W-2 for 2012 for all employers with more than 250 W-2 employees and that all health plans must issue a summary of benefits coverage in addition to summary plan descriptions starting in 2012. Mr. Marathas also noted that plan sponsors will have to being to report on the "quality of care" provided under their group health plans to both participants and Health and Human Services in 2012 and all plans will be required to pay a fee based on the number of members in the plan to fund research of comparative treatment, also beginning in 2012. 

A replay of the seminar is available by following the instructions below:

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In a fairly comprehensive course, the following significant points were made:

1.    A U.S. charity can do anything in a foreign country that it can do here, provided that the activity is consistent with the charity’s exempt purposes.

2.    For purposes of the rule that a charity may not devote a substantial part of its activities to legislative lobbying:

a.    lobbying includes action by the public in a referendum, ballot initiative, constitutional amendment or similar procedure;

b.    actions by executive, judicial or administrative bodies are not considered legislation;

c.    legislation includes foreign laws; and

d.    in certain countries ruled by authoritarian or theocratic regimes, it is questionable whether the governing body is a legislature or if a legislative process even exists.

4.    In a country ruled by a dictatorship, a charity’s criticism of the regime in the course of advocating for democracy, the rule of law or human rights would not ordinarily be regarded as intervention in a political campaign.

5.    The operation of a foreign school must meet the same non-discrimination requirements that are mandatory for domestic schools.

6.    A charity must exercise reasonable care to ensure that its assets are used for charitable purposes.  A charity can demonstrate that it exercised this care by:

a.    maintaining procedures for properly vetting a foreign grantee, such as requiring a written application from the grantee and conducting background checks;

b.    entering into an agreement with the foreign grantee that sets forth the purpose of the grant; and

c.    exercising oversight of the grant to ensure that the grant is used as intended.

7.    Proper documentation may include periodic reports, accounting of expenses, copies of receipts, reports of on site visits by agents of the granting charity and photos and videos showing the charitable program.

8.    The charity should review the reports and take corrective action, where appropriate.

9.    A charity’s exempt status can be revoked if the charity makes grants to foreign organizations and it cannot demonstrate that the grants were actually used for exempt purposes.

10.    If a corporation makes a contribution to a charitable trust, the funds must be used within the United States in order for the contribution to be tax deductible.

11.    Contributors may not earmark funds for the use or benefit of any specific organization or individual.

12.    Contributors may designate their contributions to go to a specific purpose such as earthquake relief.  A charity may also accept non-binding recommendations or advice from donors.

13.    “Friends of” charities must exercise discretion and control over the funds they raise.  The IRS looks at the following positive factors:

a.    whether the charter provides that the board has discretion to allocate funds raised to any charity;

b.    whether the bylaws provide that the board will review all requests for funds, require that the requests specify the proposed use of the funds and require a periodic accounting of funds granted;

c.    whether the bylaws allow the charity to solicit funds for a specific project or purpose approved by the charity, but retain the charity’s right to withdraw approval of the grant and use the funds for other purposes; and

d.    whether the charity makes these policies known to donors upon request, and refuses to accept contributions earmarked so that they must go to the foreign organization.

14.    A donor-advised fund may not make a grant to individuals or make any grant for non-charitable purposes.

15.    A Type III supporting organization may not support an organization that is not organized in the United States.

16.    A charity may distribute funds to foreign organizations that are not charities.  The U.S. charity must be sure that the funds are used for specific projects that further its own exempt purposes.  It must keep records and show it controls the distribution of the funds.  The charity can demonstrate that it exercises such control by implementing the following procedures:

a.    engaging in an independent decision-making process (with no requirement that the charity listen to the donor’s direction) about whether it will provide funds to a foreign organization;

b.    conducting a pre-grant inquiry to be reasonably sure that the grant will be used for exempt purposes;

c.    entering into a written agreement with the recipient regarding the use of the funds; and

d.    obtaining reports that the funds were used for approved exempt purposes.

17.    Charities, in conducting their foreign activities and grantmaking, should be mindful of the sanctions programs of the Treasury Department’s Office of Foreign Asset Control known as OFAC.  OFAC has programs that ban a broad range of programs in or with certain countries.  In some cases a charity may need to obtain a license from OFAC in order to conduct the activity.

18.    OFAC has a program that forbids transactions with specific named individuals and organizations.  A list of names is available on the OFAC website.  Violations of these programs can lead to civil fines and criminal penalties.

19.    The Commerce Department’s Bureau of Industry and Security (BIS) also restricts export of certain equipment and technology to certain countries.  Information in this program is available on the BIS website.

