Committee Business Matters MS. BJORKLUND: Good morning. I am Victoria Bjorklund from Simpson Thacher & Bartlett in New York, and I am the chair of the ABA Tax Section Committee on Exempt Organizations. To my left is Betsy Buchalter Adler from Silk Adler & Colvin in San Francisco, who is vice chair of the committee, and to my right is Michael Clark from Sidley Austin in Chicago, who is vice chair of the Committee for Legislative Developments. Welcome, all of you, to frigid San Antonio where we are, for benefit of those who are listening to this on tape, in a room large enough that the Spurs could play in it. Mike Sanders, where are you? He is always asking, “Get us a bigger room. Get us a bigger room.” So we have got a big room, Mike. I want to say a special thanks to Steve Miller who is director of the Tax-Exempt Government Entities Division of the IRS for joining us this morning. We just finished two grueling days of meetings in Washington, D.C. of the TaxExempt/Government Entities Advisory Committee. So we are especially appreciative for Steve leaving those meetings to join us here this very busy week. Deirdre Dessingue and I are both your representatives on the Tax-Exempt/Government Entities Advisory Committee. Deirdre was waving her hand in the back row there. We both would welcome feedback from you at all times on TaxExempt/Government Entities matters. I am not going to say more about the Advisory Committee now because I know that Steve is going to be mentioning it in his panel discussion shortly. I want to give you a reminder that our May meeting will be held in Washington, D.C., on Friday, May 9th. This meeting always features a sterling cast of government speakers, and this year will be no exception. Our agenda is due February 1st, which is next week. So please let me know as soon as possible if you have suggestions for particular panels or panelists. We are going to have two special focus topics slated for our May meeting. First, we are going to focus on how the war on terrorism and possibly war in Iraq has affected international charitable operations and international grantmaking, and we hope to have government speakers who are going to confer with us on current events and the current state of things, in addition to having representatives from charities who are operating overseas. The Exempt Organization Tax Review Second, we will focus on how for-profit government scandals have influenced nonprofit governance. In that vein, I have some breaking news that Elliot Spitzer yesterday announced at a meeting of the Society of New York State Accountants that he intends to introduce legislation to extend the Sarbanes-Oxley provisions to all nonprofits operating in New York. I emphasize “operating in New York,” not necessarily incorporated in New York. He has proposed that the CEOs would have to certify the financial statements and that other Sarbanes-Oxley provisions would apply to any nonprofit having assets or income of $250,000 a year or more. So it is a low threshold. There is an extensive piece that appeared overnight on the Dow Jones newswire on this, and so I just wanted to bring that to your attention because we have been anticipating that Sarbanes-Oxley would carry over informally. And now, here, it appears this is the first shot across the bow in making this a formal carryover. We do have a Sarbanes-Oxley task force that includes the Tax Section and representatives from our committee as well as other members of the ABA and other committees within the ABA Tax Section. Bonnie Brier is the chair of the Sarbanes-Oxley Task Force, and the Exempt Organization Committee members on it are Suzy Ross McDowell and Dave Shevlin. We talked this morning extensively about preventing charitable dollars from “getting into the hands of terrorists organizations through charities.” Those words are from a press release dated November 7, 2002, issued by the Treasury Department’s Office of Public Affairs. The title of the press release is Response to Inquiries from Arab-American and American-Muslim Communities for Guidance on Charitable Best Practices. The press release announces that the Treasury Department has developed voluntary Best Practices Guidelines for U.S.-based charities so that they can “avoid any ties to terrorist organizations that might lead to further blocking actions.” This is blocking actions on the revenues of those U.S.-based charities. The Best Practices Guidelines are also available on the Treasury Department Web site and comprise seven pages of recommendations. Those recommendations are grouped under four headings: governance; disclosure, transparency in governance, and finances; financial practices and accountability; and anti-terrorist financing procedures. If you have not yet read these documents, I strongly urge you to download them from the treasury.gov press release Web site. March 2003 — Vol. 39, No. 3 353 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Edited Transcript of the January 24, 2003 ABA Tax Section EO Committee Meeting ABA Transcript We discussed this press release and the voluntary guidelines extensively this morning in the International Philanthropy Subcommittee breakfast. At that time, John Edie, Janne Gallagher, and Marc Owens talked to us about comments on the guidelines, which are being prepared. If you are interested in this topic, I strongly urge you to talk to John Edie, Janne Gallagher, or to Marc Owens, as well as to Betsy and me, because we are going to be actively pursuing this not only at the May meeting, where we are going to have one or two panels on the topic, but also in the intervening months. In addition, I expect that Betsy and I are going to see if we can rush some comments into the IRS over the next week on the Form 990 request for comments which deal with international grant-making and also corporate governance. So, if you have reviewed that request for comments or wish to do so and e-mail us some comments very rapidly, we would welcome that feedback from you. Our e-mail addresses are vbjorklund@stblaw.com and bba@silklaw.com. You can see I e-mail frequently. Mike Clark will be involved with us also, even though this isn’t legislative. Do you want to give your e-mail address? MR. CLARK: Mclark@sidley.com. MS. BJORKLUND: So we welcome your input on that and will be reporting further to you as we progress because I imagine both of these areas are going to have developments between now and May. Regarding Form 1023, on December 2, 2002, right after the Thanksgiving holiday, the chair of the Section of Taxation, Herb Beller, submitted the EO Committee’s detailed comments in response to IRS Announcement 2002-92, seeking comments on proposed revisions to IRS Form 1023, the application for exemption. You will remember that we devoted over three hours of our October meeting to that topic, and I especially want to thank LaVerne Woods, who agreed to stay on after having done the project on the 1023 of the future, to co-chair with Eve Borenstein, who is also here, the project to get comments in on a very tight turnaround time over the Thanksgiving holiday. This team submitted over 50 pages of detailed comments. I am really proud of the excellent comments that this team produced. It was a stellar team of 16 people led by Laverne and Eve and including Betsy Adler, Wendell Bird, Boyd Black, Mike Clark, Susan Cobb, Jennifer Franklin, Lauren Mack, Shannon Nash, Jennifer Goldberg Reynoso, Mike Sanders, Robin Smith, and T.J. Sullivan. The comments were reviewed by Dick Gallagher and Carolyn Osteen. It has been noted to me repeatedly, and was noted at the chair’s breakfast this morning, that that was a 354 March 2003 — Vol. 39, No. 3 really huge effort and that the Tax Section is especially proud of the effort that this Committee put in all through volunteer effort and in such a short time frame. Your work is really a credit to the Committee, and I thank you all again. Tomorrow, there is going to be a meeting of the Pro Bono Committee at 7:00 a.m. Eve and I will be there. We hope some others of you may be there. We are going to talk about the new efforts that the Tax Section plans to make in the pro bono area. Following on that, there will also be VITA training for those members of the Tax Section who would like to be preparers of low-income tax returns and volunteer to do that. I have been working with Michael Hirschfeld in New York to connect with our client, the Robin Hood Foundation, which is funding low-income tax preparation so that New York residents can claim the earned income tax credit. I believe that there are going to be similar outreach efforts made in cities across the country. So, if any of you are able to participate in that, I know it will be welcome. E-mail. As I hope you all know, we have created an EO Committee e-mail list that will allow the committee chair, at this point only the committee chair because they don’t want you to get advertisements, to communicate with you by e-mail. However, this system will work well only if we and the ABA have your current e-mail address. In reviewing the ABA list, we were surprised to find that many of our newer and younger members do not seem to be listed with e-mail addresses. So we especially encourage you to make sure that the ABA has your e-mail address. I sent the first, and so far only, e-mail to this list on January 3rd, 2003, entitled “Test E-mail.” If you did not receive it, it means that we don’t have your e-mail address. If you didn’t receive that test e-mail or if you prefer not to be contacted by e-mail, would you please contact Betsy Adler about that. Betsy is going to be the keeper of the e-mail list, and as I mentioned, her e-mail address is bba@silklaw.com, or for those of you who do not prefer to use e-mail, you can contact Betsy by telephone at 415/421-7555. In addition, we appreciate the cooperation of Fred Stokeld and Tax Analysts. They were very helpful to us. They figured out a way to take the transcript of our October meeting and get it posted on the ABA Web site where all of you can access it electronically as long as you have an Adobe Acrobat reader. We hope to do this for all meetings going forward. If you need advice on accessing the transcript, please confer with Betsy Adler or with Committee Secretary Jennifer Franklin for detailed instructions about accessing that Web site. I will tell you that it is not too difficult, but you do have to know your ABA number. So, for those of you who didn’t keep your little ABA cards when they were mailed to you, you may have to find out what your number is. I regret to tell you that medical adventures have kept Tom Silk and Carol Kroch from being with us today, but we encourage them to take their vitamins, be good, and we are looking forward to both of them joining us at the May meeting. We thank those people who are filling in for them in their absence, and we do wish them well. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. In addition, I note that on December 31st, the Court of Appeals for the Seventh Circuit affirmed the judgment of the District Court denying the Global Relief Foundation, an Illinois charity, an injunction of a blocking order on its assets. There have been blocking orders that have applied to three U.S.-based charities. ABA Transcript Betsy, do you have anything, items of business? MS. ADLER: I do. Victoria being one of the world’s toughest acts to follow, I can only invite all of you to help me to do that by giving me ideas of speakers, topics, interesting issues, whether you are interested in speaking or pulling together a panel on a particular topic, or whether it is just something that you would like to learn more about from the experts in the field. E-mail me, call me, grab me at the drinks hour this afternoon, but give me ideas. I especially want to hear from people who perhaps have not spoken recently. It is not a closed club. It is a wide-open door, and I look forward to helping make a lot of those ideas into actual programs over the next couple of years. One other thing to mention, in connection with the international legal developments, there will be a workshop in Washington on February 22nd convened by United Way International, cosponsored by the Council on Foundations, and I believe Independent Sector, which will focus on bringing grant-makers and international operating charities up to speed on recent developments in the law and in Treasury’s goals for law enforcement in this area. For more information, you should contact either me after the meeting or go to any of the folks here with the Council on Foundations or Independent Sector to get more information. MS. BJORKLUND: Mike tells me we finally succeeded in getting the Intermediate Sanctions Saturday breakfast out of the list. This is the first time in years. So I don’t have to say if you go, you will be having coffee with yourself. We have a couple of minutes before Steve Miller comes up. Does anybody from the breakfast meetings want to come up to the microphone and give us a brief report of what was discussed in the breakfast meetings? Steve, you have got the mic, then. One more comment from Betsy. MS. ADLER: I just want to point out that the efforts of the various task forces really do bear fruit, even though sometimes you may wonder whatever happened to the seed that you planted. In the days of Celia Roady’s chairship of this august body, a task force headed by our own Mike Clark started to pull together a proposed guidance from the Service on section 507, private foundation terminations. I believe it was either in Doug Mancino’s reign or Carolyn Osteen’s reign that the comments were submitted, and at the end of ’02 and just recently in January ’03, the Service did issue guidance. So The Exempt Organization Tax Review all kudos to our vice chair of Law Development, Mike Clark, for having had the energy in the first place to do it and the tenacity to not let go of it. [Applause.] MS. BJORKLUND: Those are great precedential guidance, and it is nice to get revenue rulings again. Steve is going to talk, I think, a little more about expecting a bigger flow of revenue rulings, but I am sure we can continue to help by giving feedback. I did have the opportunity to talk to Sarah Hall Ingram about those revenue rulings at the Advisory Committee meeting this week, and she said that it was the ABA’s feedback that gave them the two pieces. Your work on this really does make a difference. News from the Internal Revenue Service MR. CLARK: Well, our next speaker really needs no introduction, but I will do it anyhow. We thank Steve Miller who is the director of Exempt Organizations in the TE/GE area for coming out to San Antonio today on a very short turnaround. He is leaving on a flight at noon. So we appreciate very much his taking the time to be with us today and share what is going on in his office and what is on their plate and what is important. Steve? MR. MILLER: Thanks. I feel like the flight yesterday. I don’t quite fit. I can’t wait for the flight back. Thanks. What I am going to do is just walk through a few things. You guys should kick in with questions as we go along, and then I think there will be plenty of time for questions, frankly, although I always say that and I manage to fill the dead time, but I think there will be plenty of time for questions and answers. What I wanted to do first was talk about some key current events that are going on in our office and secondly talk a little bit about the functions and what they are up to in more specific terms. Current highlights. First, we have talked in the past about the determination realignment, the fact that we have people working in examinations that are doing nothing but determination work and the fact that the determination workload has grown to a point where examination work forces have greatly diminished and hence the number of examinations we are able to do. We embarked last year on a realignment to try to pull those people over from exam so they could work for the same people who are doing determinations for the rest of the country, and we have done that at this point. One hundred agents actually as of December moved over into the Rulings and Agreements Group, 100. Now, that doesn’t mean there are fewer people doing examinations because those were people that were, for the most part, doing determinations already, but at least at this point, we have March 2003 — Vol. 39, No. 3 355 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. We are actually very happy to have with us today Jody Blazek, who is going to be our luncheon speaker, who was not able to join us because she broke her foot hiking right before the October meeting. She has recovered enough to be with us today. So we are very happy to have her here. ABA Transcript It is going to be a challenge, quite a challenge in fact to have increasing workload and a static work force, and we will see exactly how that plays out. You all will be on the front lines of what happens, obviously. One other thing I will note, as we rolled out the realignment, we have two new area managers in the determinations area. So we have Sharon Cammarillo in Los Angeles, and Sharon will have responsibility for groups in the west as well as some groups in Cincinnati, and we have Cindy Westcott who will have direct-line authority over some other groups in Cincinnati and the groups in the East, in Baltimore and Atlanta. We have purposely had them mix and match in Cincinnati so that we can get some cross-fertilization between the groups, so we could start integrating them as a national work force rather than have Cincinnati here and the rest of the work force here. They will commence. I think they are on board now. They were selected last year, and we will move forward in terms of getting everybody on the same page, using the same procedures, and doing the same things as they process cases. MS. BJORKLUND: Steve, can you tell us about how many applications were processed this past year? MR. MILLER: Whether it was 88,000, it is in that range. Whether it was 89,000 versus 88 or 86, I think it was 88.9. MS. BJORKLUND: So it stayed at the same high level that — MR. MILLER: It went up. MS. BJORKLUND: It went up. MR. MILLER: It went up as it has in past years. Right now, determinations are a little down. So I don’t know whether that is going to continue or not. There is some surmise that as the economy goes, so goes our determ receipts, and we will have to see whether that plays out. I really don’t know. We will see, but they have continued to go up, and I don’t know whether they will level out or not. The second issue that has been keeping us busy of late is one that is very specific to a segment, and that is the work in the 527 area. Just recently, Congress modified its relatively new rules in the 527 disclosure area to modify who needs the file, what they need to file and how they file and how the public gets to look at the Web site. 356 March 2003 — Vol. 39, No. 3 A batch of those changes were effective in a very short time frame and became effective in December. We had to modify the forms. We did that. We put out some guidance. We have to put out more guidance now, but, more importantly and what is going to take us quite a bit of time is the requirement of building a new Web site. That is something that is going to take a ton of money and a ton of time, frankly. Congress has mandated that, and we are going to do that. If you had asked me after matriculating for some seven years in law school and 10 or so for my master’s — it is a little less than that, but — [Laughter.] MR. MILLER: Not that much less, but a little less than that. If you had asked me whether I would be doing this sort of work, my time is being spent right now ensuring funding, putting together a project manager and her team and building business requirements, I would have been surprised. That is, in fact, taking both my time and our function’s time and will for the coming months because, by June of 2003, we will have to have a Web site that is fully searchable on elements that had not previously been searchable and a better electronic filing system for what is really a small number of organizations. But we will do that, and that is going to take a bit of our time. I will talk a little bit about the budget, if I could, and I don’t know what the current budget is, quite frankly, because we don’t have one yet. We have a continuing resolution still which basically funds us at last year’s levels. At best, it will be a mixed bag. I say mixed because, on the automation front, I don’t think it is too bad, and on the hiring front, it is not so good, as I will go into. On the automation front, we are getting some real funding for projects that we need. The 990 Electronic Filing Project, which is a very large technology project, has been funded. I will give you an update on that now as well. We are still on target for filings in ’04 of ’03 returns. Every time I say it, I think we are still right. But keep posted because one of the issues is it is a very large project. It is not just 990’s. It is the 1120 corporate returns as well, and the 1120’s and the 990’s are the first of the forms to go forward on basically a new plumbing for the Service. And then 1040’s and the other forms will follow on, but that plumbing is not in place yet. So we will have to see whether we can meet those dates. Right now, I have reason to be concerned, but it is, by far, not certain that we won’t meet it. We will know that better within the next month or so. Other technology projects that I want to just touch on — and I had mentioned this previously already, which is the 527 Web site, which was mandated by Congress, and that we are going to be working on — and that has been funded. That is a large-scale project that will take up much of our time for the next six months. Finally, we will have a revised system that we are working on this year on how we process applications: when the 1023 The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. drawn a line in the sand and we will not have any other examination people doing determinations work. Those that are in exam will do exams. Those that are in determs will do determinations. We think that is going to improve, as I have preached for years, efficiency, consistency, quality, all those good things. We will see whether it works. ABA Transcript Within a year and a half at a minimum, we will be imaging the 1023, and if we image it and we image the file, which is the intent, I will be darned if we are not going to make that public. I think that would be a very useful thing to have to compare to 990s for the world to see and for our agents to see. So that is something that will be coming probably not in ’03, but probably in ’04. We will also do some keypunching of those forms and ultimately intelligent imaging, so that we will have a better ability to compare data and to track data against lists and all of these things that we should be doing that we are not quite able to do yet. PANELIST: I think that the practitioner world would really welcome having images of the 1023s available. So, if we can encourage or work with you in any way to encourage the funding you need, do let us know that because we have all found having the 990s available has been very, very much used. PANELIST: And I think we should note that some recent statistics suggest that with regard to Form 1023, approximately 80 percent are filed by people who are not like us who do 1023s regularly, but are doing one 1023 as a volunteer for an organization with which they are involved. So they do not have experience with the form, familiarity with the form, or any sense of the meaning of some of the questions on the form or the consequences. So this would be, presumably, very helpful to them as well as to the determinations specialists who have to review those applications and, in effect, educate those individuals. MR. MILLER: Right. And less helpful for the people in this room, but I think fabulously helpful for the Service and others that are less full time in this area. Continuing on the ’03 budget. Hiring is not going to be something that we are going to see this year, probably. So the technology projects, we are getting nice funding on. Hiring, at best we will do a little bit of attrition hiring, but more than likely very little of that as well. So this is going to be a tough year for hiring, and we will have to see how our travel budget is and our training budget is. We will just have to see. We don’t know what the budget is yet. MR. MILLER: Right. And it has changed the face of philanthropy. That is true that it is the largest change over the last few years. We know the best it could be, and the best it could be would be tough on hiring. We don’t know whether they will do anything below that which would make it more difficult for us. PANELIST: Steve, is part of the thought on that project also that maybe to make your job a little easier if organizations have the capacity for e-filing that you would accept documents in electronic form, the 1023 and attachments? We are no different, by the way. We are not being treated any differently than the balance of the Service. In some ways, we are treated better, but the bottom line is the entire Service is in the same sort of straits. MR. MILLER: Well, this is not yet electronic filing. We are still receiving paper and taking a darn picture of it, which is not where we want to be, but once we are past that, as part of this project, we hope to go to the next step. It still is not electronic filing, but would be an interactive Web-based system where the person would get a tutorial basically as they went along and filled in the form. 2004 budget. I will do a moment on that. We worked well in advance on this. Our participation in the ’04 budget is almost over. Now it is up to Congress and OMB, but if they go along with what we have suggested, what the Service has suggested, we would get some relief in hiring, and that would be a very positive thing, but we will have to see. It is too soon to tell. At the end of the day, they might have to print that out and mail it in to us, but if they printed it out, it might very well be that it would come out with an automatically generated checklist that would help us process and make sure they understand what they needed to do before they mailed it in. Secondly, I think that we might be able to get some data capture, whether it is by bar code or otherwise, as we automate the process as well. So it is still a paper format, but it is a much improved paper format. I think if we do this right, if we have the right tutorials, if we have the right statements made to people as they go along, it is going to cut down on a ton of our contacts that we have to make with taxpayers, and I think that will help you guys. It certainly will help the volunteer world, and it will help us process them quicker. I think, ultimately, that might help us greatly in terms of our workload and the ability to move some people who are doing determs back over into the examination area. The Exempt Organization Tax Review Obviously, there are other things going on with the country that make everything speculative in terms of future budgets, but if we do have additional bodies that are made available to us, they will go into the examination process at this point, and we will just have to play that out. One thing I do want to note in terms of the ’04 budget, one of the things we have asked for is some staffing to create a new unit within Exempt Organizations. It is the Exempt Organizations Compliance Unit, EOCU for those of you who love acronyms, which is probably none of us. If we get any hiring at all, quite frankly, we are going to move forward with this. So, even if it is attrition hiring, we will build this out of attrition because I think it is important, as I will mention. What this would do, it has two components. The first component is a group of revenue agents, tax auditors, some clericals that would take a look at some 990s and actually do March 2003 — Vol. 39, No. 3 357 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. comes in; what happens to it; how does it get to our agents; and that is a very large technology project that impacts both the employee plans area and our area. ABA Transcript The example that I have used before and the example I will use again, because it doesn’t seem to be improving, is fund-raising expenses. It could very well be that one of the projects that these individuals undertake would be a pull of returns with various fund-raising expense questions. For example, where contributions are high and expenses are low or nonexistent raises the issue of whether they are being properly reported, among other things. So it might well be that we pull those returns, we take a look at them, and unless it is otherwise understandable from the face of the return that we correspond with these people. The correspondence may not be an examination. It may be we happen to note that you have very high contributions and no fund-raising expenses. You should know what the rules are. Here they are. We will be looking next year to see whether this continues, and by the way, if it does, we will be sending you a different sort of letter. Then it will be incumbent on us obviously to follow up with that different sort of letter, but I think if we do some of those projects, we can do them quite efficiently, and we can create a little bit of change in the way people are perceiving us in terms of whether we are looking at these returns, whether what you say on the 990 matters. We need to clean up these returns. The world is looking at them. We need to do a better job of doing that, and this is one way of us doing that. PANELIST: Where would this unit be based? MR. MILLER: It is being designed as we speak. My guess is that it would be in Ogden, but that would be a natural place for us and that is where we are looking right now. Jo Ellen Dudycha, the area manager for Central Mountain, is actually heading up a team that is designing this. The second piece of the EOCU would be a data-mining group, a small research group, and these individuals would be looking for databases. They would be looking at trends that are on those databases for 990 information or otherwise to try to feed our casework, and especially the EOCU casework, but it would be more general than that. So, for example, the team that would pull together those returns that I was talking about would probably be these data miners, one to five of them that would be basically doing research for us, scanning the Internet and things of that nature. We are not doing enough with what is out there, and we need to do a better job. So I just wanted to mention the EOCU. I think if we have any hiring at all, we are forging forward to do it, and I think the key aspect of this is that we need to take a harder look at what we are receiving in the 990’s area. PANELIST: Steven, in the data-mining area, is there more that can be done in terms of scanning the information that comes in on the 990’s, or is that still really not terribly efficient to do? 358 March 2003 — Vol. 39, No. 3 MR. MILLER: It doesn’t work yet. Whatever we get off the 990 currently, we keypunch. We do image it, but it is not intelligent imaging. We are not capturing. We are not digitizing, but there are other sources out there. We need to do a better job of seeing what is out there, trying to inquire, and doing things of that nature. The form right now, we are not doing intelligent capture of the data. We are just taking pictures, as I say, and there is some indices that we capture on a different basis, but for the most part, what we keypunch, which is very limited because of the number of resources necessary to do the dang stuff, somebody sits there and keypunches it twice and then checks it again. And it is still often questionable, but it takes a lot of time and a lot of money to do that. Technology will be available, I hope, in the coming couple of years, but it is not really available to us today. But that is something we need to capture, more data. We are pretty data hungry. Some miscellaneous items I wanted to hit on while we have time. The 1023, Victoria spoke to a little bit. Comments are in, and we do have a ton of comments, thanks to the ABA, thanks to the AICPA, thanks to a bunch of other people who have put in comments. I have seen a compilation of them only this past week. So we are still working on that. In the next couple of months, we will be pulling together the team, pulling back together the team to finish up on the Form 990. There will be another chance for you all to comment, I think, and that is because we have not done the formal OMB notice yet. We wanted to get a bigger bite at the apple, a more directed request for comments on certain items, and then we will put it out for formal notice because that is what OMB requires. That, I hope is in the first half of 2003. Form 990, there is a lot going on. I talked about electronic filing, but it is also subject to revision right now. We have put out a notice on that as well, and, Victoria, I was about to chide you all for not. She stole my thunder, as the AICPA had gotten us comments, but the ABA hadn’t. MS. BJORKLUND: We are going to work on it over the weekend, Steve. MR. MILLER: And it is darn important. If it slips, by the way, past the comment period, let it slip to give us the comments we need. The revisions that we are talking about that are discussed are very large revisions and should matter to you all. They are revisions in the area of 527, how we are tracking funds across organizations. They are revisions in the fund-raising area and how those expenses and how the income is being accounted for. There are two other issues that are of considerable more importance still. One of them is foreign grants. We went out with a request for comments on how you should be reporting foreign grants on the 990, and we have received very, very little comment. It took Treasury’s voluntary guidelines to draw those out, but we need comments. