The Lawyer s Role in Helping Charities and Foundations Deal with Conflicts of Interest

Transcription

1 The University of Texas School of Law Presented: Nonprofit Organizations Institute January 14-15, 2010 Austin, Texas The Lawyer s Role in Helping Charities and Foundations Deal with Conflicts of Interest Bob Boisture Author contact information: Bob Boisture Boisture Law Arlington, Virginia bobboisture@boisturelaw.com Continuing Legal Education

2 Introduction Directors and officers of tax-exempt charities 1 have a legal duty not to use the assets of the charity for private gain. Lawyers who represent charities likewise have an obligation to protect their clients from breaches of this duty of loyalty. This paper focuses on the legal and ethical issues that arise at the intersection of these two parallel obligations. Lawyers advising charities are likely to find themselves regularly counseling their clients boards and staff on how to deal with conflicts of interest. To provide effective counsel, the lawyer must first have a solid understanding of the legal rules governing various conflict of interest situations. Less than fifty years ago, this body of law was relatively simple and straightforward, was largely non-statutory common law, and was almost exclusively the province of the states rather than the federal government. Section I of this paper discusses the profound transformation that has turned this area of the law into one largely defined by detailed federal statutes enforced by the Internal Revenue Service. Once armed with an understanding of this substantive law, the lawyer must consider how best to prepare his or her charitable clients to deal effectively with conflicts of interest. Section II of this paper discusses the policies and procedures a charity should put in place, and then briefly discusses some of the more challenging conflict of interest situations a charity and its counsel are likely to confront. Over the course of a career, a lawyer representing charities is likely to encounter situations in which directors, officers, or employees of a charity disregard the lawyer s advice and persist in a course of conduct that advances their private interests at the expense of the charity. Section III of this paper discusses the ethical obligations of a lawyer confronting this situation. A. Overview I. The Federalization of the Policing of Conflicts of Interest Prior to 1969, the Internal Revenue Code gave the Internal Revenue Service no authority to impose sanctions on insiders who participated in prohibited private inurement transactions. While the concept of private inurement was well-established as a cornerstone of federal exempt organizations law, is was relevant only in determining whether organizations qualified as charities under section 501(c)(3). 2 Defining the standards of 1 2 This paper uses the terms charity and charities to refer to all organizations exempt under section 501(c)(3) of the Internal revenue Code, i.e., to both public charities and private foundations. The paper uses the terms public charity and private foundation (or, in some cases, simply foundation ) when it is necessary to distinguish between these two subsets of section 501(c)(3) organizations. Unless otherwise stated, all statutory references are to the Internal Revenue Code of 1986, as amended (the Code), and all reference to regulations are to the Treasury regulations promulgated pursuant to the Code. 1

3 conduct for charities directors, trustees, and employees, and imposing sanctions from breach of those standards, was the province of state law. Notwithstanding some variance in interpretation among the states, the general common law rule was that charitable trustees were subject to a strict duty of loyalty, and directors and officers of charitable corporations were subject to an analogous, albeit somewhat less demanding, obligation to deal with the corporation in good faith. The more demanding trust law standard generally prohibited trustees from engaging in any transactions with the trust. Under the corporate standard, the corporation generally had the right to void any transaction with a director unless the transaction was either objectively fair to the corporation, or the board was aware of all material facts related to the director s interest when it approved the transaction. State attorneys general had broad equitable powers to sanction charitable directors, trustees, and employees who violated these standards of conduct. 3 Beginning in 1969, however, Congress began the process of creating a parallel body of federal tax law intended to deter insider misuse of charitable assets, and to sanction such misuse when it does occur. This body of law now includes separate sets of rules governing private foundations, public charities, donor advised funds, and supporting organizations, each accompanied by targeted sanctions on insiders who violate these rules. More recently, the IRS has gone beyond these statutory rules and asserted a broader interest in the overall governance of charities and foundations. This section provides a brief overview of these developments. B. 1969: The Private Foundation Rules Through the course of the 1960s, Congress became increasingly concerned about insider abuse of private foundations. The abuse took a variety of forms, including: payments of excessive compensation; sales, leases, and loans, in which the insider paid less, or received more, than fair market value; parking stock in a foundation to maintain control of a business corporation; and making grants to advance the private economic, legislative, or political objectives of insiders. After several years of in-depth hearings, Congress concluded that, notwithstanding the equitable powers of state attorneys general, the states were not doing an adequate job of policing these abuses. In 1969, Congress addressed the problem by enacting the private foundation rules, including -- of principal relevance to this analysis -- the section 4941 self-dealing rules Over time, many states codified the standards of conduct for nonprofit directors along the lines of the Standards of Conduct provisions of the Revised Model Nonprofit Corporations Act. Revised Model Nonprofit Corporations Act, The two fundamental duties of charitable fiduciaries are the duty of loyalty and the duty of care. The private foundation rules focus overwhelmingly on the duty of loyalty. The section 4941 self-dealing rules directly regulate economic transactions between foundations and their insiders. The section 4942 payout requirement effectively prevents a donor from taking a contribution deduction for a gift to the donor s foundation of stock in a controlled corporation from which the foundation subsequently receives little or no income to support charitable activities. The section 4943 business holdings rules prevent a donor from using a foundation to hold stock as part of the donor s overall strategy to maintain corporate control. The section 4945 expenditure responsibility rules prohibit foundations from, inter alia, making grants to advance insiders legislative and political agendas or other private interests. By 2

