So why not just consolidate them and clarify that the same multiple factors apply to all questions of political intervention that arise under the Internal Revenue Code?  That’s what I suggested in this letter to Lois Lerner, exempt organizations director at the Internal Revenue Service. 

In particular, I think it is important to pick up the factor of “targeting” that was listed in the 2004 Ruling and somehow dropped out of the 2007 Ruling, to emphasize its relevance and importance.  Many broadcast ads that may appear in content to be issue advocacy look quite different when you know they have been targeted at incumbents in battleground or “swing” states or districts. 

This is something that the IRS and Treasury could, without constructing any new policy, fix now.  In the middle of the 2012 elections, I think it would be a welcome clarification.

What Is “Cause Marketing”? 

So-called “cause marketing” – which the law generally refers to as “commercial co-venturing” – is a term used to describe a kind of creative partnership between a charity and a for-profit business.  While commercial fundraising is nothing new to most charities, the commercial co-venture is oftentimes overlooked.  A commercial co-venture consists of a for-profit company partnering with a charity for the dual purpose of promoting a product and benefiting the charity.  “For every purchase of a pink water bottle, a dollar goes to breast cancer research”; or, “If Company sells 100 cars before the end of the month, Company will donate $100,000 to Charity.”  The charity reaches a new audience of potential contributors, while the commercial co-venturer benefits both from increased sales and from the “halo effect” that it generates as a result of its charitably-minded endeavor. 

Currently, 27 states define “commercial co-venturer” in their solicitation laws, and 11 require some form of registration or reporting (including California).  However these numbers are likely to rise.  Given the strict regulations surrounding commercial fundraisers, state attorneys general are not likely to give a free pass to commercial co-venturers.  Moreover, with the increased popularity of mission-driven companies like “Tom’s Shoes” or “Newman’s Own,” many for-profit companies are turning to charitable causes to promote their products.   

Which Are You? 

How do you know whether you are, or plan to engage in, a commercial co-venture?  Ask yourself:  Will your charity receive a portion or a percentage of profits from a business?  Will any of your donations be contingent on another company’s product sales?  

In California, commercial co-venturers must have a written contract in place with the charity which requires, among other things, that the company transfer all assets raised for the charity every 90 days during the campaign.  Any commercial co-venturer without such a contract must complete a registration form and pay a $350 fee to the Attorney General in lieu of the contract.  

What If the For-Profit Gets Nothing? 

What about the donation box in the grocery store?  No particular product is being sold, and any donations received are independent of store purchases.  This is most likely not a commercial co-venture.  Keep in mind, however, that even if your charity does none of the above, it is still most likely subject to annual reporting with the California Attorney General’s Registry of Charitable Trusts.

Two notes:

•  First, the CLAT in question was a testamentary formula CLAT, which had a 10-year term and essentially said “pick an annuity rate that will result in a present value for the charitable annuity interest equal to 100% of the contribution.”  It appears that the CLAT was initially formed with a fixed percentage, and was then reformed later to provide for the increasing annuity payments. 
• Second, note that the CLAT payments increased at a steady 20% per year.  This trust was not a “shark-fin CLAT,” in which the payments are very small during the initial years and increase dramatically in the final years.  The jury is still out on that one!

These nine new examples illustrate certain general principles, such as the following:  

• Charitable purposes that may be accomplished through a PRI are broad and include purposes such as combating environmental deterioration, promoting the arts, and advancing science. 
• Many different kinds of investments may qualify as PRIs, including loans to individuals, tax-exempt organizations (e.g., a 501(c)(4) social welfare organization), guaranties, and equity investments in for-profit organizations. 
• A credit enhancement arrangement also may qualify as a PRI. 
• Funding activities in foreign countries, such as assisting poor farmers or responding to a natural disaster in a developing country, can further the accomplishment of charitable purposes and qualify as a PRI. 
• A potentially high rate of return does not automatically prevent an investment from qualifying as program-related. 

