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What Every Nonprofit Should Know: Key Legal

Developments Issues

James L. Catanzaro, Jr. • Christopher J. Hennen • J. Nelson Irvine • Kirby W. Yost

November 14, 2013

Hot Topics in the Nonprofit World

Christopher J. Hennen

Increased Revocations

• In 2010, IRS began revoking tax exempt status of organizations thathad not filed their Form 990s for theprevious 3 years

• As of August 2012, 443,441 organizations had their tax exempt status revoked for this reason

• Many have applied for reinstatement, while others are in the process

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Internal Revenue Service Backlog

• IRS, when fully staffed, processes approximately 60,000 applications per year

• Generally, applications separated into 4 categories

• Depending on the category and additional information required, process normally takes either 3 months, 4-5 months, or 9 months

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Internal Revenue Service Backlog

• Currently, many applicants experiencing significant delays. One factor is high number of revocations and applications for reinstatement

• For applications requiring additional information, IRS is currently assigning applications received in May 2012

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Documenting Contributions

• Charitable deductions a huge incentive to donors

• Many nonprofits rely on this incentive for funding

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Documenting Contributions

• IRS requirements for documenting charitable contributions have become increasingly complex

• Recent tax court cases indicate higher level of disallowed deductions for failure to submit proper documentation

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Social Entrepreneurship

• New trend towards hybrid of the for-profit and non-profit structures

• Two recent entity developments

– Low-Profit Limited Liability Company (L3C)

– Benefit Corporation (B Corp)

• Significant issues remain with these hybrid entities

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Executive Compensation

• IRS rules state that nonprofit CEOs should receive 'reasonable compensation'

• In recent years, the IRS has even redesigned the Form 990, in part to force greater transparency around nonprofit compensation

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Executive Compensation

• IRS continues to prioritize CEO compensation as one of its main areas of focus in uncovering fraudulent nonprofit practices

• A helpful resource for evaluating executive compensation is Charity Navigator's recently issued 2013 Charity CEO Compensation Study, available online

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Unrelated Business Income (UBI)

• Sometimes called UBTI (Unrelated Business Taxable Income)

• UBI is income from a trade or business that is regularly carried on and is not substantially related to furthering the exempt purpose of the organization

• Increasing priority for IRS, as reports continue to indicate significant underreporting

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Charitable Solicitations

• In Tennessee, charitable solicitations governed by The Charitable Solicitations Act

• Requires that charitable organizations which solicit contributions directly or indirectly from, or within, the State of Tennessee register unless exempt

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Charitable Solicitations

• Registering in TN

– File an Application for Registration of a Charitable Organization, along with its organizing documents (e.g. a charter) and, if it has obtained one, a letter of determination of tax exempt status from the IRS

• Cost of registration varies state to state – in Tennessee, initial fee is $50.

– Annual fees vary on sliding scale

• Penalties for violation: civil fine, potential criminal

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Charitable Solicitations

• Charleston Principles govern internet solicitations

• Generally, an out-of-state entity must register if

– its non-internet activities would require registration or

– the entity targets a person in the state, repeatedly receives contributions from that state, or

– follows up online activity by inviting further offline activity

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Questions?

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Fiduciary Obligations and Duties of Nonprofit Directors/Officers

(Your Silence Can Be Held Against You)

James L. Catanzaro

What is a fiduciary?

• An individual in whom another has placed trust and confidence to manage and protect property or money

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• A director or officer of a nonprofit organization has been given assets to use for a specific benefit of the public

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• Directors and officers, therefore, are treated nearly the same as parents of children

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• As stated by law, an officer or director must satisfy duties of care and loyalty

– Duty of care: use reasonable care and judgment

– Duty of Loyalty: place interests of organization first

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The fundamental requirement for the performance of these duties is an adequate level of knowledge about the business of the organization and applicable limitations.

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Following are questions you should ask and have answered if you don't know.

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1. What are the sources of receipts for the organization and what conditions apply?

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2. What grant conditions apply and are the conditions being satisfied?

RISK: Improper use of funds may result in loss of key resource or worse!

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B. For contributions received, what conditions (if any) apply for their use?

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2. Are the organization's assets properly safeguarded?

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A. Is there an independent audit done of the organization's financial statements and does the board control that process?

• What if management practices cited in audit findings?

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B. Are there adequate financial controls in place concerning the expenditure of monies?