4 The self-dealing rules establish a broad prohibition on virtually all economic transactions between a foundation and its insiders, referred to in the statute as disqualified persons. 5 Thus, sales, leases, and loans between a private foundation and its disqualified persons are prohibited even where the terms of the transaction are more favorable to the private foundation than it could obtain in an arm s length transaction with an unrelated party. 6 The only significant exception to this overall ban is that section 4941 permits foundations to pay reasonable compensation for reasonable and necessary personal services provided by disqualified persons. 7 The self-dealing rules also incorporate targeted sanctions that punish the self-dealer rather than the foundation. More specifically, the new rules impose on disqualified persons who benefit from an act of self-dealing, a first tier excise tax equal to 5% (increased to 10% by the Pension Protection Act of 2006) of the amount involved in the act of self-dealing, along with a requirement that the disqualified persons correct the act of self-dealing. 8 For purposes of computing the amount of the tax, the amount involved in an act of self-dealing is generally the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received. 9 Thus, if a foundation makes a loan to a disqualified person, the amount involved is the full amount of the loan. Likewise, if a foundation makes a below-market sale of property to a disqualified person, the amount involved is the full fair market value of the property, not just the amount by which fair market value exceeds the amount paid by the disqualified person. The only exception is that if a private foundation pays more than fair market value for personal services provided by a disqualified person, the amount involved for purposes of computing the self-dealing tax is only the amount by which the compensation paid exceeds reasonable compensation. 10 Under the rules, correction requires undoing the transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in contrast, the only provision of the private foundation rules focused principally on the duty of care issue is the section 4944 prohibition on jeopardy investments The tables presented on pages 8 to 11present a summary, with citations, of the principal provisions of the section 4941 self-dealing rules. The self-dealing rules do permit the furnishing of goods, services, or facilities by a disqualified person to a private foundation if the furnishing is without charge and if the goods, services, or facilities so furnished are used exclusively for [section 501(c)(3)] purposes. 4941(d)(2)(C). 4941(d)(2)(E). 4941(a) and (b). 4941(e)(2) (e)(2). 3

5 which it would be if the disqualified person were dealing under the highest fiduciary standards. 11 If disqualified persons fail to correct an act of self-dealing within a specified period, they become subject to a second tier tax equal to 200% of the amount involved. C. 1996: The Intermediate Sanctions Rules While the private foundation rules gave the Internal Revenue Service a strong and appropriately targeted tool to police insider misconduct at foundations, revocation of taxexempt status remained the Service s only sanction for insider misconduct at public charities. After a series of high profile insider abuse cases involving public charities, in 1996 Congress enacted section 4958 commonly referred to as the intermediate sanctions rules imposing taxes on disqualified persons who engage in excess benefit transactions with public charities. Unlike the private foundation self-dealing rules, the intermediate sanctions rules do not establish a general prohibition on insider transactions with public charities, but rather impose sanctions only on transactions in which the disqualified person receives more, or pays less, than fair market value for goods, services, property, the use of facilities, or other items of value exchanged with a public charity. 12 The intermediate sanctions rules incorporate the same two-tiered sanctions mechanism as the self-dealing rules: i.e., immediate imposition on the disqualified person of a first tier tax and an obligation to correct the excess benefit transaction, followed by a much higher second tier tax if the disqualified person fails to make the required correction. The Treasury regulations promulgated pursuant to section 4958 contain a provision under which a charity and its disqualified persons can earn a rebuttable presumption that an insider transaction is not an excess benefit transaction if the board process approving the transaction meets three requirements. 13 These requirements are: (1) that the transaction be approved by a board or board committee composed entirely of individuals who do not have a conflict of interest with respect to the transaction under review, (2) that the decision be based on appropriate comparability data, and (3) that there be a contemporaneous written record of the board s decision. As discussed below, the new Form 990 focuses prominently on whether a charity has employed this process in reviewing and approving executive compensation and other insider transactions. D. 2006: Donor Advised Funds and Supporting Organizations Taken together, the private foundation self-dealing rules and the public charity intermediate sanctions rules cover most of the charitable landscape with detailed rules (e)(3). 12 The tables presented on pages 8 to 11 present a summary, with citations, of the principal provisions of section 4958 intermediate sanctions rules. 13 Reg

