Legal counsel for nonprofit organizations
and social entrepreneurs

An Explanation of Tax Gross-Up Payments

Posted on by bentakis

In today’s edition of Paul Streckfus’ fabulous publication, the EO Tax Journal, he discusses a recent article in the Chronicle of Higher Education about the hefty compensation packages of some private college presidents. The article focuses on one politically sensitive piece of compensation: the tax gross-up. This refers to an extra payment to an executive to cover the taxes the executive owes on his/her base compensation. The practice is so politically sensitive that many public companies have stopped making gross-up payments to their executives for fear of angering shareholders. But gross-ups are apparently still prevalent among private colleges.

This prompted Paul to ask: “If a college pays the tax on a bonus to its president, isn’t the president liable for the tax on the tax payment, or does the college pay that, too, and if so, doesn’t that go on ad infinitum?”

I sent Paul the following explanation:

You are correct that when you increase someone’s pay to cover taxes there is also tax on that increased amount. When you gross up, you need to use algebra to find the amount of extra payment that is enough to pay the taxes on the original (pre-gross-up) amount as well as the taxes on the extra payment. The end result should be that, after taxes, the employee ends up with exactly the pre-gross-up amount.

The algebraic equation we use for this is: tax rate (pre-gross-up amount + x) = x, where x equals the gross-up amount. I am fairly math illiterate, so there may be better ways to do this, but this is what has worked for me in my employee benefits practice.

So, for example, if the executive’s base compensation is $300,000, and her tax rate is exactly 30%, the equation would look like this:

.30(300,000 + x) = x.

I won’t embarrass myself by attempting to show you how I worked out the algebra (there are algebra solving applications online), but in this example x equals $128,571.43.

Thus, if you add $128,571.43 to the executive’s base compensation, you pay her a total of $428,571.43. Her tax rate in this example is 30%, so when she pays taxes on $428,571.43, she ends up with after tax compensation of exactly $300,000.

Of course, when you take into account the different rates for state and local taxes and employment taxes, it gets more complicated, but this is basically how you figure out the gross-up amount.

UPDATE: Paul Streckfus graciously reprinted my email in the following day’s edition of EO Tax Journal.

Posted in Employee Benefits, Executive Compensation | Leave a comment

IRS Considers Changes to Group Exemption Procedures

Posted on by bentakis

At the recent Western Conference on Tax Exempt Organizations, which took place at Loyola Law School on November 29 and 30, Holly Paz (a senior official in the Internal Revenue Service’s Exempt Organization division) discussed considerations at the IRS regarding “group exemptions” and “group returns.”

Under the “group exemption” process, a central or national organization may certify the tax-exempt status of smaller organizations that are under their general supervision or control. The IRS has recognized group exemptions dating back to 1940, but it was not until 1968 that formal procedures for group exemptions were issued. The current procedures for group exemptions are set forth in Revenue Procedure 80-27, which is now over thirty years old. The group exemption process is an essential tool for organizations looking to expand nationally and create local affiliates (something we deal with often at Tax-Exempt Solutions). Rather than pay the $400 or $850 fee for a separate Form 1023 for each local affiliate, a central organization may pay a one-time fee of $3,000 to maintain an exemption for all current and future affiliates, subject to certain requirements discussed Publication 4573, available here. In addition, a central organization may submit a consolidated Form 990 on behalf of all of the organizations covered under the group exemption.

The group exemption process presupposes that the central organization will exercise considerable scrutiny over its local affiliates. The central organization is, in effect, responsible for determining the tax-exempt status of its local affiliates in place of the IRS. The IRS has been concerned about the lack of transparency and accountability in the group exemption process, and in June 2011 the Advisory Committee on Tax Exempt and Governmental Entities (ACT) issued a report recommending (among other suggestions) the elimination of the group 990, and the issuance of more detailed guidance regarding the responsibilities of central organizations. More recently, in October 2012 the IRS began sending a compliance check questionnaire to central organizations that are part of a group exemption, which can be found here. At the Western Conference last week, Holly Paz reported that the questionnaire has been sent to about 2,000 central organizations so far, and that the results will be reported to the public for comment in 2013.

Organizations currently acting as central organizations, and those considering expanding nationally in the future, should take note of the deliberations at the IRS on this subject, and be prepared for more detailed guidance regarding their supervisory responsibilities.

Posted in Form 1023, Group Exemptions, Local Affiliates | Leave a comment

Non-Profit News Organization Receives Tax-Exempt Status After Long Delay

Posted on by bentakis

The non-profit news organization “San Francisco Public Press” has been awarded tax-exempt status as a 501(c)(3) after an astounding 32-month wait. The IRS has traditionally taken a skeptical view of journalism organizations that apply for 501(c)(3) status as “educational” organizations, leading to long delays in these applications. Given the financial difficulties faced by the journalism industry, there have been a growing number of news outlets looking to use the non-profit tax-exempt model. Hopefully the favorable ruling given to San Francisco Public Press signals a shift in attitude towards such organizations at the IRS.