20.    Charities that have foreign investments may have to file certain information returns (besides the 990) such as:

a.    Forms 926 and 5471 relating to foreign corporations;

b.    Forms 3520 and 3520-A relating to foreign trusts and foreign gifts;

c.    Form 8621 relating to passive foreign investment companies and qualified electing funds; and

d.    Form 8865 relating to foreign partnerships.

21.    Under the income tax withholding rules, a charity that makes a payment to a nonresident alien or a foreign organization, such as compensation for services performed in the United States, may need to withhold tax on a portion of the payment and pay it over to the IRS.

22.    If a charity has a financial interest in or signature authority over a foreign financial account, such as a bank account, brokerage account, mutual fund or trust and the aggregate value in the accounts exceeds $10,000 at any time, then the charity may be required to file Form 90-22.1, popularly known as FBAR. 

23.    Failure to file an FBAR when required to do so may result in civil penalties and criminal penalties.  If a charity failed to file an FBAR for earlier years, it should file the delinquent reports and attach a statement explaining why the reports are late.

Among the projects directly relating to Exempt Organizations are:

• Updating grantor and contributor reliance criteria; 
• Regulations on additional requirements for charitable hospitals;
• Final regulations on the new supporting organization requirements;
• Update on guidance for distributions by private foundation to foreign charities;
• Guidance on excess business holdings and program-related investments rules;
• Regulations on new donor advised funds rules; and
• Final regulations on church tax inquiries and examinations.

Treasury also released final regulations under various Code Sections to implement the redesigned Form 990 .  According to Treasury "All tax-exempt organizations required to file [990s] are affected by these regulations."

• allow for new threshold amounts for reporting compensation; 
• require reporting on a calendar year basis; 
• modify the scope of organizations subject to reporting upon a substantial contraction;  
• eliminate the advance ruling process; 
• change the public support computation to five year; and 
• clarify that support must be reported using the organization's overall method of accounting. 

   

To be a Type II supporting organization, a charity must satisfy three tests:

1.                  the organizational test set forth in IRC Section 509(a)(3)(A),

2.                  the relationship test set forth in IRC Section 509(a)(3)(B)(ii), and

3.                  the control test set forth in IRC Section 509(a)(3)(C).

While the district court  concluded that the charity failed both the relationship test and the control test, the Court of Appeals based its decision on the failure to satisfy the organizational test. The Court said that this test was the most straightforward. 

The regulations permit a Type II supporting organization to satisfy the specification requirement by designating a “readily identifiable” class of supported charities, but need not identify them by name. 

The problem with this charity was that its certificate of incorporation designated as supported organizations,

“the class of organizations . . . which support, promise and/or perform public health and/or Christian objectives, including but not limited to Christian evangelism, edification and stewardship.”

The court agreed with the IRS that this formulation does not make the supported organizations “readily identifiable” – there is no limit on geographic area and no limit on types, such as churches or seminaries. Therefore, it is not a public charity but a private foundation.

It is not clear what level of specificity would have been satisfactory. It is clear, however, that charities should attempt to iron out the parameters with the IRS rather than go through the expense and agony of litigation.

Under current law, a charitable organization could face revocation of its tax-exempt status and a corresponding assessment in current years based on an audit of years that are closed for purposes of assessment (even though the charitable organization may have met all the requirements to maintain its tax-exempt status in the years open for assessment).

The report includes an interesting quote from a 1922 Supreme Court case, United States v. Oregon Lumber Co., 260 U.S. 290, 299-300: “Statutes of limitation are vital to the welfare of society, stimulating activity, punishing negligence, and protecting parties from the prosecution of state claims, when, by loss of evidence from death of some witnesses, and the imperfect recollection of others, or the destruction of documents, it might be impossible to establish the truth.”

The Office of the National Taxpayer Advocate was established by Congress in 1996 to help taxpayers resolve problems with the IRS and recommend changes that will prevent the problems in the future.

1. IRA Charity Contribution. The law allowing tax free distribution from an IRA (up to $100,000 for those over 70½), if the distribution is contributed to charity, is extended through 2011. If done in January, 2011, the taxpayer can elect to have the distribution deemed made on December 31, 2010. Code § 408(d)(8)(F)

2. Contribution of Conservation Easement. The more favorable deduction rules for contributions to charities of capital gain real property made for conservation purposes are extended until 2012. Code § 170 (b)(1)(E)(vi)

3. Contribution of Book Inventories to Public Schools. The enhanced deduction for contributions by corporations of book inventories to public schools is extended through 2011. Code § 170(e)(3)(D)(iv)

4. Contribution of Food Inventory. The enhanced charitable deduction rules for contribution of food inventory are extended until 2012. Code § 170(e)(3)(C) (iv)

5. Contribution of Computers. The enhanced charitable deduction rules for corporate contributions of computer inventory are extended until 2012. Code § 170(e)(6)(G)