6 prohibiting or regulating insider transactions. However, in the years prior to 2006, Congress became increasingly concerned about what it came to regard as two soft spots in this regulatory design: donor advised funds and section 509(a)(3) supporting organizations. Following enactment of the private foundation rules, both donor advised funds and supporting organizations had come to be regarded as vehicles through which donors could retain a degree of control over donated assets comparable to what is possible with a private foundation, while both avoiding the tough private foundation rules, and receiving the more favorable charitable deduction treatment afforded to gifts to public charities. To preclude this end run around the private foundation rules, Congress enacted the donor advised fund and supporting organization provisions of the Pension Protection Act of Donor Advised Funds Public charities sponsoring donor advised funds have an obligation to exercise active control over distributions from the funds, and to reject any distribution recommended by a donor or donor-designated advisor if that distribution would confer an impermissible private benefit on the donor, the advisor, or a related party. In practice, however, sponsoring organizations often failed to meet this obligation, and, instead, approved distributions that were of questionable charitable value but that provided compensation, loans, grants, or other substantial economic benefits to donors, advisors, and/or related parties. Because generally neither the donors and donor-designated advisors, nor the persons benefitting from the donor advised fund distributions, had substantial influence over the sponsoring organization s overall operations, they were not disqualified persons for purposes of the intermediate sanctions rules, and, therefore, were not subject to sanction under those rules. Charities sponsoring donor advised funds sometimes also permitted donors, or donordesignated advisors, to make recommendations with respect to the investment of the assets held in the donor advised fund. As with distributions from the fund, sponsoring organizations that permit such investment recommendations have an obligation to reject any recommendation that is not in the best interest of the charity, including recommendations that would inappropriately benefit the donor, donor-designated advisor, or a related party. However, as with distributions, sponsoring organizations often failed to exercise this required oversight. For example, sponsoring organizations sometimes accepted donor recommendations that the donor advised fund retain stock in the donor s closely held corporation, even though this stock offered a much less favorable risk-return profile than the sponsoring organization could have achieved from alternative portfolios. The donor advised fund provisions of the Pension Protection Act of 2006 address these problems from several complementary perspectives. 14 At the heart of the new donor 14 In addition to the three provisions discussed in this section that regulate transactions between a sponsoring organization and donors, donor-designated advisors, and their related parties, the donor advised fund provisions also include provisions that: (1) deny a charitable deduction for contributions to a donor advised fund if either: (a) the sponsoring organization is a non-functionally integrated Type III supporting organization, or (b) the sponsoring organization fails to obtain a written statement from the donor acknowledging that the sponsoring organization has exclusive legal control over the donated assets( 170(f)(18)); (2) subject donor advised funds to the private foundation business holdings limits ( 4943(e)); and (3) require sponsoring organizations to include on their annual Form 990 various information about their donor advised funds ( 6033(k)). 5

7 advised fund rules are three provisions that directly regulate transactions between a sponsoring organization and donors, donor-designated advisors, and their related parties. 15 Under the first of these provisions, any grant, loan, compensation, or similar payment from a donor advised fund to a donor, donor-designated advisor, family member of a donor or donor-designated advisor, or an entity that is a 35% controlled entity with respect to any combination of the foregoing persons (collectively, a donor advised fund s disqualified persons ), constitutes an automatic excess benefit transaction under section Thus, a loan or payment of compensation from a donor advised fund to a disqualified person is a prohibited excess benefit transaction even if the transaction is as or more favorable than the donor advised fund s sponsoring organization could obtain in an arm s length transaction with an unrelated party. Moreover, the entire amount of the payment not just the amount that exceeds the fair market value of the consideration provided by the disqualified person -- is treated as an excess benefit. Under the second of the new donor advised fund provisions, sponsoring organizations are subject to a 20% tax on taxable distributions with respect to a donor advised fund. 17 Taxable distributions are defined as any distribution from a donor advised fund: (1) to a natural person, (2) to an organization, if the distribution is not for a charitable purpose, and (3) to a disqualified supporting organization or to a private foundation, unless the sponsoring organization exercises expenditure responsibility. 18 Finally, under the third provision, donors, donor-designated advisors, and certain related parties are subject to stiff sanctions for recommending or benefitting from, a donor advised fund distribution that results in any of the foregoing parties receiving a more than incidental benefit Supporting Organizations Under section 509(a)(3), an organization that does not independently qualify as a public charity may nonetheless qualify for public charity status if it operates in support of one or more public charities. The policy rationale is that the public charities that benefit from the activities of the supporting organization will actively supervise its operations, thereby obviating the need to subject the supporting organization to the strictures of the private foundation rules. In practice, however, many supporting organizations particularly, so The tables presented on pages 8 to 11 present a summary, with citations, of the principal elements of the Pension Protection Act s automatic excess benefit transaction, taxable distributions, and more than incidental benefit rules for donor advised fund. 4958(c)(2), (f)(1)(e), and (f)(7) (c). Disqualified supporting organization is defined in 4966(d)(4)