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. some reviews based on criteria for pulling some 990’s or on trends that we found. ABA Transcript actually, with the applications we got, some of whom are in this room, by the way. Finally, corporate governance is in there. It was not a surprise to us that we wanted to talk to people about what changes were going to be necessary in the corporate governance area. Again, I think it is incumbent upon you all to come to us with your comments. Otherwise, we are just going to assume that you are going to be okay with what we do. MS. BJORKLUND: We should probably mention that the next public meeting of the advisory committee will be held in the spring at which time another exempt organization project will be discussed. Let the transcript reflect I was joking. [Laughter.] MR. MILLER: But the bottom line is we are going to do something in many of these areas. You need to be a part of that process. I was unaware of Elliot Spitzer’s move, but it is not a surprise, not a surprise, and the discussion and concerns over foreign grants should not be a surprise. It wasn’t to us when we put out the notice. So we need input. We need it sooner rather than later, quite frankly. In the 990, that is the external part of the program. We also have a group on the inside of the Service that is working on whether the information we are getting is useful for examination purposes, is it useful to classify and to catch what we need to catch to select someone for examination. So there will be other changes that arise out of that group, and I think it is fairly clear to say that the 990 is neither easy to use for you all nor is it as effective as it should be for us or for the public generally to see what is going on within the organization. If 990 e-file occurs on the basis we hope it will, some of those changes will be incorporated for that, and some will probably have to wait because of the timeline, but we are moving and we will continue to work there. I also wanted to touch on the advisory committee. Victoria mentioned what they have been up to. They have been remarkably valuable to us. We have two vacancies coming up. Victoria, I don’t know whether the public knows who those are or not. I don’t think I can say. MS. BJORKLUND: I don’t think so. We haven’t said. MR. MILLER: But there will be two slots opening up. We went out and asked for people to apply, and, once again, as in the original application process, we in EO have much more interest than any other part of TE/GE. So we have a wonderful base of people, from which over 30 people applied for the two slots. In the next month, I will be contacting some of you all to set up interviews. The process is we will talk to people. We will then make recommendations to Evelyn [Petschek]. Evelyn will then make recommendations up the line all the way to Treasury, who ultimately has the selection authority. So it is not a short process, but it is well underway, and I was very gratified, The Exempt Organization Tax Review I don’t know that the meeting date is public, but it is around the time of the ABA spring meeting. Last year, you may recall that the project that was recommended to the Service was the life cycle of a public charity and a life cycle of a private foundation which would be a Web-based function having a subway map approach with IRS documents and instructions behind each click on the subway map. PANELIST: [Tape change; in progress] — project obviously is public as well. MS. BJORKLUND: Yes. The new project is the determination process, the Form 1023, and what changes can be made as we disclosed at the October meeting and discussed in detail. So the advisory committee members will be presenting the recommendations to the Service on improvements for the determination process at that spring meeting. MR. MILLER: Deirdre and Victoria have been spending a ton of time with the other AC members on this, and I very much appreciate it. As I say over and over again, it is a very large issue, a resource issue for us, and we want to make sure that the determination letter process is the most efficient and effective way of getting to where we need to be because we are spending just a ton of time and effort on it. Last miscellaneous item is one that also was discussed this morning and will be discussed again and I think will be the subject of the May meeting, one panel or more, and that is the foreign grant area. I just wanted to discuss a couple of points on the voluntary guidelines that Victoria has discussed and you all are aware of. First, they are voluntary, and that is obvious, but not so obvious to some. They are voluntary. Secondly, they are not tax guidelines. Rather, as Victoria mentioned, they were envisioned to try to help those who were concerned that either their donations or the organizations to which they were donating would be blocked under various executive orders by OFAC (Office of Foreign Assets Control) or others. They really were intended for people who had specific concerns because [of] some of the blocking orders that had occurred, and that was their genesis and intent. Finally, we have solicited comments informally, and I might as well solicit them more formally. If you do have comments, if you do have concerns and want to go outside of the ABA or otherwise, call me. Contact me 202/283-2200. These are not ours, but we would be glad to broker the exchange with the Office of Enforcement at the Department of Treasury whose guidelines they are. If you want a point March 2003 — Vol. 39, No. 3 359 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. This was not a surprise to us that there might be some discussion of foreign grants and reporting. ABA Transcript I want to take just a couple of minutes before we go to question and answer, and I am going to rock pretty quickly through here, but I want to touch on a couple of points in the various areas within EO. Customer Education Outreach will be the first one. We are about to embark on a pretty ambitious small organization workshop program in CE and O. Thirty-six small seminars, seminars for small organizations. They are not so small. They are 75 people or so in 12 cities over the next year. Those are aimed specifically at organizations that are up and running, but are run by volunteers. They are in-house people who don’t make it to meetings like this. So that is the aim there. We also are going to increase our presence at the tax forums, and the IRS tax forums are IRS-wide. They are in various cities around the country, and thousands of practitioners come to them. For the last couple of years, I was resistant to our presence there. I couldn’t imagine that people had an interest when they were doing 1040’s in our area, and I was wrong. They do have an interest because of what Victoria mentioned. Many of our organizations come in with 1023’s, even if they are done by tax professionals. They are done by tax professionals who do one or two a year who are volunteers or otherwise. We had at each of our seminars in these cities, 500 to 600 people show up, which was a great surprise to us and which indicated that we were tapping into a group of people who needed some help and that we hadn’t gotten to before. Over one-half of the questions at these things were churchrelated questions, and that indicates to me that these people are volunteering at their local church or at their local agency or wherever they can to do some help. And they need some help from us. So we are going to do more next year in this area, but it really does point to the fact that we need to do a better job across the spectrum of practitioners than we have to date. MR. MILLER: We are going to be doing a series of seminars beginning this year for those who are about to apply, not for those who are up and running, but for those who are about to apply. There the Tool Kit will be extremely helpful, also. So that is one of the things that Bobby is working on for this year. We had the small organization conferences last year. We are increasing the number of them this year. This will be a new product, the application, “how to apply” seminar. So they may be held in conjunction with state charity officials in various sites. In the examination area, I will talk a little bit about the determinations realignment, what all that has meant, and what the trend in determinations has meant to examinations. I want to emphasize, reemphasize that we have diminishing resources in the exam area. They won’t diminish further, but we have diminished resources in the area. The numbers of organizations and the issues we seem to face, they don’t seem to diminish. So we are having a challenge, and have been over the last couple of years, and we need to be careful in our response, but we need to get back out there and reestablish ourselves a little bit. So we have done a series of things in this regard. The key thing, frankly, will be the exempt organizations compliance unit that we are going to be able to reach out and touch many more taxpayers, we think, hopefully in as nonthreatening way as we can, but specific to that taxpayer, which is always going to be somewhat threatening. Limited scope examinations started up last year and will continue this year. We will have to see how they do, but these are examinations that generally take about one-half the time of the broader examinations, if that. When we knock on your door, it will be for a specific purpose. If we happen to see something along the way, we will broaden it out. Otherwise, we will work that one issue and move on. We hope to be able to talk to more taxpayers because of that as well. We are also going to do some correspondence examinations, where it works, and that is not everywhere, but we are going to do some correspondence examinations. So those are the types of things we are going to work on in examinations. It is a challenge. PANELIST: I would just like to add a footnote. Shannon Nash is here, and Jennifer Franklin is here. I apologize if others who have participated in our Tax-Exempt Tool Kit are here and I am not mentioning you by name, but we have also had tremendous success in running the Tax-Exempt Tool Kit as a pro bono outreach in various cities where we hold meetings. We have also had a very large response of volunteers coming to the seminars. Finally, in R&A, I just wanted to touch a moment on guidance, and it may not be evident from what you have seen to date, but we are spending more assets out of Lois’ shop and more assets out of Sarah Ingram’s shop than ever before on guidance, and I think that will bear fruit within the coming months. Hopefully, by the May meeting, but certainly by this time next year, I think you will see an increase, a substantial increase in the amount of guidance that gets out there. I have taken the liberty of sharing with Bobby Zarin at the Service the materials for the Tax-Exempt Tool Kit, and she has been most appreciative of the work we have done. The Service is looking at that as they prepare their new materials. That does not mean that all the guidance you are going to see is going to be of the nature of the final intermediate sanctions regulations, but I do think you are going to see a fair mix of that type of project, along with some slightly more limited-scope guidance projects. 360 March 2003 — Vol. 39, No. 3 The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. of contact, give me a call and we will work that issue as we have with some groups in the past. ABA Transcript MR. CLARK: I think we have 10 minutes for questions. Why don’t you come up to the mic and be sure that you identify yourself. MR. MILLER: My watch is fast. MS. BJORKLUND: I will open with a question. Can you tell us what is happening on the EO/CPE text? MR. MILLER: Let me give a little background. Obviously, traditionally it has come out in the fall in book format. We are talking now about doing more just-in-time training for our people, which would mean that we would release it on the Internet as a particular project was rolling out. A perfect example of that is the recent — I think it has gone out, and we had a discussion — credit counseling area. And you will see more of that in the future. We may do a compilation at the end of the year, and, quite frankly, we may not, depending on what the budget looks like. It is expensive to put out paper. So we are at least going to be releasing them as they come out. As particular projects start up, we have a project in our implementing guidelines on credit counseling. We are going to have a select number of revenue agents working that project, going to a class on credit counseling and we will use this text. So it is, we think, a more efficient way to get the information out, and we hope that you all find it useful as well. We have talked to people who have had mixed blessings. Obviously, people have enjoyed the heft of getting a book and the certainty of it, but we are heading, I think, in a different direction. That is not certain yet, but my guess is we are going to release them throughout the year. There may be a compilation at the end of the year. There may not. That really is going to wait. MS. ADLER: One challenge to the private bar in using that excellent guidance if it comes out sporadically rather than at the time when we all know to look for it is that unless we get in the habit of checking the IRS Web site or looking at the exact proper segment of that Web site, we won’t necessarily know that this very helpful information is there. So, if you are going to shift to a just-in-time release, I would hope that you would give some thought how to make it generally known that that is available. MR. MILLER: We will still, I think, be dropping it to Fred and [The Exempt Organization Tax Review]. So that should help. MS. BJORKLUND: Fred, did you have an article about the credit counseling text being released? The Exempt Organization Tax Review MR. STOKELD: We put that chapter on Tax Notes Today. MS. BJORKLUND: Okay. Well, I apologize. I know I missed it. So maybe we will try and think of ways that maybe the ABA can do a better job. Maybe we could e-mail all of you just to alert you when the EO CPE text pieces do come out because this practitioner community is very interested in those texts. So maybe that is a service we could provide. MS. ROADY: This is Celia Roady, Washington, D.C. Steve, could you talk a little bit about the CEP audits? Are they still proving to be useful for the IRS, and what are your plans going forward with the CEP audit approach? MR. MILLER: CEP audits are our large case audit program, and they are fruitful from a dollar viewpoint, quite frankly, and they are fruitful because, like every other sector of the economy, we have a large skew in terms of the income and assets that are held by particular segments of our organizations. So we need to spend some time at the high end of those, and the highest end of those, they are hospitals and colleges and universities. There are other very large organizations. It is our intention to continue to devote at least a third of our time to that area. What we may do and what we have tried to do will be renaming it the Team Examination Program, rather than CEP. It will be broadened out. The current grouping of large organizations is less than 1,000, and that sort of ignores another 1,000 or so organizations that are very large. So we are going to put that in this group, and then we will have a larger pond from which to fish. That may mean, obviously, that we use limitedscope audits in that area as well because there will be more taxpayers. Even at 30 percent, we don’t have sufficient energy or resources to do the coverage we would like, but there are the changes. Probably in the May meeting, we will have a better sense. It is being designed. It is being discussed with internal stakeholders, but I see the CEP program continuing. It may be changed a little bit because it may be applied to more people, but we will continue to devote a substantial amount of our time to that area. MR. HASSON: Jim Hasson, Atlanta. A follow-up to that question. Your audit guidelines for hospitals, colleges, and universities are about 10 years old, if memory serves me correctly. Have you undertaken an effort with the team of folks that have been through the CEP exams to try to refine those audit guidelines to make them more efficient both for the Service and for the organizations? MR. MILLER: Yes and no. The answer in the short run is no. Why I think we will be doing that is because, in this year’s implementing guidelines, one of our projects is to review what we have done in the area of hospitals, to review what we have done in the area of colleges and universities, March 2003 — Vol. 39, No. 3 361 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Now I have, once again, filled up almost all my time, a sly plan. No questions, right? ABA Transcript So, in the market segment area that we have talked about before, we have divided up the world. We have separate pieces. Colleges and universities are one. Hospitals are another. We can’t do a market segment study in those. We cannot do 100 examinations of those organizations. We just don’t have that type of resource. So what we are doing in those two areas is we are culling and doing exactly what you suggest, which is pulling in our auditors and audit reports and seeing exactly what we have learned. One of the products probably would be a streamlined set or a revised set of audit guidelines. As part of that process, my guess is we will come out to you to talk about what you guys believe we have found and haven’t found and what problems there are in the system. We are not currently working on redrafting those. We are at an earlier stage in the area. MS. BORENSTEIN: Eve Borenstein, Minneapolis. Steve, you know this committee is very supportive of shoring up the deficits and resources and helping the IRS work as efficiently as possible in a climate of very restricted resources, which leads me to a logical question. The GAO report gave the total number of EO employees, which I thought was a shockingly, appallingly low number, but you just mentioned that 100 exam agents have really been administratively given the right designation, that now they are over in determs. How many exam agents do we actually have on the ground right now? MR. MILLER: 200 to 300. MS. BORENSTEIN: Thanks. MR. LUNDY: Joe Lundy, Philadelphia. Another follow-up question about CEP audits. Up to about two or three years ago, you, the Service, used to give us a box score where we were with CEP audits. I don’t think I have seen one of late, and I used to find it very helpful. MR. MILLER: You mean a generalized discussion? There is no reason for us not to do that. There is no reason for us not to be more proactive in what we are finding. As I have said before, when we have projects ongoing, at the end of the day the people responsible for coordinating those projects are responsible for drafting a report, and those are going to be public. There is no reason why we wouldn’t give a broader statement as to our CEP program as well. AUDIENCE MEMBER: This is a follow-up for an ongoing question, and that is the status of the market segment projects. There have been various announcements over the years of different market segments, and those segments get geared up to get ready for the auditors. Then it is a year and a half or so before the auditors arrive, and I understand it is an issue not only of developing what questions you want to ask, but of mobilizing resources. Can you let us know where that process is? MR. MILLER: I think that it is a new way of doing business for us, and it has gone much slower than I would like, but it should not be a huge surprise that they are going slower. It is actually a positive thing in some respects because I would not want to forge forward and do a lousy job, quite frankly. Sometimes we have held back because we weren’t ready, and we won’t push until we are ready. I know that is sometimes frustrating when people have geared up. It is certainly not a positive public relations thing to have happen, but we are going to be ready when we come out. Our people are going to be trained. We are going to have the right audit guidelines, the right check sheets, and hopefully we will get better as we become more mature in the process, but it has been somewhat frustrating for us inside as well as for external stakeholders. PANELIST: Can you give us a sense, for example, of when the check sheets might be released for community foundations in advised funds? Are we looking at somewhere in the next quarter or somewhere quite distant from that? MR. MILLER: No. I would hope the next quarter, actually. MR. CLARK: Well, thank you very much, Steve. We always appreciate you coming and thank you very much for your comments, and we will let you catch your flight. MR. MILLER: Thanks, guys. MS. BJORKLUND: Thanks, Steve, so much. MR. LUNDY: Yes, statistics. How many are in process, how many were closed, how many were closed with adjustment, without adjustment, those were public figures, and I followed them closer than baseball averages. So I am just curious if we are going to get back to that. Thanks. MR. MILLER: That is just a function of what goes into speeches, I guess. I will take that as an action item. 362 March 2003 — Vol. 39, No. 3 [Applause.] The Uniform Management of Institutional Funds Act: New Developments MS. BJORKLUND: The next panel is on UMIFA. [Pause.] The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. and to figure out and learn from that and move forward in a particular guidance area or in an examination area, in those two segments. ABA Transcript I am Ellen Aprill from Loyola Law School. We are going to have a panel on the Uniform Management of Institutional Funds Act, UMIFA. When Victoria asked me to moderate this panel, I didn’t have a clue what this was. Now that I have spent some time on it, I don’t know how I lived without knowing what it was. I hope all of you will feel the same. We have some Californians in the room. We have an EO discussion group. We have had UMIFA questions just about three times a day for the last few weeks. Let me introduce the panelists that we have with us, talk about how we are going to structure the panel, and then turn it over to them. To my far left is Janne Gallagher, who is the deputy general counsel of the Council On Foundations. She is a graduate from Trinity College and Boston College Law School and has worked in EO for many years. To my immediate left is Morey Ward of Morgan Lewis & Bockius. She is recently back there from having been at the Joint Committee on Taxation. Her law degree is from AU, and both of them have LLM’s from my alma mater, Georgetown. We do not have with us, unfortunately, Carol Kroch, who had foot surgery that did not heal as quickly as she hoped. We very much miss her. She very much misses being with us. She did a wonderful outline that we will be using. We have two goals for the program. One is to give you context for some current very pressing issues in this depressed stock market because of UMIFA. Then the other goal is to introduce you to the current effort to review UMIFA. Carol is one of the ABA advisors for that revision of UMIFA, and she wants very much to have any comments from you as they undertake this effort, this goal of updating UMIFA, of making sure it is consistent with other uniform acts. So, please, you have the current draft of the revision among the materials. Review it carefully, and get comments to Carol or Susan Gary, who is the reporter. The way we are going to organize the panel is that Morey is going to talk about UMIFA past and present, tell you why it was enacted and introduced, what some of the issues are currently. Janne will also, if she wants to, speak briefly on some of the present issues, and then she will address in particular UMIFA, the future, what might happen under the revision, and then we hope to open it up for questions. So I turn it over. MS. WARD: As Ellen mentioned, we are sad to be without Carol today. She has participated in several of our calls, preparing for the panel, but we were relieved that Janne is well-positioned to take over Carol’s piece of the panel. Janne is very modest about her accomplishments as counsel to the Council’s counsel, but you should know that she The Exempt Organization Tax Review spends a lot of time traveling around the country, trying to make this land a safer place for UMIFA. It is not an easy job. She talks to a lot of very depressed people, financial officers for community foundations. It is hard to talk about UMIFA with depressed people. It is really not the spirit booster that you would like it to be under those circumstances. She reported to me on Tuesday that her audiences are starting to think that she is funny when she talks about UMIFA, which is all that you can really hope for under the circumstances. As Ellen said, I am going to provide a little background on how we wound up with UMIFA and what problems have arisen with respect to the current version. Prior to the 1960’s, institutions holding endowment funds were overwhelmingly conservative in their investment policies. Based on longstanding interpretation of the trust law, prudent man standard for investing, institutions tended to invest their endowment funds in high-yield, fixed-income securities and a few high-dividend stocks, Government bonds, that sort of thing. As phrased in the restatement of trusts, the prudent man standard directed trustees investing endowment funds to make such investments and only such investments as a prudent man would make of his own property. This standard combined with the traditional trust law rule requiring that only income be spent from an endowment resulted in very conservative investment strategies. In the late 1960’s, however, the dramatic increases in stock prices during that decade and the success of several wellknown institutions, including Harvard, which had invested heavily in high-growth stocks, caused many institutions to rethink their strategy, but most felt that they were reluctant to move to greater investment in stocks given that the spending rules require that only current income from endowment investments be spent. So, in 1972, the National Conference of Commissioners on Uniform State Laws swooped in to help solve this controversy. Fundamentally, UMIFA is intended to permit the governing boards of charitable and educational institutions to switch to a total return method of accounting for endowment investments and to help avoid distortion of sound investment policies. To accomplish these goals, UMIFA gives us five things: first, a standard of prudent use of appreciation in invested funds; second, specific investment authority; third, authority to delegate investment decisions; fourth, a standard of business care and prudence for government boards; and fifth, a method of releasing restrictions on the use or investment of funds by donor agreement or court action. The first item on the list, use of appreciation, which is Section 2 of UMIFA, applies to the use of an institution’s true endowment; that is, funds given to the institution by a March 2003 — Vol. 39, No. 3 363 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. MS. APRILL: There is material in the back of the room that you will find useful for this presentation. ABA Transcript investment, such as the funds must be only invested in 30-year Treasury bonds. Since only income from true investments can be spent, the tendency I mentioned earlier was to invest in high-yield, fixed-income instruments that offered little or no appreciation. Section 2 of UMIFA is intended to solve this problem by expanding the definition of income and permitting the total return method of accounting. So