salk 2012- compensating trustees

Setting and Defending Trustee/Manager Compensation

Edwin K. Hunter Hunter, Hunter & Sonnier

March 14, 2012 Salk Institute’s Private Foundation Trustees’

Tax & Management Seminar

Why pay at all? Egalitarian Answer

• Restricting board membership to those who can afford to work for nothing leads to an elitist organization.

• Imagine Congress composed of nothing but volunteers.

• Even successful families have members with financial difficulties that need compensation for their time.

40th Annual Salk Institute's Private Foundation Trustees Seminar

Why pay at all?

Market Driven Answer

• If incentives did not improve performance, businesses would pay a pittance to all of their employees.

• Illa nanscisceris cui solvis


Why pay at all?

Pragmatic Answer • Many prioritize their

attention, time and energy… pro bono frequently finds the action stack bottom

• Treasury cited a notorious “inadequate oversight by volunteer boards of directors” when seeking intermediate sanctions for publicly-supported charities

• Even a tiny PF check can generate a healthy feeling of guilt… the dollar bill in the letter including a survey


Why pay at all?

Political Answer

• A public perception of benefits flowing to those running private foundations blackens philanthropy’s image and leads to adverse legislation

• Or perhaps the public would be most impressed by getting the work done?


Why pay at all?

Envious Answer

• Most publicly supported charities have voluntary boards… PFs should not differ

• Recall supra Treasury’s position on the need for intermediate sanctions because of ineffective public boards?


The Private Foundation game is changing rapidly!

• Foundation assets growing

• Rising PF charitable asset ratios

• Program-Related Investments

• Grant effectiveness metrics

• More trustee control over investment strategies 0

100,000,000

200,000,000

300,000,000

400,000,000

500,000,000

600,000,000

198

4

198

6

198

8

199

0

199

2

199

4

199

6

199

8

20

00

20

02

20

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20

06

Non-Charitable Use Assets Current Dollars (thousands)







• More trustee control over investment strategies

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F

PSC


The Foundation Center’s PRI Read








Evolution of Default Investment Standard

Safe ListOrdinary Prudence

As If Your Own MPT



Rapidly Vanishing Misconceptions 1. Non-compensated trustees enjoy reduced exposure to

liabilities for poor investments 2. A trustee who parrots his personal investments in selecting

the trust’s assets has strengthened his defenses 3. Trustees can net trust breach gains against trust breach loses 4. A fast trip to the bottom is okay if more or less everyone

finds the bottom eventually 5. No harm, no foul – where a risky investment eventually

recovers value 6. A trustee with everything in F.D.I.C. insured C.D.s can sleep

soundly 7. Acting on a broker’s professional advice automatically protects

the trustee 8. Portfolio diversification simply reflects the old adage “don’t

put all your eggs in one basket”


CompStats Axe Grinders?

• COF & ASF Studies – Tiny sample

• COF <600 • ASF <400

– Self-selected – COF aggregates

community and public foundations with PFs

• Ambiguous unclear how respondents addressed – Travel & conferences – Liability insurance – Grant matching – Discretionary grants – Non-trustee fees

paid to professionals


CompStats COF’s Median Fee Pronouncement

• Another tiny sample biased by self-selection

• Based on a median 12 person board

• Averages in the responding CFs and Publicly Supported Foundations

• Averages in zeros to produce a median


CompStats Our Stratified PF Universe


990 CompStats Reported Comp Expenditures


19931994199519961997199819992000200120020

20,000

40,000

60,000

80,000

100,000

120,000

140,000

PF Size

<100,000

<Million

<10 Million

<50 Million

<100 Million

Larger

CompStats Reported Comp (000) by PF Size


CompStats Poorly Designed Studies Fail to Identify Variables


Courtesy of Randal Monroe

Statutory Constraints

• Private inurement • Private benefit • Taxable

expenditures • Self-dealing • State fiduciary law • Minimum payouts • Net investment

income excise tax

• Reg. §1.501(c)(3)-1(c)(2) • PF operated for other

than charitable purpose • A minimal amount

forfeits exempt status • Applies only to individuals

whose relationship with an organization offers them an opportunity to make use of the organization's income or assets for personal gain