8 called Type III supporting organizations 20 operated without any meaningful supervision by their supported organization(s), leaving those in control of the supporting organization relatively free to make distributions and/or investment decisions that resulted in substantial private benefit. As with donor advised funds, the supporting organization provisions of the Pension Protection Act address this problems from multiple perspectives. 21 Of direct relevance to this analysis, these provisions include an amendment to the intermediate sanctions rules parallel to that for donor advised funds, under which any grant, loan, compensation, or similar payment by a supporting organization to a disqualified person is treated as an automatic excess benefit transaction. 22 As under the donor advised fund provision, the full amount of the grant, loan, compensation, or similar payment is treated as an excess benefit. 20 To qualify as a supporting organization, an organization must have one of three types of relationships with its supported organization: (i) operated, supervised, or controlled by one or more [supported organizations] (a Type I supporting organization), (ii) supervised or controlled in connection with one or more [supported organizations] (a Type II supporting organization), or (iii) operated in connection with one or more [supported organizations] (a Type III supporting organization) ( 509(a)(3)(B)). The Type III relationship is by far the most attenuated, and thus offers the greatest potential for abuse. 21 In addition to the automatic excess benefit rule discussed above, the supporting organization provisions include: (i) new Form 990 disclosure requirements ( 6033(l)), (ii) a requirement that the Secretary promulgate regulations establishing an annual payout requirement for supporting organizations ( 1241 of the Pension Protection Act (a non-code statutory provision)), (iii) subjecting supporting organizations to various provisions of the private foundation rules ( 4943(f) and 509(f)(2)), and (iv) restrictions on the ability of non-operating private foundations to treat distributions to supporting organizations as qualifying distributions under 4942 ( 4942(g)(4)) (c)(3). The tables presented on pages 8 to 11 present a summary, with citations, of the principal elements of the Pension Protection Act s automatic excess benefit transaction rule for supporting organizations. 7

9 Summary of Insider Transaction Rules Governing Private Foundations, Public Charities, Donor Advised Funds, and Supporting Organizations The citations included in these tables may be found in the endnotes beginning on page22. Private Foundations Public Charities Donor Advised Funds Automatic Excess Benefit Transaction Taxable Distributions Transactions Resulting in More than Incidental Benefit Actions Subject to Tax Acts of self-dealing i The following transactions between a foundation ( PF ) and a disqualified person ( DP ): o Sales, exchanges, or leases o Loans or extension of credit o Furnishing goods or services Payment of compensation by a PF to a DP Transfers of assets to or for the use of DPs Agreement by a PF to make a payment of money or property to a government official, other than an agreement to employ the official, if made within 90 days of the official s termination of government service Excess benefit transactions Any transaction in which an organization provides an economic benefit directly or indirectly to or for the use of any DP if the value of the benefit provided by the organization exceeds the value of consideration (including the performance of services) received for providing the benefit. iii Automatic excess benefit transactions Grants, loans, compensation, and similar payments from a DAF to a disqualified person are treated as automatic excess benefit transactions under the public charity intermediate sanctions rules. iv Taxable distributions are any distribution from a DAF: To a natural person, For a non-charitable purpose, or To: A disqualified supporting organization (as defined in 4966(d)(4)), or A private foundation (other than the sponsoring organization), unless the sponsoring organization exercises expenditure responsibility. v Private benefit distributions The act by a donor, donor-designated advisor, family member, or 35% controlled entity of giving advice that results in a sponsoring organization making a distribution from a DAF that results in any person receiving a more than incidental benefit. viii Exceptions Acts not treated as self-dealing ii Reasonable compensation for reasonable and necessary professional services provided by a DP Interest-free loans by a DP to a PF Rent-free leases by a DP to a PF Provision of goods or services by a DP to a PF without charge Provision of goods or services by a PF to a DP if provided on terms no more favorable than those available to the general public Transactions between a PF and a DP pursuant to various types of corporate reorganizations Various exceptions for payments by a PF to government officials The following distributions do not constitute taxable distributions: vi to any organization described in 170(b)(1)(A) other than a disqualified supporting organization, vii to the sponsoring organization of the donor advised fund, and to another donor advised fund. No tax is imposed under 4967 if the transaction is subject to tax under the 4958 intermediate sanctions rules. ix Supporting Organizations Automatic Excess Benefit Transactions Automatic excess benefit transactions Grants, loans, compensation, and similar payments to substantial contributors, family members, and 35% controlled entities Loans to disqualified persons x Loans to organizations described in 509(a)(1), (2), or (4) do not constitute automatic excess benefit transactions xi 8