it authorizes appropriation of net appreciation of an investment for spending purposes. Under UMIFA, a governing board can release a restriction on the use or investment of a fund by obtaining the written consent of the donor. UMIFA also provides that if written consent can’t be obtained from the donor, the institution can apply to the appropriate State court for release of the restriction. This provision also requires that you notify the State AG and give him or her time to respond to the application for release of the restriction. An institution is permitted to spend current income plus an amount of appreciation that the board determines is prudent. This provision contains a floor on a charity’s ability to spend net appreciation. The floor is the historic dollar value of the fund. Historic dollar value is defined as the total value of the fund at the time the fund was originally contributed plus the value of any subsequent contributions at the time that they are made. Interestingly, the way the provision is written, it doesn’t really look as though you could apply to a court for release of the restriction if you had a living but difficult donor who didn’t want to agree to the proposed release of the restriction. So an institution can’t spend appreciation if the value of the fund is at or below its historic dollar value. Stay tuned because we are going to be coming back to this critical issue later on. UMIFA has now been adopted in 45 states and the District of Columbia, although actually from my own recent research, we may actually be down to 44 states. It appears that Florida repealed its version of UMIFA effective January 7th, 2003. The next important UMIFA provision, Section 4, is a general grant of investment powers to clarify the authority of a governing board to select investments for its endowments. Section 4 provides a nonexclusive list of investments that are appropriate in order to allow boards to adopt a flexible, diverse, long-range investment plan for their endowments. It is not clear to me that this repeal was intentional. Florida was revamping its state educational system, and in the process, they repealed the entire education title of the Florida code. Essentially, the provision clarifies that as long as the board acts with prudence and within the terms of any gift instrument, it can invest in any vehicle it deems appropriate. Section 4 also clarifies that a board may mingle funds in one common pool for investment purposes. Section 5 of UMIFAclarifies the governing board’s authority to delegate investment management and to pay for investment advisory and management services. Prior to UMIFA, the law was unclear as to the board’s authority to delegate investment management even to an officer within its own organization, much less to an outside investment manager. Section 6 of UMIFA establishes a standard of care for a member of the governing board that is comparable to that of the director for a business corporation rather than that of a private trustee. UMIFA altered the standard by which governing board members are judged from the prudent man rule to a clearer, somewhat more modern rule that is similar to the Restatement of Trust’s prudent investor rule. I think Janne will get into this issue later as the current drafting committee continues to refine where the investment authority should land. Finally, Section 7 of UMIFA provides two mechanisms for releasing donor restrictions on an endowed gift: donor restrictions, such as a requirement that a fund be used specifically to build a new physics building, or a restriction on 364 March 2003 — Vol. 39, No. 3 Just to be clear, prior to UMIFA, the only way you could modify a donor restriction was through a cy pres action. UMIFA procedures were designed to provide a simpler process for releasing restrictions. I made a few calls to people in Florida who you would think might be aware of what had occurred, and I asked them, “What has happened to your UMIFA?,” and they essentially thought I was making a crank call. “What did you call me?” [Laughter.] So I am optimistic that this may have simply been an oversight on their part, that they pressed the delete key on the entire education title and weren’t aware that they deleted UMIFA since Florida’s version of UMIFA only applied to educational institutions when they existed. To help Janne out on her piece of it, I am going to run through a couple of other uniform acts that the uniform commissioners have dealt with since UMIFA. They dovetail into what Janne needs to be able to talk about because the drafting committee has been considering those uniform acts in redrafting UMIFA. Briefly, we have the Uniform Prudent Investor Act which revamps the rules that govern the actions of trustees. As I mentioned earlier, the objective of the old prudent man rule is the production of income and the preservation of principal. Under this rule, the focus was on the propriety of each investment in isolation, with certain investments prohibited entirely because of case law. UPIA allows trustees to adopt contemporary theories of portfolio management which focus on the relationship of an individual investment with respect to the entire portfolio and assess risk in the context of the entire portfolio. We also have the Uniform Trust Code, which is quite recent. It is huge. It is a national comprehensive law of trusts. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. donor on the condition that the principal be invested and preserved in perpetuity. ABA Transcript The UTC also provides a somewhat modified standard for when a court may release a restriction on the use of charitable trust assets. Finally, we have the Uniform Principal and Interest Act, which provides procedures for trustees and personal representatives in allocating assets to principal and income and in distributing assets to beneficiaries and heirs. The act takes into account changes made to the trustee investment authority by the Uniform Prudent Investor Act since the changes made by that act alter the fiduciary obligations of the trustee to beneficiaries and heirs. My final charge for today was to highlight a couple of issues that have come up with the current version of UMIFA. I think the most prevalent problem — I know Janne and I have both encountered this one, and based on my conversations last night, many other people have as well — because of the recent market declines, many institutions have funds, particularly newer funds, that are below their historic dollar value. The question is: what can I spend from my underwater fund. Section 2 of UMIFA really only addresses an organization’s ability to spend appreciation from a fund. It doesn’t restrict an organization’s ability to spend current income when a fund has fallen below historic dollar value. Of course, a board might decide that it is prudent for it not to spend current income if a fund has fallen below historic dollar value, but it is not prevented from doing so. But Section 2 clearly doesn’t permit any expenditure of appreciation when a fund is at or below historic dollar value. So the next question is: can I aggregate my endowment funds for purposes of determining historic dollar value since the benefit of this approach, of course, is that the newer funds get the benefit of the amount by which older funds have exceeded their historic dollar value. I think from many institutions’ perspectives, since they are already pooling their endowment funds for investment purposes and are clearly permitted to do that under UMIFA, how come they can’t decide historic dollar value on an aggregate basis? Unfortunately, UMIFA doesn’t have any provision relating to spending appreciation on a pooled basis, and, in fact, as Elliot Spitzer has, helpfully pointed out, in his guidance on this issue, all references to appropriation of appreciation for spending in UMIFA are phrased as references to an individual fund. So, he concludes, and I think that most other people that have looked at this issue have concluded, that you really cannot aggregate funds for purposes of spending appreciation. The Exempt Organization Tax Review The one other issue that I thought might be worth mentioning that is being discussed some these days is the concept of donor standing. There have been several high-profile suits or threatened suits by donors who are disgruntled about the management or use of their donations. Traditionally, of course, donors don’t have any standing to challenge once they have made a completed gift to the institution. Challenges are left to the State AG or, in some cases, affected beneficiaries, but there has been this interesting case, the Carl Herzog Foundation v. University of Bridgeport, in which the Connecticut appellate court decided that the Connecticut version of UMIFA, specifically Section 7 of UMIFA dealing with the release of restrictions on funds, gave the Herzog Foundation standing to sue the university. When the university applied money that the foundation had given it for nursing scholarships, it closed down its nursing program and applied the money to other purposes without notifying the foundation. The Connecticut Supreme Court reversed in 1997, but I think the case made a number of people blanch at the prospect of donor standing, but given the number of cases that are going on now, Princeton University has been sued and BU has just been through some ugliness on this issue, I think it is a subject that is coming up. MS. GALLAGHER: Let me start with a brief description of the process for drafting and revising uniform laws. These laws are the responsibility of the National Commissioners on Uniform State Laws, which convened a panel to revise UMIFA about a year and a half ago. The committee met twice in 2002. It is scheduled to meet again in April 2003. The next step following the April meeting will be the report of a final draft proposal to revise UMIFA to the full body of the National Commissioners on Uniform State Laws which meets in August. There has been very, very little attention paid to the ongoing revision process. It is actually a quite open process. To be a voting member of the committee, you must be one of the uniform commissioners of State laws. However, they welcome observers who represent various interest groups that will be affected by the revisions, and thus far, although I have been participating as an observer on behalf of our foundation members, other constituency groups have not been participating in this process. I would suggest to all of you who have clients with interests in this area that this is something to which they may want to pay some attention. I would also like to thank the reporter, Susan Gary, who pushed ahead over her Christmas vacation to make the draft that you see available for broad review. She was unable to complete in time for this meeting her comments to that draft. So you will, when you review the draft, find that there are certain inconsistencies between the text and the comments. In those cases, you should rely on the text, not the comments. Sometime prior to the April meeting, there will be another draft that will include the reporter’s comments. March 2003 — Vol. 39, No. 3 365 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. The objective was the codification of existing law drawing from common-law sources, statutory law, and the Restatement, but there are few reform elements in there as well. I am not going to attempt to review all of it here, but I will just say that the main provision I want to mention is Section 405(c) of the UTC which permits a settler to enforce a charitable trust without limitation. This concept has been imported somewhat into the revised UMIFA provisions regarding donor standing. ABA Transcript Assuming that the foundation was to continue distributions from that fund at its previous spending rate, that means that the community is losing about $2 million this year in charitable giving because of the constraints placed on spending by the Uniform Management of Institutional Funds Act. There were a great many funds created in the late 1990’s when the stock market was very high. All of those funds now are below their historic dollar value, and the continued slump in stock prices, I am told, is now extending further and further back in time the number of funds that are now underwater. I am going to spend my time talking about what I think are the four most important policy changes that attend the revision to the Uniform Management of Institutional Funds Act. When you read the draft, you will see there are lots of opportunities to question particular ways that things have been drafted. There are some things that clearly need to be cleaned up, but the overwhelming issues that I think the group needs to focus on are, first, the proposal to abolish the concept of historic dollar value in favor of a total return-based spending policy. Such a policy would be subject to a prudence standard which would require that the amount expended be consistent with preserving the purchasing power of the corpus. I am going to come back to that. The second policy question is a provision in the draft which would grant standing to some donors to sue charities under some circumstances to enforce gift restrictions. Third, we have a policy that would allow the governing board of a charity to release donor restrictions in the case of funds with a present value of $100,000 or less. The proposal to adopt a total return spending policy rule reflects the fact that over time distinctions between principal and income have become increasingly less meaningful. UMIFA in 1972 went halfway down the total return road. It clearly authorized investing for total return. However, it failed to authorize spending based on that concept, leaving in place the ability to spend income and to spend so much of a fund’s appreciation as exceeds the fund’s historic dollar value. Over the years since UMIFA has been adopted with a generally rising stock market, a great many institutions have instituted spending rules or some people call them take-down rules, which are effectively, say, that you will draw down from an advised fund X percent, 5 percent, 6 percent — I saw some 7-percent figures in the late 1990’s — of the fund’s average asset value over a typically 15 to 20 trailing quarters. That was certainly the customary approach among community foundations. 366 March 2003 — Vol. 39, No. 3 Of course, with the current drop in market and possibly because some of those percentage rates were set too high in the late 1990’s, we do now have all of these funds that are below their historic dollar value. I think that most of the lawyers who have looked at the issue agree that those funds can continue to spend any natural income that they may have, dividends, interest, rent, royalties, although I know of two lawyers who disagree fairly vigorously even on that point. What I am seeing is what I think is a very troubling trend, to take funds that have been invested for long-term growth and put them back into good old Government bonds. So we are in a sense recreating the fact patterns that existed that led to the original enactment of UMIFA. The proposed solution in the current draft is to say that a governing body may expend as much of an endowment fund as it deems prudent as long as that expenditure is consistent with the goal of conserving a fund’s purchasing power. So there are two key changes in this draft. One is getting completely away from the notion that there is something called principal and something called income into allowing a measurement that is based on a percentage of asset value with the expectation that investing for long-term growth will create a rate of return that is sufficient over time to preserve that asset’s purchasing power. But the second key change here is that reference to purchasing power. Current UMIFA, as most attorneys interpret it and with the exception of a couple of states including possibly New York and certainly Massachusetts and Rhode Island, says that the governing board of the fund should take inflation into account in determining how much of a fund’s appreciated value to appropriate, but it doesn’t require that that historic dollar value number be inflation-adjusted. I assume that that is the case because back in 1972, when this statute was being drafted, if one had had to adjust for inflation, one would never have been able to do any spending, for those of you who remember what inflation was like in the 1970’s. Nonetheless, the way that UMIFA is currently drafted does permit a charity to maintain an endowed fund only at its historic non-inflated, inflation-adjusted value, with the effect that the fund over time becomes increasingly less important. The current draft also has a series of eight other factors that boards should consider in making their spending decisions under this new rule. Most of those are drawn either directly from or are approximations of standards that are found in various places in the old UMIFA. There are two that are new and worth mentioning briefly. One is that the governing body must consider the intent of the donors to the endowed fund in determining how much of a fund should be expended. We have no particular guidance right now as to what people are thinking about in how you would determine intent, whether you would look to a side letter that the donor gave you or something like that. The second is that you should consider the perpetuation of the endowment, and there is kind of a double consideration there that I am unclear as to how it would work in practice. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. In looking at some material for the next meeting that I am traveling to later this afternoon, which is a meeting of our larger community foundation members, I ran across a statement by one CEO that the Uniform Management of Institutional Funds Act is now impacting two-thirds of that foundation’s endowed funds. ABA Transcript It is a difficult drafting process because one of the other things that UMIFA does is that it says that when a donor says things like “income only,” you can disregard that. So it was awkward to try to come up with those kinds of words. The revised draft would also continue to permit, as current UMIFA does, any spending that is authorized under any other law under the terms of the gift instrument or by the organization’s charter. The Council of Michigan Foundations has put on its Web site an interesting series of documents that are suggested amendments to gift agreements and to organizing charters in Michigan for Michigan community foundations. They may be of interest to some of you who are looking for forms. I would caution only that Michigan is a particular drafting problem because there is a State tax exemption available for contributions to permanent endowments. So Michigan attorneys have to thread that needle rather carefully in order not to lose the benefit of the State tax exemption. The issue of donor standing I think is a critical one. It would represent a very broad policy change. Current law for the most part, with the exception of the recent Smithers case in New York, generally has not granted donor standing to sue to enforce charitable gift restrictions. Morey mentioned the Herzog case. In the Boston University situation, the donor apparently was alleging fraud as a way to try to get standing. The drafting committee has proposed that donors be given limited standing to enforced gift restrictions under these safeguards. The restriction would be required to be incorporated in the gift agreement. It couldn’t be implied from the circumstances surrounding the fund raising. The right would be exercisable only by donors; no personal representatives, no heirs. As any of you who have practiced in this area know, quite often issues that arise, arise not with a donor, but with the heirs. The ability to sue would be limited solely to enforcing the gift restriction. The donor would not be permitted to challenge other decisions by the governing body. In the comments, the reporter analogizes back to the Herzog case and says that while the foundation in that case would have been allowed to sue to enforce the restriction that the asset be used only to fund scholarships for nursing students, the foundation would not have been allowed to challenge the university’s decision to close the nursing school. Finally, and this I think will be quite controversial, the right is limited to donors who make an original gift having The Exempt Organization Tax Review a suggested value of half-a-million dollars or more. That number is in brackets, which is in the draft. That is how the uniform commission has handled this sort of thing. When the states are considering this, they can substitute their own number for the $500,000 that the drafters are currently suggesting. The right to sue terminates at the earlier of the death of the donor or 30 years. Third, the draft has an interesting provision that would permit a charity to unilaterally release donor restrictions following the death of the donor or the inability for any other reason to get the donor’s consent. A governing board could release restrictions on funds having a current value less than $100,000 — that is the suggested amount — if the value of the fund is insufficient to justify its cost of administration. This is intended by its proponents to permit, for example, universities to roll up small scholarship amounts into a larger scholarship fund without the necessity of seeking court approval for that process. Nonetheless, I think there is in my mind at least an inconsistency between giving donors standing to sue to enforce gift restrictions and then saying, “But once you are safely out of the picture, if your fund is small enough, we know you meant it to be perpetual, but tough luck.” Finally, there is the question of the application of the Uniform Management of Institutional Funds Act to trusts. The current law excludes from UMIFA split-interests trusts and trusts that are not trusteed by the charitable institution. In other words, a trust that has a trustee that is a bank or another financial institution is not included in current UMIFA, although seven states amended UMIFA to include community foundations in trust form. The current draft would apply Section 3 of UMIFA, which is the spending rule, to all charitable trusts excluding, again, the split interest trusts. Morey mentioned the change in the standard to be applied by the governing body. It’s reasonable care and judgment under the current UMIFA; the proposal would move it to the prudent investor rule articulated in the Uniform Trust Code and elsewhere. I am not sure there is a significant real difference in that change. I would be interested in whether other people have a view on that. Finally, I would note that Morey mentioned that the Uniform Trust Code does provide settlor standing. The Uniform Trust Code also, as drafted, applies to charitable trusts. It has been adopted so far only, I believe, in Kansas, but if you are concerned about questions of donor standing, you really should be monitoring the process at your State legislature of enacting the Uniform Trust Code as well. PANELIST: I think it has been introduced in other states. So Kansas may not be alone for long. MS. APRILL: We are going to open it up to questions now, and I promised all the California people, I would ask the California question that has been preoccupying us for the past couple weeks. March 2003 — Vol. 39, No. 3 367 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. There was a good deal of discussion at the last drafting session about what accommodations should be made for a donor who would prefer to have the amount that they contribute preserved, more or less intact, consistent with the old rules or modified rule. So there is a provision in this draft that would permit a donor to opt out of the spending rule if they used a defined set of words, defined in the text, or some close approximation of that defined set of words. It is something like “I don’t want Section 3 of UMIFA to apply to my fund.” ABA Transcript California has a provision that says that nothing in the California UMIFA alters the status of governing boards or the duties and liabilities of directors under other laws of this state. So, in particular, for nonprofit directors, it seems to say that the nonprofit rules trump, and California’s nonprofit corporation, public benefit corporation code, says that in doing investments, you have to avoid speculation. Therefore, a lot of people in California are worried about whether even in the endowment fund you can invest for total return if some of the investments are risky. Any guidance in the Uniform Act, saying at least where this act applies, it trumps other rules, could be helpful or some other coordinating rules. So any thoughts? MS. GALLAGHER: I always thought that California was peculiar. This isn’t completely responsive, but it is worth pointing out that UMIFA uses a term that is somewhat peculiar to it called “governing body,” and that is a broader term than the “organization’s board.” PANELIST: Arguably it is. We don’t know exactly. MS. GALLAGHER: I mean, I think the reporter comments to the original 1972 draft made clear that they intended it to be broader than the “organization’s board,” which I guess would suggest in California, you might have a board that continues to have obligations under the nonprofit corporations code, but if you have a different body that is actually administering a fund within that corporation, it would be subject to the UMIFA. PANELIST: Which is a hard position to live with. Other questions? MR. GALLAGHER: I am wondering if the commission has consideration of — Richard Gallagher, Milwaukee. I’m sorry — in consideration of revisions is considering the relationship between UMIFA and bankruptcy and creditors’ rights, which I think is an interplay that concerns a lot of organizations at the present time. A second related issue is what is an expenditure under UMIFA. If a 100-year-old college has an endowment fund of $50 million and they are down to their historic cost and they have got to tend to the dollar bond-out standing and they can’t even go to court to get the permission to get into the $50 million because that would somehow convert the restricted fund to unrestricted fund, they are confronted with selling the college campus to save the endowment fund. It is hard for me to believe that that was the intent of any donor, but I think it is a conflict that we get into. 368 March 2003 — Vol. 39, No. 3 MS. GALLAGHER: I can answer the first question easily. Bankruptcy has not come up during the course of the drafting discussions, although it is a question that I have been getting a little more frequently, lately, as to what the status of these funds would be in bankruptcy. My best guess is that once you are in bankruptcy, all bets are off. No? Marion, would you enlighten us? Because I really am interested in the answer to this myself. MS. SMITH: Marion Fremont-Smith from Boston. In general, true endowment is protected in bankruptcy, and that is why it is so very important. I was going to ask a question or ask you to discuss it. One of the problems with UMIFA that people ran into with the accounting profession was the concept that because the appreciation was available, that amount of funds had to be listed on your financial reports as available to creditors. Both the New York Attorney General and the Massachusetts Attorney General issued specific opinion saying that is not the case and that this was a misinterpretation based on the idea that these funds would be protected in bankruptcy, and that only once the board had appropriated the funds was it available in that short time between the appropriation and the expenditure. Further, you could not — and this is particularly in the New York one — if you don’t spend it, you can’t carry forward. If you have appropriated at the end of the year, it hasn’t gone out, then you can’t build up all this back unused appreciation and then take a great big slug a later time if your numbers go up or down, but there is good precedent on the bankruptcy. MS. GALLAGHER: Thank you. That is very helpful. I think for people who are interested in a more detailed discussion of the problems with the accounting rules, Antonia Grumbach at Patterson Belknap did a very good UMIFA piece that parsed through that, and I assume it is available on Patterson Belknap’s Web site. Morey, do you want to take a shot at the second part of Dick’s question? MS. WARD: Dick, I have forgotten the second part of your question. MR. GALLAGHER: Let me comment. It is my understanding of the case law that what she has defined as true endowment might be protected, but I think that true endowment in that context, unless I am misstating, means really clear donor restrictions with income-only use in the nature of a trust, I think is what some of the old cases say. The UMIFA definition of “gift instrument” includes deed, grant, [inaudible] agreement, memorandum, writing, or other Government document, including the terms of any institutional solicitation from which an institutional fund resulted. You look at old documents or old colleges and that is kind The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. One of the issues we have encountered in California and I assume other states have as well is what standard trumps what if you have different standards and rules in different parts of your governing body. ABA Transcript charities generally, we will have a panel on that issue specifically. MS. APRILL: Complicated since bankruptcy is Federal. These are uniform acts. MR. GALLAGHER: This is my second question. Morey had a junior-senior moment and couldn’t remember it, and I couldn’t remember it at all, but it was what is an expenditure. In the context we are talking about, I guess a question posed by my hypothetical college down to its $50-million historic dollar value cost is a $10-million bond issues outstanding, and the creditors are threatening and the school is about to be closed. Is it an expenditure for the historic dollar amount to be used to pay off that bond, or is that in a single entity approach simply a balance sheet transfer which puts the college in the same financial position it was in afterwards as it was before? Because if it is not, and I fear it is not, the college is in the ironic position of having to go bankrupt, have the endowment fund for a close-down — Other questions? MS. BJORKLUND: Victoria Bjorklund, New York. The New York State Attorney General has required that historic dollar value be incorporated in the number of settlement-type contracts that many organizations enter into. Was there any thought given to how deletion of historic dollar value might affect older contracts that tie contractually into UMIFA? MS. GALLAGHER: No. I will say that reading through the draft myself, I