• Board and signature requirements

• Credit card use

• Handling of contributions

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C. How is compensation set for officers?

• Excessive benefit transactions

• Waste of assets

• Use of survey data/experts

• Board involvement!

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D. Is there an effective conflict of interest policy and process in place?

• Annual disclosures?

• Findings by uninterested members

• Taking other bids

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3. Is the organization in compliance with applicable laws and reporting obligations?

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A. Who prepares the organization's Form 990 and what is the process for approval and filing of same?

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B. Are there processes for periodically reviewing the purpose, mission and operations?

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C. Does the board have access to and hire legal counsel?

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A Key Point of Clarification

What level of inquiry if necessary?

•Is the Board to function as a super CEO?

•What level can be expected of the volunteers?

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The obligation depends upon the facts, but reliance upon experts and management may suffice provided that a reasonable logic underpins such reliance

•What about really complex proposals that are of potentially significant impact?

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Ultimate Downside

• If officers and directors do not have a handle on these basic questions, their silence may be construed as acceptance of or agreement to inappropriate and/or wrongful acts

– Personal liability

– Organizational loss of exempt status

– Loss of support

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Questions?

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Governance Issues for Directors and Officers

DELEGATION, RELIANCE AND ACCOUNTABILITY

J. Nelson Irvine

What Board Members Should Know and Do

• Acting Responsibly and Avoiding Liability

• Acting Corporately as a Board

• Acting Personally as an Individual by each Director and Officer

• Acting or Not Acting

• Guidelines for how to act or not act as a director and/or officer

CORPORATE GOVERNANCE

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Duties of Directors and Officers

• Prescribed by:

– Corporate law and common law, cases, attorney general opinions, organizational documents, bylaws, codes of ethics, articles of associations, articles of organization or trust documents and agreements

• Delegated by:

– Board of directors

– Committees of the Board

– Officers authorized to delegate duties by designated persons in charter

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Duties of Directors Compared to Officers

Both have Duty of Loyalty and Duty of Care

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General Standard for Directors – Duty of Care

a) A director shall discharge all duties as a director, including duties as a member of a committee:

1) In good faith;

2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances; and

3) In a manner the director reasonably believes to be in the best interests of the corporation.

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General Standards for Directors - Reliance

(b) In discharging such duties, a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by:

1) One (1) or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented;

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General Standard for Directors - Reliance

2) Legal counsel, public accountants or other persons as to matters the director reasonably believes are within the person's professional or expert competence; or

3) A committee of the board of directors of which the director is not a member, as to matters within its jurisdiction, if the director reasonably believes the committee merits confidence.

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Duties and Responsibilitiesof Directors

– Directors:• Oversight and general responsibility:

"all corporate powers shall be exercised by or under the authority of, and the affairs of the corporation managed under, the direction of the corporation."

–May rely: on others: officers, employees, professional advisors, committees, and "others" e.g. volunteers [proposed law]

–May delegate: to others [officers, employees, professional advisors, and volunteers]

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Duties and Responsibilities of Officers

• Officers: Have Delegated Duties and Responsibilities:– By the Bylaws, the Board, Others Officers

"Each officer has the authority and shall perform the duties set forth in the bylaws or, to the extent consistent with the bylaws, the duties prescribed by the board of directors or by direction of an officer authorized by the board of directors to prescribe the duties and authority of other officers."•May rely•May delegate

• Officers: May or May Not be Directors

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Reliance on Others

A director or an officer is not acting in good faith if he or she has knowledge concerning the matter that makes reliance otherwise permitted unwarranted

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Delegation of Duty to Review Form 990

• Can an executive director delegate the duty to the board or a director?

• Can a director delegate the duty to the executive directors?

• Can the board delegate the duty to a committee of the board?

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Who is Looking at Your 990?

• Forms 990 are public records

– Donors and creditors as well as regulatory agencies such as the State Attorney General pick up information from Forms 990

– Reporting agencies like Guidestar use and rely on information in the Form 990

– State and local tax assessors may use and rely on statements of mission, purpose and related activities

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990 Review Process

• Part VI, Governance, Management and Disclosure

– Section B. Policies• 11a. Has the organization provided a complete

copy of this Form 990 to all members of its governing body before filing the Form?

• 11b. Describe in Schedule O the process, if any, used by the organization to review this Form 990

– ARE THE DIRECTORS INFORMED ABOUT THE PROCESS?

