Caution for Nonprofits Doing Business with Insiders: IRS Revokes 501(c)(3) Status Based on Management Company Relationship

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Picture a 1,000-piece jigsaw puzzle of a frightening image with a single piece missing. No matter which piece is missing, the image is still frightening. Now picture the same jigsaw puzzle with 400 pieces missing. The image may appear to be terrifying if you squint at the pieces that are there, but it’s possible that if the gaps were filled in, the image would not be troubling. Enter Internal Revenue Service (IRS) Private Letter Ruling (PLR) 202306009, the jigsaw puzzle with 400 pieces missing. In this case the missing pieces are the relevant facts. The IRS is required to redact identifying information from letter rulings before publication but can sometimes be overzealous with the Sharpie, making the published ruling difficult to analyze. Such is the case with PLR 202306009. But because this ruling deals with an important issue for tax-exempt organizations—how to structure business arrangements with founders and other “insiders”—it is worth the effort to try to piece it together.

IN DEPTH


Background

In PLR 202306009, the IRS revoked the Section 501(c)(3) status of a nonprofit organization (Charity) dedicated to providing foster care services, including child placement and family support services. The stated basis for the revocation was that Charity’s earnings inured to the benefit of Charity’s founder and his spouse. With the hope that the reader is sitting down while reading this part of the summary, inurement was found despite the following facts:

  • Compensation was never alleged to be excessive (in fact, there are facts suggesting that at least the initial compensation was below fair market value).
  • The agreement at issue appears to have been reviewed and approved by an independent board that relied on comparable arrangements prior to giving its approval.
  • The compensation arrangement did not create an equity-like incentive.

Given the severity of the punishment (i.e., the IRS found that the result of the arrangement was so egregious as to warrant revocation of tax-exempt status as opposed to the imposition of intermediate sanctions penalties), it is important to clearly identify the pieces of the puzzle that we have and the pieces of the puzzle that are missing.

The Pieces We Have

  • Charity was formed for the purpose of providing foster care services, including related counseling and training. The IRS stated that this purpose was a qualifying charitable purpose.
  • After several years of Charity’s operation, the executive director and founder of Charity and his wife formed a for-profit management company (ManageCo) to provide management services to Charity and potentially other organizations.
  • A management agreement was drafted and submitted to Charity’s board of directors for approval. Charity’s board looked at comparable arrangements and market research prior to approving the agreement with ManageCo, but there was no competitive bidding process.
  • Under the management agreement, ManageCo provided fairly routine management services, including the provision of an executive director to Charity (who presumably was the founder and previous executive director). Other services included administrative support, financial reporting and budgeting, coordination with auditors, information technology support, human resources support, program development and strategic planning, and database management to meet legal requirements for foster care providers across multiple states.
  • There appear to have been frequent operational meetings between staff of Charity and ManageCo.
  • ManageCo retained the right to own any copyrights and other intellectual property that was created during the term of the agreement.
  • The length of the management agreement term is redacted, but there is no discussion of it being excessive in length. The agreement automatically renewed, with either party having the right to terminate the agreement prior to renewal.
  • The compensation was based on a percentage of gross revenues and was initially set at what appears to be a below-market level because of Charity’s limited financial ability to pay. The management fee was subsequently increased at least twice as Charity’s budget grew, each time by written agreement of the parties and based on analysis of market conditions.
  • There was no factual finding that the compensation under the management services agreement was unreasonable or that the term of the agreement was excessive.
  • Charity’s board was tasked with annual assessment and evaluation of ManageCo’s performance and achievement of stated objectives.
  • ManageCo had the right to provide similar services to other entities, but Charity was “the main client” of ManageCo based on IRS review of ManageCo’s tax returns. The “vast majority” of management fees that Charity paid to ManageCo were in turn transferred to the founder and his wife through salary and shareholder distributions from ManageCo.

