The maze to determine a board member s independent status Laura J. Kenney and Peggy A. Bradshaw*

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1 The maze to determine a board member s independent status Laura J. Kenney and Peggy A. Bradshaw* The definition of independent is amazingly complicated. One would think it intuitive to determine whether a voting member of a governing body a board member of a tax-exempt organization is independent or not. The new Form 990, however, has made determining who falls within this definition a complex task a sort of maze, in fact. As recommended in the instructions for the new Form 990, in the Sequencing List To Complete the Form and Schedules, it is helpful early on in the process of preparing the Form to determine if there are any related organizations. Other determinations, such as whether a board member is independent, depend on knowing this. Independence test A board member will be considered independent only if he or she meets three tests for the entire tax year. The tests start out simply enough, but each has exceptions and multiple parts and is reliant on other, sometimes complex, determinations. First independence test Is the board member compensated as an employee of the organization? Is the board member compensated as an officer of the organization? Is the board member compensated as either an employee or officer of a related organization? If the answer to any of these questions is yes, the board member fails this test and so is not independent. A board member who receives compensation for working for the organization, or for a related organization, as an officer or other employee generally is not independent. There is an exception, however, for certain clergy who have taken a bona fide vow of poverty and do not receive taxable income personally for the payments. These members do remain independent for purposes of the Form 990 reporting. Second independence test For a board member to be considered independent under the new definition, he or she generally cannot be compensated as an independent contractor of the organization or a related organization. There are exceptions for certain payments, however. He or she can be: compensated up to $10,000 as an independent contractor; Reimbursed under an accountable expense reimbursement plan for expenses incurred while serving on the board; 1 or Paid reasonable compensation for serving as a board member. None of these things will compromise the board member s independence for Form 990 reporting purposes. Therefore, board members can be paid in some circumstances e.g., for independent contractor services up to the $10,000 threshold and still remain independent.

2 Third independence test The third test of a board member s independence is another multipart test. Neither the member nor anyone in the member s family may be reportable on any of the four parts of the organization s Schedule L, Transactions With Interested Persons, or on a related organization s Schedule L. Family members generally include: spouse parents, grandparents or great-grandparents brothers or sisters (whether whole or half blood) and their spouses children (whether natural or adopted) and their spouses grandchildren and their spouses great-grandchildren and their spouses Schedule L Transactions with interested persons A board member or family member is reportable on Schedule L of the new Form 990 if he or she is deemed to have a transaction with the organization as an interested person. Schedule L reports transactions with interested persons in any of the four following sections: Part I Excess Benefit Transactions Part II Loans to and/or From Interested Persons Part III Grants or Assistance Benefitting Interested Persons Part IV Business Transactions Involving Interested Persons Within the four parts of Schedule L there are different definitions of interested persons and different thresholds for reporting transactions. Part I Excess benefit Only certain types of tax-exempt organizations, specifically those exempt under Section 501(c)(3) and Section 501(c)(4), can have interested persons reportable in Part I of Schedule L as having received an excess benefit transaction. The reason is that the excess benefit transaction rules of Section 4958 cover only Section 501(c)(3) and Section 501(c)(4) organizations. A complete discussion of all the definitions and circumstances in which an organization has an excess benefit transaction, including the type of transactions that may result in an excess benefit transaction, is beyond the scope of this article. 2 According to the Schedule L instructions, however, (a)n excess benefit transaction generally is a transaction in which [a Section 501(c)(3) or 501(c)(4) ] tax-exempt organization directly or indirectly provides to or for the use of a disqualified person an economic benefit the value of which exceeds the value of the consideration received by the organization for providing such benefit. These are the transactions, whether purposeful or inadvertent, that would be subject to the intermediate sanctions under Section The term disqualified person includes: all those who are or were (during the last five years) in a position to exercise substantial influence over the organization; the disqualified persons of an organization s supporting organization; donors and donor advisors to a donor-advised fund;