think it is clear that we can’t simply eliminate the definition. Even if the ultimate decision of the group is to move towards the spending rule, there is a need to have historic dollar value there without regard to anything else, but I think your point about the settlements is really well taken. MS. BJORKLUND: In addition, in New York when practitioners draft, they often specify the historic dollar value because there has been a question of — for example, in the case of a bequest, whether it is the amount on the date of death or two and a half years later when it is actually paid out to the estate. That has made a big difference in the recent market as to whether the historic dollar value is the date-of-death amount, which may have been higher than the amount when it is actually paid out. Finally, I would like to note that New York State requires the treasurer to give an annual report of historic dollar value and uses on an account-by-account basis. If the treasurer has not done that, then mergers and other corporate reorganizations that require the Attorney General’s consent are not allowed to go forward until that account-by-account report is given. I am not sure what would happen here, but it is just another factor. MS. APRILL: Again, this underscores Carol’s plea that people look at this very carefully and get to her any comments she can give as the ABA advisor to the group that is revising UMIFA. MS. ADLER: Betsy Adler, San Francisco. I just wanted to point out that all of you who are debating whether you wanted to come to Chicago in September for the committee meeting then, those who are interested in the issues of bankruptcy and endowment or bankruptcy and The Exempt Organization Tax Review MS. APRILL: I was going to suggest that to you at the break. Dick will have one more question, and then we will be out of time. MS. APRILL: I think Marion is going to rescue us again. MS. SMITH: I am going to take issue with my good friend, Dick. The UMIFA came out of a study called the Law and Lore of Endowment Funds. It really was never intended to go to what we call funds functioning as endowment because that is not a true restriction. A board isn’t allowed to restrict, but it truly means regardless. I think the language that Dick read had to do with where it came from, from outside, whether it didn’t have to be. This is a declaration of trust, but it is in a contract or it is in a deed of gift or something like that. But I didn’t want us to leave with an impression that it was broader than it was really meant to be. MS. WARD: I guess the only response — this may not be entirely responsive, Dick, but I think this is an issue that many organizations have dealt with in one way or another. By mistake or by intention, some have spent below their historic dollar value and then turned around and said, “What do we do now?” The question is can you correct a violation of UMIFA after it has occurred. I think for one reason, probably not. I don’t think you can just move unrestricted funds over and now bless them and say they have become true endowment for exactly the reason that Marion points out. The board cannot effectively restrict those funds, and I don’t think you have corrected your UMIFA violation in that context. It is also possible, I suppose, that the board would have some fiduciary duty to the donors of the unrestricted funds, who although they gave unrestricted funds and said you can do with it as you wish may not necessarily have intended those funds to then become restricted to some other donor’s purpose. March 2003 — Vol. 39, No. 3 369 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. of hard to find, and the problem I think is board-restricted kinds of funds that become your typical endowment fund where there is not a clear donor instrument, but UMIFA by its terms has converted it to an endowment type of fund. I think the status of those assets under creditor protection rates is perhaps less clear than it would be in the case of a clear donor restriction. ABA Transcript PANELIST: Which leads to this point about the FAS-124 issue. PANELIST: Which we had done at dinner last night, too. PANELIST: Right, which is really very interesting, but very unpleasant because the FAS-124 says explicitly that if a fund has declined below historic dollar value as result of investment decline, not because of the spending rule, then the organization and the institution is obligated to take the unrestricted funds and move them over to bring it back up, which it is clearly not what UMIFA requires, but it is an accounting, I think, misunderstanding of what the law is. The accounting firms have acknowledged that it is not what is legally required, but it is what they are required to do by FAS-124, which means that you need to make sure that there is a big footnote that explains that these are not funds which have become legally restricted or donor restricted. They are still unrestricted funds and are available. MS. APRILL: The schedule tells us we are now on a break until — I will let Victoria decide. MS. BJORKLUND: I really want to thank this panel so much. We had requests to have the UMIFA panel, and I am really glad we did it. And the timing was excellent because of the timing of the UMIFA project. Jody Blazek is going to be talking more about the interplay of legal and accounting at lunch. That was something else that we have been asked to do, and we are glad to comply with your requests, but I really want to thank all of you for this panel for working so hard on this project. I know you have had many calls and really worked on your materials. It was a great panel. Thank you. See you at 11:00. [Applause.] [Break.] The Use of For-Profit Subsidiaries by Exempt Organizations MS. BJORKLUND: We are very happy to have with us Joe Lundy and Suzanne Ross McDowell who kindly agreed to talk on a topic that I have long been interested in and that I can’t remember when we last covered at this committee, which is the Use of For-Profit Subsidiaries by Exempt Organizations. So, with that, I give you Suzy and Joe. MS. McDOWELL: Thank you, Victoria. This is a topic that 25 years ago was, I guess, like UMIFA. Everyone was trying to figure out can I have a taxable sub 370 March 2003 — Vol. 39, No. 3 and, if so, what do I need to do to set one up and will it really protect my exempt status or whatever you were trying to do. Now, 25 years later, this has really reached a stature where I think it is part of the EO lawyer’s tool kit; that everyone knows or should know the basics of for-profit subsidiaries. In this vein, I came across an interesting statistic. Like many of you, I am kind of a pack rat and I have old articles that occasionally I trip over as I am looking for something else. Jim McGovern, who is a former director of the old EO/EP division at the Service, wrote an article in 1988 called something like “Taxable Subsidiaries: A Policy Issue for the Eighties.” It had an interesting statistic in it. He said in the decade from 1977 to ’86, 593 private letter rulings had been issued on taxable subsidiaries, but what was more interesting is how many rulings had been issued in the decade before. Does anybody want to take a guess of how many there were in the decade before? PANELIST: Twenty-five. MS. McDOWELL: Twenty-five? That is a pretty good guess. There were eight. In ’67 to ’76, there were eight, and then in the next 10 years, there were almost 600. Probably about 80 percent of those were in the health care industry, and now I think that has probably changed as well. I don’t have any specific statistics, but if you just look at the private letter rulings that are coming out, you see that for-profit subsidiaries are being used for all kinds of different purposes and by different types of organizations. What Joe and I are going to cover is four main topics. Joe is going to talk about reasons for setting up for-profit subsidiaries and, equally important, reasons for not setting up for-profit subsidiaries. I am going to talk about the things that you need to do to make sure that your strategy works if you do set up a for-profit subsidiary and what the tax rules are in setting it up and operating it, and then I will briefly discuss the current status of legislative efforts to change section 512(b)(13). Then Joe will finish up with things to consider in exit strategies. In fact, Mike Clark was just saying during the break that in recent months, he has found more and more clients coming and saying, “You know, I would really like to get rid of that subsidiary that I set up 20 years ago.” So I think that is another indication that taxable subsidiaries are, shall we say, a mature industry. The one thing we are not going to cover, because I think it could be a program in and of itself, is choice of entity. There are certainly many ways to set up affiliated entities other than C corporations, but we are going to be focusing on C corporations. Victoria has just asked me to mention that there are materials on this subject in the committee handout. Those materials do have a section on choice of entity which you can look at on your own time. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. MS. APRILL: Last, last question. ABA Transcript MR. LUNDY: Well, no, but you might add that this is an auspicious day. I was searching back to see in history what other things have happened on today, and among the things to be noted are that Caligula was assassinated, Sir Winston Churchill died, Ted Bundy was executed, gold was discovered at Sutter’s Mill outside Sacramento, the Boy Scouts were founded, and last but not least, beer was released in the United States in cans for the first time. [Laughter.] So, with that, I will launch into a presentation of what are some of the common reasons to establish and maintain a for-profit subsidiary of a tax-exempt organization. By far and away, the reason that most practitioners turn to use a for-profit subsidiary is as a safeguard against the definitional requirement of a 501(c)(3) organization. It is sort of textbook. Everybody can quote it in their sleep that the definition of a (c)(3) includes the language that it is a corporation and a community chest fund or foundation organized and operated exclusively for religious, charitable, et cetera, purposes. The word “exclusively” gets a lot of attention. Then we fall into an array of perplexing language in the regulations as to what this word “exclusively” means. The outline, as you can see, starts to go through the various approaches. You first see that there is in the regulations an operational test requirement in -1(c) of the (c)(3) regs, and there, the key language is that the organization will be considered operated exclusively for one or more exempt purposes only if it engages primarily in activities that accomplish such purposes and will not be regarded if more than a substantial part of its activities is not in furtherance of an exempt purpose. A little further along in the -1(e) part of the same regulations, we see language that addresses the issue of permitting a trade, carrying on a trade or business, and in that context, we get slightly different language and we get a sense that an organization may operate a trade or a business as a substantial part of its activities if the operation of such trade or business is in furtherance of its exempt purpose and if the organization is not organized or operated for the primary purpose of carrying on an unrelated trade or business. When I go through those two provisions in the regulations, I am about as clear as I am when somebody asks me whether an activity is substantially related to the exempt function. Does it contribute importantly, et cetera? Here again, we have the same kind of array of language that perplexes anyone looking at the topic. Well, in Revenue Ruling 64-182, the Treasury and the Service came forth with a measure that has by most practitioners’ views really captured the essence of where we ought to go to determine whether a certain level of non-exempt activity of unrelated trade or business could jeopardize an organization’s tax-exempt status. The Exempt Organization Tax Review In putting forth this commensurate-in-scope requirement, this commensurate-in-scope test in Rev. Rul. 64-182, it is interesting to note exactly the facts in that very, very brief Rev. Rul. In that Revenue Ruling, we have essentially a grant-making organization that owns and operates a commercial office building, rents out the space and uses the income from owning and operating the commercial office building to make grants to other charitable organizations. In that ruling, the Service ruled that that organization did meet the “primarily” test because it was shown to be carrying on through such contributions and grants to charitable programs activities that are commensurate in scope with its financial resources. That requirement, commensurate in scope with financial resources, is determined on a case-by-case basis such that nobody should look at this particular Revenue Ruling and think that you can qualify just because you happen to have facts similar to this Revenue Ruling. That being the case, practitioners, when I first started to practice in this area, such as Bill Lehrfeld and the like used to tell me, “Joe, there is a 30-percent rule of thumb, and that is, wherever you see roughly more than 30 percent of the revenue of an exempt organization that is unrelated to the exempt mission, the exempt function, you should take alert. You should consider whether to continue those types of activities within the exempt organization or to spin them off into a separate entity, a for-profit entity.” And I took Bill’s and other practitioners’ words to heed, and I have always abided by that. Having said that, there is no fast rule, and, therefore, while one can sometimes determine where you are clear and where you are not, there is no rule. So, having said that, one of the reasons, one of the prime reasons for creating a taxable subsidiary is to remove from the exempt entity an unrelated activity and thereby improve, if not ensure, that it will satisfy the “exclusively” requirement of 501(c)(3). Moving right along to the other ones that may be of greater interest to most of us, one of the other reasons to move an activity into a for-profit subsidiary is in the case of an organization that relies upon the public support test for purposes of its public charity status. Contributing an activity to a for-profit subsidiary will improve the possibility, probability that it will continue to so satisfy. In satisfying the relevant support fraction, the denominator of the fraction will always contain unrelated business income activities, and, yet, the numerator will not. By pushing an activity into a for-profit subsidiary tautologically, the percentage of good receipts will increase, thereby increasing the probability that an organization will qualify under the public support fraction. Yes, Victoria, were there to be a dividend distribution from the for-profit subsidiary up to the tax-exempt parent, it would reverse that effect because, again, the net investment income would likewise be included in the denominator of the public support fraction but not in the numerator. However, the timing of the dividend distribution is controllable, and by virtue of maintaining control on the lever as opposed to having it automatically dumped into the organization in a year in which March 2003 — Vol. 39, No. 3 371 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Joe, do you want to add anything before I launch in? Oh, no, you are starting off. So I guess you have a lot to add, don’t you? ABA Transcript to avoid the possibly contaminated property in the chain of title belonging at any time to the exempt parent. Another important reason is to potentially minimize Federal income tax liability. That is, there are several ways in which one can reduce the amount of unrelated business taxable income as the result of pushing an activity into a forprofit subsidiary. Organizational structure of a for-profit business is usually much more efficient than a nonprofit to maximize productivity. So many times a for-profit subsidiary is utilized to obtain greater accountability, to obtain greater flexibility, to obtain third-party financing, to qualify for more favorable state laws. For instance, take the case of forum shopping to obtain more favorable laws regarding indemnification of officers and directors. By incorporating in another state in which the laws regarding the conduct of that activity are more favorable than they are in the state in which the exempt organization is incorporated, one can obtain the more favorable treatment for that activity. Example. If the exempt entity is a trust and it is incurring unrelated business taxable income, it would possibly, if not probably, be taxed at a higher rate than it would be if such UBTI were being earned in a for-profit corporation. So, by pushing the activity down into a for-profit subsidiary of the charitable trust, the rate of tax is reduced, ergo the tax obviously would be reduced. Furthermore, the rules relating to what expenses can be taken to offset the amount of income are more generous, are slightly better in the case of a for-profit corporation than they are in the case of a tax-exempt entity. That is, the applicable language in section 512(a) talks in terms of all of the expenses that you would normally be able to take to the extent that they are “directly connected.” The “directly connected” language of 512(a) would not be applicable in the case of determining allowable expenses once that activity is housed in a for-profit subsidiary. Thus, certain indirect expenses that might be otherwise lost were the activity conducted at the level of the exempt organization may be allowable in computing the taxable income of the for-profit subsidiary. As the outline goes on to identify, there are several other tax-related reasons to use a for-profit subsidiary. One might be to limit certain public disclosure requirements. The activities that are reported on the Form 1120 of the for-profit subsidiary, are not open for public disclosure. So, to the extent there is certain information of an activity that one wishes to shield from disclosure — for example, from competitors — by spinning the activity to a for-profit subsidiary, it will receive much less light of day. Finally, a two-edged sword. There may also be an opportunity to minimize state and local tax liabilities, and I will talk a little bit about those in a second, but let’s go to some of the non-tax reasons for incorporating an unrelated activity as a for-profit subsidiary. First and foremost, similar to the “exclusively,” “primarily” reason on the tax side would be to limit liability from the conduct of a particular activity. So, for example, we frequently see a piece of real estate that may be subject to certain environmental concerns transferred to a for-profit subsidiary. If the activity of operating that real estate is going to be “unrelated,” the reason to hold the property in the for-profit subsidiary is to try to insulate the exempt parent from potential liabilities that might be otherwise incurred. I am far from knowing much about environmental law, but I know enough to know that you would not want to convey the property down from the exempt parent. Rather one would want to acquire it directly in the for-profit subsidiary so as 372 March 2003 — Vol. 39, No. 3 As Suzy indicated, some cautionary notes; why would you not wish to move directly into using a for-profit subsidiary? Well, first and foremost, the “kiss” principle. Complexity. Why does one want to create another entity to care and feed? There are obviously housekeeping requirements that Suzy is going to talk about in order to have the separate identity of the subsidiary respected. Then there is the task of maintaining relations between the parent and the subsidiary, and there is also the added administrative expenses, both initial and continuing. I am going to talk a little bit later about the problem of exit strategy, the potential tax liability on dissolution or on distribution of property out of the for-profit subsidiary. I think that is one of the more interesting topics of this discussion. FUTA liability issues should not be overlooked. If you are transferring an activity that is labor intensive into a for-profit subsidiary, new FUTA liability will be incurred. While the maximum cost could be as much as $434 per employee, as a practical matter, because of the offset given to state unemployment insurance, I believe that the amount of additional cost is about $56 per employee as the result of having that person employed by the for-profit subsidiary level as opposed to the exempt parent. State and local tax considerations can be extraordinary. Certainly, in a state in which there is an all-or-nothing approach to the taxation of unrelated business income, one would incur tax that one would not otherwise incur by pushing the activity down into a for-profit subsidiary. There are also issues of transfer taxes, franchise taxes, and gross receipts taxes that may become applicable to the extent the activity is being operated in a for-profit subsidiary instead of as a division of the exempt parent. Finally, transferring an activity to a subsidiary may require a myriad of third-party approvals, some of which may not be easily obtained without significant concessions and additional consideration. Suzy? MS. McDOWELL: Thanks, Joe. I might mention a couple other points to add to Joe’s comments. One is, as far as tax-exempt status goes, using a taxable subsidiary can be not only a proactive means of The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. meeting a certain requirement is critical, one can control, to some extent, meeting a public support test. ABA Transcript Several years ago, there were rulings which are generally believed to have been issued to AARP which had huge programs of insurance and other member benefits that threatened its exempt status under section 501(c)(4). AARP dropped services related to provision of these benefits into a taxable subsidiary, and this saved its tax-exempt status. Then, just recently, a little over a year ago, there was a ruling involving an Internet Service Provider. Originally, the organization had been set up strictly as a public service. It was just providing Internet access as a public service, but as the Internet industry grew, they wanted to provide service at a market rate as well as providing service to some groups at a below-market rate. Their exempt status was revoked, and then retroactively, they regained their tax-exempt status by dropping the activities involving sales to the public at fair market value into a for-profit sub. So that is something to keep in mind if you have a client who is being audited. Also, just recently, a ruling came out. This was right around Christmas time which involved a charitable remainder unitrust. Joe had mentioned some of the issues with trusts, how you can improve your rate, but for a charitable remainder unitrust, you can’t have any UBIT at all or the trust is taxable for the entire year. This involved a situation where a number of trusts were limited partners in a partnership, and the partnership then created a foreign corporation presumably in a tax haven country. MR. LUNDY: All of this was to permit the trust to invest in hedge funds, offshore hedge funds for the most part. MS. McDOWELL: Right. And the for-profit sub then invested in, as Joe said, these hedge funds which invested in debt-financed property. What the ruling held is that once the income passed up through that foreign subsidiary and was paid out to the trust, it was a dividend and it was tax-exempt. We had seen this issue in the late ’80s and the early ’90s with insurance companies, offshore insurance companies, and Congress enacted 512(b)(17) saying, in the case of insurance income from a controlled foreign corporation, it would not be treated as a dividend. But section 512(b)(17) only applies to insurance income. The Service is quite aware of what they are doing. This isn’t a situation where a taxpayer has slipped something by them. They clearly do understand that this enables organizations to simply avoid the debt-financed property rules by setting up a foreign corporation which is not that difficult to do. So those are just a couple other additional thoughts on reasons for using taxable subsidiaries. Now, assume that you have decided that setting up a for-profit subsidiary is the route for your client to take. Notwithstanding Joe’s cautionary notes, it still seems like the The Exempt Organization Tax Review right thing to do. Then you need to make sure that you get it done right, and that involves, first, that you set it up in a way that ensures it is going to be treated as a separate entity. I will talk about what you need to do, but it is so simple that no one should fail to be treated as a separate entity. Then I will talk about the general tax rules for setting up the corporation. We will wade just up to our ankles into Subchapter C, and then I will talk about the importance of dealing at arm’s length when you have a parent and subsidiary. That really is very key. So, in terms of being treated as a separate entity, that, of course, is absolutely key to the strategy of using a taxable subsidiary. If you fail to do that, then everything is attributed back to the parent and you have wasted all your time and your client’s money. So what does it take to be treated as a separate entity? First, you need to have a business purpose. What is a business purpose? You don’t need to do a whole lot to have a business purpose. You need to have some minimal business activity. The one thing that is not treated as a business purpose is saving federal income taxes. I don’t have the cite for this, but I know there is one. While saving federal income taxes is not a business purpose, saving state and local taxes is a business purpose. So that is a little bit of a parochial view from the federal government’s perspective, but one that we will certainly go with. Once you have a valid business purpose, you have a business activity, and you are going to carry it on, the rule is — that everyone knows from Moline Properties — that your corporate entity is not going to be disregarded unless it is a sham or it is acting as an agent for the parent. The sham test, I think, is pretty easy to avoid. The case that came out on this involved the Church of Scientology, and they had not paid attention to any corporate formalities at all. They had completely overlapping boards. The board never had a meeting. They operated as if the parent and the sub were just one entity, and you can’t do that. In terms of what is an agent, that gets a little bit trickier. You could more easily fall into that. The general rules as to what is an agent apply in the tax area. There would rarely be a situation where you have actual authority for the sub acting as an agent, that is, a written contract, but you might have apparent authority. If the lines of distinction between the parent and the sub are blurred, apparent authority would arise when a third party could reasonably believe that the sub was acting as agent for the parent. So you need to observe various formalities, not only corporate formalities that I will talk about in a minute, but also operational formalities. The employees who are working for the sub need to have their own stationery. They need to have their own business cards. Employees who work for both the parent and a subsidiary also need to use the right business cards and the right stationery at the right time. That gets a little bit more difficult than just getting them printed up, and that is where I think we really need to educate our clients because, once you set these things up, your clients are then going to be March 2003 — Vol. 39, No. 3 373 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. avoiding challenges to tax-exempt status, but also a defensive means of saving tax-exempt status. ABA Transcript I know I have seen instances where people sign on the wrong stationery or sign with the wrong title because most non-lawyers don’t think about these things as much as we do. MR. LUNDY: Just to give you an idea of how significant this can be today, within the last year, a group of medical malpractice defense practitioners have approached me to assist them to build defenses around arguments being made by the plaintiff’s malpractice bar to the effect that in a complex group of exempt health care organizations, all of the organizations should be treated as one economic unit acting either without separate identity or as agents for each other, so as to increase the pot that the jury would use to measure punitive damages — whether we could appropriately teach the right lesson to the organization as a whole. So, argues the plantiff’s malpractice bar, if you just looked at the entity that committed the alleged malpractice, teaching it a lesson may only require a million dollars, but if you look at the sum of the parts as a whole, this is a $100-million case. So what Suzy is talking about has very significant potential implications. MS. McDOWELL: That would be a good story to tell clients so that they don’t really view it as lawyer mumbo jumbo, which has often been my experience. Yeah, yeah, yeah, but we’ve got work to do. We can’t worry about all these details, but the details are important. As I say, they are easy, but they are important. The next point is that the parent and subsidiary need to have separate boards. The boards need to meet regularly, and they might not have a lot to do, but they need to meet regularly. Delaware does permit a corporation to have only one director, and I think that is kind of a double-edged sword because corporations with one director don’t have formal board meetings, and formalities such as keeping minutes of Board decisions are easily overlooked. Unless there is a good business reason for having only a single director, I would encourage them to have more than that, which moves us to the issue of overlapping boards. I think that we know that having identical boards for the parent and the sub is a problem. In many private letter rulings, you will see a statement that a majority of the members of the subsidiary’s board are outsiders, which is to say they are neither officers or directors of the parent corporation, but you also see rulings where this is not the case, where maybe five out of nine are insiders. There is one ruling where there is two-thirds overlap. So there is not a clear rule, although if you go in for a ruling from the Service, you might find that they are going to push you to have a majority of the board be outsiders. Finally, the other rule in terms of being recognized as a separate entity — and you will see this in all the private letter rulings — is that the parent has represented that it and its 374 March 2003 — Vol. 39, No. 3 officers and directors will not be engaged in the day-to-day operations of the subsidiary. In other words, the parent ought to act like a shareholder, not act like it is an officer of the subsidiary. This means, as a general rule of thumb, the parent and the sub should have separate CEOs, but it is generally okay to have other overlapping officers and directors, and depending upon the size of the operation, there may be no alternative. There might not be several full-time jobs in the subsidiary. If you do have overlapping officers, you should keep very careful records. The officers should keep time records as to what they are doing and who they are doing it for at different times or, alternatively, you can structure a more general contract. You can have a contract that is just a flat fee in exchange for so many dollars. For example, John Doe, vice president of the for-profit subsidiary, will act as a consultant to the parent on the following matters. That looks very much like a third-party contract would look, and if you can get that to work, I think it is better than just an allocation on the books. One thing that I find curious is, notwithstanding this rule that the parent should not be engaged in the day-to-day operations of the sub, the Service recently issued a ruling saying that a parent corporation could issue stock options on the stock of its for-profit sub to the parent corporation’s officers and directors, which it seems to me would create a clear incentive to have a lot of interest in the day-to-day operations of the subsidiary. That is an issue that wasn’t really discussed in the ruling, but I thought that was really interesting. For anybody that hasn’t seen the ruling, it is PLR 200225046. We are getting short on time. Let me buzz through the rules for setting up a sub. First, the general rule under section 351 is that, when you create a new corporation and you transfer assets to it and controlling shareholders get back stock, there is no tax liability on that transaction. But, as with every good tax rule, there are exceptions. In this case, there are two exceptions. If you transfer a property where the liabilities exceed the basis, you will have tax on the transfer to the extent that the liability exceeds the basis. Then there is the so-called boot rule. If the parent receives something other than stock, such as a note, for example, that is boot and the parent will be taxable on the boot. But then there are exceptions to the exceptions. The exceptions to the boot rule are — first, you can look at section 512(b)(5). Is the transferred property of a type that the gain could be excluded under 512(b)(5)? If not, say because it is inventory, well, then you can look at whether this transferred property is substantially related. So there are ways to try to avoid that rule. If you can avoid paying the tax, you can really have one of these wonderful situations where you have your cake and eat it, too. If you avoid the tax on boot under 512(b)(5), you, nevertheless, can get a stepped-up basis in your taxable subsidiary. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. operating them on a day-to-day basis, and it is important to point out to them how important it is to observe these types offormalities. ABA Transcript If the parent owns 100 percent of the sub, then there is really no issue, but if there is a split in the ownership between the parent and others, then you do have potential issues. Say the parent puts in assets and then other parties put in cash and the parent gets 70 percent of the stock and the other parties get 30 percent of the stock. The question is have you valued. These can be very difficult issues. What you really need to do in this kind of situation is get an outside appraisal so that you value those assets and you are sure that you don’t have any issues of private benefit or private inurement. Of course, if the outside party pays too much, that is okay. You are only worried if the parent pays too much. tive of the exempt organization world as it relates to the use of for-profit subsidiaries. MS. McDOWELL: The particular provision that Joe is talking about is in Title 3, which is the miscellaneous provisions, which is always where you find the good stuff. Just by way of background, as you all know, so-called passive income, dividends, interest, et cetera, are excluded from UBIT, but then there is a rule in section 512(b)(13) that, if passive income, with the exception of dividends, is paid to a parent that controls a subsidiary, it is taxable to the extent that the subsidiary is engaged in a business that would be an unrelated business if operated directly by the parent. The rule in section 512(b)(13) was enacted in 1969, and it was directed at prohibiting for-profit subsidiaries from paying inflated amounts of rent and royalties to the parent, because the for-profit subsidiary would have a deduction for them, reduce its taxable income, and then the parent would not pay tax. In the extreme case, neither the taxable subsidiary nor the parent would pay tax on income generated from operation of an unrelated trade or business. You also need to pay attention to these rules after the sub is set up, and if you have any kind of substantial dealings between the parent and the sub, you really should have written contracts. Again, you should have valuations. This rule sat on the books for 28 years, and it never had any impact at all because it was so easy to walk around it. “Control” was defined as 80 percent or more. Frequently, this comes up in connection, for example, with a trademark license. If the sub is going to be operating using the parent’s name, the parent will need to license the right to use the mark to the sub. MR. LUNDY: Of all classes. So many practitioners would form a second class of stock, a preferred stock, and give the preferred stock to a close friend of the organization who would likely agree upon death to contribute the stock back either to the organization or to the designee, thus breaking the applicability of section 512(b)(13). What is a fair royalty to pay for that? That is a very difficult question to answer, although there are economists who write long reports, most of which I can’t understand, but after talking about all of these economic theories, they will tell you what the value of the trademark license is and what royalty should be charged. Rental agreements are usually easier because there is a market for renting lists, and if the organization does rent its lists, it knows what the market rate for the list is. Similarly, leases for office space, agreements for providing administrative services like payroll — usually it is pretty easy to figure out the value of those properties and services. What I am going to do, because we are running very short on time, is to turn this back to you, Joe, and let you talk about exit strategies. MR. LUNDY: As you are turning the discussion back to me, let’s talk a little about the CARE Act and what it might do. MS. McDOWELL: All right. MR. LUNDY: I think that will segue well. Tell us a little about the provision that you and I have discussed in the CARE Act that would be, in my view, just extraordinary from a perspecThe Exempt Organization Tax Review MS. McDOWELL: Yet, they still effectively have control. Then the other way to get around section 512(b)(13) arose from the fact that the 512(b)(13) rules didn’t contain any attribution rules. So you could have the parent organization and then you could have a first-tier sub and a second-tier sub, and when the second-tier sub paid, say, royalties up to the parent, the parent didn’t control the second-tier sub because it didn’t own it directly and because there were no attribution rules. This was just a simple way to walk around it, and I have already said meeting the business purpose requirement to have an organization recognized as a separate entity is not that high a bar. So this sat on the books. No one really thought about it for 28 years. MR. LUNDY: No, until people like Marcus Owens and the like got fed up with the 512(b)(13) regime. In effect, I remember Marc making comments back in the early ’90s saying it had effectively lost any utility, and, again, Congress in ’97, as we all know, it is old history, revamped, put a significant amount of teeth into it, and there we are today. And now here comes the CARE Act, and what would it do? It would significantly dilute the impact of potential UBIT to the point where it would not subject to tax any amounts exchanged for March 2003 — Vol. 39, No. 3 375 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. In setting up the sub and in operating the sub after it is set up, you have to strictly adhere to arm’s-length rules. We have private inurement. We have private benefit. We have intermediate sanctions. You all know a disqualified person includes entities that are controlled by disqualified persons, so that you can have the intermediate sanctions rules brought into play here. So it is very important that, when you set up a for-profit subsidiary, you be sure that what the parent receives is fair market value for whatever it transferred. ABA Transcript It would, in effect, permit the deduction at the payor level, no inclusion at the recipient’s level, so long as the amounts that are being passed between the parties are at arm’s length, in exchange for fair value consideration. In order to ensure that there would be some tension to the requirement of arm’s length fair market value, there would be a 20-percent penalty imposed upon a determination that the amount that was being used was in excess of the arm’s length fair market value, using section 482, a transfer pricing rules-type of an approach to measure whether this is fair and reasonable. That is the segue, really, that I was trying to get into for purposes of the exit strategy. For whatever reasons, an exempt organization forms a for-profit subsidiary. I think that one of the new check list requirements we will have to consider is the type of property that is being transferred into a for-profit subsidiary. It would be an exercise of separating the potential fruits from the labor to be provided at the for-profit level from the fruits of the capital that will be required to conduct the activity of the for-profit entity. To the maximum extent possible, any capital requirements would be, in some fashion, made available to the for-profit entity to the maximum extent possible, subject to the old thin capitalization rules on a leverage basis, on the basis of a lease, or on a loan, or on a royalty basis in the case of intellectual property. Even today, when one considers that strategy, I think there are very significant reasons for maximizing leverage as opposed to outright transfers of property. That is, even though there would clearly be under the existing 512(b)(13) regime unrelated business income generated at the exempt parent level, such income would otherwise be subject to tax at the for-profit subsidiary level. So you may have a rate differential, but, in any event, that income is going to be taxed, either way. By leaving the property that is required to generate that unrelated business income, in the exempt entity, one does not put it into the for-profit solution and subject gain on its appreciation to a possible General Utilities tax. General Utilities is a doctrine that arises out of a 1935 Supreme Court decision which I confess I had not reread until Suzy asked me to talk about for-profit subsidiaries. I went back and I reread, which I hadn’t read since I was a student at NYU in the late ’60s, the General Utilities decision, and it is fascinating, a fascinating case. Among its more interesting features, just to capture your imagination, is the relatively brief, simple facts. General Utilities was a corporation that made an investment, listen to this, on January 1 of 1927. Who is making investments on the first day of the year? It bought 20,000 shares of stock of a company for a dime a share. In January of 1928, 12 months later, several of the officers and owners of General Utilities met with a potential buyer and agree to sell the 20,000 shares for a little over $56 376 March 2003 — Vol. 39, No. 3 a share, a profit in excess of $1.1 million on a $2,000 investment. With much deliberation the transaction is prepared in a fashion that caused General Utilities to distribute the stock to be sold to its shareholders as a dividend, then the next moment the General Utilities shareholders sold the stock to the buyer. This was intentionally done to avoid a tax at the corporate level. The commissioner says, “No. Tax should be imposed upon General Utilities because it, in effect, sold the stock to the buyer as agents for its shareholders. Alternatively, General Utilities, in effect, sold the stock because it declared a dividend payable in cash. It used the stock to satisfy the liability to satisfy the dividend declaration.” The case goes to the Board of Tax Appeals. The Board of Tax Appeals holds for the taxpayer. The commissioner appeals to the Fourth Circuit Court of Appeals. The Fourth Circuit Court of Appeals reverses the Board of Tax Appeals and the taxpayer appeals. Supreme Court slaps the wrist of the Fourth Circuit and says, in effect, “You erred. You were just terrible in this case, so much so that we don’t even think that we are going to remand this case for your further consideration. We think that it is clear. General Utilities wins.” With that the underlying principle of the case gets codified in the 1939 code, ’54 code, and not until the ’69 code do you see the deterioration of General Utilities doctrine. In 1986 there is a complete reversal, Congress repeals the General Utilities doctrine in all but very limited situations. As the result of that, under the regime of sections 311, 336, 337(b)(2), unless appreciated property in for-profit solution distributed to a controlling exempt parent is going to be used by the exempt parent for an unrelated purpose, the appreciation is going to be subject to tax at the level of the distributing entity, the for-profit subsidiary. Regulations under 337(d) are critical to this. My time has run out. The outline covers those regulations. They are very important to a complete understanding of this topic. One last, last comment. Perhaps it will become a “best practice” when one forms a for-profit subsidiary of a tax exempt to maintain a tickler that just before the end of three years from the end of the year in which that for-profit subsidiary is formed requires a judgment as to whether to attempt to cause that subsidiary to become tax exempt. This is the last moment to consider whether you really want to bury the assets that are then in that entity and for all time have them potentionally subject to a General Utilities upon distribution from corporate solution. Thank you. MS. McDOWELL: Let me just add one further thing on section 512(b)(13). Joe said that under the CARE Act, it would be diluted, and I am sure he didn’t mean for that to sound pejorative. We were just short on time. In fact, as people have reflected on 512(b)(13), they have realized that as long as the amount paid by the subsidiary to The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. fair value passing between a controlled entity and its parent. It could be a for-profit sub, and it could be another tax-exempt entity, a controlled tax-exempt entity that had unrelated business income. ABA Transcript MR. LUNDY: We are not getting around anything. I agree with that. I don’t know what the effective date might be going forward, but the last version that I saw would make this provision of the Act retroactively effective to December 31, 2000. MS. BJORKLUND: Thanks so much to Suzy and Joe. Sorry we are out of time, but I am sure they are willing to take your questions at lunch and during the break. So thank you for a terrific panel. Update From a task force of the Subcommittee on Political and Lobbying Activities and Organizations MS. BJORKLUND: Greg and Miriam, if your panel can come up before the lunch meeting? It is an “Update from a task force of the Subcommittee on Political and Lobbying Activities and Organizations.” I am going to let our co-chairs of that subcommittee, Greg and Miriam, explain to you what the task force is doing and what they are updating. MS. GALSTON: I am Miriam Galston, and to my right is Greg Colvin. We are the two co-chairs of this subcommittee. Beth Kingsley, our panelist, is one of the people actively involved in the task that we are going to describe to you. We are examining the relationship between 501(c)(4)’s and — rather I should say the extent to which 501(c)(4)’s can engage in political activity. And “political activity” is not a term of art. It is a word I just made up to cover a multitude of sins, which we will elaborate on in this 40-minute segment. The task force is going to, hopefully, issue a report that will summarize the existing state of the law on the kinds of political activities that (c)(4)’s can engage in, the standard for determining what is political activity for (c)(4)’s, and quantitatively the level at which (c)(4)’s can engage in such activities. In addition, we are going to examine the state of the law on the possibility of gift tax being applied to contributions to (c)(4)’s in certain instances. We have been working on this for a month or two. We have been helped by a number of members of our subcommittee. In particular, I just want to thank now Beth Kingsley, who is here, for her extremely well-argued, thorough memo, Rich Thomas, who couldn’t make it, Lloyd Mayer, and Barbara Rhomberg. Other people on our subcommittee have not yet produced results, but we intend to make sure that they will actively take part in this project. The reason we are focusing this year on this topic is because, one, there is so little guidance out there, precedential, non-precedential, anything you want to look to; and even more importantly, since BCRA and the pressure on soft The Exempt Organization Tax Review money in elections that BCRA imposed, the word on the street is that (c)(4)’s are going to be the recipients of an awful lot of money that has electioneering or campaign purposes. We want to, therefore, understand what are the situations in which (c)(4) organizations can be properly used as vehicles for political campaign activity as an alternative to the more highly regulated section 527 organizations. With that as an introduction, Beth is going to start by talking about the standard to be applied in identifying what activities will be considered political for (c)(4)’s. Then I will talk about quantitative issues, how much of whatever it is that Beth talks about can (c)(4)’s do. Greg will then move onto a proposal that we are talking about for a bright-line rule or a safe harbor in this area, and, finally, if people haven’t fled to the tables, Greg will also talk about where we are in the law of gift tax and how it applies to contributions to (c)(4)’s. Beth? MR. COLVIN: We do have a written progress report. Copies were FedEx’d. It arrived here just about 10:00. If you didn’t pick one up, it is up in the back. Jennifer can provide you with one at your table or chair. MS. KINGSLEY: I am going to attempt briefly, given the time constraints, to summarize or at least hit the high points or points of confusion, perhaps, in various legal standards explored that might define what is this political activity. I think that is a good term to use because it is undefined. It is not a term of art, and it is what we are trying to pin down. We do know that from the statute that (c)(4)’s — well, they must be operated exclusively to promote social welfare. The regulations tell us that “exclusively” means “primarily,” and further tell us that direct or indirect participation or intervention in political campaigns is not the promotion of social welfare. So that is the thing which may not be the primary activity of our (c)(4)’s. That language is obviously very similar to the prohibition on 501(c)(3)’s and their campaign intervention prohibition, which strongly suggests that this is describing the same set of activities. There is support for the conclusion that that is what the IRS has in mind. There is a Revenue Ruling 81-95, the point of which was to state affirmatively that, yes, (c)(4)’s may engage in political activities, so long as it is less than primary, but in getting there and in talking about what are political activities, it doesn’t really nail down the line, but points to some (c)(3) rulings and, therefore, again, strongly suggests that (c)(3) campaign intervention is (c)(4) political activity. I also think that as a matter of principle and for a variety of reasons, (c)(4) political activity cannot logically be broader than (c)(3) campaign intervention. In other words, if something is permissible for a (c)(3) as a charitable activity, it must necessarily be appropriate social welfare activity for a (c)(4). So I think that sets an outer limit on what we are looking at, and the question, of course, is whether that is exactly the definition that would be applied. March 2003 — Vol. 39, No. 3 377 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. the parent is a fair market value amount, there is no reason to penalize the parent. ABA Transcript Another factor that we have looked at as not actually defining “political” necessarily, but that which is not social welfare, is activities that promote private benefit, and it ties into our analysis to the extent the private benefit being furthered is a partisan interest. The key case that raises this point is the American Campaign Academy case, which was obviously about a (c)(3)’s status. The conclusion was that there was a substantial private benefit to the Republican Party, so that that organization could not qualify under 501(c)(3). MS. KINGSLEY: [Tape change; in progress] — in the private benefit of a party. It would also not qualify under (c)(4). This theory was put forward by the IRS in a proposed denial of (c)(4) status that was issued to Empower America, and they made an express statement there that the private benefit, which cannot be — more than insubstantial for a (c)(3) is the same — let me see if I — qualitative private benefit that may not be primary for a (c)(4). It is just a quantitative measurement that is different, which means that it is relevant to look at the operations of a particularly an issue advocacy organization. I find in going through — I think the Empower America case demonstrates how difficult it can be to apply this test, that it is — unless there is a historical connection to a party, as there was in American Campaign Academy, substantial funding from partisan sources, expressly partisan bias in statements or materials of the organization, it is very difficult to draw a clear line on private benefit that — because an issue — an issue slant, an advocacy group, is going to often agree with parties, but is also going to not always agree with them because a “political party” by definition is a broad entity, and it is going to be fairly easy for an organization as Empower America did to say sometimes we criticize Republicans and sometimes we agree with Democrats. Except, I think, in extreme circumstances, it is hard to really apply this, but it is something that I think needs to be brought to mind. To the extent there is private benefit and the advancement of explicit partisan interests being conducted by a (c)(4), that does not promote social welfare. There have been a series of letter rulings that stated that — these went from ’96 through ’99 — stated explicitly that the activities which are campaign intervention for a (c)(3) are the same thing that is political for a (c)(4), that may not be primary, and are the same thing which are exempt function for a 527. I think we have to read that as limited to the electoral context, but the idea is the same factsand-circumstances analysis gets applied. Some places where I find the reasoning of these letters to raise interesting questions for (c)(4)’s is it came out of private letter rulings. It was not an attempt to issue guidance for (c)(4)’s. To the extent it sheds any light on the (c)(4) question, it is only incidental to getting the answer — answer the question that was in front of the IRS at the time. One of the things I find particularly intriguing is the treatment of dual character activities, a grass-roots lobbying message that was conceded to have a legislative lobbying purpose, but also an electoral purpose. Communications may have several effects and may have several intents behind them, and because the organizations in those cases said our purpose is to influence elections, those dual-purpose activities were found to be a 527 exempt function, which leaves me wondering how is a dual purpose lobbying message treated if it is conducted by a (c)(4). I think that is an interesting and unanswered question. There is also a question raised by another facet of section 527 which is the 527(f) tax on certain activities, which is not exactly the same. It is not imposed on the exact same activities as are permitted to a 527 organization as its exempt function, at least under certain reserved sections of the regulations, the indirect costs of operating a PAC, a separate segregated fund, and activities permitted under the Federal Election Campaign Act. We have had discussions — I think there is question as to how far that reaches, those exceptions, but there is some set of activities that don’t trigger that tax when they are conducted by a (c)(4). Then the question is if they don’t trigger the tax, how do we count them for a primary purpose. I think that is also unanswered. There are competing interests, policy interests of consistency and simplicity of administration, and on the other hand, concerns about (c)(4)’s as being a conduit for soft money and the idea that political activities ought to be conducted out of these 527’s, that that is what has been set up as the appropriate place for it. Another thing we need to look at is the effect of section 527, which defines “political organizations,” and what is covered for a 527 organization is called exempt function activity. It is defined in some ways somewhat more broadly than “campaign intervention” in that it covers not only elected office. So there are some things that are political for 527 that are exempt function that are not campaign intervention for a (c)(3) and, therefore, presumably not political for a (c)(4). Finally, just really quickly, I think there is an argument that can be made that the Constitution requires a degree of clarity and certainty that has not been provided and that the facts-and-circumstances approach cannot provide and that certainly an express advocacy line does provide. I don’t know if that is the only place you can draw a bright line, but I think one may need to. There is still a question of how 527 relates to (c)(4) political activity as it applies to campaigns for elected office, which is an area of overlap. MS. GALSTON: Now that we know what it is that we are talking about, the question I am going to address is what does it mean when the statute says that a (c)(4) must be exclusively 378 March 2003 — Vol. 39, No. 3 The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. As a practical matter, for organizations attempting to apply it, it suffers from the fuzzy nature of the facts and circumstances test that the IRS applies, and for a variety of reasons, I think (c)(4)’s could raise more significant and serious constitutional concerns with the lack of definition there. ABA Transcript Two caveats. One is typically any authority that we have been able to find tends to discuss either the electoral activities of an entity or the private benefit activities of an entity, some of which could be political as well, and ask is it too much for the (c)(3) or the (c)(4) to be engaging in it. But when we turn to the question of whether a (c)(4) is properly engaged primarily in social welfare activities, we have to add together or aggregate in some fashion both the campaign activities of that entity and those that constitute a private benefit, if any. The second caveat is the usual one. This is all done under the facts-and-circumstances standard. So whatever number we come up with in this “how much is too much,” will have to then be determined through a facts-and-circumstances filter, adding, of course, to the ambiguity. I want to talk about three alternative measures for how much is too much. One, the obvious one is that primary means more than half, and, therefore, the non-primary stuff could be 49 percent. The consequence is that a social welfare organization will be properly exempt under the code if it engages 51 percent in social welfare activities and up to 49 percent in other kinds of activities — private, political campaign, political more generally. This is obviously the most permissive standard you can think of. It is good because it is the most flexible. The only authority that we know of for taking this position is a statement made by our very own Marc Owens once, standing on one foot, in 1990. As far as we know, there is no written statement that actually endorses that standard. That standard doesn’t actually square so well with the fact that it “primarily” is itself an interpretation of “exclusively.” So the pedigree of this standard, primary, might suggest that we ought to go for something lower rather than something higher. However, strong support for picking a 49-percent rule or something at the high end is the fact that there are constitutional free speech issues that are raised. In particular, I am thinking about what happened when there was a constitutional attack on limits on the lobbying activities of (c)(3)’s, and the Supreme Court, in upholding the code’s limitations on lobbying by (c)(3)’s, argued that it is always possible for the (c)(3)’s to engage in their lobbying activities through a (c)(4). So there is this wiggle room, using a (c)(4). on the record in legislative history of section 527 or parts of the 527 provisions that it would like all campaign type and other political activity undertaken by (c)(4)’s to be put in 527’s. There is some phrase like that is the appropriate place for this kind of activity to be. So I will leave it there. The highest possible standard or the most flexible standard for (c)(4)’s non-social welfare activity would be 49 percent. Alternatively — and this is the second model — we could import the (c)(3) standard which is applied, say, in the case of lobbying, which is that it not be — that the lobbying activities not be substantial and then, in this case, that the political activities of the (c)(4)’s not be substantial. That has some support that was mentioned by Beth in some rulings that seem to equate the rule for (c)(3) and (c)(4) purposes, that is, the prohibition in the