– DO THE DIRECTORS PARTICIPATE IN THE PROCESS?

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Schedule O990 Process Statement

Example 1

• "Form 990 is prepared by an independent CPA firm and submitted to the executive director for review"

• [Form 990, Part VI, Section B, Line 11]

– DIRECTORS HAVE A DUTY AND A RIGHT TO BE INFORMED

– DIRECTORS HAVE A RIGHT TO INSPECT RECORDS

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Schedule O990 Process Statement

Example 2

"Form 990 is prepared by the independent accounting firm, then reviewed and verified by the chief financial officer and reviewed by the chairman of the finance committee. Copies of the form are then sent to all members of the executive committee for review and comment. Copies are made available to all members of the board of directors. The final version is filed with the Internal Revenue Service."

[Form 990, Part VI, Section B, Line 11]

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Protection from Liability under Tennessee Law

Neither a director nor an officer is personally liable for any action taken or not taken as a director or officer

or any failure to take any action, if he or she performed the duties of office in compliance with the

corporate standard

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Immunity under Tennessee Law

• All directors, trustees or members of governing bodies of nonprofit corporations and organizations "shall be immune from suit arising from the conduct of the affairs of" such corporations and organizations

• BUT such immunity is removed when such conduct "amounts to willful, wanton or gross negligence"

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Additional Liability Protection in Charter

The charter may contain a provision eliminating or limiting the personal liability of a director to the corporation or its members for monetary damages for breach of fiduciary duty as a directors:

•Except for:

– breach of the duty of loyalty

– for acts or omissions not in good faith or intentional misconduct or a knowing violation of law

– unlawful distributions

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Right of Contribution for Unlawful Distributions

A director held liable for an unlawful distribution is entitled to contribution from every other director who

voted for or assented to the distribution without complying with the applicable standards of conduct as well as from each person who received the unlawful

distribution

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Are Directors Sometimes Trustees?

• Nonprofit corporation directors are not trustees

• Nonprofit corporation officers are not trustees

• What if the bylaws refer to directors as "trustees"?

• What if directors or officers are also "trustees" of a trust?

A trustee has a higher standard of conduct.

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When is a Director a Trustee?

• When he or she is acting in a capacity other than as a director or officer

• When he or she has fiduciary duties under employee benefit plans and ERISA

– e.g. officers who are administrators of plans

• When he or she participates in a decision to change an exempt purpose or function of the corporation, i.e. amend the charter or bylaws

– e.g. use of donated property – cy pres – notice to attorney general

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When is a Director not a Trustee?

• TNCA provides:

"a director shall not be deemed to be a trustee with respect to the corporation or with respect to any property held by the corporation, including, without limitation, property that may be subject to restrictions imposed by the donor or transferor of such property"

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Duty of Loyalty Issues

The Three "C's"Conflicts of interest

Corporate opportunity

Confidentiality

Corporate law

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Conflicts of Interest

• if approval is obtained from the attorney general and reporter; or

• If approval is obtained from a court having equity jurisdiction in an action in which the attorney general and reporter is a party

• if the transaction was fair at the time it was entered into or

• if the transaction is approved, after disclosure, by independent directors, who have no direct or indirect interest, either acting as a board or as a committee of the board; or

"A conflict of interest transaction is a transaction with the corporation in which a director or officer of corporation has a direct or indirect interest."

A conflict of interest transaction is not voidable or the basis for imposing liability on the director or officer:

By comparison, a conflict of interest transaction by a trustee is voidable

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Corporate Opportunity

• A corporate director, of both a nonprofit and a for profit corporation, must offer first to the corporation any business opportunity that involves an activity in which the corporation has an interest before the director takes the business opportunity for himself or herself

• The requirement in standards of conduct that a director act in good faith requires the director to make a full and timely disclosure of the business opportunity– e. g., an opportunity to purchase a piece of real

estate that the nonprofit corporation could use for its business

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Confidentiality

• The requirement that a director keep confidential the business of the nonprofit corporation arises under the duty of loyalty in:

– Conflict of interest situations

– Corporate opportunity situations

– Contract negotiations

– Employee and HR reviews and decisions

– Regulatory compliance matters; and

– Executive Sessions of the Board

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Rights of Directors

• To be informed

• To have access to management: CEO or Executive Director or Officers of the Board