10 Summary of Insider Transaction Rules Governing Private Foundations, Public Charities, Donor Advised Funds, and Supporting Organizations Private Foundations Public Charities Persons subject to tax Disqualified persons xii Substantial contributors to the PF Foundation managers Owners of more than 20% of a business entity or trust that is a substantial contributor to the PF Family members of the foregoing (see definition below) 35% controlled entities (corporations, partnerships, trusts, and estates in which the persons listed above own or hold more than 35% of the combined voting power, profits interest, or beneficial interest) Government officials Disqualified persons xv Any person who was, at any time during the 5 years preceding the excess benefit transaction, in a position to exercise substantial influence over the organization. Family members (see definition below) 35% controlled entities Amount Subject to Tax For self-dealing transactions other than the payment of compensation for personal services, the amount subject to tax (the amount involved ) is the greater of the amount of money and the fair market value of the other property received, or the amount of money and the fair market value of the property given. xiii For acts of self-dealing involving the payment to a DP of compensation for reasonable and necessary personal services, the amount subject to tax is the amount by which the compensation paid exceeds reasonable compensation. xiv The amount subject to tax is the amount of the excess benefit, i.e., the amount by which the value of the benefit provided by the organization exceeds the value of the consideration provided by the DP. xvi Donor Advised Funds Automatic Excess Benefit Transaction Disqualified persons xvii A donor to a donor advised fund A donor-designated advisor Family members (see definition below) 35% controlled entities The entire amount of the grant, loan, compensation or similar payment constitutes an excess benefit. xviii Taxable Distributions The entire amount of the taxable distribution is subject to tax. xix Transactions Resulting in More than Incidental Benefit A donor to a donor advised fund A donor-designated advisor Family members (see definition below) 35% controlled entities xx The amount subject to tax is the value of the more than incidental private benefit. xxi Supporting Organization Automatic Excess Benefit Transactions With regard to grants, compensation, and similar payments xxii Substantial contributors Family members 35% controlled entities With regard to loans xxiii Any person treated as a disqualified person under the section 4958 intermediate sanctions rules (see above) The amount subject to tax is the entire amount of the grant, loan, compensation, or similar payment. xxiv 9

11 Summary of Insider Transaction Rules Governing Private Foundations, Public Charities, Donor Advised Funds, and Supporting Organizations Private Foundations Public Charities Donor Advised Funds Automatic Excess Benefit Transaction 1 st and 2 nd Tier Taxes and the Obligation to Correct First tier tax and obligation to correct A DP who engages in an act of self-dealing is immediately subject to a first tier tax and an obligation to correct the act of self-dealing within a specified taxable period. xxv Correction means undoing the transaction to the extent possible, but in any case placing the PF in a financial position no worse than that in which it would be if the DP were dealing under the highest fiduciary standards. xxvi Second tier tax A DP who fails to correct an act of selfdealing within the correction period is subject to a second tier tax. xxvii Same as under the private foundation selfdealing rules (see above) xxxi Same as under the public charity intermediate sanctions rules xxxiv First tier tax Manager s tax A foundation manager xxviii who participates in an act of self-dealing, knowing it to be an act of selfdealing, is subject to the first tier manager s tax, unless the manager s participation is not willful and is due to reasonable cause. xxix Second tier tax A foundation manager who refuses to agree to part or all of the required correction is subject to the second tier manager s tax. xxx First tier An organization manager xxxii who participates in an act of self-dealing, knowing it to be an act of selfdealing, is subject to the first tier manager s tax, unless the manager s participation is not willful and is due to reasonable cause. xxxiii Second tier None Same as under the public charity intermediate sanctions rules xxxv Taxable Distributions No correction requirement A fund manager xxxvi who agrees to the making of a taxable distribution, knowing that it is a taxable distribution, is subject to the manager s tax. xxxvii Transactions Resulting in More than Incidental Benefit No correction requirement A fund manager who agrees to the making of a distribution from a DAF that results in any person receiving a more than incidental benefit, if the fund manager knew the distribution would result in such benefit, is subject to the manager s tax. xxxviii Supporting Organization Automatic Excess Benefit Transactions Same as under public charity intermediate sanctions rules xxxix Same as under public charity intermediate sanctions rules xl 10

