Section 501(c)(3) recites as a condition of exemption that no part of the funds of an organization shall inure to a private shareholder or individual. Although this provision has been a part of the Code since the first income tax law was enacted, it is only in rare instances that the courts have upheld revocation of exemption because of private inurement.
This situation has left the Service essentially powerless to prevent most self- dealing transactions that are prohibited under state law but rarely enforced in the state courts. In 1950 Congress did attempt to prohibit certain self-dealing transac- tions between foundations and substantial contributors through section 503. This legislation followed disclosures of the private use of assets of foundations controlled by a single donor and his family or a single corporation. The provisions were not made applicable to religious organizations, schools, hospitals, and those other exempt organizations that derived a substantial part of their support from the general public and governmental units.
Under the prohibited transactions sections, certain dealings between substantial contributors and persons and corporations related to them were declared to be grounds for revocation of exemption. Forbidden were loans without adequate security and a reasonable rate of interest, payment of unreasonable compensation, preferential treatment whether through the rendering of services or purchasing of securities, selling property without adequate consideration and other acts that involved or resulted in a substantial diversion of the organization's property.
The prohibited transactions sections had serious shortcomings and were the subject of widespread criticism. Internal Revenue Service and Treasury officials claimed that the standards of "reasonableness," "adequate security," "substantial diversion" were too loose, making the law difficult and expensive to administer, hard to enforce, and otherwise insufficient to prevent abuse. By applying only to dealings with substantial contributors they omitted the important area of self- dealing between organizations and directors and officers who were not contributors.
Finally, the sanction of revocation of exemption was clearly inappropriate.
The self-dealing rule adopted as part of the Tax Reform Act of 1969 reflected an attempt to rectify the shortcomings of the prohibited transactions sections. Thus, section 4941 now imposes categorical prohibitions with specific limited exceptions and, as already noted, provides for personal penalties on the self-dealer and on those foundation officers who knowingly participate in the transaction, while leaving the foundation's funds intact.
The major drawback of the self-dealing rules, in fact, is that they represent an example of overkill, penalizing persons innocently involved in actions that serve only to benefit the foundation. By applying to both direct and indirect self-dealing, they now prohibit arrangements entered into inadvertently and often under circumstances impossible to avoid. In spite of an attempt to devise strict standards, some of the rules still are framed in terms of "reasonableness," prohibit "excessive"
compensation and use a standard of adequate security. The use of the terms
"knowing," " w i l l f u l , " and "due to a reasonable cause" have further compounded uncertainty for managers anxious to abide by the rules. In fact, some commentators have suggested that it would have been preferable to retain the standards contained
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in section 503, changing only the sanctions from loss of revocation to penalties on the self-dealers.
The private foundation rules apply to foundation managers and disqualified persons. "Managers" are defined as officers, directors, or trustees, and "with regard to any act or failure to act, the employees of the foundation having authority or responsibility with respect to such act or failure to act." The definition of disqualified persons is extremely broad, encompassing foundation managers and, in addition, substantial contributors (more than 2 percent of all gifts and contributions if more than $5,000), the immediate families of these persons, and corporations, trusts, and partnerships owned or controlled by them.
It is far easier for private foundations to identify their substantial contributors than any large operating charity could, whether it be a university, a hospital, or a social welfare institution. Furthermore, it does not appear that the principal problem in these institutions is dealings with substantial contributors and organiza- tions controlled by them, and the administrative burden not only of identifying such individuals and entities but attempting to police all dealings with them would be overwhelming. It is therefore recommended, at least until more evidence of abuse appears, that any new rules applicable to public charities be limited to transactions between trustees, directors, and principal officers and the organizations they serve, thereby including only those persons with final responsibility for and control of the organization's assets. For purposes of this paper, the individuals to whom the provisions would apply are called "Trustees," following the pattern of the Uniform Supervision of Charitable Trustees Act in force in several of the states.