case of (c)(3)’s and the limitation in the case of (c)(4)’s on electoral activity. There is support for this standard also in the proposed denial letter that was issued to Empower America, where the IRS referred to the existing standard vis-à-vis (c)(4)’s and political activity as not substantially benefiting the Republican Party or Republican politicians. The third option is something in between 49 percent and not substantial. What would that look like? Well, it could be anything, but for purposes of discussion, it would be a standard that permitted (c)(4)’s to engage in non-social welfare activity to a substantial degree as long as that activity were incidental to its primary or exempt purpose. The only authority for this standard also comes from the Empower America proposed denial letter, and I won’t go into that. The strengths of that on a policy basis is that it is flexible. It seems more in accord with the actual statutory language that a (c)(4) should be engaged primarily — or rather exclusively — in social welfare activities. The weakness is that, in an area that is populated largely by vague and indeterminate standards, the kind of intermediate standard that I am suggesting would stand out as a candidate for first place. So it would be difficult to administer, difficult to even talk about. A second problem is that, if you look at the Empower America letter, which is the only authority for having some kind of intermediate standard, you see that the IRS was talking about an intermediate standard in the context of non-social welfare activity that was not electoral. It was private benefit, but not electoral. So there is a possibility that the IRS would be prepared to be more lenient on non-social welfare activity that was purely private benefit, but not electoral, than it would be for 501(c)(4) activity that was electoral. Now I am going to pass the baton to our patient member of our committee, Greg. I wonder if in the context of political activities, campaign or other political activities, there would be constitutional problems. If the (c)(3) can’t do it, the (c)(4) can only do it to a very limited degree. So that is an objection to having a lower permissible amount of political activity and in favor of having a higher one. I am going to have to really summarize my remarks before they are drowned out by the clatter of dishes and the rumbling of stomachs, including my own. An objection — since I am a teacher, I like to object to my own objections — is that Congress explicitly has gone What I would like to address is, first of all, to get a clear view of what is happening here, what is at stake for the The Exempt Organization Tax Review MR. COLVIN: Thank you. March 2003 — Vol. 39, No. 3 379 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. engaged in social welfare activities, which has been interpreted as “primarily.” The authorities that exist — whether they are precedential or not or commentary by practitioners or academics — tend to focus on the negative or not-social-welfare side, which we have been calling political for the purposes of this panel, and that is what I will do, too. ABA Transcript There are many organizations that claim (c)(4) status. Some of them are health-related HMO-type organizations. Some of them are just organizations that didn’t want to be private foundations under (c)(3), so they chose (c)(4) status. What we are concerned about here is organizations that have a huge advocacy component. Many of them are familiar names, Sierra Club, National Rifle Association. There are other large organizations like the AARP, the League of Conservation Voters. These organizations will be affected by these marginal questions of what is political and what is not and how do we measure it because if you fail to be a (c)(4), then what are you. The classic Revenue Rulings and cases that have looked at too much private benefit were ones where the (c)(4) was caused to be a taxable corporation, and it lost its exemption on its end-of-the-year surplus, although it didn’t lose the benefit that a (c)(3) would lose if it were not exempt; that is, the access to deductible contributions. In the case of a (c)(4) that is too politically active, what you lose is your (c)(4) status, but then you qualify as primarily political and you fall into section 527, but 527 is quite odd and potentially draconian because being a 527 means a lot of things. One is that you have a 35 percent tax you pay on your investment earnings, but also you now have to disclose donors and recipients of expenditures, and you have to file a notice of status that you are a 527 within a very short period of time. If you don’t do those things and you haven’t done those things because you thought you were a (c)(4), then the taxes really pile up on you, and they pile up in increments of 35 percent, which multiplied times three exceeds 100 percent of what your revenues might be in a year. So it is important to maintain the (c)(4) status, but in maintaining it, in meeting a primary purpose test, this balancing between what is primary and what is secondary is one that can be tipped by very small expenditures. Two percent can flip you from 49 percent to 51 percent, and that is why this area that we are examining is so complex and one which really would benefit from rules that are clear, that have integrity, and that classify activities in a manner that meets a common-sense view of what is political and can be understood by those who are filing tax returns. There are also important donor expectations at stake. If you are a donor to a 527 organization, you can expect that you won’t get a tax deduction, that your contribution will be entirely used for aggressive political activity, and you will be personally disclosed and potentially famous. If you give to a 501(c)(4) organization, you can have the sense that your contributions might be used up to 49 cents on the dollar, one might suppose, for political activities, but you will not be disclosed. Your privacy is protected. 380 March 2003 — Vol. 39, No. 3 Now, of course, that expectation runs into serious trouble if the organization you gave to fails to qualify as a (c)(4). So, in our effort to find bright lines here, the question is what do we measure, and we look to a very recent successful example of measuring First Amendment speech activity and that is the 501(h) expenditure limitation on lobbying that is made elective to those public charities that wish to be governed by it. We are leaning toward recommending something similar here, that some percentage might be selected well below 49 percent, such as 40 percent, that that percentage be based on total annual expenditures and that very careful work be done to allocate fund-raising and administrative expenses which could go either way and which, if they are not allocated properly, again, could tip you from 49, 51 one way to the other way. All of that seems fairly straightforward and, of course, leads to a lot of interesting planning opportunities such as what do you do in the last month before your year closes in order to make sure that you have got enough social welfare activity to meet that expenditure standard. However, we do have trouble with consistency with 527(f). In the interest of time, I will just use one example to illustrate that difficulty. One of the things that 501(c)(4) organizations do is they engage in member communications, which may be quite partisan; that is, a 501(c)(4) organization could send out to its members a slate card of those candidates for public office that it supports or it doesn’t support. Now, that activity would seem to us to be thoroughly partisan. It certainly would fail to meet a 501(c)(3) intervention standard if a (c)(3) organization were to send such a slate card to its own members. However, the regulations under 527(f) differentiate between taxable and non-taxable political expenditures. Section 527(f) is that piece of 527 that says a 501(c) entity that pays for a political expenditure will have to pay a 35 percent tax on it to the extent of its net investment income. That is because the congressional preference was that political expenditures be off loaded into a separate segregated fund (a PAC). There are exceptions to that, and one of the exceptions where the 527(f) tax does not apply, the investment income tax does not apply, is member communications. There are a few others that are similar: paying the administrative expenses of a PAC; the staff costs; or paying the fundraising expenses of a PAC. We allow 501(c) organizations (except charities) to have those kind of expenditures, and even though they are eminently political, tax is not imposed on them. Well, in the situation here, one of those kinds of expenditures, if we follow the same principle as 527(f), could become a very large component of the expenditures of the 501(c) and combined with its issue ads, its contributions to candidates and so on comprise, in fact, much more than 49 percent of total expenditures. So, in that sense, it would violate our purpose here, our policy purpose, which is to ensure that somehow the dominant purposes of the organization and its activities are not political. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. organizations and their donors when we are looking at these questions of what kind of bright line for measuring political versus non-political or social welfare versus non-social welfare activity — is being examined. ABA Transcript Turning, finally, to the issue of gift tax, this is a real puzzle. This is one of the issues where after every time I speak on this, somebody — usually it is someone highly placed like Ken Kies who was counsel to the Senate Finance Committee — comes up to me and says what you said can’t possibly be true, which leads me to believe that it must be inherently unconstitutional and not successfully challenged through all the circuits to establish that or there must be something in the theory of gift tax that would really, if it were thoroughly explored, lead a court to conclude that the gift tax was never intended to penalize people who make gifts to (c)(4)’s. If you make a gift to a (c)(3), you are free of gift tax. If you make a gift to a 527 political organization, you are free of gift tax. It is only when you give to the intermediate 501(c)(4) that you are potentially — and I don’t mean just potentially, under a Revenue Ruling issued by the Service 20 years ago, 82-216 — subject to gift tax, which if you have given more than your $11,000-a-year annual exclusion and also given more than your million-dollar unified credit, and believe me, there are people who are in that place, you have had to pay rather quickly a 55-percent gift tax amount as the level of the tax rate increases. That, you might say, has the positive policy result of forcing people to choose between thoroughly non-partisan (c)(3) activities and thoroughly political 527 activities, but with disclosure. Here are some interesting things that we found about gift tax, and without a clatter of dishes, may I take a — MS. GALSTON: Yes. You have about four minutes. MR. COLVIN: Four minutes. All right. Here are some interesting things that we have discovered in our research on gift tax. Probably the one that shocked me the most was to learn, as we dug into it something that I wish I had focused on before because of its significance. The gift tax is the responsibility of the donor to pay in the first instance under 2502(c). It turns out the recipient 501(c)(4) organization is secondarily liable of the donor fails to pay, and the IRS can assess the gift tax against the recipient for up to a year after the statute of limitations expires for the donor. So this is potentially a (c)(4) recipient problem and not just a donor problem. It has always amazed me that even if the IRS were not enforcing this particular application of gift tax that some adversary in the ideological wars between (c)(4)’s and 527’s The Exempt Organization Tax Review hasn’t picked this up and used this to cause great difficulty for the other side. Perhaps it is like mustard gas and no one wants to touch it because it could backfire. Let’s look at some of the issues that come up to indicate to us maybe there is something wrong with the picture. There are, in fact, in addition to the IRS Revenue Ruling in 1982, court decisions back in the ’40s and ’50s where the IRS did pursue gift tax on gifts to (c)(4)’s, and they were upheld in the courts in three cases we were able to find. However, more recently in the ’60s and ’70s, the Stern and Carson cases were decided. The Stern case seemed to indicate that in the case of a gift to a (c)(4), the definition of a “gift” being a transfer made without full and adequate consideration, that maybe there is consideration, and the consideration is either that the donor expects to benefit from the outcome of the advocacy or that the advocacy is really a service performed for the donor. If the Service were to take this approach, large donors would move away from a donation agreement, to service agreements with their recipients to indicate they were getting a quid pro quo for the amount that they were paying. The Carson case suggests that there is something on a policy basis that is not really right about applying gift tax to these transfers. There is some attention that we are giving to a particular Treasury regulation — I won’t give its number because it is in our progress report — that indicates that maybe gifts to (c)(4)’s can be argued are in the ordinary course of business as a bona fide transaction at arm’s length and free from donative intent, the theory being that when the donor desires to participate in the political process or to affect public policy, that is something by definition free of donative intent. It is different than leaving money to your children or to your friends. I should finally say that where we are thinking of coming out on this is to recommend to the Service that there basically be a moratorium on the gift tax that is not being enforced anyway. That is, Revenue Ruling 82-216 be withdrawn for further study, given all of these concerns, and in the meantime, the Service will not treat these gifts as taxable. MS. BJORKLUND: Well, on that, I want to thank this task force for your hard work. You have now had a flavor of what they are doing, and if you are interested in giving them input, please do contact them. I am sure they would be very interested to hear from you, and we thank you for this progress report and look forward to getting your full report. I am sure the Service does as well. Thank you. To lunch. Thank you. That was very useful. [Applause.] [Luncheon break.] Update from the Form 1023 Task Force MS. ADLER: I would now like to turn over the panel microphone to Eve Borenstein and LaVerne Woods for an update March 2003 — Vol. 39, No. 3 381 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. So, there may have to be in a safe harbor, let’s say, of 40 percent, a departure from the 527(f) standards, to basically say, look, if you want clarity, if you want certainty that the IRS is not going to challenge your (c)(4) status for excess political activities that all of what is political under the 501(c)(3) intervention standard, all of what might be private benefit to a partisan interest must be kept less than 40 percent on an annual basis, and we know that is a different standard than 527(f), but that is what you have to adhere to, to get the safe harbor. ABA Transcript MS. WOODS: Thanks, Betsy. I am LaVerne Woods from Seattle, and in the interest of time, each of our panelists today will be introducing him- or herself. The IRS issued Notice 2002-92 in October, just a fraction of a day prior to our October meeting in Los Angeles. That notice asked for comments on a new draft Form 1023 that was released with that notice. There is a draft of the form itself. There is a new draft of instructions, and there is an all new draft of an overview that precedes the instructions in the package that the IRS released in October. As Victoria described this morning, we had a panel in October which provided some very initial feedback to the IRS on that draft, and then a hastily convened task force was put together which Eve and I co-chaired. A large number of people devoted a great deal of time on very short notice in the fourth quarter of the year, particularly over the Thanksgiving holidays. I simply want to say thank you and commend all of those who participated in this project. There was a lot of hard work. We submitted our comments, 50 pages of comments which are in today’s packet, on the due date of December 2nd to the IRS. I received this week an update on the status of the IRS’s project from Cindy Westcott in the Cincinnati Center. Cindy is the leader of the EO Determinations Customer Satisfaction team that has heroically undertaken this very herculean project. I understand from Cindy that the IRS received some 20 electronically submitted sets of comments and in addition some unnamed number of hard-copy comments. At this time, I understand that the IRS is in the process of consolidating and collating those comments into a single working document, separating those into comments on the instructions and comments on the form itself, and will soon be taking up the challenge of combing through those comments. It is my understanding that to date there has not been any substantive review of those comments. In October, we were told that the goal for the new Form 1023 was to have it in final form and active in fiscal 2004. I asked Cindy whether that was, in fact, still the goal. I am told that fiscal 2004 is the goal, but I also understand that there may be some delay. So take that for what it is worth. MS. BORENSTEIN: Let the record show that “There may be some delay” is in quotes. I wanted to express appreciation and kudos to the IRS’s Rulings and Agreements Branch, especially the Customer Satisfaction team that was led by Cindy Westcott. And Steve Miller this morning told us that she is now the area manager for half of the determinations in the country. 382 March 2003 — Vol. 39, No. 3 Her team took the initiative. You may remember we met Cindy Westcott here at the EO Committee in May of 2001. We got this nice behind-the-scenes, what they are doing in processing the existing form. Past there, they took the initiative to try to satisfy customers and make the determinations process livable by trying to redo the form. They were certainly encouraged by the Advisory Committee to TE/GE’s emphasis on this area and obviously strongly supported by both Lois Lerner when she came into Rulings and Agreements as well as by Steve Miller. You know their titles, so we will leave them unmentioned. The tasks that they were able to accomplish in a relatively short period of time in 2002 in drafting a full revision of the 1023 and its instructions has really been an amazing one. We as a group — obviously, you will see this if you read the submission — commend their output. We not only strongly commend the output, the draft itself, but also the public review that it has engendered. Steve Miller this morning promised that public review will continue; that there will be a second bite at the apple as they update what that process and revision — the new 1023 — might look like. They have transformed the present 1023 and instructions to something that much more closely approximates plain English. We believe it will indeed alter the process that applicants engage in to be one that provides access and, more importantly, valuable education about (c)(3) qualification to applicants. In the time we have today, our panel is going to attempt to highlight some of our comments that you would see in the submission, and some other arenas that we thought worth mentioning that fall outside of the 1023 revised process as presently contemplated by the Service. We think those areas might be useful in trying to advance the revision’s goals, which I should state we thought were three-fold: (1) clarifying the application process so that users better understand the process itself, are better able to complete the form, and, in fact, are better educated as to the (c)(3) qualification rules they will need to comply with on an ongoing basis, assuming that they are appropriately determined to be (c)(3). (2) The second goal of the revision process is dealing with the paper influx that the Determinations Unit has been avalanched under, facilitating a much more expeditious handling of the application from a paperwork perspective, both receipt and review. (3) Most importantly — or at least something that ties back to the first goal of the substantive review process for the exemption application being more effective — having the Form work to ferret out common potential disqualification arenas, and more appropriately directing for additional scrutiny and review and communication with applicants the areas that have raised some concern and need with respect to educating applicants. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. from the Form 1023 Task Force, and they will introduce the panel. ABA Transcript MS. WOODS: Thanks, Eve. I wanted to follow up on the expressed goal of enhancing the educational aspects of the Form 1023 and, in particular, for new and smaller organizations that don’t have the benefit of representation by a legal counsel or accountants who are expert in this area. In particular, I would like to make a few observations about the new overview section that was added and that precedes the instructions in the new package. I think it is a very valuable element of the new overall package. It does, however, clearly reflect that tension that we all face every day, the stress between the need for plain language for their particular audience, I think for this overview, and the great challenge of using plain language and at the same time being technically accurate. One of the things we tried hardest to do in our comments was to identify those places in the overview where that difficult line to walk seemed to result in a slip to one side or the other of the plain language/accuracy tension. One of the areas where it seemed to be the biggest problem in the new overview section was, unsurprisingly, in the private foundation/public charity distinction. This is unsurprising to us because, frankly, the stuff is devilishly complex and quite a challenge to explain in plain language. The overview as drafted gave the impression that all 501(c)(3) organizations were subject to the public charity rules. We made some suggestions regarding further bifurcating the discussion of the two categories. I noted in reviewing the submission on the Form 1023 that the AICPA made that they went a step further, a step I would personally endorse, which is a recommendation that there be a Form 1023 and something like a Form 1023-PF. Plain-vanilla private foundation applications are fairly simple and don’t require much of what goes into the public charities’ side. In any event, we hope that the form as reconfigured will, from an educational standpoint, clarify that distinction. I would also hope that perhaps the form itself can be bifurcated in a more meaningful way that would also simplify the application on the private foundation side a good deal. MS. FRANKLIN: For those of you on tape and those of you who haven’t noticed me running around the meetings, I am Jennifer Franklin from New York. I am going to talk a little bit about the impact of the revised Form 1023 on small, newly formed organizations that are seeking 501(c)(3) status and may not be familiar with the rules or as familiar with the rules as we would be. From a positive perspective, I think, as LaVerne mentioned, the overview is quite detailed and does go into a lot of helpful information in certain topic areas, and I think also the instructions are also quite detailed. So, when you are answering the questions, I think that an applicant gets a lot The Exempt Organization Tax Review of background information that may help them answer the questions more easily than would be the case with the current Form 1023. I also think because the questions in the revised Form 1023 are more detailed, there is a whole section of just like yes-and-no questions, that there may be less need to go into supplemental inquiries with new applicants and go through rounds of correspondence which may presently be the case with the current form. Also, as LaVerne mentioned, because the overview, the instructions, and the questions are so detailed, I think the 1023 application package, as we have seen it in the revised form, could be a very good educational tool for small, newly formed organizations, both during the determination process and then afterwards, and I am going to make a few more comments about that in a minute. On the, I guess I would say, less positive side, I think that many of the questions that appear on the revised form really do need to be read together with the instructions in order to fully understand the question, and you may have someone who is not a practitioner or is just a volunteer for an organization that is trying to quickly fill out the form and they will think, “Oh, I don’t need to read the instructions really. They are really long. I don’t want to take the time.” They will try and kind of breeze through the questions without reading the instructions, and they may miss some of the nuances of the questions. For example, I believe there is a question about Internet activities that says do you conduct any activities over the Internet, and if your organization has a Web site, they are going to say yes. Well, if you read the instructions, it says if you only maintain a Web site to put up information about your programs and activities and you are not really doing anything over that Web site like selling goods or services, et cetera, then you don’t need to answer yes to the question. So that would be an instance where the organization answers the question yes when the organization really isn’t involved in the activity that the IRS is seeking to find out more information about. One solution to this that we did, I believe, mention in our submission was that it might be helpful in certain areas to print the instructions or part of the instructions with a question. I know that makes the form a little bit more lengthy, but I think it might be helpful for small, newly formed organizations. Another comment that I see when you look at the revised Form 1023 is certain of the questions speak to activities that maybe in the future that a small, newly formed organization just has no idea what they are going to be doing in the future, and in certain areas like fund- raising and gaming activities, they ask the percentage of the organization’s total time to be devoted to an activity. Small organizations are going to have absolutely no concept or any idea of how much time they are going to be spending on these type of activities. So it is, I think, a little hard for them, very difficult for them to even allocate any percentage to that, and they may want to be doing fund-raising, but they may think, oh, if I put 10 percent, March 2003 — Vol. 39, No. 3 383 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. So having done our introduction, we are each now going to take no more than five minutes to stay on schedule and give you these highlights. ABA Transcript So I think certain of those questions are just kind of almost unnecessary to have in the form, especially for a new organization. I think that it just causes more confusion when you are trying to fill out the form. I wanted to talk a little bit about the organizational test because, as you may be aware, there is a more detailed section regarding the organizational test in the revised form than there is currently, and I think that it is a helpful improvement. Two of the requirements of the organizational test to be a Section 501(c)(3) organization are clearly laid out in the form. However, I think that there are certain other requirements of the test that are not there. There is no mention of private inurement. Usually an organizing document needs to prohibit any private inurement or private benefit, and I think there is also no discussion of any limitation on political activities, which is another provision that I believe the IRS would want to look for when they are examining an organizational document of a potential 501(c)(3) organization. LaVerne had mentioned before and I am going to talk a little bit more about the educational impact of the revised Form 1023 both during the determination process and following the determination process. I think as I mentioned, because the overview and instructions and questions are more detailed, an applicant does get more of a background in the rules and requirements that their organization will have to comply with on a going-forward basis, and I think in certain respects, it is better to have a more detailed overview section. It might eliminate the need to consult other IRS publications. I would think if you are running a small organization and it says consult publication 557, publication 578 and you are getting all these other documents you have to look at that are quite lengthy, it might be better to have everything that you really need in one section. That being said, I think that sometimes too much information can be very overwhelming, and I think as LaVerne mentioned, there are certain aspects of the current overview section that can be a little overwhelming. For example, there is a very detailed discussion of excess benefit transactions and kind of a primer on, I would say, public charity law with no mention of any of the private foundation excise taxes, and for certain small organizations, they may be looking for that kind of guidance. MS. FRANKLIN: [Tape change; in progress] — could be used as educational tools that are not emphasized as much in the overview and the instructions. For example, I think that the discussion of the 501(h) election perhaps could be elaborated upon, so that there is a little bit more information. I believe that there is not a whole lot of description in the overview and the instructions on this point. 