• To have access to books and records, minutes, financial statements, Form 990, Form 1023, charter, bylaws, codes of ethics

• To participate in decisions to vote including the right to dissent and have dissent recorded

• To be indemnified

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Director's Right to Inspect Records

• Members of nonprofit corporations have had a right to inspect records under the Tennessee Nonprofit Corporation Act [T.C.A. §§ 48-66-101 to 105]

• Tennessee Business Corporation Act was amended effective January 1, 2013 to give directors a right to inspect "books, records and documents of the corporation at any reasonable time to the extent reasonably related to the performance of the director's duties as a member of a committee"

• Tennessee Nonprofit Corporation Act is being amended in a similar manner

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Tennessee Nonprofit Corporation Act Proposed Amendments

Proposed Director's Statutory Right of Inspection:

(a) A director of a nonprofit corporation is entitled to inspect and copy the books, records and documents of the corporation at any reasonable time to the extent reasonably related to the performance of the director's duties as a director, including duties as a member of a committee, but not for any purpose or in any matter that would violate any duty to the corporation or law other than this [act]. [T.C.A. § 48-66-105(a)]

Common Law provides for is right now.

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Tennessee Nonprofit Corporation ActProposed Amendments

"Document" means:

A. Any tangible medium on which information is inscribed, and includes any writing or written instrument.

B. An electronic record.

"Electronic" means relating to technology having electrical, digital, magnetic, wireless, optical, electromagnetic or similar capabilities.

"Electronic Record" means information that is stored in an electronic or other medium and is retrievable in paper form through an automated process used in conventional commercial practice . . . [T.C.A. §48-51-201(14), (17) and (18)]

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Tennessee Nonprofit Corporation ActProposed Amendments

• Proposed Duty to Inform

– A statutory duty of an officer to inform either a superior officer, the board of directors, or a board committee about affairs of the corporation within the scope of the officer's functions or of any action or probable material violation of law involving the corporation or breach of duty by an officer, employee or agent of the corporation

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Tennessee Nonprofit Corporation ActProposed Amendments

• Proposed Contract Rights – Removal of Officer– a provision that, except as otherwise provided in the

charter or bylaws, an officer may be removed at any time with or without cause by the officer who appointed the officer being removed unless the board provides otherwise. This provision is based on and modeled after the Model Act 3rd Ed

– DELEGATION, RELIANCE AND ACCOUNTABILITY

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Tennessee Nonprofit Corporation ActProposed Amendments

• Proposed Electronic Notices

– For example, "notice or other communications may be delivered by electronic transmission "if consented to by the recipient" or "if the electronic transmission is otherwise retrievable in perceivable form; and the sender and the recipient have consented in writing to the use of such form of electronic transmission".

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Questions?

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Unrelated Business Taxable Income

Kirby W. Yost

Tax Exemption

• A Tax Exempt Entity generally does not pay income tax because that income funds a purpose that the IRS has recognized as tax-exempt

• BUT- If the income received is unrelated to the tax-exempt purpose of the entity, it is unrelated business income (UBI or UBTI), and therefore subject to taxation

• The entity must report and pay income taxes for UBTI at the corporate rate

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What is Unrelated Business Income?

"… any trade or business the conduct of

which is not substantially related (aside from the

need of such organization for income or funds or the

use it makes of the profits derived) to the exercise or

performance by such organization of its charitable,

educational, or other purpose or function

constituting the basis for its exemption under section

501 ..."

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3-Part Test

• So, considering whether an income-producing activity creates UBI, look at the 3-part test:

1. Is it a trade or business?

2. Is it regularly carried on?

3. Is it substantially related to furthering the exempt purpose of the organization?

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So, What is a"Trade or Business"?

• An activity can still be a trade or business if it is included within a larger group of activities related to the entity's exempt purpose

– For example, if an exempt organization that publishes a magazine related to its exempt purpose, sells advertising in that magazine, selling the ads is a trade or business (even though it is a part of a magazine related to the exempt purpose)

• Something that has a "Profit motive" – whether it actually brings a profit or not

– It may have a "profit motive" if it resembles an activity done by taxable commercial entities

– Does the entity's tax-exemption provide the entity an unfair advantage in carrying out the activity?

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Regularly Carried On

• Activities must show a frequency and continuity

– How does the frequency compare to similar commercial activity carried on by taxable entities?