These examples reflect the types of investments that the IRS previously has recognized qualify as PRIs in private letter rulings issued to specific foundations.  Having these examples in the tax regulations, as opposed to scattered non-precedential private rulings, should provide more comfort that these types of investments are viewed by the IRS as legitimate.  

In addition, the new examples provide a sense of what certain foundations have been doing in the field and how PRIs have evolved, as the examples are based on real-world activity.  My partner Rob Wexler co-chaired a PRI task force on behalf of the American Bar Association Section of Taxation that submitted proposed PRI examples to the IRS in March 2010, on which these proposed regulations are largely based. 

Comments on the new regulations can be submitted to the IRS until July 18, 2012.  We will consider submitting comments, depending on the responses that we receive from clients and friends.

However, a possible new obstacle has recently landed in their path.  In December 2011, Congress passed the Consolidated Appropriations Act of 2012 (HR 2055), which appropriated federal funds for the fiscal year that began last October.  Every year the appropriations act includes some provisions purporting to restrict the use of appropriated funds for lobbying under certain circumstances.  (The GAO reports that it has always interpreted these constraints narrowly.)   

This year, for the first time, Section 503 of the Act, which applies to appropriations for the Departments of Labor, Health and Human Services (HHS), and Education (and related agencies) included a provision prohibiting the use of appropriated funds for “any activity to advocate or promote any proposed, pending or future Federal, State or local tax increase, or any proposed, pending or future requirement or restriction on any legal consumer product, including its sale or marketing, including but not limited to the advocacy or promotion of gun control.” 

Public health organizations that receive federal funding to support prevention of public health problems are concerned that this extremely broad and vague new constraint on the use of federal funds may undermine their ability to accomplish the improvements and protections that the funding they receive was intended to promote.  Indeed, I’m already hearing stories from across the country suggesting that the new language is severely chilling advocacy efforts far beyond activities aimed at changing laws.  Some public health officials, advocates, and even academics who have received funding subject to the new Section 503 language have become unsure about what they can say and do.  Time will tell how the new language is implemented, but there is little doubt of its immediate chilling effect on the ubiquitous public health prevention efforts that rely in part on federal funds. 

Nonetheless, public health organizations can use the opportunities that the tax code provides to advocate for the removal of this restrictive language, as well as aggressively to promote (perhaps with non-federal dollars) beneficial solutions to pressing public health concerns.  The key to success in these efforts is understanding the rules governing lobbying, and having the confidence and support to deploy them in the most advantageous way. 

The Committee subsequently withdrew this opinion, although we don’t know why.  Nonetheless, the issues raised in the opinion should still be of concern to estate planning attorneys who sit on charity boards.  

In fact, the Standing Committee on Ethics and Professional Responsibility of the State Bar of Nevada recently addressed a similar issue.  The Nevada Committee considered two questions: 

(1)       May a lawyer who sits on the board of directors of a company (which we assume means “charity”) render estate planning services to a client interested in naming the charity as a beneficiary of a gift or bequest; and 

(2)       If so, must the lawyer disclose his relationship with the charity to the estate planning client? 

The Committee noted that the lawyer has a fiduciary obligation to the charity in his capacity as a director, and that such duties would limit his ability to advise his estate planning client, as he could not disclose information about the charity that might be relevant to the client (for example, the charity’s pending bankruptcy).  Further, the competing goals of advancing the charity’s interests and representing his client’s interests could create a conflict of interest.  However, unlike the Maryland situation, the Nevada Committee found that the lawyer could remedy this conflict with appropriate written consents from both parties. 

So estate planners serving on charity boards should check their state’s professional responsibility resources carefully before offering legal services to would-be donors to the charity ― it may not even be allowed with the donor’s consent! 

Under Internal Revenue Code Section 4958, the IRS may impose intermediate sanctions on any “excess benefit transaction” between an applicable exempt organization and an insider of that organization. 