384 March 2003 — Vol. 39, No. 3 Also, as LaVerne mentioned, the types of public support tests, I think, are — you know, it is very complicated, and it is probably difficult to put them in an overview, but perhaps a little more detail would help a new organization, especially when an organization has to actually comply with those tests on a going-forward basis. That brings me to the five-year advance ruling period. I don’t think there is much of a discussion of that in either the overview or the instructions, and that is something that I find that small, newly formed organizations just — it is a very hard concept for them to understand, and even the lawyers I work with who I supervise on pro bono projects seem to have the same experience. They don’t know what a five-year advance ruling period is, and I know we have had pro bono clients that have come back to us after five years when they get their Form 8734 and they are panicked because they have no idea what to do with the form. And I think it might be nice to have something in that overview or the instructions that kind of explains you will get this form in five years and this is what you do with it. Just as a last point, which I think Eve is going to discuss in more detail, the financial budget portion of the 1023 could be a great stepping stone to filling out the 990, but there are certain, I think, revenue and expense categories that do not match up between the two forms. So you kind of get in your head one idea of what types of revenues and expenses should be categorized in a certain way on the 1023, and then you go to fill out your 990 after a year of activity, and you are learning the system all over again. So I will pass it to Eve. MS. BORENSTEIN: Well, we couldn’t have planned that segue better if we tried. My way of hitting my five minutes is going to be talking extremely fast. I have three points. I am going to start with the most boring and get to the most interesting. The most boring is the financial presentation. Our submission says — it makes an extremely forceful point — that the 1023 should use a consistent financial presentation format to the 990, that we should use the revenue categories on the Form 990 because, quote, “it would be extremely helpful to applicants to be introduced to revenue categories that most exempt organizations are required to report upon,” end quote or duh. [Laughter.] MS. ADLER: Let the record reflect that that word was “duh.” MS. BORENSTEIN: The 1023 format presentation for revenues continues to use a framework that basically — I don’t know if I am allowed to say this — bastardizes the support schedule. It is not the same, but it is close, and we obviously have compelling reasons of simplification and the fact that the support test is irrelevant to many applicants to end this bifurcated or trifurcated scenario in which organizations in The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. I am going to be held to the 10 percent, if I put 50 percent, et cetera, et cetera. ABA Transcript On the opposite side — the expense presentation — it is still the case that the 1023 doesn’t use the same categories as the Form 990, and we suggest it do so partly to avoid the need for the additional attachments that are almost always required since the most common areas of expenses are not availed of on the 1023, thus forcing applicants to use attachments. That was my boring point. Now one that should be nearer and dearer to many of our hearts, you’ll find our submission does say that the IRS should protect signatures from disclosure. The 1023 is a document available for public inspection. Our submission says signatures upon the 1023, upon the 2848, and upon the check that is presented for the user fee all should not be disclosed. We can’t ask the IRS to change the law. I guess we could ask, but it doesn’t work. I have a quick anecdote which is that a very large client of mine a number of years ago got $202 million, and I did their exemption application. They hired a lot of consultants, including one to design their Web site, upon which they would post their 1023 as a method to meet their public inspection requirement. So I go to their Web site, and I am a little puzzled to see Form 2848 as the link and not Form 1023. Well, the consultant had shuffled the public inspection copy, and my power of attorney landed on top. So that is how they ID’d the link. When you clicked on it, the first thing you saw was my CAF number, and the second page showed my signature and, of course, my client’s signature. The second part of this anecdote is that this fall, my office ordered for a client a public inspection copy from the IRS because my client didn’t have it. We paid the 15 cents per page. . . . Actually, this one was free. If it wasn’t my client, I would have had to say it was for commercial purposes and paid. When it came six weeks later, a copy of their 8718 was included, which had a copy of their $500 check. My client had recently paid me. The photocopy of the check from 1996 proved to be a check that was exactly identical to their current check — having the same account number at the same bank and the same authorized signer. I relay these anecdotes to emphasize privacy concerns; it is imperative that we get the word out that signatures and checks should not be out there. When Steve Miller talked this morning about the imaging that they hope to do for the 1023’s, allowing them to be burned onto CD-ROM or otherwise posted by the IRS, it highlights the problem that public inspection of 2848’s and 8718’s, and the new user fee attachment to the revised 1023, will bring regarding visibility of signatures. A personal bone of contention here is that I don’t want people copying my signature, or calling into the IRS with my CAF number. The Exempt Organization Tax Review The third point I wanted to make is that in trying to have the process of the form completion be more educational and more expeditious for the IRS processing, there is much more detail. There are 20 more questions added to the form that, in some ways, provide an inadvertent road map to the potholes that groups need to avoid to properly qualify under (c)(3) in the current climate. I think we are allowing groups to position themselves to avoid those potholes in one of two ways. Either they can apply prior to having fully initiated activities without any malice on their part, and not hit the potholes because they are not doing any of these things. Alternatively, since it is so clear that the yes answer is going to raise more questions, an applicant can just pretend that they won’t do that and wishfully check the no answer. In light of the kind of public imaging of 1023’s we can expect, and the lack of exam resources, which we all know is part and parcel of the mix here, I am concerned that this revised process will highlight disparities between what the exempt organization sector is saying they are going to do and what they actually do. I want to mention the AICPA submission — we had 45 copies in the back of the room this morning, and I think they are all gone now. In the interest of fair disclosure, I also worked on their submission. They tackled this problem by suggesting a universal advanced ruling process occur whereby the (c)(3) sector would be applying for a quick letter for most entities that met the organizational test and the appropriate prohibitions, the ones that are required in organizing documents, but then the harder questions which we support as being appropriate questions to ferret out areas of common non-compliance would be asked on an ongoing basis as the organization conducts its activities in its first few years. This would occur by having each year those questions be answered, perhaps attached to a Form 990, so that the forum of public transparency was also watching. Then, at the end of a set period of time, perhaps five years, the organization would get a final letter assuming that there were not further areas of inquiry, or if there were, perhaps through a correspondence audit or other determinations exam intersection based on the fact that the answers they gave as they became more operational tripped some of those areas of sensitivity. So that is food for thought I think we need reflect upon — whether some sort of check in the earlier years of an organization’s operation is appropriate or better, and also whether we could use a 1023-EZ for smaller organizations. MS. WOODS: If I may for just a second, I would like to follow up on Eve’s second point on the privacy concerns. One innovation in the Form 1023 that I think is a very positive one is that it gives organizations the opportunity to effectively, as I see it, get an unusual grant ruling in the context of the application. However, there is a series of questions concerning the putative unusual grant that asks for, among other things, the identity of the donor, which if this is going to be subject to public inspection seems to run March 2003 — Vol. 39, No. 3 385 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. their first four years, assuming they have already used up a year in their advanced ruling period, have to do three different revenue presentations — one on the 1023, one on their 990’s annually, and one on the 8734 — in filings with the IRS. ABA Transcript MR. CLARK: I am Michael Clark from Chicago, Sidley Austin. I wanted to highlight a couple of areas that as you are going through the form that we noticed were substantially changed from the current form and led to some questions about what exactly does the IRS want this extra information for and is the requesting and obtaining of this information going to increase the efficiency of the process or instead lead to both the IRS and our clients being bogged down. So I want to just highlight a few of those and some of our reactions to it. One thing that stands out quite noticeably is the IRS wants to know a lot more about the relationships between the people that have a governance responsibility for the organization instead of just the name, rank, and serial number and a few kind of general questions, some of which I never quite figured out why we had. I really didn’t care whether a Government official appointed somebody to the board. That didn’t really come up in my practice very often in 20 years. Anyhow, they have honed in on who the folks are that are governing the organization. So we have much more detailed questions about relationships between the party, between the parties on the board, compensation, contracts with people that are in a governance function, and a kind of obscure question about substantial influence of the folks on the board with respect to related organizations. One of the questions that we raised in our submission about some of this information is, first of all, they were asking for things like job descriptions and résumés for anybody that was compensated, and with new organizations, that is frequently something that is pretty much up in the air. So we are a little bit concerned that the IRS is asking for a bunch of additional information that then really isn’t going to be terribly useful to them in the process. One of the other points that came up along the way also is the question that we — at least I have certainly encountered. In sitting around the table last night, it seemed to be a common experience that the IRS is still fairly confused about what to do with related persons on a board of directors. Certainly, in the private foundation context, that is not out of the ordinary, but it is also not impermissible for a public charity to have related persons on the board of directors, and yet, a determination specialist continually comes back with the question demanding that you put outsiders on your board. That, with all due respect, . . . just isn’t the law. So we are hopeful that if the IRS, indeed, goes forward with the form with these kind of questions, that at least we have some training for some of the determ specialists so that we will actually, hopefully get intelligent use of that information rather than additional questions about control that really shouldn’t be asked. 386 March 2003 — Vol. 39, No. 3 The other thing that comes up is there is this kind of question with related parties, how did you resolve conflicts of interest in compensation. Well, you know, when you have a related board, you try and make the compensation fair, but you don’t really ever resolve the conflict. It doesn’t go away. It was there, and you did your best to deal with it. Again, there is a rather detailed request for an explanation which I think struck most of us as being more information than the IRS really needs as a general rule. Another question where, again, we had some concerns, in the specific checklist of questions there are several questions asking how much time the organization spends doing certain things. The question we all had, why are they asking that? For example, there is a question asking what percentage of time is spent on fund-raising, percentage of time on gaming, unrelated business, non-exempt activities. All of those are things that the IRS needs to know if you are going to be doing those activities, but it struck us that, first of all, in the determ process, it is going to be a very rare organization that you could intelligently evaluate whether there is so much of that activity going on, a non-exempt activity, for example, that you would worry that the organization wouldn’t get, be entitled to exemption at all. Again, this is something that I think needs perhaps some additional education as the process proceeds to either hone down those questions or make sure that they are used wisely. Another area you will see is information on the intellectual property of the organization. That is a specific question wanting to know who owns the copyrights and intellectual property rights. That certainly is a good question and one that I don’t have any qualms about having it on the application. I think it is a good idea to have that disclosed. However, in my experience, I once had a determs specialist tell me that because somebody on the board of directors had prepared the religious education materials and hadn’t relinquished the copyright — she wasn’t charging for them, but she had prepared them and technically owned the copyright — that the organization couldn’t possibly be exempt in that situation. It seems to me there is a fair amount of confusion within some of the people doing determs on the questions of how intellectual property ownership relates to the possibility of having exemption. Anyhow, those are some of the hot buttons that I noticed, and, Lauren, I think you are up next. MS. MACK: Lauren Mack from Foster City, California. I guess I have three things to talk about, mostly practical, especially the first two. The first thing I wanted to comment on was the new draft 1023 does consolidate both the user fee form and the waiver, 872(c) waiver, into the form itself, which I think is a great simplification and makes life easier. In putting the comments together, we identified some other forms that could also easily be at least included in the package automatically, if not built into the form itself. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. contrary to all other practices with respect to donor identity. So that is another item that both our submission and the AICPA submission commented on. ABA Transcript MS. ADLER: They have told us they can’t bind it into the form because the 5768 goes into a different database that is kept in Ogden and isn’t processed as part of the 1023, but certainly they could include the form in the booklet and say send it there, which would be a great boon to the smaller organizations. MS. MACK: Two other forms that fall into sort of the same category of it would be nice to see them included in the package, even if they are submitted separately. Obviously the 2848 power of attorney is submitted with the 1023. So that is an easy one to leave in the package. Then the third form was the SS-4 for those organizations that haven’t applied yet. The next thing I want to comment on very briefly is they have retained the magic question, are you going to do bond financing, and it looks really easy like a yes-or-no question and you get to the instructions and they say by the way, if you check yes, who is going to issue the bonds, how many bonds are you going to issue, and send us your offering document. Chances are extremely great that the organization will not know at the time it forms its 1023 who its issuer is unless they have already made arrangements. Most organizations have a choice of issuers. They might have an idea of the bond amount, but they certainly will not have written an offering document. I think the Service needs to sit back and take a look at what their concerns are and is there a better way to get the information. This, you may recall, built out of the nursing home conversions and financing abuses that they found in the late ’80s. It is a leftover question. I think it is just impractical, and they are not going to be able to get the information they are looking for anyway. The last thing, just to comment briefly, is in general how the new package might affect health care organizations, and I think in general most of the changes wouldn’t have a dramatic impact. I think health care organizations might be more likely than others to have more sophisticated counsel, at least either an accounting firm or a law firm they are working with. So I think they get more help. Two things. One helpful thing is the changes to the supporting organization Schedule D now correctly asked the right questions for a parent in a health care system, but, on the other hand, I think Schedule C needs some further work. You will see some specifics in our comments about it. It is drafted very well for an acute care hospital, but many of the health care organizations going in today are not acute care hospitals. They are clinics. They are physician practice groups, and the questions are not designed well for those organizations even after you read the instructions. The Exempt Organization Tax Review I will turn it over to Betsy. MS. ADLER: Well, being the last speaker, I will speak really, really quickly. The intellectual property question is one I just want to highlight again. Mike mentioned that. Most newly formed organizations who are represented by people in this room and our ilk will be getting advice in the formation process that this is an issue they should think about: will they be creating what lawyers call intellectual property, who will own it, who will use it? We will alert them to the possibility of legal issues requiring an intellectual property law specialist to help them understand what their opportunities are, what the pitfalls are, and how to deal with them. We were told this morning that for the 80 percent of applications that are not filed by the likes of us, chances are that those folks will not even think about this issue. So the presence of a question in the revised proposed 1023 is a good way to bring this to the attention of those folks, that maybe there is an issue here, that this is something they should think about. That said, in our comments we suggest some alternative language for asking those questions that we hope will focus the attention of anyone filling out the form on the possible inurement and private benefit issues that should be guarded against in structuring intellectual property ownership and intellectual property transactions. Turning now to Form 8734 and the advance ruling process: in our dreams that whole process is abolished or at least streamlined. Whether that is a pipe dream or truly possible, your guess is as good as mine. I am not optimistic. However, I think we can realistically hope that the process will be made more user friendly and clearer, so that the grassroots groups who get their five-year letter don’t suddenly think that they are about to have their exemption revoked, which they all do. They all come in practically in tears saying aren’t we going to be a 501(c) anymore, and we say no, no, no, that is not what the IRS is asking. In the course of revising the various standard form letters that I know Cindy Westcott and the Customer Satisfaction team have been working on, our hope is that they will fold that kind of public education into their new documents so that the organizations don’t see that letter as a threat to their very existence. The AICPA in their comments proposed a whole different structure for this. They suggest that organizations could get a universal advance ruling, a UAR, that would be pretty much of a pro forma, but then every year on the 990, they would be answering a lot of questions. After five years of filing a 990, they would get a real ruling when the Service has actual information about the money that came in and the activities that were conducted. Again, is that eminently sensible proposal likely to be reality? Who knows? Watch this space. We will be talking about it as the years go by. I think it is also possible that as the 990 becomes a more interactive and electronic document, revisions to the 990 March 2003 — Vol. 39, No. 3 387 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. The first one would be the Form 5768 for the 501(h) lobbying election. I think Jennifer mentioned doing some more education about making that election, but from a pure mechanical perspective, perhaps they could either put a check-the-box item in or, again, just simply automatically include that form. ABA Transcript I really hope that to the extent that we move toward an interactive application process, the Service will be able to use that team Steve spoke of this morning that is doing data mining to draw from that interactive process information to help them revise the form and improve it on an ongoing basis. I am hoping LaVerne and Eve will continue to be our people looking at this issue as this process continues. MS. WOODS: Thank you, Betsy, and thank you to all the panel members and all the task force members. [Applause.] MS. BJORKLUND: While the next panel comes up, I will just make a couple of comments. Of course, the advisory committee is hard at work on its report on these topics, and one interesting question that I would like to ask the prior panel is if the Form 8734 and the advance ruling period were done away with and yet there was some kind of five-year review for all organizations, where would the IRS with its limited resources find the people, the bodies to do that five-year review? Any thoughts? MS. BORENSTEIN: I think some of the thought here is having cream rising to the top. With greater public accountability and transparency, and if the right questions are going to be asked more often, there will be some natural selection process of who should be asked these questions as opposed to having everyone at point of entry working to be given approval and then taking their chances in the audit lottery. So, if the streamlining works, I am hoping there will be a better exam focus through that compliance unit. MS. BJORKLUND: Of course, the number of organizations would probably be gone by the five-year mark, also. LaVerne? MS. WOODS: I would also say that because there would be very little review for most organizations at the outset, those individuals currently reviewing the 1023’s could presumably be focused instead at the five-year point instead of the initiation. MS. BJORKLUND: Do you think that would open the door for fraud, which is one of the criticisms we have heard? MS. WOODS: Well, I guess I view that question as being something like a lot of the questions we had in the context of the Internet. Is there any more opportunity for fraud than we have under the current system? I am not convinced that there is. 388 March 2003 — Vol. 39, No. 3 We know that there is both fraud and silliness in exempt organizations as in any area. I think there is quite an opportunity for fraud with a Form 1023. I don’t think we open the door any wider. MS. BJORKLUND: Thank you. Issues Facing Academic Medical Centers MS. BJORKLUND: With that, we go to our final panel of the day which is “Issues Facing Academic Medical Centers.” Chris Jedrey had recommended this as a topic to me a while ago, and we slated it in and we are very happy to have him and his panelists. I will ask him to introduce the panel. MR. JEDREY: Thanks, Victoria. First, I can’t tell you what a privilege it is to be in the only room in the United States designed by Piranesi. You have the large overwhelming space, the small, despairing individuals, general air of impending doom. It is really very impressive. Academic medical centers. We are going to cover several topics. Jim Hasson has produced a splendid overview of tax issues and research. We have also attached an article that Bob Louthian and I wrote covering a subset of the issues Jim will talk about. T.J.’s talk is titled “Balancing Governance, Business, and Tax Issues in Academic Medical Centers,” and then as time allows, I will spend a little bit of time talking about some non-tax issues, conflict-of-interest issues in the research area. We will start with Jim. For definition purposes, although I expect most of you are clear about this, “academic medical center” is a term of art for the 125 centers across the country, the elements of which are a medical school, one or more hospitals, one or more faculty practice plans. The line is if you have seen one academic medical center, you have seen one academic medical center. They are organized in all kinds of odd ways, ranging from the old Thomas Jefferson University structure where the hospital, the medical school, and the faculty were all in a single corporate entity at one end of the spectrum to Northwestern at the other end of the spectrum where the hospital, the doctors, and the medical school are on a campus and are interrelated in a variety of ways, but from a corporate point of view are quite separate. Then you have other structures where — this is common in the state systems — where the medical school employs the faculty who provide all of the academic staff to the teaching hospital or the pattern that is more common in Boston where, for the most part, the physicians are on the payroll of the hospital or a hospital affiliate foundation and the medical school has only a handful of full-time employees and provides some support for teaching. From a structural point of view, it is a complex universe, generally made up of tax-exempt or state entities. So, with that by way of an introduction, Jim, if I could turn it over to you. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. could make the 8734 superfluous because the Service would already have that information. Anyone who didn’t automatically qualify under the numerical tests could be invited to submit a facts-and-circumstances explanation at that time, which leads me to my last point of the possibility of further revisions to the 1023 and how that can happen. ABA Transcript I want it recorded for the tape. I am glad we are being tape-recorded. For the benefit of my partner, Herb Beller, we are business casual, so, therefore, no ties. All of you guys that have been up here in ties before, you are violating the rule. [Laughter.] MR. HASSON: I appreciate very much the chance to talk with you. It gave me a chance to kill a lot of trees with the paper that I produced that is there in the back of the room. I hope everybody has picked it up. I am not going to bore you by going through all of that. It is far too lengthy, and it covers far more than we have time to talk about. It discusses such things as exemption and unrelated business income and tax-exempt financing and payroll tax liabilities and royalties to inventors and so forth. The principal focus is on all of the tax issues that surround the conduct of research in academic medical centers. So, for your late-night reading, that may be of some interest, but for purposes of this afternoon, I really want to focus on just two of the topics that are there — the distinctions that have evolved over the past several decades between basic research and applied research on the one hand and between research and testing on the other. These are issues that arise in a variety of contexts, but I wanted to talk about them primarily this afternoon in the context of unrelated business income and tax-exempt financing. The principal notion that I want to advance is that the Internal Revenue Service needs to reexamine the position that it has held for the past 35 years or so with respect to research and especially with respect to clinical drug trials. Hopefully, this Committee will find this is something that is worthwhile pursuing and providing some additional information and analysis to the Service on that topic. The first of these distinctions, the distinction between basic and applied research, for exempt organization, appears only in one place statutorily, and that is in the 512(b) exception that applies to organizations that are formed for basic research. This distinction shows up in other places in the code that are not directly relevant to exempt organizations, such as the research tax credit, but for our purposes, it shows up statutorily in 512(b). It also appears administratively in the tax-exempt financing area, and the citations are on page 20 of my long outline. The basic analysis for tax-exempt financing is that, first of all, private persons cannot use bond-financed facilities more than incidentally, and sponsored research can be private use of bond-financed facilities by the sponsor of that research. The Service used the concept of basic research in 1997 in crafting safe harbors for sponsored research by academic medical centers. This administrative guidance in the form of a Revenue Procedure, Revenue Procedure 97-14, is not nearly as well known, it seems to me, as the corresponding guidance that The Exempt Organization Tax Review was provided for management contracts. Almost everyone seems to be well aware of the management contract principles in Revenue Procedure 97-13, but are not nearly as familiar with the research provisions in 97-14. These research principles in the Revenue Procedure were apparently developed from the legislative history in the 1986 Tax Reform Act. After the 1986 Act, there were arduous attempts through proposed regulations to develop some meaningful guidance in this area. That effort at developing regulations ultimately did not prove successful, and instead, safe harbors were developed in the 1997 Revenue Procedure. It provides that only basic research can be sponsored research of the sort that can be conducted in facilities financed with tax-exempt bonds. It also goes on to provide how the amount of the royalty or the license fee can be determined, and states that it has to be determined only when the invention is available for use. The result of all of that means that, at least in my opinion, the most unqualified people in the world are making decisions as to what is basic research as distinguished from applied research, and that means that it is tax lawyers, for crying out loud, that are making these kinds of decisions. And even worse than that, it is bond lawyers that are tax lawyers that are trying to make these distinctions. I tried to discuss this distinction intelligently or semi-intelligently with M.D.’s and Ph.D.’s, and they tell me I am nuts, which probably is true, all of which suggests to me that this type of guidance, while well-meaning, has resulted in a situation in which there are all sorts of scientifically irrational decisions being made in the design of facilities to be financed with tax-exempt bonds. So, for