• Are the activities pursued in a manner similar to how for-profit organizations pursue comparable commercial activities?

– Hospital operating a sandwich stand for 2 weeks during a state fair – NOT "regularly carried on"

– Hospital operating a commercial parking lot every Saturday to raise money – IS "regularly carried on"

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Not Substantially Related to Exempt Purpose

• Activity does not contribute importantly to accomplishing that entity's exempt purpose (other than by supplying funds)

– Rev. Rul. 81-138 – Chamber of Commerce's lease of building below market rent to an industrial tenant for the purpose of spurring economic development was substantially related to the Chamber's exempt purpose

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Not Substantially Related to Exempt Purpose

• Consider the size and extent of the activities vs. the nature and extent of the exempt function the activity intends to serve

– To the extent an activity is conducted on a scale larger than reasonably necessary to perform an exempt purpose, it does not contribute importantly to the function the activity intends to serve (that excess portion would be UBI)"

• Selling products created from performance of exempt purpose CAN be "Substantially Related"

• Dual use of assets or facilities – consider each use or activity independently

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Trade/Business Activities Excluded

• Selling donated merchandise (i.e. thrift shop operated by tax exempt entity)

• Certain bingo games • Distribution of nominal cost

items, which are incidental to soliciting donations

• Renting mailing list to another charitable organization

• Convention and trade show activity – if entity's purpose is to promote/educate on respective industry

• Any trade/business where substantially all work is performed by volunteers

• Any trade/business performed primarily for the convenience of members, employees, students, patients, etc. of the entity

• Qualified sponsorship income (where sponsor gets only acknowledgement)

These activities (along with a few others) are specifically excluded from the definition of "unrelated trade or business":

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UBI Exclusions

• Interest and other investment income • Royalty income • Rents• Certain research income • Gains/losses from sale of property• Income from services provided under Federal License

(very narrow exclusion)• Member income of co-op electric company (very

narrow exclusion)

* FOR EACH EXCLUSION, YOU MUST THEN CONSIDER WHETHER AN EXCEPTION APPLIES

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Exceptions to Exclusions

• Investment income EXCEPTIONS

– investment is debt-financed

– Annuities received from a controlled corporation

– income is from a security loan

• Royalty income EXCEPTIONS

– Royalty is debt-financed

– Royalties received from a controlled corporation

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• Rental Income Exceptions

– Rent from real property or personal, only under "mixed lease" situations, so long as personalty rents = 10% or less

• Rent is income from unrelated debt-financed property

• Rents received from a controlled corporation

• Rents received from certain organizations (Social clubs, VEBAs, SUBS, GLSOs (narrow exception)

• Rent attributable to personal property = more than 50%

• Rent amount is based on net profit of tenant

• Rent is in exchange for personal services (i.e. hotel room rent)

Exceptions to Exclusions

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• Gains/losses from sale of property

– Except from unrelated income from debt-financed property

• Income from services provided under Federal License

– Except if income is from unrelated debt-financed property

Exceptions to Exclusions

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Special Rules

• If an organization is one of the following, it must consider UBI under special rules:

– a Social Club (under 501(c)(7))

– a Voluntary Employee's Beneficiary Association (under 501(c)(9)) ("VEBA")

– a Supplemental Unemployment Compensation Benefit Trust (under 501(c)(17)) ("SUB")

– a Group Legal Services Organization (under 501(c)(20)) ("GLO")

– a Veterans' Organization (under 501(c)(19))

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Deductions for UBI

• If income is UBI, the organization can take a deduction for its expenses directly connected to that unrelated trade or business

• Where the organization makes dual use of property or activities, those expenses must be allocated appropriately to only deduct expenses used for UBI

• This includes a deduction for expenses directly connected with debt-financed property or the income derived from it

• Special circumstances for advertising expenses where advertising sales are an "exploitation of an exempt activity"

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Questions?

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Disclaimer

This presentation is provided with the understanding that the presenters are not rendering legal advice or services. Laws are constantly changing, and each federal law, state law, and regulation should be checked by legal counsel for the most current version. We make no claims, promises, or guarantees about the accuracy, completeness, or adequacy of the information contained in this presentation. Do not act upon this information without seeking the advice of an attorney.

This outline is intended to be informational. It does not provide legal advice. Neither your attendance nor the presenters answering a specific audience member question creates an attorney-client relationship.

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