Not-For-Profit/Exempt Organizations Blog : Non-Profit Lawyers & Attorneys : Proskauer Rose Law Firm : Tax & Corporate Law for 501(c), 501(3) Organizations

Corporate Governance for Not-for-Profit/Exempt Organizations. Edward S. Kornreich, Partner, described the responsibilities and obligations of the members of the board of a tax-exempt organization, particularly in regard to the unique issues related to conflicts among not-for-profit entities that have overlapping Board members. Recent information requests issued to not-for-profit boards, including those from the New York State Governor’s Task Force on Not-For-Profit Entities, were also discussed. 

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. 

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The Code of Conduct has five general principles:

• Act with loyalty and proper purpose
• Act with skill, competence, prudence, and reasonable care
• Abide by all laws, rules, regulations, and founding documents
• Show respect for all stakeholders (this includes the general public)
• Review investment strategy and practices regularly

Organizations that would like to implement the principles from the Code of Conduct must adopt detailed policies and procedures that reflect and address the five general principles above.  The Code of Conduct contains illustrations and examples of some of these policies and procedures.  The illustrations and examples are not exhaustive, however, and the actual policies and procedures for each organization will depend on the particular circumstances, along with the regulatory and legal landscape, of each organization.

The Code of Conduct and a detailed description of the general principles stated above can be found here.

For more information and background about investment management rules affecting not-for-profit organizations in New York, please see our October 7, 2010 blog entry. 

In particular, NYPMIFA should provide relief to those charities struggling to manage endowment funds in tough economic times, especially when those funds are underwater.  Boards are advised to educate themselves about the Act's new and important rules.  NYPMIFA largely follows UPMIFA, but also contains its own unique requirements.  For example, NYPMIFA: (1) sets out clear standards and factors to be used by a board, board committee, or delegated investment manager when managing and investing institutional funds; (2) requires a written investment policy; (3) subject to certain conditions (including, in particular, written notice to certain donors), permits charities to apply a spending policy to endowment funds based on certain specified standards of prudence, and moves away from the "historic dollar value" standard; and (4) makes available a streamlined process by which donor restrictions can be lifted (i.e., certain restrictions on gifts over 20 years old where the applicable fund is less than $100,000).

Charitable institutions with endowments are encouraged to review NYPMIFA in its entirety to fully understand the extent of the Act's new requirements.  Importantly, officers should ensure that their Board is aware of all of the Act's changes and that the relevant institutional policies, particularly investment policies, and practices are reviewed and revised accordingly.

For further background on the management and investment of institutional funds in New York, please see our November 11, 2009 blog entry.

2. Transparency - Not only does the IRS want to make sure that your organization is doing the right thing, but it wants to know exactly how you are doing it.  Moreover, the IRS not only cares that you tell it about your processes, but it wants to make sure that the public is also aware of what your organization is doing behind closed doors.  Even on its Form 990, the IRS asks whether the organization makes not only the Form 990 available, which is required by law, but whether the organization also makes its Conflict of Interest Policy and financial statements available to the public, even though it is not legally required to make these documents available.  The IRS does not want to guess at how you accomplished something, it wants enough information about the process behind the result to feel as though its agents were beside you when you made the decisions leading up to the result.  If you are not already, you need to conduct your organization as though all eyes are watching...because in many ways, they are.

3. Compensation - This area is one of the most active areas for the IRS.  As seen by the compensation surveys that the IRS has sent to hospitals and colleges/universities, the IRS is certainly interested in the kinds of salaries that the management of exempt organizations is receiving.  Moreover, in this difficult economy, the public has focused in on the amount of compensation that top executives in not-for-profit organizations are receiving.  So, if your organization had a "good year," you should still determine whether or not the executive's compensation for his strong performance is reasonable under IRS standards.  Just because a CEO performed well in one year is no defense for paying him or her compensation that is so high that it is unreasonable.  Using Boards to help determine compensation should be measured against the organization's sector, location, the job's responsibilities, the individual's skills and experience, and the size of the organization.  Importantly, each exempt organization should document the executive compensation decisions of its management and other highly compensated or key employees.  Increases in salary should be measured against both the organization's performance and the employee's.  Finally, if you do not have one already, you should put in place a compensation policy, which details your organization's compensation philosophy, compensation plan design, and how compensation decisions are generally made.  If necessary and practical, an organization should enlist the help of a compensation consultant.

4. Joint Ventures - The IRS is paying attention to exempt organizations' participation in joint ventures.  Specifically, the IRS is inquiring on the Form 990 about the revenues, expenses, assets, and liabilities that the venture generates for the organization.  Joint ventures are often structured so that the exempt organization does not recognize any unrelated business taxable income ("UBTI") or even lose its exempt status.  To that end, joint ventures should be structured so that they have adequate protections in place to ensure that the venture is operated for exempt purposes, including using binding charitable purpose provisions, preferred governance rights, and certain dissolution rights to the participating exempt organization.  This sort of partnership has arisen quite frequently in the health care field, where hospitals are often members of these types of ventures.  With the new Code Section 501(r) created by the Patient Protection and Affordable Care Act, tax-exempt hospitals will have to comply with additional requirements to maintain their tax exemption.  Accordingly, when hospitals enter into joint ventures, it is important that not only that the Section 501(c)(3) requirements are kept in mind, but that the requirements of Section 501(r) are also considered.

5. Endowments/Investments - With the economic downturn, nearly every exempt organization has looked at its endowment or investment policy and tried to determine what it could do better or differently in order to increase or maintain the funds that it currently has.  On a state level, there has been statutory development around UPMIFA, which updates UMIFA, a statute that provides uniform and fundamental rules for the investment of funds held by charitable institutions and the expenditure of endowments to those institutions.  UPMIFA establishes a more clear and precise set of rules for investing funds in a prudent manner and also eliminates the idea of "historic dollar value," which under UMIFA, is the threshold for what a charity can prudently spend an endowment down to.  Accordingly, investment officers at charities should be clear on these rules if they apply in their state.  Investment policies should reflect any change in state law and the investment committee's adherence to such policies.  Failure to adhere to appropriate state standards and manage your institution's funds under these standards will certainly draw the attention of the IRS.  Note: New York is one of a handful of states that have not yet enacted UPMIFA.  Please visit our blog for a more in depth discussion on fiduciary obligations and the prudence standard for endowments in New York.

For more information on current developments in the law of tax-exempt organizations, please visit Bruce R. Hopkins's Nonprofit Law Center.

Expenditures

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.