The Pieces We’re Missing

  • What percentage of Charity’s expenses did the management fee represent? If an extremely large percentage of a nonprofit’s expenditures are paid to an entity owned by insiders (or even unaffiliated for-profit entities), that fact can be evidence of more than incidental private benefit and can threaten tax exemption. This was the case in Church by Mail, a case that the IRS relied on heavily in this ruling, but which had more egregious facts. However, the mere percentage in and of itself is not determinative and is simply one fact to be considered in the overall analysis. In the United Cancer Council case, for example, the percentage of contributions retained by the for-profit fundraiser was certainly eyebrow raising but, according to the courts, was merely a percentage that needed to be reviewed in the overall facts and circumstances.
  • How credible were the comparables and market research that Charity’s board used in its review? Were any other management companies even in existence in the area that could have provided the same services as well or as cheaply as ManageCo did?
  • Did ManageCo provide services to other entities or at least offer its services to other entities? If ManageCo had been formed solely to provide services to Charity, that is a fact that the IRS has used historically to support more than incidental private benefit arguments. However, in the letter ruling, the facts stated that there was an intention for ManageCo to provide services to other entities, and that the management fee was not the only source of income to ManageCo.
  • Were the founder and/or the founder’s spouse on Charity’s board of directors? If they were, did they participate in the review and approval process of the arrangement, or did they recuse themselves? The likely answer is that the board was entirely independent because otherwise the IRS would have noted this adverse fact as a basis for supporting its conclusion.
  • Was the management agreement dated retroactively? In the facts, there is a mention of two agreements and a suggestion that the first agreement was effective on a retroactive basis. In the second agreement, which appears to have replaced the first agreement, there is no discussion of retroactivity. Retroactive effective dates can raise issues but are not per se improper; frequently parties agree to business terms and formal documentation is drafted later with retroactive application clearly spelled out. In the analysis section of the letter ruling, the IRS doesn’t mention the retroactive effective date issue, so presumably it was not problematic or used as a basis for revocation.

Putting the Pieces Together

There is no question that a meaningful perception issue is raised whenever a charitable organization enters into business arrangements with insiders or their businesses. Such arrangements, however, are not prohibited for Section 501(c)(3) public charities and are not uncommon. It is also not uncommon for nonprofits to outsource various management and administrative services. Unfortunately, given the limited number of facts provided to us in PLR 202306009 due to redactions, it is impossible to determine whether the IRS actions in this specific situation were correct or overreaching.

What we can see in the puzzle is several very troubling statements made by the IRS that are either incorrect or overstated. For example, twice in the ruling the IRS states that the arrangement with ManageCo was not an arm’s length arrangement simply because Charity did not put the arrangement out for competitive bidding. While relying on comparables is certainly part of an arm’s length analysis, whether an arrangement is put out for competitive bidding is not. (See generally, the regulations under Section 482 of the Internal Revenue Code.) In the ruling there was no question that ManageCo had excellent credentials to provide the relevant services; the only issue was whether there were better and/or cheaper services available.

The IRS also found that the management agreement gave “substantial control” over Charity to ManageCo, and therefore indirectly to the founder and his wife as insiders. This conclusion is troubling because the specific provisions cited by the IRS in support of such finding seem fairly routine for management services agreements. In particular, the IRS found it suspect that the financial interests of Charity and ManageCo were aligned under the management agreement: because ManageCo would provide expertise in strategic planning and program development, this would have the effect of increasing Charity’s revenues, which would in turn increase the fee paid to ManageCo (recall that the IRS did not find that the fee ever exceeded fair market value).

Finally, it is concerning that the IRS looked beyond the charitable organization itself to find grounds for revocation. The IRS cited ManageCo’s apparent lack of other meaningful customer relationships, and its decisions regarding salary payments and shareholder distributions, in support of the conclusion that Charity’s tax exemption should be revoked. Assuming that Charity’s board was in fact independent at the time the management agreement was approved, it is unclear how the board would be in a position to evaluate the management company’s business model and financial plans to analyze whether private inurement might occur.

Takeaways from PLR 202306009

Unless the case makes its way to court, we’ll never know whether the revocation in PLR 202306009 was appropriate under the specific facts and circumstances. However, much can still be learned from the pieces that we have. When considering any arrangement between a Section 501(c)(3) organization and an insider, or a business entity owned by an insider:

  • Recognize the apparent importance of a competitive bidding process to the IRS. The ruling reflects a new focus on this procedural step in a nonprofit board’s analysis of a proposed business arrangement, particularly where insiders are involved.
  • Clearly document the comparables that the board used in making its decision and the basis for approving the arrangement.
  • Ensure a robust conflict of interest policy is in place and that its procedures are precisely followed.
  • Include express provisions in management agreements to confirm that ultimate authority remains with the nonprofit’s board.

Even if all of these steps are taken, business arrangements between a charitable organization and its insiders are subject to a heightened degree of scrutiny. Nonprofit boards should exercise additional care when considering such arrangements, especially given the lack of clarity provided in this recent ruling.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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