12 Summary of Insider Transaction Rules Governing Private Foundations, Public Charities, Donor Advised Funds, and Supporting Organizations Private Foundations Public Charities Donor Advised Funds Automatic Excess Benefit Transaction Taxable Distributions Transactions Resulting in More than Incidental Benefit Tax rate On self-dealers xli First tier tax: 10% of amount involved Second tier tax: 200% of the amount involved On foundation managers xlii First tier tax: 5% of amount involved up to a maximum tax of $20,000 Second tier tax: 50% of amount involved up to a maximum tax of $20,000 Joint and several liability xliii If two or more persons are liable for the first or second tier taxes on self-dealers or foundation managers, all such persons are jointly and severally liable. On disqualified persons xlv First tier tax: 25% of amount involved Second tier tax: 200% of the amount involved On organization managers First tier tax: 5% of amount involved up to a maximum tax of $20,000 xlvi Second tier tax: None Joint and several liability xlvii Same as under public charity intermediate sanctions rules xlix First tier tax li 20% on amount involved 5% manager s tax up to a maximum tax of $10,000 Second tier tax None Joint and several liability lii On donor, donor-designated adviser, or related person 125% of the more than incidental benefit liii Fund managers 10% of the more than incidental benefit, up to a maximum tax of $10,000 liv Joint and several liability lv Definition of Family Member For purposes of the definition of disqualified person, family members include a disqualified person s: xliv spouse, ancestors, and children, grandchildren, and great grandchildren and their spouses For purposes of the definition of disqualified person, family members include a disqualified person s: xlviii spouse, ancestors, children, grandchildren, and great grandchildren and their spouses, and brothers and sisters and their spouses (not treated as DPs under the private foundation self-dealing rules) Same as under public charity intermediate sanctions rules l Not applicable Same as under public charity intermediate sanctions rules lvi Supporting Organization Automatic Excess Benefit Transactions Same as under public charity intermediate sanctions rules lvii Same as under public charity intermediate sanctions rules lviii 11

13 E : The IRS Focus on Charity Governance The following statement appears on the Charities and Non-Profits portion of the IRS website: The IRS is dedicated to ensuring that charities operate exclusively for charitable purposes and use their assets to accomplish charitable ends. Good governance is important to increase the likelihood that organizations will comply with the tax law, protect their charitable assets and, thereby, best serve their charitable beneficiaries. 23 Consistent with this statement, over the past several years the Service has placed increasing emphasis on charity governance. In February 2007, the IRS posted on its website a preliminary staff discussion draft of possible good governance practices for charitable organizations. The draft was widely criticized as overly prescriptive, and the Service has since withdrawn it. But the Service s overall emphasis on charity governance has only intensified. Some critics have aggressively challenged the Service s position, questioning on empirical grounds the Service s asserted link between a charity s governance and its legal compliance, and arguing that nothing in the Code gives the IRS the legal authority to regulate charity governance. 24 However, senior IRS leaders have made clear that the Service has no intention of backing off. 25 Reflecting the Service position, the proposed revision to the Form 990 released for public comment in June 2007 contained a new section on Governance, Management, and Disclosure. This section Part VI of the final version of the new Form requires a public charity to disclose, among other information, the following: the number of voting members on its governing body, how many of these members are independent, Life Cycle of a Public Charity, Governance and Related Topics 501(c)(3) Organizations, See,e.g., Owens, Charities and Governance: Is the IRS Subject to Challenge?, 2008, 106b4e3a8863/Governance%20article.pdf. See, e.g., Nonprofit Governance The View from the IRS, Remarks by Sarah Hall Ingram, Commissioner, Tax Exempt and Government Entities, at the Georgetown University Law Center Continuing Legal Education Conference, June 23, 2009, gtown governance_ pdf. For this purpose, a member of an organization s governing body is independent only if the following three circumstances applied at all times during the organization s tax year: 1. The member was not compensated as an officer or other employee of the organization or of a related organization, 12