that reason, it seems to me that this is an area that is worthy of some considerable attention. What about the testing distinction? As everybody knows, the regulations under both 501(c)(3) and 512 tell us that testing is not research. Well, the Service came along in 1968 with a Revenue Ruling that said clinical drug trials are testing and, therefore, are not research. That has produced a whole series of subsequent rulings, both Revenue Rulings and private letter rulings, that I note in my outline. The principal point that I want to make from those materials that I cite in the outline is that the 1968 Revenue Ruling was a factual determination. It was not a legal determination, even though some of the subsequent rulings by the Service appear to treat that 1968 Revenue Ruling as a determination of law. It was a determination of fact. So what is an academic medical center to do? Well, it can try to develop its own internal procedures and its own internal documentation and be prepared to litigate an issue such as the Midwest Research Institute case that I cite in the outline on page 10. But maybe that is not the best way to go about addressing this issue. Maybe the issue ought to be addressed more effectively, administratively, by a reexamination of the factual bases upon which that 1968 ruling was issued. Maybe we need to get additional information in front of the Internal Revenue Service and request some sort of reexamination. March 2003 — Vol. 39, No. 3 389 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. MR. HASSON: Thanks, Chris. ABA Transcript So the point is, maybe it is time, given all the advances in technology, the advances in research that are going on, that this 1968 position ought to be reexamined, and maybe there are ways that this committee and the Section can be helpful in that regard. Chris and Bob Lothian’s paper that is attached does a very good job of summarizing all of that, and so I would invite any comment you might have, Chris. MR. JEDREY: Jim, it strikes me that the determination could be made based on the nature of the research, which is more or less what the current scheme tries to do. That is, determine whether it is basic research or some other kind of research. There is also kind of an integral part argument here that some academic medical centers make, which is that because the activity is integrated with their teaching or their patient care, it should be treated differently. Do you have any opinion on what the right direction is, which of these is most likely to be helpful in helping the IRS to find their way through this thicket? from a tax administration point of view, unless they are going to give up the field, it is easier for them to evaluate an integral part argument. You are working, for example, with researchers in a cancer institute. The principle for a clinical trial is that clinical trials are about research and not patient care. That is one of the bright-line rules. However, a recent study suggests that neither the researchers nor the patients think about clinical trials in that way. If you talk to the researchers who run clinical trials, they regard the protocols under the trials as just another treatment alternative available to them. They are dealing with a patient, and they do what they can within the currently established protocols, and they move on to these research protocols when they need to do so for the patient’s benefit. Clearly, clinical trials are part of the clinical care of the patient, and the conceptual difference between clinical trials and clinical care in the academic medical center world is artificial. MR. HASSON: I agree with that. Basically, there are two ways of trying to approach it. There is the approach of saying, “Well, let the individual academic medical center that happens to get audited deal with it,” and maybe that will produce either some publicized information or some litigation that will clarify the field, or maybe the better way is some more systematic development of that kind of information you are talking about that could prompt an administrative review. MR. HASSON: I will just use anecdotal experience. I have been involved with three CEP audits of academic medical centers in recent years. The issue of clinical drug trial revenues came up in all three. In at least one of those, we had to take a very substantial issue to Appeals. We finally were able to persuade the Appeals officer that, for the very reason you mentioned, because we were able to show that M.D. candidates and Ph.D. candidates were involved in doing the clinical drug trials and, in fact, did most of the work, that the work was in furtherance of the educational purpose of the academic medical center. So, therefore, that integral part, “in furtherance of” type of analysis carried the day, but I am not sure that we should have been required to make that connection. MR. JEDREY: It would be helpful if there were some form of guidance indicating that there is a safe harbor for clinical research that is integrated with patient care and research, leaving the routine testing issue to a facts-and-circumstances determination. Therefore, in the absence of such integration, the Service could still try to make a distinction between routine testing and scientific research. Though God knows how the Service will determine whether a particular piece of research is routine or has scientific merit. Given my wanderings around academic medical centers and looking at what is going on in these laboratories, it is hard for me to conceive of a rational argument that the work is not scientific research. So I wonder if having to go through all of that detailed procedure and documentation of the involvement of M.D. and Ph.D. candidates is really what ought to be required. I am really going to talk primarily about physician compensation in an academic medical center setting, although I do want to key in on one of the points that Jim just made, which is, when you are arguing with the IRS and you are in an educational or an academic setting, always use as your backup argument that you have got an educational purpose and that the activities are somehow furthering education, not just promoting health. MR. JEDREY: It seems to me the hard question is from a tax administration point of view. Unless the Service is going to give up the ground and simply say research is research, I think it is very hard for the reasons that you have articulated for the Service to determine, from an intellectual perspective, what is “research” and what is not. I, like you, have been in the position of explaining to a doctor or professor that the IRS doesn’t regard what he is doing as research. It brings a very forceful response, in my experience. It just seems to me, I think that the law is a lot less specific and precise in that area, and it offers you an extra opportunity to make a point with them, especially if you get to appeals, so it’s always a good thing to do in that setting. 390 March 2003 — Vol. 39, No. 3 T.J.? MR. SULLIVAN: Thanks, Chris. Physician compensation is a big issue in academic medical centers, primarily with the clinical faculty in faculty practice plan settings and otherwise. The latest statistics I have seen from AAMC suggest that there are 85,000 clinical faculty The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. The Food and Drug Administration for decades has had four different phases for clinical drug trials, and as you go through those, you can see how the FDA is evolving its view of how these different phases of clinical drug trials are to be identified and categorized. Even so, the FDA treats all of the phases as scientific research. ABA Transcript In fiscal ’99, the amount of revenue generated by faculty practice plans was $13.7 billion, and that is about 34.5 percent of the total revenue received by an average medical school. So we are really talking about a fairly significant activity and a big part of an academic medical center’s revenues. As Chris said when he was describing the infinite variety in the corporate structures of academic medical centers, most are made up largely of elements that are nonprofit and taxexempt. That means when we are talking about physician compensation, we have to be very careful to make sure that we follow the tax rules as well as the Medicare Stark and anti-kickback rules. It helps to remember about faculty practice plans that the IRS was hostile to their tax exemption in the first place, and it is only after three losses in the Tax Court in the early ’80s that the IRS realized that they had lost that battle and that faculty practice plans, even though controlled by physicians in most cases, were going to be held by the courts to be tax-exempt. The IRS acquiesced in one of those cases, and the positions they now take on faculty practice plans do recognize exemption, but they are looking for certain characteristics that were present in those cases. Most notably, they are looking for the absence of a one-to-one correlation between productivity of revenues by the physician and the income for that particular physician and also some external approval mechanism for physician compensation, either the dean or the trustees of the university or the medical school or such — some external control over compensation. The Service had then (in 1980) and still has today a sensitivity to physician involvement in setting their own compensation. So, even though we get a limited free pass with respect to governance in the faculty practice plan setting, we don’t necessarily get a complete pass with respect to setting compensation. Again, we are looking at the interplay between the exempt organization rules, the Stark rules, and the anti-kickback rules, each of which has some liberalization in one fashion or another with respect to the academic medical center setting or faculty practice plan setting. When we are talking about compensation, just like with any other exempt organization, primarily we are focusing on demonstrating reasonable compensation, but most of the focus today in faculty practice plans and anywhere else for that matter is on productivity-based compensation and incentive compensation. The IRS knows this. That is the good news. Marv Friedlander has said that we may actually get some IRS guidance in this area this year, but in the meantime, we are left to test compensation decisions under the general rules applicable to any exempt organization compensation decision. The big thing for those of us dealing with incentive comp or productivity-based comp is that the 4958 final regs left us without any specific discussion of revenue-sharing types of The Exempt Organization Tax Review transactions. So we have to parse through historical IRS positions and then figure out where we are today. The biggest part of that history is Revenue Ruling 69-383, which was a situation where the Service blessed the splitting of what I view as adjusted gross revenues in a hospital department, the radiology department. The hospital was globally billing for the professional and technical component and then split the revenues, so that the physicians got adequately compensated for the professional component and the hospital got adequately compensated for the technical component. The difficulty that we face is that neither the Service nor taxpayers always speak precisely using clear terminology with respect to revenue. So what the meaning is of “gross revenue” or “adjusted gross revenue” in one particular setting or document may get mixed up with what is net revenue or what is net income, and, of course, net income implicates the section 501(c)(3) inurement prohibition. We have to be really careful when we are using terms and trying to determine what the Service is meaning when it is using terms such as “net revenue” and “net income.” Also, it is important in the physician compensation setting to distinguish whether we are talking about net revenue or net income by individual physician or by groups of physicians. The STARK law, in the faculty practice plan setting actually encourages or at least permits payment of physicians by group if you have got at least five physicians. I think the Service is much more reluctant to approach things that way and still is much more comfortable looking at revenue sharing where it is physician by physician. So we have to be careful with that Stark-Tax interplay. The market, of course, is moving heavily toward productivity and wants to move heavily toward compensating physicians based on the net income or profit at least developed by an individual physician, if not developed by that department. It is probably easier to do it department by department, but, again, I think the Service would be more reluctant to bless something like that. Given where we are today, it is always best to try to follow the 4958 process and use the comparability standard and independent approval. That gives you a great deal more flexibility than you might otherwise have. If you look at the integrated delivery network rulings that came out in the mid ’90s, I think they represent the high water mark of what the Service has blessed with respect to physician compensation, but there also is a general information letter that was issued in January 2002 and is cited in my outline that summarizes where we are and the factors that the Service will look at in evaluating incentive compensation. Certainly, comparability is key, as is the presence of a cap or ceiling on total compensation that prevents any sort of a windfall for the particular physician. A cap also, fundamentally in the view of the Service, separates compensation from what might otherwise be a disguised equity type of distribution. March 2003 — Vol. 39, No. 3 391 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. members across the country. We are talking about a lot of physicians, so it means a great deal in terms of revenue for the academic medical centers. ABA Transcript such and such a range. As Chris was saying, all of the academic medical centers are different. The guy that is a departmental chair at one institution has authority and responsibility vastly different from the person that has the same title at another academic medical center, maybe even in the same town. PANELIST: T.J., could you just give an example of how one of those caps might be phrased or structured, so that people get a sense of what you are talking about? MR. SULLIVAN: Yes. One way you might do it is to say, “in no event will any physician be compensated at higher than 95 percent of the MGMA reported compensation for that particular specialty.” MR. JEDREY: In terms of getting Towers, Perrin, or Mercer, or whomever, to give a signoff on a particular package, you can get from MGMA and other surveys quite precise information associated with clinical productivity, but once you go beyond this into the administrative duties, first, there is no database, and, second, as you are suggesting, Jim, a department chair in one place is a very different job than a department chair in another place. The Service would rather see a high cap than no cap. They like something that is objective and acts as a limitation on the total comp. MR. HASSON: How are you seeing these folks trying to take that into account? Again, we have to be careful that we are distinguishing between gross or adjusted gross income, that is sometimes referred to as net revenue, and the actual net income of the charitable organization, which is where I think we get into a great deal more difficulty. The Lorain Avenue Clinic decision from 1958 is still out there, and we got a little bit of a warning last year from the IRS in the form of a section 162 case, Pediatric Surgical Associates, that is also cited in my outline, where, on the taxable side, the Service denied a deduction for compensation where owner-physicians were being compensated in what looked like additional revenue or profits made off of the employee-physicians in their group practice. There is still a distinction between a disguised equity type of compensation versus actual compensation for professional services. We always have to report the compensation properly, and in faculty practice plans, I think there are two things that still are important in addition to the things I mentioned above, first, the dean’s approval or trustee’s approval, that structural external approval of comp and second, the continuing need to avoid an outright one-to-one correlation between productivity and income. MR. JEDREY: T.J., is it going to be acceptable to the Service if you treat an individual physician like a profit center and compensate him or her based on his or her personal net? MR. SULLIVAN: They haven’t said so yet, but I would say if I had to handicap things, that may be our high-water mark. I think we can get there. I don’t know that we can get much farther any time soon. In other words, we can get to the individual profit center if we do it just right. Six docs, I don’t know. MR. HASSON: Let me ask a question. What you are seeing in the comparability studies that folks are trying to get, you find the experts that are going to say here is the guy we have reviewed and we determine appropriate compensation is in 392 March 2003 — Vol. 39, No. 3 MR. JEDREY: They do it in a bifurcated way. They do the clinical piece, and where they have 10 surveys. Then they do the other administrative piece based on anecdotal information, and do a blended rate based on the allocation of the person’s time. It is not very scientific. MR. SULLIVAN: And it is expensive. MR. HASSON: The question is could I comment on the implications of Revenue Procedure 97-13 in the faculty practice plan setting and that some people seem to argue that 97-13 even applies in an employed physician setting, especially where they are employed by a tax-exempt corporation rather than by the university or the hospital. I don’t think Revenue Procedure 97-13 applies. I mean, that would be my argument. MR. JEDREY: The complexities of these arrangements are great. For example, there are cases where the faculty is, in whole or in part, leased from one entity to another, which would put you in a slightly more difficult territory. MR. HASSON: Well, yes. I think T.J.’s answer is correct. The problem is when I am not bond counsel, when I am borrower’s counsel, the issue doesn’t come up until we get the tax certificate the day before the closing or the day before the preclosing, and so, at that point, it is too late to back out and get other bond counsel. So you are going to have to do what that bond counsel demands, and some have demanded that you satisfy the conditions of 97-13 which generally you can by making sure that you have one-year contracts. Docs don’t like it, but — MR. JEDREY: Except for senior physicians who you recruit, this world generally works on the basis of rolling one-year appointments. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Also, I think the Service will just about insist in looking at your compensation arrangement that it be structured in such a fashion as not to create a disincentive for providing charity care or serving Medicaid or other low-pay patients or for performing research and teaching activities if we are talking about a faculty practice plan. ABA Transcript MR. JEDREY: The dean sends out a letter and reappoints you when and you go forward on that basis to eternity, or what seems like eternity. One point to elaborate on, T.J. In my experience, in terms of compensation approval methods that the Service will accept, they will accept a circumstance where the department chair approves compensation for everyone but himself or herself, and then the president or the dean of the medical school approves his compensation. The Service also will sign off on arrangements where you have a lay compensation committee, made up of board members who are not employed physicians, who are delegated the responsibility by the board, if that is permissible under State law, to make the final determination of compensation. However, in the original Faculty Practice Plan case, the Brigham Anesthesia case, the Service relied on the Harvard Compensation Guidelines, an external standard against which physician compensation is measured. Therefore, there are a variety of ways you can get the IRS to conclude that physicians are not setting their own compensation. Let me take just a few minutes on the conflicts-of-interest issue. The issue that Jim started with is I think an issue that hasn’t had its day yet. The amount of clinical trial income has grown enormously. The IRS’s standards are quite antique, and I agree 100 percent with Jim’s recommendation that it would be good to clarify this so that we don’t have to go through the struggles that Jim is talking about with respect to CEP audits. The research area offers a similar kind of problem. Research activity is growing very quickly, particularly corporate-sponsored research, and the components of the university that deal with the areas I am going to talk about, for odd historical reasons, tend to be outside of the purview of the university’s general counsel. Research administration for human subject research runs through an IRB, which is an entity created under federal regulations associated with federal grants. It sits off there on the side, a little hard to explain from a corporate structure point of view, but it sits out there because the feds say you have to have one. It has the final say on approving human subjects research for the organization. Then, somewhere else, typically in another part of town, you have the technology transfer office, and, again, there tends not to be any direct relationship with the general counsel’s office; they work away, day in and day out, licensing technology. In an environment where endowment values and endowment returns are falling, there are a number of these institutions who are unsatisfied by their licensing arrangements. The nice thing about licensing is the tax treatment is certain, and there is no risk associated with revenue stream. However, where the institution is involved in something that it thinks has significant economic potential, there is a lot more interest today in the institution having an equity kind of stake. It puts The Exempt Organization Tax Review these institutions in the position of making judgments that they are not used to making, and potentially committing substantial financial and other resources. A great example of this is Boston University which supported a high-tech venture called — a biotech venture called Seragen and invested enormous amounts of money into something that ultimately, I guess the polite phrase would be, didn’t turn out all that well. [Laughter.] It falls into the “So, Mrs. Lincoln, otherwise, what did you think of the play?” category. The conflict issue arises in the following circumstances. The principal investigators, who in many cases are very important people in their world, often have quite complex relationships with the corporate sponsors. They may be medical directors. They may also serve on advisory committees, or attend educational sessions in Cortina or other lovely places. There are lots of perks. There are sometimes equity opportunities. There isn’t a comprehensive scheme on the non-tax side for dealing with conflict of interest issues. OHRP, is a federal agency which oversees federally funded human subjects research. If you do federally funded research, you enter into a federal-wide assurance, essentially a contract with the government. In that contract, you promise the feds that you will conduct all of your human subjects research in accordance with these federal rules, including the corporate- sponsored research. However, OHRP has not adopted a conflict of interests policy. Two of the trade associations, the Association of American Medical Colleges and the Association of American Universities, have come out with policies. There are two kinds of conflicts. There is an institutional conflict where the institution, like Boston University, has made an investment, and then there is an individual conflict, where the principal investigator himself or herself is receiving money, or stock options, or gold watches, or some other form of compensation from the corporate sponsor. With respect to the institutional conflicts, there is a pretty solid consensus emerging that the institution doesn’t have to walk away from conducting research where it has an economic interest. What these policies recommend — and one could question how practical this is, but what they recommend is a firewall. That is, you structure your affairs so that the technology transfer and investment offices don’t have anything to do with the people who make the decisions about whether you are doing the research or not. Now, as a practical matter, that is easy to do because they exist in parts of the institution that don’t naturally talk to one another. The challenge is, they link up at the top levels of the institution, and, in circumstances where the institution has a lot at stake, the higher-ups may have an incentive to lean on the research administration folks. That is the hardest problem to deal with. It is not difficult to say that you can’t have your technology transfer and investment people talking to your research peoMarch 2003 — Vol. 39, No. 3 393 (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. MR. HASSON: Right. ABA Transcript It is harder at the higher levels to avoid institutional pressure on the people who are authorizing the research. It is hard to prevent pressure being brought on them by higher-ups in the university if, in fact, the institution has a significant economic stake in the research; in any event, the rule emerging here seems to be a firewall. On the individual conflicts side, practice varies. One practice is the principal investigators are important people and they do whatever the hell they want. That seems to be the operating principle at a lot of places. At places that are being more careful, efforts are made to manage these conflicts by having the conflict disclosed and then making sure that you have procedures in place so that the economic interest of the principal investigator is not going to warp or distort the research results. Again, the principle is easy to articulate, not easy to work out in practice. AAMC and AAU both take the same position. It will be interesting to see whether when OHRP, the federal regulator of research, finally takes a position on individual conflicts, whether OHRD lines up with the AAMC and AAU. AAMC and AAU take the position, with respect to individual conflicts, that there should be a strong presumption against the university-conducted research. That is, if you have a PI who has a significant financial interest, you should not do the research at your institution. That leads to a conversation much like the one Jim and I were talking about when you explained to the doctor or professor that what he is doing is not, in the view of the IRS, research. Telling the important principal investor that you are not going to do his clinical trial is an ugly thing in the real world, but what the trade associations are advising is a very high standard — do not do the research absent compelling arguments to the contrary. Presumably, a compelling argument would be that this is the only place where the research can be done. There is only one place that is geared up to deal with this issue and, practically speaking, if the doctor or professor doesn’t do it, it just isn’t going to get done. This is an area full of risk for significant harm to institutions and to the reputations of researchers. In the very public scandals in recent years involving clinical research, several of which were at very distinguished, very important institutions, where federal research was shut down for a short period of time as a warning shot across the bow by the feds, in many of those cases lurking in the facts was an undisclosed conflict. The PI, in addition to being critical to the conduct of the research, was also linked economically to the corporate sponsor. So, when the bad thing happened, reporters and others questioned whether the PI would have enrolled this person in the clinical trial, or would 394 March 2003 — Vol. 39, No. 3 have taken some other risk, if it were not for the economic payoff that the PI hoped to achieve. This is an important issue, and one that hasn’t had nearly the amount of attention that it should have. This is, in part, because the General Counsel’s office in these big institutions, which are generally quite sensitive to conflict issues doesn’t relate as directly as I think they should to either the technology transfer office or the research administration office. There is another standard emerging in this area, which is interesting. When meeting with IRB administrators, I learned that they don’t want to be determining whether conflicts exist. They want that to be done somewhere else. So now there is a conversation going on about having a general conflict office or committee responsible for making these determinations. The best practice that is emerging is that you have a disclosure process that brings this information into the conflict office or committee. They evaluate it, and then they send it down to the IRB with a recommendation. The recommendation can be to avoid the conflict, that is, don’t do the research, or the manage the conflict. If it is to manage the conflict, the recommendation comes with certain requirements of how it should be managed. The IRB then has the following choice. The IRB can adopt the recommendation or it can do something stricter. That is, the IRB could receive a recommendation to manage the conflict in the following way, and the IRB could say, “You know, we are just not going to do this at all. This is so fraught with conflict. We don’t think it is a good idea,” or, “We are going to do it, but we are going to add even more bells and whistles than the conflict committee required.” The IRB, however, cannot do something less strict than the recommendations. Anyway, with that, this is the end of our time and our presentations. Victoria, do you want to take questions? MS. BJORKLUND: If you would like to. MR. : Sure. MS. BJORKLUND: Are there any questions from the audience? [No response.] MS. BJORKLUND: If not, we will meet you at the bar. Thank you very much, gentlemen. We appreciate it. [Applause.] MS. BJORKLUND: Some of us are going out to dinner tonight informally. If others are interested, we are going to a nearby seafood restaurant. If you would like to come with us, just let me know. The Exempt Organization Tax Review (C) Tax Analysts 2003. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. ple, because the technology transfer people and the investment people don’t know where the research people are, couldn’t find them in the directory, and don’t deal with them on a regular basis. There is a natural separation.