The insider (a “disqualified person” under the Code) can be liable for a tax of 25 percent on any “excess benefit” received.  If the excess benefit transaction is not corrected (e.g., any excess payment returned), a second-tier tax of 200 percent on the excess benefit is imposed.  Officers and directors who approve the transaction also may have tax liability. 

In reviewing insider compensation, the IRS typically aggregates all compensation provided for services and determines whether the overall compensation was reasonable. 

However, the organization must clearly indicate its intent to treat a benefit as compensation at the time the benefit was paid.  If the organization fails to substantiate that a compensatory benefit is being provided to the insider as compensation, the IRS will treat the payment as an “automatic” excess benefit transaction, which means the amount is taxable without regard to whether the benefit was reasonable. 

This issue often arises when an organization provides certain fringe benefits but doesn’t report them as compensation.  For instance, paying for spousal travel can be an excess benefit payment.  Providing use of an employer’s vehicle also may qualify.  In every case, the organization should determine whether it is reasonable to provide the benefit and, if provided, whether it must be reported as compensation. 

One way to provide “written contemporaneous substantiation” that a payment was intended as compensation is by reporting the benefit to the IRS, either by the exempt organization (on Form 990, and Form W-2 or Form 1099) or the disqualified person (on Form 1040).  

If the exempt organization did not report the benefit as compensation on its original Form 990, it is possible to amend a prior return to recognize the benefit as compensation, provided the amended return is filed before the start of an IRS examination of either the exempt organization or the disqualified person for the year when the transaction occurred. 

Expense reimbursement also may result in an “automatic” excess benefit transaction, if not done properly.  These payments should be made in compliance with an “accountable plan” (requiring that reimbursed expenses have a business connection, be properly documented, and that any excess amounts be returned within a reasonable amount of time).  Payments that are not made under an “accountable plan” are included in the employee’s gross income, reported as wages or other compensation on the employee’s Form W-2, and subject to withholding and payment of employment taxes.  If these amounts are not documented as compensation, they are also automatic excess benefits under Section 4958. 

Automatic excess benefit transactions easily could be a source of potential tax liability in an IRS audit, for both the insiders receiving the benefit and possibly the officers and directors who approve the payments.  In addition, the organization will have an obligation to attempt to correct the payments and will need to report that it was party to an excess benefit transaction on its Form 990, a public document, which the organization certainly will want to avoid. 

For more on Section 4958, see http://www.irs.gov/charities/charitable/article/0,,id=123298,00.html. 

For more on automatic excess benefit transactions, see http://www.irs.gov/pub/irs-tege/eotopice04.pdf.

The most extensive coverage has appeared in a two-part article by Rick Cohen, published in Nonprofit Quarterly earlier this month.  The story also ran in the Los Angeles Times. 

This is not the first time such a thing has happened.  In my book, Fiscal Sponsorship:  6 Ways To Do It Right, at page 73, I cite the case of Media Network, a documentary film sponsor that collapsed in 1997 in similar fashion. 

While the full story and the future of IHC may not be clear right now, many are asking:  What can be done to prevent this from happening? 

I suggest that sponsors take these precautions—and that projects watch to make sure they do: 

1.    Make it clear everywhere—in the fiscal sponsorship agreement, in writing to donors, and on Form 990—that the sponsor treats funds received for the purposes of a project as restricted under the charitable trust doctrine.  The sponsor can obtain unrestricted funds by charging administrative fees, but otherwise the funds dedicated to the purposes of one project may not be used to pay the expenses of another, or to pay the sponsor’s general overhead. 

To be clear:  a fiscal sponsor is not a bank.  Each restricted fund belongs to the sponsor, not the project.  However, each project fund is impressed with a trust commitment “for the charitable purposes of” the project, and the sponsor has the legal duty to honor that trust.  Within the limits of those purposes, the sponsor has discretion and control over spending decisions.  But if the sponsor breaches that duty, the state attorney general can intervene to enforce the charitable trust in the public interest. 