• Private inurement

• Private benefit

• Taxable expenditures

• Self-dealing

• State fiduciary law

• Minimum payouts

• Net investment income excise tax

• Must be more than incidental to forfeit exempt status

• Applies to outsiders, but foundation manager could possibly fall within purview



• Private inurement

• Private benefit


• Self-dealing


• Minimum payouts


• IRC §4945

• Treas. Reg. § 53.4945-6(b)(2)

• Avoided by demonstrating compensation paid in good faith belief that they were – reasonable

– consistent with ordinary business care and prudence

• Fact and circumstances issue

• Objective proof of subjective belief


Statutory Constraints • Private inurement • Private benefit • Taxable

expenditures • Self-dealing • State fiduciary

law • Minimum payouts • Net investment

income excise tax

• IRC §4941(d)(1)(D) • IRC §4941(d)(2)(E) exception

– Personal services – Reasonable, not excessive – Necessary to carryout exempt

function

• Resolved by objective proof of an objective fact, cf. taxable expenditure

• Treas. Reg. §53.4941(e)-1(e)(1)(I)- continuing transaction with penalty in each year or partial year, Fabonacci process 40th Annual Salk Institute's Private

Foundation Trustees Seminar

Statutory Constraints • Private inurement

• Private benefit


• Self-dealing


• Minimum payouts


• Related to IRC §508 – Mandatory insertion of TRA 69

provisions in governing instrument

– Effort to mobilize AGs

• General obligation- put the principals interest ahead of your own


Statutory Constraints • Private inurement

• Private benefit


• Self-dealing


• Minimum payouts


• IRC §4942

• IRC §4942(g)- qualified distributions include reasonable and necessary administrative expense

• Thus, compensation disallowed as reasonable may subject PF to excise tax for failing to meet the 5% requirement if there is no carry forward and management plays close to the line

40th Annual Salk Institute's Private


Statutory Constraints • Private inurement • Private benefit • Taxable

expenditures • Self-dealing • State fiduciary law • Minimum payouts • Net investment

income excise tax

• IRC §4940 • Net Investment Income tax

base equals gross investment income and capital gain net income reduced by investment deductions

• IRC §4940(c)(3)(A)- “...there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred for the production or collection of gross investment income or for the management, conservation, or maintenance of property held for the production of such income....”


The IRS Positions • Litigation of PF compensation issues relatively

uncommon • The sparse jurisprudence for the most part

features egregious facts • In general, disclosed data from Forms 990-PF

and 4720 show a low level of self-dealing penalties imposed for compensation issue

• “Facts and Circumstances” usually bars rulings- Rev. Proc. 2011-3, 2011-1 I.R.B. 111

• But, positions are nonetheless on the table, in large measure as a result of the for-profit compensation jurisprudence


The IRS Positions For-Profit Concepts Accepted

• Pension for directors past personal services not self-dealing if not excessive-Rev. Rul. 74-591, 1974-2 C.B. 385

• Premiums for split-dollar for trustee permit excepted under IRC §4941(d)(2)(E) if total compensation not excessive- PLR 9539016

• Deferred compensation permitted as well- but distribution benefit on cash basis only


The IRS Positions Reliance on Unvetted Conclusions

• TAM 9008001- total directors’ compensation >75% than COF average for foundations of its size – ≈1:2.4 compensation to grant ratio – agony, worry, stress, and humiliation

justification rejected – 40X expectation justification

rejected – Build-up method employed

• Kermit Fischer consistently cited – $4 to $5 per $1,000 of foundation

assets, plus 5% of foundation income.” – Claim that most foundations use

formula – Witness failed every qualified

appraiser test – Bank trust officer 40th Annual Salk Institute's Private


The IRS Positions IRM Guidance to Auditors

Pt 4, Ch 35, Sect 2-“Audit Techiques for Business Returns”- “The examiner should take into account such factors as: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, whether alleged compensation is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.”


