In the world of private foundations, it is not unusual to compensate related parties for services they provide to the foundation—however, compensation is hardly an “anything goes” situation. The Boston Globe recently published an article about a private foundation founder’s three daughters being compensated handsomely for full-time employment, where a little digging by the newspaper revealed some large questions about whether that compensation was appropriate or even legal. This blog post will discuss the issues around compensation in the private foundation world and the larger realm of 501(c)(3) organizations.
Private foundations vs. public charities
In the 501(c)(3) landscape, there are two main categories: public charities and private foundations. All 501(c)(3) organizations face fairly rigorous regulation, due to the fact that they are both exempt from tax and eligible for tax-deductible contributions.
However, private foundations are subject an additional layer of regulation, because they are private in nature (i.e., often funded by a single family or corporation), whereas public charities are more public in nature (the theory being that the public oversees them through the power of the purse). One specific regulation that applies to private foundations only is the restriction against self-dealing, discussed further below.
Self-dealing concerns for insiders
Self-dealing is an issue that private foundations must wrangle with on an ongoing basis. Essentially, under section 4941 of the Internal Revenue Code and related regulations, a private foundation’s disqualified persons—those who control and fund the foundation—are prohibited from direct and indirect financial transactions with the foundation unless a specific exception applies. Unlike the regime around intermediate sanctions, which applies to public charities, fair market value and reasonableness are not the guiding standard for self-dealing; the rules are often described as draconian and rightly so.
More specifically, the term “disqualified person” includes the following:
- a substantial contributor to the foundation;
- foundation managers (officers, directors, trustees, or person with similar powers);
- any owner of more than 20 percent of the combined voting power of a corporation, profits interest of a partnership, or beneficial interest in a trust/association which is a substantial contributor;
- family members (spouses, ancestors, children, grandchildren, great-grandchildren, and spouses of children, grandchildren and great-grandchildren) of an individual described above;
- controlled entities (e.g., a corporation of which disqualified persons own more than 35 percent of the combined voting power); and
- certain government officials.
While the self-dealing rules expressly prohibit compensation to disqualified persons, an important exception allows compensation, payment of expenses and reimbursement of expenses for personal services provided by disqualified persons, if the amounts are reasonable and necessary to carry out the foundation’s exempt purposes, and are not excessive.
In general, reasonable compensation is the amount that would ordinarily be paid for like services by a like enterprise under like circumstances. The Boston Globe article focuses on a family foundation that is paying each of the founder’s daughters over $100,000 annually for ostensibly serving in a full-time role as executive director or in helping to review grants. The rub is that the foundation typically only makes grants to about twelve organizations annually, on average—and tends to make grants to the same organizations (which requires less supervision and due diligence than first-time grants). This goes to whether the women’s positions are truly full-time. Further, the article points out that at least one of the daughters is the owner and operator of a separate business—which also goes to whether she is devoting full-time attention to the foundation, as reported. While $100,000 or more may be a reasonable salary for a full-time executive director at a foundation that makes many grants each year, or that makes complex grants that require much supervision, it is harder to say that it is reasonable for the duties and obligations that appear to be involved here.
Providing protection for foundations
Reasonable compensation is not a black-and-white area; it involves some subjectivity—and uncertainty. For public charities subject to the intermediate sanctions rules under Section 4958, there is a process they can follow to raise a presumption of reasonableness for compensation:
- Using an independent body to review and determine the amount of compensation;
- Relying on appropriate comparability data to set the compensation amount; and
- Contemporaneously documenting the compensation-setting process.
Private foundations aren’t subject to Section 4958, but it is generally recommended that they follow the rebuttable presumption process when determining compensation nonetheless (to the extent possible—if a family foundation’s entire board is made up of family members, then independent body review won’t be possible). This makes sense, as the process stresses looking at numbers for comparable positions, having the compensation package approved by those without a conflict, and documenting the process in a timely fashion. It is possible to obtain a compensation opinion in conjunction with this process, as well, where a professional consultant will do the research to obtain comparability data.
Family foundations that wish to pay a disqualified person to perform personal services for the foundation would be wise to, at the very least, look to comparability data when designing a compensation package. In addition, the position should truly be comparable—an executive director at a foundation that dispenses only a handful of grants annually should not be compared to an executive director that oversees hundreds of grants or an actual operating program. The important takeaway here is that while it is not per se prohibited to compensate a disqualified person, like the daughters at issue in the article, it is something that should be approached with care—and a healthy dose of documentation.
The reality of regulating foundations
The article includes commentary from some well-known practitioners in the exempt sector, who tend to agree that the compensation situation appears problematic from a self-dealing perspective. However, it also makes the point that the IRS is in a tough position with respect to regulation and policing, as its numbers have been cut drastically in recent years. To illustrate, there are about 85,000 private foundations in existence, and last year only 230 of them (around 2 percent) were audited. An unnamed IRS agent is quoted as saying that the money going to the daughters is “not your traditional holy-crap dollar amount” relative to what some other foundations pay their employees. In other words, although it may violate the self-dealing rules, it may not be egregious enough to warrant investigation.
Yet the revenue that both the federal and state government lose on such arrangements—given that founders get a deduction for contributing money to the foundation—does add up. And it’s possible more regulators will take notice and action.