14 any family or business relationships that exist among its officers, directors, trustees, or key employees; whether the organization contemporaneously documents the decisions of its board and any committees with authority to act on behalf of the board; whether the organization has a written conflict of interest policy, whether that policy requires officers, directors, trustees, and key employees to disclose annually interests that could give rise to conflicts, and whether the organization regularly and consistently monitors and enforces compliance with the policy; whether the organization has a written whistleblower policy; whether the organization has a written document retention and destruction policy; and whether the organization s process for determining compensation for the organization s officers and key employees satisfies the requirements of the intermediate sanctions rebuttable presumption rules. 27 In addition, new Schedule L, Interest Party Transactions, requires organizations to provide detailed information on any loans to, or loans received from, interested persons, grants or assistance benefitting interested persons, and any business transactions involving interested persons. 28 The new Life Cycle of a Public Charity resource on the Service s website makes clear that the Service is not agnostic on the answers to the Form 990 s new governance questions. The Governance and Management Policies section 29 explicitly states that the Internal Revenue Service encourages charities to: 2. The member did not receive total compensation or other payments exceeding $10,000 during the organization s tax year from the organization or from related organizations as an independent contractor, other than reimbursement of expenses under an accountable plan or reasonable compensation for services provided in the capacity as a member of the governing body. 3. Neither the member, nor any family member of the member, was involved in a transaction with the organization that is required to be reported on Schedule L (Interested Party Transactions) for the organization s taxable year, or in a transaction with a related organization of a type and amount that would be reportable on Schedule L if required to be filed by the related organization. IRS Form 990 Instructions, Copies of Part VI of the Form 990 and Form 990 Schedule L are included as Attachments 1 and 2. For this purpose, interested persons are defined as current or former officers, directors, trustees, key employees, and five highest compensated employees listed in Form 990, Part VII, Section A. See Schedule L Instructions, 1-2. For section 509(a)(3) supporting organizations, disqualified persons as described in section 4958(c)( 3)(B) are also interested persons. The Governance and Management Policies section of The Life Cycle of a Public Charity appears on the IRS website at: 13

15 rely on the rebuttable presumption test of section 4958; adopt and regularly evaluate a written conflict of interest policy based on the sample policy contained in the instructions to the Form 1023; 30 require its directors, trustees, officers and others covered by its conflict of interest policy to disclose, in writing, on a periodic basis any known financial interest that the individual, or a members of the individual s family has in any business entity that transacts business with the charity; regularly and consistently monitor and enforce compliance with its conflict of interests policy; ensure that governing bodies and authorized sub-committees take steps to ensure that minutes of their meetings, and actions taken by written action or outside of meetings, are contemporaneously documented.; adopt a written policy establishing standards for document integrity, retention, and destruction; consider adopting and regularly evaluating a code of ethics; and adopt a policy for handling employee complaints and establish procedures for employees to report in confidence any suspected financial impropriety or misuse of the charity s resources. II. The Lawyer s Role in Helping Clients Deal with Conflicts of Interest A. Helping Clients Put Appropriate Policies and Procedures in Place Given the tough Internal Revenue Code sanctions on the use of a charity s resources for the private benefit of its directors and employees, as well as the IRS intense focus on charity governance, the lawyer advising a charity should encourage the organization s leaders to review periodically the strength of the organization s governance. Providing the client s leadership with a copy of the Governance and Related Topics section of the IRS Life Cycle of a Public Charity resource, described above, may be a useful way to begin this conversation, both because it provides a reasonably comprehensive list of possible actions to strengthen governance, and because the IRS imprimatur underscores the importance of the issues. In framing this discussion, the lawyer should help the client s leadership understand several fundamental points: (1) that the IRS does not have the authority to mandate any particular governance policies and procedures, (2) that adopting policies along the lines suggested by the IRS will almost certainly cause the IRS to view the organization in a more favorable light, and (3) that whatever its policies, the organization and its insiders face stiff sanctions if they fail to ensure that its assets are used exclusively for charitable purposes, and not for the private benefit of insiders. 30 A copy of the IRS sample conflict of interest policy is included as Attachment 3. 14

16 In light of these facts, a strong case can be made that, at a minimum, charities should: (1) adopt and ensure the effective implementation of a written conflict of interest policy that is consistent with the sample IRS policy, (2) ensure contemporaneous written documentation of the actions of the board and board committees, and (3) use the rebuttable presumption procedures in setting executive compensation and reviewing insider transactions. Beyond this, the lawyer should encourage a charity s leadership to consider carefully, in light of the organization s own facts and circumstances, the extent to which the organization should adopt the Service s other recommendations. The lawyer may also want to encourage the client s leadership to review some of the excellent publicly available resources on charity governance. For example, Independent Sector and BoardSource have jointly developed a workbook, available free of charge on the Independent Sector website, for boards that want to undertake and in-depth review of their organization s governance. 31 A. Advising Clients on Difficult Conflict Situations Helping charities establish appropriate policies and procedures for dealing with conflicts of interest is a straightforward task, with well thought out models and abundant advice readily at hand. Advising clients on how to deal with actual conflict situations can be much more difficult. The following are examples of relatively common conflict situations that can be particularly challenging for a charity s counsel: Executive Compensation. Historically, many public charity and private foundation boards have permitted the organization s CEO to exert inappropriate influence on setting his or her compensation. Indeed, Congress enacted the intermediate sanctions rules in direct response to the notorious case in which the United Way of America board permitted CEO William Aramony to award himself an excessive compensation and benefits package with no effective board oversight. Much more recent controversies involving the presidents of American University and the J. Paul Getty Trust make clear that neither the intermediate sanctions rules nor the private foundation self-dealing rules have entirely eliminated the problem of the dominant charity CEO effectively eliminating board oversight of CEO compensation. Board Member Roles and Compensation. Another difficult conflict situation arises when an organization s board members consider the possibility of having the organization compensate them for their service as directors and/or as employees. Where the board is considering compensating all board members, there are no independent directors to serve as objective guardians of the organization s interests. Such board compensation is reasonably common among private foundations, and the Council on Foundation s periodic compensation surveys provide useful benchmarking data. Board compensation is much less 31 The Principles Workbook: Steering Your Board Toward Good Governance and Ethical Practice, Independent Sector and BoardSource, available free of charge at: 15

