United States: IRS Releases FAQs Clarifying 2006 Form 990 For Exempt Organizations

On April 26, the Internal Revenue Service (IRS), in a significant tax planning and governance development for exempt organizations, released new "FAQs" supplementing the instructions for the 2006 Form 990 (that is, the Form 990 used as the tax return for the fiscal year beginning in 2006). This new informal guidance from the IRS provides additional clarity on the controversial new Form 990 questions relating to board structure, when to report compensation for directors and officers who have relationships with other organizations, how to report compensation for all "disqualified persons," and relationships between directors, officers and other insiders (the notorious line 75b).

This development is relevant to all Section 501(c) organizations, including those recognized as exempt under Sections 501(c)(3), (c)(4) and (c)(6). Many organizations with tax years in the months ending July through December are just now filing their Forms 990 for the tax year beginning in 2005, and as a result will not have to use the 2006 form for some time. However, the 2006 clarified instructions for line 75b may be helpful to organizations filing the 2005 return. The IRS previously published FAQs on the 2005 returns, which are posted at http://www.irs.gov/charities/article/o,,id=156648,00.html.

It is no secret that the IRS has had growing concerns regarding conflicts of interest, relationships among directors, directors serving the organization as vendors, and the resulting effect on executive compensation. These concerns have been manifested directly in (a) specific conflicts of interest questions in the 2006 "Community Benefit Compliance Check Questionnaire" sent to approximately 550 hospitals and health systems last summer, (b) the February 2007 release by the IRS of proposed, suggested governance guidelines for Section 501(c)(3) organizations, (c) current audits of Section 501(c)(3) organizations and (d) related comments by senior IRS officials about the important relationship between effective governance and maintenance of tax-exempt status.

These IRS concerns have also resulted in considerable complexity in the information required to be included on and with the Form 990, particularly in the areas of reporting compensation and reporting business interests and other sources of compensation for directors, officers, key employees, and the five highest paid other employees, professional independent contractors and other independent contractors. In a very real sense, the Form 990 is a "lagging indicator" of the IRS’s growing interest in potential conflicts of interest involving leaders of exempt organizations and the potential effect of those interests on the compensation provided to the senior management of those organizations.

We interpret these new developments as evidencing the IRS’s increased interest in evaluating director-as-vendor relationships in the context of exempt status generally, and the prohibitions against private inurement and excess private benefit, in particular. We also interpret them as evidencing interest in the potential that business and family relationships among board members may create intra-board relationships that could affect whether the board, or certain members of the board, are capable of rendering good faith, disinterested decisions (i.e., the potential that board decision making could be biased by perceived or actual quid pro quo relationships).

The good news for the 2006 Form 990 is that through the FAQs the IRS has simplified somewhat the complex filing requirements and the data that must be filed with the return. The IRS has made the following key changes that reduce the complexity of the 2006 return:

• Two of the eight types of relationships that created "related organizations" under line 75c, for purposes of disclosing compensation received by the reporting organization’s directors, officers, key employees and the five highest paid other employees, professional independent contractors and other independent contractors (i.e., "insiders") from related organizations, have been deleted. These are what the IRS has labeled as relationship six (the filing organization and another organization are partners or members in a common partnership or LLC) and relationship eight (an insider has substantial influence over the filing organization and another organization). This means that information about these previous categories of related organizations, including in some circumstances compensation, will not have to be reported.

• Regardless of the category of relationship, the reporting organization need not include the federal employee identification number (FEIN) of taxable related organizations in response to line 75c.

• The reporting of loans and advances in line 25c relates only to interest on the loan and not to the amount of the loan itself. This was an error in the instructions that has been corrected.

• When attempting to identify those business and family relationships among "insiders" that must be reported under line 75b, the organization may limit its responses as follows: (a) the questions relate only to relationships existing as to the filing organization itself (in other words, it is not necessary to take into account relationships with insiders of related organizations), (b) an insider’s business relationships are only for those in the insider’s personal capacity and not those of the insider’s business (in other words, the relationships of the insider’s business are not attributed to the insider) and (c) the filing organization needs only to ask the questions necessary to elicit the line 75b information and does not need to go beyond this in gathering the information required under line 75b.

• A volunteer board member serving without compensation, but who receives reimbursements from the reporting organization for substantiated expenses related to board service, is still treated as a volunteer board member of the reporting organization. This means that the "volunteer exception" to reporting other sources of compensation under line 75c will apply in this situation to the extent provided.

• The separate reporting of compensation and benefit expense under lines 25a (for current insiders), 25b (for former insiders) and 25c (for all other disqualified persons) will not need to be accompanied by detailed spreadsheets showing all sources of compensation and benefits.

However, the bad news for the 2006 Form 990 is that the announced changes must be tempered with the realization that the IRS is actively interested in learning much more about the interests and relationships of organization insiders, particularly board members.

We encourage exempt organizations to view the focus on line 75b not strictly as a Form 990 issue, but rather in the larger context of corporate governance and its relationship to preservation of tax-exempt status. The IRS appears to be signalling its willingness to look more closely at whether the structure and composition of a governing board may be inconsistent with continuing exempt status.

Thus, our recommendations are for executive leadership to authorize the organization’s general counsel to:

• Brief the board on these new developments

• Provide guidance to the board and executive staff, based in part on these new FAQs, on the completion of the 990, particularly with respect to lines 75b and 75c

• Use the guidance if applicable to influence how the organization responds to the similar requirements on the 990 for the year beginning in 2005 (if not yet filed)

• Work with the governance/nominating and conflicts committees to (i) develop a simplified method of reporting the information necessary to answer lines 75b and 75c and (ii) examine more closely board controls and nomination guidelines with respect to director-as-vendor relationships and business and family relationships among directors.

The FAQs are available on the IRS website: http://www.irs.gov/pub/irs-tege/2006_form_990_qas_final.pdf .

Learn more about our Tax Exemption practice and lawyers at: http://www.mwe.com/info/taxexemption/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.