6.  UBIT from Certain payments from Controlled Subsidiaries. The special favorable grandfather rules for payments such as rent, royalties or interest income by a controlled organization to its controlling parent under agreements in effect on August 17, 2006 (pursuant to the 2006 PPA) are extended until 2012.  Code § 512(b)(13)(E)(iv)

7. Contributions of property by S corporations. The new law extends until 2012 the special basis adjustment rule. This limits the reduction in a shareholder’s basis in the S corporation stock by the pro rata share of the contributed property’s adjusted basis rather than its fair market value. Code § 1367(a)

(Please note, in the links provided to the relevant provisions of the Code, the dates have not yet  been updated to reflect the extensions.)

• Best Practices for Board Members
• The Effects of Health Care Reform
• Executive Compensation Developments
• Ethics Issues Facing In-House Counsel 

In her introductory remarks, Amanda H. Nussbaum, Partner, highlighted that on September 17, 2010, New York modified its laws governing the management and investment of charitable assets of New York not-for-profit organizations.  Specifically, the NYS legislature adopted, subject to certain modifications, the Uniform Prudent Management of Institutional Funds Act, ("NYPMIFA").  All charities are encouraged to review NYPMIFA in its entirety to fully understand the extent of the Act's new requirements.  NYPMIFA applies to all charitable assets, not just endowments, and can be found in more detail in our October 7, 2010 blog entry.

Best Practices for Board Members.  Bob Kaufman, Partner, described how increased outside scrutiny of tax-exempt organizations requires increased attention by boards, particularly with respect to governance questions now asked on IRS Form 990.  Critical responsibilities of all board members are the selection, evaluation, and, if necessary, replacement of the CEO, but also support, encouragement, and assistance to the CEO.  Good practices include how replacement directors are selected, compensation practices and audit committees, and being able to answer "yes" to the Form 990 questions of whether the organization has certain key policies.

The Effects of Health Care Reform.  Elizabeth Mills, Senior Counsel, described highlights of this year’s health care reform act relating to tax-exempt organizations both as employers and as charitable organizations.  Health plans maintained by exempt organizations for their employees are subject to the same new rules as those of taxable employers, many of which are effective beginning January 1, 2011 or even sooner.  Depending on whether the plan is "grandfathered," these rules may include coverage of preventive services, limitations on waiting periods to obtain coverage, prohibition of preexisting condition limitations, and application of nondiscrimination rules to insured plans.  Tax-exempt hospitals are also subject to specific new requirements that are effective now.  Finally, the health reform legislation includes many funding opportunities for education and innovative care arrangements, some of which require partial funding from private sources.  More information can be found at Proskauer's Health Care Reform Task Force web page.

Executive Compensation Developments.  Lisa A. Berkowitz Herrnson, Senior Counsel, described how nonqualified deferred compensation for executives of tax-exempt employers is governed by the rules of Code Section 457.  If a plan does not satisfy the requirements to be an "eligible deferred compensation plan" under Code Section 457(b), it will be considered to be an "ineligible deferred compensation plan" under Code Section 457(f) and will then need to ensure that it also complies with the rules under Code Section 409A.  The IRS has announced its intention to issue additional guidance concerning certain aspects affecting "ineligible deferred compensation plans" in the near future.

Ethics Issues Facing In-House Counsel.  A. Nicole Spooner, Associate General Counsel at the Open Society Institute, described the New York Rules of Professional Conduct  and how those rules can apply to in-house counsel.  Specifically, in-house counsel should be aware of the level of protection and confidentiality afforded business and legal services that they provide and should determine the extent of their attorney-client relationships.  Moreover, in-house counsel should be aware of how their practice can be limited across state and international jurisdictions, including limitations on privilege and what information can be kept confidential.  Finally, in-house investigations should be conducted with these principles in mind and in-house counsel that are not the primary counsel in an organization should still realize that they have responsibilities under the Rules of Professional Conduct and can also be in violation of the Rules.

A replay of the seminar is available by following the instructions below:

 Go to  https://university.learnlive.com/proskaueronlineevents

Login with your existing user name and password.
If you do not have a user name and password, please select the "New Student Registration" button to create a new account. You will need to enter the Proskauer Company Code: 9736529.
Select the "Catalog" tab at the top of the page. Select the "Enroll" button to the right of the course titled "Trick or Treat Seminar 10-29-10."
Select the "Continue" button in the pop up.
Select the "Launch" button to open the course and begin watching. Please be sure to allow pop-ups and click the boxes that appear on the screen to receive CLE credit.