3 investment advisors for donor-advised sponsoring organizations; members of their families; and the more-than-35-percent-controlled 3 entities of any of those above. Those in a position to exercise substantial influence over the organization include the voting members of the governing body and those with the office or powers of president, chief executive officer, chief operating officer, treasurer or chief financial officer. If a board member, certain family members, certain more-than-35-percent-controlled entities, or any of the other disqualified persons has received an excess benefit in a transaction with the organization, it would be reportable in Schedule L, Part I. That would mean that he or she would not be considered independent. Likewise, if a board member were deemed to be an organization manager who participated in or approved the excess benefit transaction for another disqualified person, he or she would be reportable in Schedule L, Part I, and would not be independent. Finally, it should be noted that there are no minimum thresholds for reporting. Part II Loans Does a board member have any loans to or from the organization that are outstanding as of the end of the organization's tax year? If so, that member is not considered independent for purposes of the new Form 990. The size of the loan does not matter. Neither does it matter whether the board member borrowed money from the organization or lent money to it. Salary advances, other advances, and receivables with interested persons are reportable on Schedule L. Interested person for these purposes includes current or former officers, directors, trustees, key employees reportable on the new Form 990, and the five most highly paid employees. 4 It also includes certain additional people from organizations that sponsor donor-advised funds and from supporting organizations, specifically: donors and donor advisors of sponsoring organizations, investment advisors of donor advised funds and substantial contributors of supporting organizations; their family members; and their more-than-35-percent-controlled entities. The organization, or a related organization, must report loans between that organization and any of these persons. There are, however, some exceptions to this section for reporting loans to and from the organization. If the transaction is an excess benefit transaction, it is reported in Part I instead. There is also an exception for an advance under an accountable plan. Other exceptions include pledges receivable, accrued compensation, and loans and receivables made in the organization s ordinary course of business (e.g., market rate loans from a credit union and hospital bills for medical services). But any loan involving an interested person, as defined for purposes of this part, that does not fall within any these exceptions must be reported. In that case, if the individual involved is a board member or family member of a board member, that member will not be considered independent.

4 Part III Grants, etc. A board member or family member is reportable on Schedule L of the new Form 990 if he or she has received any grant or other assistance at any time during the organization's tax year. This may include grants, scholarships, fellowships, internships, prizes and awards. The group of interested persons for Part III starts with current and former officers, directors, trustees and key employees who are reportable on the new Form 990; substantial contributors; and related persons. The term related persons includes: members of an organization s grant selection committee; family members of any of the above; the more-than-35-percent-controlled entities of any of the above; and an employee or the child of an employee of a substantial contributor or the more-than-35-percentcontrolled entity of a substantial contributor, but only if the employee or employee s child received the grant at the suggestion of the substantial contributor or the controlled entity, or under a program funded by the substantial contributor that was intended to benefit such employees or their children. There are exceptions for Part III, also. It does not report transactions with interested persons that are otherwise reportable on Parts I or II for excess benefit transactions or loans with the organization. Part III also does not include regular business transactions or compensation for services, including taxable and nontaxable fringe benefits treated as compensation. This section also excludes grants to the employees (and their children) of substantial contributors or of their more-than-35-percent-controlled entities, as long as the grants are awarded in an objective and nondiscriminatory manner based on pre-established criteria and reviewed by a selection committee. Also excluded are certain grants or assistance provided to an interested person as a member of a charitable class if comparable assistance is provided to other members of that charitable class that the organization intends to benefit in furtherance of its exempt purpose. Among the items that are reportable, however, and are not excluded from reporting under this exception, are grants for education, travel or other similar purposes. Such similar purposes, in turn, can include producing a report or similar product, achieving some specific objective or improving the interested person s artistic, musical, scientific, teaching or similar skills. 5 Thus, a board member who wins a prize in an organization s golf fundraiser may not, under a literal reading of the Schedule L instructions, be considered independent. It is easy to imagine how complex it would be for a large institution to keep track of all the relationships of its board members, other substantial contributors and grant selection committee members and cross check those names with scholarships it may provide, particularly when family members may have different last names. As with the other parts of Schedule L, if a board member or a member of his or her family must be reported in this part, the board member is not independent for purposes of the Form 990.

