25 function with respect to grants and transactions as if it were a public

25

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activities in which any member of the organization's staff, any board member or any major contributor has a substantial financial interest, either directly or through his or her family.*

s

Commentary

This recommendation would prohibit improper business dealings between a nonprofit organization and its governing body or substantial contributors. It would, however, permit dealings between such parties in aid of the organization and its beneficiaries, but under carefully scrutinized circumstances. The recommendation would be uniformly applied with respect to all charities, but to the extent feasible, inter- ference with normal business transactions would be avoided.

The thrust of the recommendation contemplates the application of the pertinent principles of Chapter 42, appropriately modified,

5 6

to all section 501(c)(3) organizations.

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In the case of an exempt organiza- tion other than a private foundation, the rules would apply to business dealings between a tax-exempt organization and persons associated with its governing board and officers (together with their families and entities, such as trusts, in which these persons may have an interest).

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In the case of private foundations, the current definition of disqualified persons would continue to include substantial contributors and persons closely related to them.

In line with the Commission's recommendation, section 4941 could be amended to permit the occurrence of such transactions as loans, leases, purchases or sales of property and rendition of services between an exempt organization and a disqualified person under defined arm's-length circumstances. It is recognized that in the case of private foundations, transactions comparable to these were authorized until 1970 and prohibited thereafter because of difficulties of review.

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The intensified audit program of the Service should, however, provide it with sufficient resources to maintain a comprehensive scrutiny of such transactions.

In specific situations a degree of administrative discretion would be

vested in the Service to abate or excuse the penalty tax which would

otherwise be applicable. For example, the tax might be abated where a

reasonable and good faith (but unsuccessful) attempt was made to

utilize arm's-length standards; this might occur, for example, where a

transaction is entered into in reliance upon an independent appraisal by

a qualified appraiser.

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The statute and regulations thereunder would be drawn within particularly narrow confines in cases in which the transaction in question involves a disqualified person who controls (alone or through family or associates) a private foundation. In these instances, an affirma- tive showing that the transaction in question benefits the foundation would be required. By the same token, beneficial transactions proscribed by present law for private foundations would be permitted (for example, a fair lease which is favorable to the charity).

In the case of an independent foundation or a public charity, the self-dealing rules could be drawn with sufficient flexibility to enable the organization to engage in business dealings with officers or trustees under certain limited circumstances. Such dealings might be allowed where there is some important reason to do so, provided that (1) the parties deal at arm's-length, and (2) the transaction results in an overall economic benefit to the charity. Such rules would be coupled with a requirement that the charity disclose the full particulars of the transac- tion to the Service in advance. Certain acts, however, (for example, transactions involving excessive payments or charges, and loans to insiders) might be flatly prohibited for all organizations, including public charities and independent foundations.

6

°

One method that might be considered to achieve the foregoing would be to utilize the procedures developed under section 4975

6 l

(applying penalty excise taxes on disqualified persons with respect to any transac- tion prohibited by ERISA with a qualified retirement plan). Section 4975 statutorily prohibits all transactions between the classes of parties specified unless the transactions fall within a specifically enumerated statutory exception.

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Further, the Treasury has authority to issue administrative exemptions from these prohibitions, either on a class or an individual basis.

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All of the exceptions permitted, whether statutory or administrative, have the effect of imposing an arm's-length standard.

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This type of total prohibition, with specific exceptions for acceptable classes of arm's-length transactions, might be an appropriate method for implementing this recommendation. Experience gained under section 4975 should be useful in this regard.

It is not contemplated that the adoption of an arm's-length standard

should in any way prevent or impede the enforcement of any state or

local law imposing rules of conduct that are more strict than such

standards. Thus, for example, a state law that now forbids transactions

between officers or directors and their charitable organizations would

not be affected by the imposition by an arm's-length standard for

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federal penalty excise tax purposes. Additionally, any improper benefits realized from self-dealing transactions should be recoverable via litiga- tion instituted by state or federal authorities; such a rule, consistent with the policy of present section 4941 (which may impose a penalty tax upon the disqualified persons and foundation managers, but not on the foundation itself), would be preferable to imposition of a financial penalty upon the organization, which would have the effect of transfer- ring assets from the affected organization to the government as the tax is paid.

Finally, to assist in the determination of fair market values for purposes of the suggested arm's-length standard, the Service might establish a program of enrollment or certification for appraisers.

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By providing a means for ascertaining a value which the parties may rely upon with confidence, the Service would eliminate a major source of difficulty under both the proposed standard and present section 4941.

Sanctions (such as the removal of "licenses" or the application of a penalty tax) could be used to safeguard against unethical or dishonest practices.

Commission Recommendation

9. That to discourage unnecessary accumulation of income, a flat payout rate of 5 percent of principal be fixed by Congress for private foundations and a lower rate for other endowed tax-exempt organiza-

tions.

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Commentary

This recommendation would assure that both private foundations and endowed operating charities distribute or apply for direct operational charitable purposes reasonable amounts annually, sufficient to prevent unjustified accumulation of income, but also not in such great amounts as to cause erosion of principal.

The Commission recommendation respecting the rate of "payout"

applies to all section 501(c)(3) organizations with endowments. The

payout rate of 5 percent

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would be fixed to permit prudent

management of the organization's principal funds. Because financial

circumstances change over time, however, the 5 percent rate could be

reviewed after a period, such as five years, and, if appropriate, (after

hearings) changed by the Congress at the expiration of that period.

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