2.    The sponsor’s board should set a reserve policy to maintain a strong minimum of general, unrestricted funds, so that the sponsor can meet its overhead expenses even if administrative fees from projects were to take a sudden drop. 

3.    The sponsor should have internal financial controls that would discourage any one person from invading project funds.  Since many fiscal sponsors centralize check-writing authority for all projects in a few top managers, major disbursements should require a second signature or a second pair of eyes.  Where required by law, the sponsor must have a board-level audit committee and an annual independent audit by a CPA firm.  The accounting firm can issue a management letter to the board to address defects in internal controls. 

4.    The sponsor’s board of directors needs to pay attention and oversee the program.  Among other things, the Board should receive frequent financial statements showing the condition of the fiscal sponsor’s unrestricted general fund, to make sure that reserve requirements are met and that there is no improper “borrowing” from project funds.

5.    Strive for transparency.  Project directors should receive frequent (or have immediate online access to) internal financial statements showing the condition of their project fund.  The project’s fund accounting should always show cash on hand in excess of incurred expenses.  A positive balance that relies on a “receivable” from the sponsor’s general fund is a danger sign; the project director should jump on that immediately. 

6.    The sponsor cannot afford to be too soft-hearted.  General funds should not be advanced to projects.  If the cash in the project fund isn’t sufficient to meet payroll or other costs, employees will need to be laid off and project expenses curtailed.  Reliance on grants receivable, loans, and pledges is risky business.  And some sponsors may need to revisit their administrative fee structure if not enough unrestricted money is being generated to meet the costs of audits, controversies, full insurance coverage, and other elements of risk management. 

7.    Some fiscal sponsors, in the public health field, for instance, must rely heavily on government grants that are paid on a reimbursement basis.  In those cases, projects may need to incur or pay expenses before receiving grant funding.  Operating such a fiscal sponsorship system successfully requires very careful, professional planning by experienced grants managers, but it can be done.

8.    The sponsor’s annual IRS Form 990, accessible to the public via Guidestar, can reveal that a fiscal sponsor is in trouble.  Look at Part X, the Balance Sheet, Lines 27, 28, and 33.  If unrestricted net assets are negative, and total assets are less than temporarily restricted (project) assets, it can mean that the sponsor has borrowed from or misspent funds held in charitable trust for the projects’ purposes.  The sponsor may not have the cash to cover all the projects’ check requests.  The Form 990 might not be filed until almost two years after the sponsor goes in the hole to its project funds, so projects should demand more frequent balance sheets.  IHC’s unrestricted net assets went negative back in 2008; its projects could have transferred to another sponsor or taken other protective action in 2009. 

9.    The sponsor needs to be adequately insured.  When I was on the board of Community Initiatives in San Francisco with Jan Masaoka and John Kreidler, our motto was “buy insurance by the truckload.”  Besides general liability and directors’ and officers’ insurance, consider employee dishonesty and theft, non-owned auto, special event coverage, discrimination, harassment, molestation, and employee claims.

10.    The National Network of Fiscal Sponsors has published guidelines for best practices.  These are a valuable resource for all concerned to determine whether a sponsor’s program is up to the industry standard. 

Are fiscal sponsors inherently weak?  Not at all.  By sponsoring a range of projects, the whole can be stronger than the sum of its parts.  But just like any other charity—a hospital, college, museum, church, or social service group—it may fall into a deficit position for any number of reasons, pulling down all of its  departments, scholarship funds, and special programs. 

For more tips on doing fiscal sponsorship right, see www.fiscalsponsorship.com.