IRC §162 Jurisprudence Kennedy, Jr. vs. Comr, 671 F.2d 167 (6th Cir. 1982)

a. Employee qualifications b. Nature, extent and scope of work c. Size and complexity of the business d. Comparison of pay with others of

similar gross and net income e. Prevailing general economic conditions f. Prevailing rates of compensation for

comparable positions g. Salary policy towards other employees


IRC §162 Jurisprudence Kennedy, Jr. vs. Comr, 671 F.2d 167 (6th Cir. 1982)

h. The amount of compensation paid to the particular employee in previous years i. The success of the employee’s efforts j. Profitability of the business k. Absence of the usual fringe benefits such

as a pension or profit sharing plan, stock options, etc. which are available to executives of other companies of comparable size

l. Unusual capability of employees m. Bonuses not paid in the ratio of stock

holdings 40th Annual Salk Institute's Private


Setting Defendable Compensation Starting the Process

• Formal process in resolution or by-laws

• First step – Recommendation from

the chief executive – Compensation

committee report – Study from a

compensation consultant

– Resolution in a regular board meeting


Setting Defendable Compensation Contingent Arrangement EO Jurisprudence

• People of God Community v. Com’r, 75 T.C. 127 (1980), organization's net earnings inured to the benefit of private individuals where compensation based on a percentage of EO’s gross receipts with no upper limit, burden on tax payer to establish reasonableness

• World Family Corp. v. Comr., 81 T.C. 958 (1983)- exempt from taxation under §§501(a) and 501(c)(3) despite fund raisers receiving a percentage of contributions, stating “(t)he law places no duty on individuals operating charitable organizations to donate their services; they are entitled to reasonable compensation for their efforts.”


Setting Defendable Compensation Potential Conditions for Augmented Pay

Portfolio performance

Measured philanthropic results

Objectives achieved Obtaining a degree or

certification

Completion of a project within budget, such as • Installation of new accounting

system

• Construction of foundation facilities


Setting Defendable Compensation Reductionist Get Better Results

Break down and document the trustee’s task into its elements

Crude reduction might be Investments

Grants

Administration

Dig deeper

By my Park City Neighbor, Prof. Helga Kolb


Setting Defendable Compensation Moving Towards the Pixels

Function

Administration Investment

Charitable Mission

Tax & Other Compliance

DirectPortfolio

Management

Hiring

Formulating JobDiscription

StaffingAscertainment

Supervision

Communication&

Morale

SelectingPortfolioManagers

MeasuringInvestment

Performance

SettingRisk-Return

Policy

ReplacingManagers

Setting Grant GuidelinesSoliciting ProposalsDefining/Updating Mission

Ascertaining “Client” NeedsDeveloping Mission Oriented Expertise

Communicating with “Clients”&

Serving on “Client” Boards

Developing and Deploying PRI Skills

Community Relations

PerformanceReview


Setting Defendable Compensation Document Trustee Activity

• Periodic practice, perhaps every 5 years unless significant change has occurred

• Sampling is acceptable, but use common sense

• Maybe 25% of the board • Maybe during a calendar quarter • Don’t forget travel, attendance at

conferences, grantee functions, continuing education, monitoring investment advisor results, studying investment opportunities, reading articles and books, serving on other non-profit boards as a de facto representative of the foundation, education and study specific to program-related investments such as monitoring the activities of the PRI


Setting Defendable Compensation Document Trustee Qualifications & Accomplishments

• Degrees and certifications • Professional compensation rates • Awards and recognitions • Experience and special

qualifications in areas supported by the foundation – e.g. experience and study specific to

area homeless issues – e.g. scientific/medical training for

research PRI proposals – e.g. years of site visits with particular

grantees – e.g. publications and presentations on

topics related to charitable mission

• Investment experience and success


Setting Defendable Compensation

Isolate Direct Charitable Activities

• More non-operating foundations now choose direct action

• PRI’s take more care, monitoring and expertise than direct grants

• Ratio of charitable to investment assets climbing and usually require significant attention


Setting Defendable Compensation

Acquire the Opinion of a Comp Expert

Embrace

1. Engage expert before fixing compensation

2. Expert with Qualified Appraiser character

3. Experts relied on by parties to transactions

4. Experts accepted by a variety of courts

5. Experts who interview trustees and managers

6. Solid credentials

Avoid

1. Hiring expert after audit notice

2. Algorithm-statistical form studies

3. Hired guns who general work in litigation context

4. Academics with no court or deposition history

5. Experts who decline site visits and interviews

6. Jacks of all trades 40th Annual Salk Institute's Private


Southern Half

A webcomic of romance, sarcasm, math, and language


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