17 common for public charities, and, as a result, a public charity board that decides to compensate its members is well-advised both to explain clearly in writing its rationale for concluding that board compensation serves the interests of the organization, and to be conservative in setting the amount of that compensation. This situation becomes particularly difficult when board members consider defining roles for themselves that require an unusually large time commitment, and then compensating themselves in proportion to this expanded role. The most extreme case is when the board considers employing a significant number of board members on a full or substantial part-time basis. Related Charitable and For-Profit Organizations Under Common Control. Challenging conflict issues also arise when a charity and a for-profit organization operate under common control and share staff, facilities, or services, or engage in other inter-organization transactions. In one version of this fact pattern, the charity and the for-profit have the same, or substantially overlapping boards. In another variant, a dominant founder populates the charity board with individuals that the founder expects will passively support his or her plans. In either case, the lawyer must attempt to educate both those in effective control of the two organizations, and the independent members of the charity board, if any, about the substantial risks inherent in failing to police the conflicts inherent in this structure. Deference to a Founding Donor. It is not uncommon for the founder of a charity to have a proprietary attitude toward the organization s assets and operations. It is also not uncommon for the other members of such an organization s board to adopt, or at least acquiesce in, the view that it is the founder s organization. This risk is particularly great when the founder is a charismatic and effective leader. As part of an overall pattern of deference to the founder, the boards of such organization often fail to ask the tough questions they should be asking about conflicts of interests between the organization and the founder. The lawyer s challenge is to persuade the founder and/or the other members of the organization s board that they have a legal obligation to, and a prudential interest in, squarely addressing these conflict issues There are no formulaic answers for the charity lawyer dealing with these and other similarly complex conflict situations. Each situation is unique, arising in its own complex context defined by the particular history, culture, and operations of the charity, the personality and character of its leaders, and the nature of the conflict of interest involved. The lawyer confronting such a situation will need not only knowledge of the law, but also a high degree of judgment, diplomacy, and political acumen. As discussed in the following section, the lawyer must also be prepared to deal with the possibility that the individual employees or directors of the charity may disregard the lawyer s advice and persist in a course of conduct that advances their private interests at the expense of the charity 16

18 III. Rule 1.12: The Organization as Client In dealing with conflict situations, a charity s lawyer must bear in mind that his or her client is the organization, and not its directors, officers, or employees. Consequently, the lawyer needs a solid understanding of his or her professional obligations when the client s agents consider or take actions contrary to the client s interests. Rule 1.12 of the Texas Disciplinary Rules of Professional Conduct addresses the lawyer s obligations when his or her client is an organization rather than an individual. 32 Paragraph (a) reads as follows: (a) A lawyer employed or retained by an organization represents the entity. While the lawyer in the ordinary course of working relationships may report to, and accept direction from, an entity s duly authorized constituents, in the situations described in paragraph (b) the lawyer shall proceed as reasonably necessary in the best interest of the organization without involving unreasonable risks of disrupting the organization and of revealing information relating to the representation to persons outside the organization. Thus, a lawyer retained by a charity represents the entity. While the lawyer necessarily interacts with the charity through the individuals who serve as the charity board and staff, when the charity s interest conflicts with the private interests of one or more of these individuals, the lawyer has an obligation to proceed as reasonably necessary in the best interest of the organization In deciding whether and how to address a particular conflict of interest situation, the lawyer should give due weight to the charity s interest in avoiding disruptions to its operations and in protecting the confidentiality of organizational information. Paragraph (b) of Rule 1.12 provides more detailed guidance on when an entity s lawyer is required to act to protect the entity from a conflict of interest. This paragraph reads as follows: (b) A lawyer representing an organization must take reasonable remedial actions whenever the lawyer learns or knows that: (1) an officer, employee, or other person associated with the organization has committed or intends to commit a violation of a legal obligation to the organization or a violation of law which reasonably might be imputed to the organization; (2) the violation is likely to result in substantial injury to the organization, and 32 The text of, and official comments on, Rule 1.12 are included as Attachment 4. 17