5 Part IV Business transactions Certain business transactions with interested persons must be reported on Part IV of Schedule L. These include sales, leases, licenses, services or joint venture activities for which payments were made during the organization s tax year if: (1) all the payments between the interested person and the organization made during the tax year exceed $100,000, (2) the payments from any single transaction were more than $10,000 or one percent of the organization s total revenues, whichever is greater or (3) any member of the disinterested person s family received any compensation payments in excess of $10,000. Whether the transaction is reportable depends on the payments received during the tax year. The year in which the transaction was entered into is not important for Part IV. Interested persons for Part IV includes: current or former officers, directors, trustees and key employees; family members of any of the above; an entity more than 35 percent owned, directly or indirectly, individually or collectively, by any of those above; and a for-profit entity of which the current or former officer, director, trustee or key employee was an officer, director, trustee, key employee, or a partner or member with more-than-five-percent direct or indirect ownership interest. There is a special provision for management companies. A transaction with such a company is reportable if a former officer, director, trustee or key employee of the exempt organization (i.e., one who served in that capacity within the last five years) is now a direct or indirect more-than-35-percent owner of, or an officer, director, trustee or key employee in, the management company. This transaction would be reportable on the related organization s Schedule L. Therefore, if that former officer, director, trustee or key employee is now also involved with a management company doing business with the related organization, and is a current board member of the reporting organization, he or she would not be considered independent with respect to the reporting organization. The exceptions for this section include excess benefit transactions reportable on Part I, loans reportable on Part II, grants and assistance (other than business transactions) that are reportable on Part III and compensation reported on Part VII, Section A of the core Form 990. Organizations can use the favorable reasonable efforts process (see below) for Part IV as well as Part III, providing relevant interested persons, current or former officers, directors, trustees and reportable key employees with an annual questionnaire and the pertinent instructions and definitions. Part IV is the portion of Schedule L likely to have the most reporting and receive the most attention for determining whether or not a board member is independent. Express reasonable efforts process How does an organization ensure that it is able to capture and report certain transactions with board members, their family members and their companies when the management of the organization may not know about all of the respective relationships and arrangements? The good news is that there is now a bright line approach to some of these murky questions.

6 The new Form 990 instructions formally introduce a concept that was used previously by the IRS in a Q&A format in response to practitioners feedback about related-party reporting. 6 The earlier guidance involved the level of effort needed to answer the related-party items on Lines 75b and 75c on the Form 990 returns for tax years 2007 and earlier. For the new 2008 Form 990, the organization need not provide otherwise required information if it is unable to obtain that information after making a reasonable effort to do so. One example of a reasonable effort is the organization s distribution of a questionnaire annually to the relevant individuals with appropriate instructions and definitions as well as the name, title, date and signature of the person reporting such information. There are five areas that allow this express reasonable efforts process, two of which are in Schedule L. The five areas include information on: a grant or assistance to an interested person (Part III of Schedule L); a business transaction with an interested person (Part IV of Schedule L); whether a board member is or is not independent (Part VI, Line 1b of the core form); certain family or business relationships between officers, directors, trustees or reportable key employees (Part VI, Line 2 of the core form); and compensation from a related organization to officers, directors, trustees, certain key employees and the five most highly compensated employees. Therefore, organizations generally may rely on the diligence and accuracy of the board members responses to the annual questionnaires. Conclusion The question of independence is very important to the IRS and the public. The first page of the new Form 990 asks for the number of voting members of the governing body and the number of independent voting members of the governing body. This question is repeated in the Governance section, Part VI, of the core Form 990. Recommendations for approaching determination of independent board members, as well as preparation of other parts of the newly revised Form 990, include these: Follow the Sequencing List To Complete the Form, particularly with regard to determining and listing both related organizations and the filing organization s officers, directors, trustees, reportable key employees and five most highly compensated employees. Take advantage of the express reasonable efforts approach and prepare annual questionnaires for the relevant parts of Schedule L. Start as early as possible and do not underestimate the amount of time and effort that will be required. Although some will find that determining the independence status of a voting member of a governing body simple and straightforward, many more will find it is a confusing and involved maze. As with any complex task, it is best not to underestimate the effort and time that will be required to complete it.

7 * Laura J. Kenney is a senior tax manager in Grant Thornton LLP's Northeast Higher Education and Not-for-Profit practice, in the Boston office. Peggy A. Bradshaw is a senior tax manager in Grant Thornton LLP's Washington, DC,- area Not-for-Profit practice, in the McLean, VA, office. 1 See Reg (c). An accountable plan is an expense reimbursement plan that reimburses employees and board members for ordinary and necessary business expenses connected with the organization. Such a reimbursement requires adequate substantiation within a reasonable period of time and requires the payees to return amounts in excess of expenses that are substantiated within a reasonable period of time. A reimbursement that meets these tests is excluded from being reported on Schedule L. 2 See King, Excess Benefit Transaction Audits: What Happens When the Boss is the Target? 20 Exempts 3, page 3 (Nov/Dec 2008). 3 See Section 4958(f)(3). 4 For Section 501(c)(3) and (c)(4) organizations, interested person also includes the family members and more-than- 35-percent-controlled entities for the current or former officers directors, trustees and key employees. 5 See Section 4945(g)(3). 6 Available at This article was originally published in Taxation of Exempts, July/August 2009, RIA.