• This program will provide Exempt Organizations with information on:   
• Best Practices for Board Members
• The Effects of Health Care Reform
• Executive Compensation Developments
• Ethics Issues Facing In-House Counsel
• Tax Developments in 2010

1.      “Private Sector Outreach”

The government provides further links that offer tools for fostering a partnership between the government and charities to identify terrorist concerns.  These links include, for example, Treasury’s Office of Foreign Assets Control “Risk Matrix for the Charitable Sector,” which sets forth the common risk factors related to disbursing funds to grantees (especially overseas).  There is also a valuable link to Treasury’s “Anti-Terrorist Financing Guidelines: Voluntary Best Practices for U.S.–Based Charities” and the recently issued “Protecting Charitable Giving Frequently Asked Questions.”

2.      “Coordinated Oversight”

Treasury describes its interactive cooperation with other federal agencies and with state and local officials in developing anti-terrorist abuse policies for charities.  Links with additional relevant information are also provided.

3.      “Targeted Investigation”

Treasury describes the activities of its Office of Intelligence and Analysis, the IRS Criminal Investigation Division and OFAC in investigating terrorist financing in the charitable sector.  Links with additional relevant information are also provided.

4.      “International Engagement”

Treasury describes its information sharing and oversight concerning the national charitable sector through multilateral entities, such as the Financial Action Task Force.  Treasury also provides links with additional relevant information, including a link to FATF’s "International Best Practices for Combating the Abuse of Non-Profit Organizations."

In the Frequently Asked Questions link, Treasury sets forth the following important advice:

• "Charities should conduct a risk-assessment of their operations to determine if they are vulnerable to terrorist exploitation, such as the types of activities in which they are engaged and the regions in which they are operating.  OFAC’s Risk Matrix can be a particularly useful tool for this purpose.
• Charities should consider adopting measures to mitigate these risks, such as those found in the Treasury Department’s Voluntary Guidelines.

For those charities operating in high-risk regions, Treasury provides guidance on how to mitigate the risks of terrorist exploitation. These anti-terrorist financing procedures include, but are not limited to, the following steps that a charity should take before any charitable funds are distributed to foreign recipient organizations:

• Collect basic information about recipients of funding;
• Conduct basic vetting of recipient organizations, including checking their names against OFAC’s List of Specially Designated Nationals and Blocked Persons (the “SDN List”);
• Conduct basic vetting of key employees, including checking their names against the SDN List;
• Review the financial and programmatic operations of the foreign recipient organization (e.g. periodic reports, on-site visits, etc.)."

The Treasury Release and associated links should be studied by all charities and their advisors. 

Over the years, there have been a number of challenges to the parsonage tax exemption based on church and state separation constitutional grounds.  In 2002, the Ninth Circuit sua sponte in Warren v. Commissioner asked the taxpayer and the government to brief the constitutional issue. The Court also asked Professor Erwin Chemerinsky of the University of Southern California to write an amicus brief, which concluded that the provision was unconstitutional.

Eight years after President Bush signed the new law on May 20, 2002, Judge Shubb of the Eastern District of California (on May 21, 2010) declined to dismiss the latest challenge to the parsonage exemption. 

The court wrote that “plaintiffs have alleged sufficient facts which, if accepted as true, ‘leave open the possibility’ that an objective observer would determine that §107 goes too far in aiding and subsidizing religion by providing ministers and churches with tangible financial benefits not allowed secular employers and employees . . . In sum, the court believes that plaintiffs have sufficiently alleged that a reasonable and objective observer would perceive §107 as endorsing religion and as having a predominately non-secular effect.”

Judge Shubb wrote that a statute like Section 107 is unconstitutional if it fails to satisfy any prong of the famous 1971 Supreme Court Lemon opinion.  In Lemon, Chief Justice Burger set forth a three pronged test:

1. The statute must have a secular legislative purpose;

2. The principal or primary effect must be one that neither advances nor inhibits religion; and

3. The statute must not foster an excessive government entanglement with religion.

The district court found that the plaintiffs sufficiently alleged that the parsonage exemption has the unconstitutional effect of advancing religion, thereby failing to satisfy the second Lemon prong, and refused to summarily dismiss the case.

The court also refused to dismiss the constitutional challenge to the California parsonage exemption.  In an interesting footnote, the court noted that, unlike the federal parsonage exemption, California’s exemption is not limited to fair rental value.  This fact, according to the court, “would strengthen plaintiffs’ claims that California is impermissibly benefiting religion.”

While this case has not received wide-spread publicity, a finding of unconstitutionality can cost clergy billions of dollars in tax over the next few years.  This burden would likely be passed on to the religious institutions that employ clergy.

As was done in 2002, religious organizations should monitor this case closely and be ready to intervene and file papers as amicus to help preserve this significant and hoary exemption.

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.