Posted in 501(c)(3) | Leave a comment

IRS Takes a Hard Line on Private Benefit and Private Inurement Rules

Posted on by bentakis

A recent private letter ruling by the IRS denying the tax-exempt status of an organization under section 501(c)(3) of the Code highlights some of the risks inherent in business dealings between an organization and its officers or directors. Under the Internal Revenue Code, a 501(c)(3) organization’s activities must not substantially benefit a private individual or company, other than a benefit that is incidental to the organization’s charitable purpose (the “private benefit” rule). In addition, with limited exceptions, the rules prohibit most types of tax-exempt organizations (not just 501(c)(3) organizations) from using their assets to the benefit of individuals who are in a position to control the organization (the “private inurement” rule). This latest private letter ruling shows the IRS applying these rules quite strictly.

PLR 201235021, released on August 31, 2012, addresses the tax-exemption application (Form 1023) of a non-profit corporation formed “to facilitate the identification of worthy charities and to foster giving by donors in a very timely manner and rapid response time” through online giving and mobile phone technology. The organization developed an online donation management system including a mobile phone application, and contracted with a related for-profit LLC to provide all the necessary hardware, software and administrative services.

The day-to-day affairs of the organization were managed by its Board of Directors, which comprised three individuals, identified in the ruling as B, C, and D. These three individuals were also the sole owners of the for-profit LLC.

The initial agreement between the organization and the LLC provided the LLC with a fee of 20% of the donations collected through the donation management system, which the organization claimed (without supporting documentation) is “well below” the average that charitable organizations ordinarily spend. The organization later restructured, apparently in an attempt to minimize the conflict of interest, by removing C and D from their Board. After D left the organization’s board, an amended contract was signed reducing the fee 8%. B signed the contract on the organization’s behalf and D signed the contract on the LLC’s behalf.

The IRS concluded that the contract with the LLC violated the rules against private benefit and private inurement, and this was fatal to the organization’s application for tax-exempt status. The IRS pointed to several key factors influencing its decision, including:

This ruling illustrates that organizations should proceed with the utmost caution when entering into contracts with related individuals. Procedure is just as important as the substance of the contracts, and at a minimum, organizations should (1) obtain comparable quotes from outside businesses to determine that the fees are not higher than fair market value, (2) hold board meetings to consider the data before entering into the contract (making sure that conflicted members are removed from the discussions); (3) document such meetings contemporaneously with detailed minutes; and (4) structure the contracts to avoid the appearance of a “joint venture” between a tax-exempt organization and a for-profit entity. Of course, circumstances may require more elaborate safeguards, and sometimes an organization may need to steer clear entirely of contracts with related individuals, so it is always safest to consult with a lawyer first.

Posted in 501(c)(3), Private Benefit, Private Inurement, Private Letter Rulings | Leave a comment

Confusion at the IRS regarding 501(c)(3) applications

Posted on by bentakis

Greg McRay at Foundation Group has a great post illustrating the confusion at the IRS resulting from the clash between the rules regarding retroactive granting of 501(c)(3) status and the rules revoking 501(c)(3) status from organizations that fail to file the annual Form 990 for 3 years in a row.

A 501(c)(3) organization generally receives tax-exempt status retroactive to the date of its incorporation under state law so long as it submits a Form 1023 to the IRS within 27 months of its formation. As Greg explains, there are exceptions to this 27-month rule for churches, nonprofits with gross revenue averaging less than $5,000 per year, and some other organizations. There is also an exception for organizations that file late as a result of a misunderstanding of the law or events beyond the organization’s control, so long as the organization acted reasonably and in good faith, and the granting of retroactive tax-exempt status does not prejudice the interests of the government. IRS Publication 557 provides further explanation of the 27-month requirement and its exceptions.

However, all tax-exempt organizations (except for churches) are also required to file a Form 990 every year, and will have their tax-exempt status automatically revoked if they fail to file for 3 consecutive years.

Apparently, the latter rule has resulted in the IRS computer system automatically revoking the tax-exempt status of organizations with a date of incorporation 3 years prior than the date of the Form 1023 submission, before tax-exempt status has even been granted, and despite the exceptions to the 27-month rule.

We will be watching this situation closely. If your organization is caught in the crossfire of this confusion, we can help. But this does illustrate the point that, if at all possible, it is best to file for 501(c)(3) status well before 27 months after incorporating your organization!

Posted in 501(c)(3), Form 1023 | Leave a comment

We Launched a New Website

Posted on by bentakis

Welcome to the new website of Tax-Exempt Solutions PLLC. We will be posting news and legal developments of interest to the non-profit community here, so check back often. Our contact info is listed below if you have questions or need personalized assistance.

Posted in Uncategorized | Comments Off