Defining the acts to be prohibited requires balancing a desire to prevent private inurement by what are essentially insiders with the desire to permit those transac- tions that are necessary to the easy and proper functioning of the institution or that would cause it detriment if they were to be discontinued. We do not want public charities paying excessive salaries to officers and directors, purchasing goods from them at prices higher than could be charged elsewhere, paying higher commission through their brokerage house than their competitors charge, or higher rent in a building owned by them than they would pay elsewhere. On the other hand, if the rent is at the prevailing rate, or the commission is the same or less than that charged by other brokers, the public charity should be able to participate in the transaction. In short, it is not necessary or desirable to establish absolute prohibi- tions against all transactions between public charities and their managers. Nor at the outset would it be advisable to attempt to prohibit "indirect" self-dealing as this could well be used by overly zealous officials to subvert the intent to deal with a limited group of prohibited acts.
Accordingly, the Commission should consider recommending that the following acts be prohibited:
any sale or exchange or lease between a public charity and a trustee at higher than fair market value;
any lending of money or extension of credit by a public charity to a trustee;
any borrowing of money from a trustee other than at a reasonable rate of interest or with no more than adequate security;
any payment by a public charity to a trustee of unreasonable (or excessive) compensation;
any furnishing of goods, services, or facilities by a public charity to a trustee on a preferential basis or by a trustee to a public charity at higher than fair market value.
2701 In order to mitigate uncertainties that will inevitably arise in connection with the standards of reasonableness, it is recommended that in any instance in which a trustee has a conflict between his interests and those of the charity, there should be a presumption that any action taken by the charity is in its best interest if the matter has been fully disclosed to the charity and considered and voted upon solely by those trustees who are disinterested with respect thereto, and the disclosure, consideration, and decision are appropriately reflected in the records of the charity.
In such instance, the burden of overcoming the presumption that the transaction was proper would be on the Service.
It is also recommended that a provision be included permitting certain special exceptions of both persons and transactions in the discretion of the Secretary of the Treasury after notice of opportunity for a public hearing. A provision of this nature is now part of the prohibited transactions section of the Code dealing with employee retirement income security plans and has already proved beneficial to persons affected as well as the Treasury.
Consideration should be given to whether prohibitions are to be applied to both the self-dealer and those other members of the board who approved the transaction, as is the case in regard to self-dealing by private foundations, or only on the self- dealer and not on a manager or fiduciary acting as such, as is the pattern in the pension legislation. The penalties for violation of these provisions could be excise taxes similar to those applicable to private foundations or reliance on the equitable remedies discussed in the first section of this paper. Enforcement through use of equity powers would provide the most appropriate remedies, the major drawback being that in cases with small amounts involved there may be a reluctance to initiate judicial proceedings and thereby undercut the impact of the rules. A possible solution would be imposition of a mandatory initial excise tax of a minimal amount and referral to the courts under equity powers if there is no correction or restitution.
Ill SPECULATION
Just as trust law has developed limitations on the extent to which fiduciaries can risk funds of others that are entrusted to their care, there is no reason why the federal government should not require that funds donated for tax-exempt charitable purposes should not be so invested or used that they could be lost. Since 1969, private foundations and their managers responsible for investments are subject to excise tax if they invest the foundations's funds in a manner that would jeopardize the carrying out of the organization's exempt purposes. There is no reason why this rule should not apply universally to all 501(c)(3) organizations. It is true that public support may not be forthcoming if a large portion of the funds are lost, but in most cases this may not be known by individual contributors and, if it should become known, it will often be too late to recover the improperly invested funds.
These activities are now prohibited in connection with private foundations under section 4944, which imposes a tax on the fiduciaries of a charity who authorize an investment knowing that it is jeopardizing the carrying out of the organization's exempt purposes. A similar prohibition should be extended to all organizations exempt under section 501(c)(3). The prohibition against speculation would not extend to program related investments. As will the self-dealing prohibition, the sanctions could be either court-imposed equitable remedies or penalty taxes or a combination of the two.