As described in the opinion, the local Girl Scouts chapter in Manitou, Wisconsin, like more than 300 other local Girl Scouts “councils,” held a license from the national 501(c)(3) organization to sell Girl Scouts cookies and other merchandise.  This naturally brought significant revenue to the chapter.  When the national organization attempted to consolidate the chapter with other local councils, effectively revoking its license as a separate council, the chapter sued, claiming that it was a “dealer” (i.e., a franchisee) under the Wisconsin Fair Dealership Law and that its franchise could not be terminated without good cause, regardless of what any contract with the national group provided.  The appellate court agreed, at one point comparing the Girl Scouts to Dunkin’ Donuts, and the national Girl Scouts’ effort to consolidate the chapter was stopped. 

How important is this case to other charity networks with a less commercial hue?  It’s not clear.  While the cookie sales are definitely a distinguishing factor, it’s not that hard to fall under the definition of a franchise under the laws of many states (see, for example, the California Franchise Relations Act).  It typically involves a three-part test, although statutes do contain exceptions: 

• The putative franchisor (the national organization) grants the chapter a right to offer or sell goods or services to the public under a marketing plan;
• The marketing plan is substantially associated with the franchisor’s mark; and
• The franchisor charges a fee for using its mark. 

For example, a charity that licenses an educational program to local chapters and receives a percentage of resulting tuition in return might very well meet all three prongs.  (Of course, the details of this test and how they’re applied vary from state to state—e.g., New York requires only two of these prongs—so it’s important to consult local counsel.) 

The results of an “accidental franchise” can be dire—disclosure and registration requirements may apply, and franchisee protections may limit the parent’s ability to enforce its affiliation agreement if the chapter goes rogue.  Of course, the franchise laws were intended to protect the public from unscrupulous franchisors, and most parent-chapter affiliations in the charitable sector probably don’t trigger this sort of concern.  But there is unlikely to be any case law or regulatory guidance to give much comfort on this point.   

Fortunately, an accidental franchise can usually be avoided, by structuring the relationship to fail at least one prong.  The first prong—selling goods/services to the public—often is inapplicable to nonprofit parent-chapter affiliations, although offering goods or services to the public might technically be enough.  (Note, however, that the federal Franchise Rule, enforced by the Federal Trade Commission, does not apply to relationships unless they are entered into with the expectation of profit.  See FTC staff opinions on this matter here and here.)  Where the first prong is met, the second—using the parent’s brand—will usually be met too.  In that case, the third prong can be avoided by charging no fee to chapters, or working with counsel to structure the fee so that it doesn’t resemble a typical franchise fee. 

So, in the end, even though your charity network may not look much like Dunkin’ Donuts, it may still be wise to consider precautions to avoid franchise hang-ups.

The IRS Form 990 (filed by tax-exempt organizations) includes a number of schedules, including Schedule R: “Related Organizations and Unrelated Partnerships,”  which was rolled out for tax years beginning in 2008.  The 2010 instructions for Schedule R clarified that charities should report charitable remainder trusts (CRTs) that are “related” to the charity in Schedule R, Part IV, including the name and address of the CRT, its taxpayer ID number, and the value of the charity’s interest in the CRT.  This disclosure obligation met with a fair bit of resistance from the tax community, who noted that CRT donors do not expect their information to become public—especially as the names of individual donors to public charities are not subject to public disclosure.  The IRS responded to this resistance, revised the 2011 Schedule R instructions, and reported at the recent Western Conference on Tax Exempt Organizations that charities will not have to disclose the names and other identifying information of their “related” CRTs, but will only have to report the type of the trust. 

That’s the good news.  

The bad news is that the cat is mostly out of the bag anyhow.  The name, address, taxpayer ID number, and asset balance of all CRTs are now available online!  Just log onto Guidestar.org and search for the name of the trust.  (Many donors include their name in the name of their CRT—such as “The John Smith Charitable Remainder Trust,” so you can search for many CRTs via the donor name.)  You can even search for “Section 4947(a)(2)” entities (which include CRTs) by zip code—so search your zip code and see if any of your neighbors has a CRT!