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 600,000,000

growing
Non-Charitable Use Assets
Current Dollars (thousands)

500,000,000

• Rising PF charitable
asset ratios 400,000,000

• Program-Related
Investments 300,000,000

• Grant effectiveness 200,000,000

metrics
• More trustee control 100,000,000

over investment
strategies 0

2000
2002
2004
2006
1984
1986
1988
1990
1992
1994
1996
1998

changing rapidly!
• Foundation assets
growing
• Rising PF charitable PSC
asset ratios
• Program-Related Blurred
Investments
Lines

OF
• Grant effectiveness
metrics

PF
• More trustee control
over investment
strategies


changing rapidly!
growing
• Rising PF charitable
asset ratios
• Program-Related
Investments
metrics
over investment
strategies


The Foundation Center’s
PRI Read


changing rapidly!
growing
Evolution of Default Investment
• Rising PF charitable Standard
asset ratios
• Program-Related Ordinary
Investments
As If Your
Safe List MPT Own
Prudence

metrics
over investment
strategies


changing rapidly!
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 40th Annual Salk Institute's Private
paid to professionals Foundation Trustees Seminar

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


CompStats
990
Reported Comp Expenditures


CompStats
Reported Comp (000) by PF Size
PF Size
<100,000
<Million
140,000
<10 Million
<50 Million
120,000 <100 Million
Larger
100,000

80,000

60,000

40,000

20,000

0
1993 1995 1997 1999 2001
1994 1996 1998 2000 2002


CompStats
Poorly Designed Studies Fail to Identify Variables

Courtesy of Randal
40th Annual Salk Institute's Private Monroe

Statutory Constraints
• Reg. §1.501(c)(3)-1(c)(2)
• Private inurement • PF operated for other
• Private benefit than charitable purpose
• Taxable • A minimal amount
expenditures forfeits exempt status
• Self-dealing • Applies only to individuals
• State fiduciary law whose relationship with
• Minimum payouts an organization offers
• Net investment them an opportunity to
income excise tax make use of the
organization's income or
assets for personal gain

• Must be more than
• Private inurement incidental to forfeit
• Private benefit exempt status
• Taxable • Applies to outsiders, but
expenditures foundation manager could
• Self-dealing possibly fall within
• State fiduciary law purview
• Minimum payouts
• Net investment
income excise tax

• IRC §4945
• Private inurement
• Treas. Reg. § 53.4945-6(b)(2)
• Private benefit
• Avoided by demonstrating
• Taxable compensation paid in good
expenditures faith belief that they were
• Self-dealing – reasonable
• State fiduciary – consistent with ordinary
law business care and prudence
• Minimum payouts • Fact and circumstances issue
• Net investment • Objective proof of subjective
belief
income excise tax Annual Salk Institute's Private
40th

• Private inurement • IRC §4941(d)(1)(D)
• Private benefit • IRC §4941(d)(2)(E) exception
• Taxable – Personal services
expenditures – Reasonable, not excessive
• Self-dealing – Necessary to carryout exempt
function
• State fiduciary
law • Resolved by objective proof
of an objective fact, cf.
• Minimum payouts taxable expenditure
• Net investment • Treas. Reg. §53.4941(e)-
income excise tax 1(e)(1)(I)- continuing
transaction with penalty in
each year or partial year,
Fabonacci process

• Private inurement • Related to IRC §508
• Private benefit – Mandatory insertion of TRA 69
provisions in governing
• Taxable instrument
expenditures – Effort to mobilize AGs
• Self-dealing • General obligation- put the
• State fiduciary principals interest ahead of
law your own
• Minimum payouts
• Net investment
income excise tax


• Private inurement • IRC §4942
• Private benefit • IRC §4942(g)- qualified
• Taxable distributions include
expenditures reasonable and necessary
• Self-dealing administrative expense
• State fiduciary • Thus, compensation disallowed
law as reasonable may subject PF
to excise tax for failing to
• Minimum payouts meet the 5% requirement if
• Net investment there is no carry forward and
income excise tax management plays close to the
line

• Private inurement • IRC §4940
• Private benefit • Net Investment Income tax
• Taxable base equals gross investment
expenditures income and capital gain net
• Self-dealing income reduced by investment
deductions
• State fiduciary law • IRC §4940(c)(3)(A)- “...there
• Minimum payouts shall be allowed as a deduction
• Net investment all the ordinary and necessary
income excise tax 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 employeesAnnual Salk Institute's Private
40th
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


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 compensationInstitute'stheir efforts.”
40th Annual Salk
for Private

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

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


Moving Towards the Pixels
Administration Formulating Job
Investment
Discription Direct
Portfolio
Staffing Supervision Setting Management
Ascertainment Risk-Return
Policy
Measuring
Performance
Investment
Review Selecting
Hiring Portfolio
Performance
Managers
Communication Tax & Other Compliance
& Replacing
Morale Managers
Function
Defining/Updating Mission
Soliciting Proposals Setting Grant Guidelines

Developing Mission Oriented Expertise Ascertaining “Client” Needs

Developing and Deploying PRI Skills

Communicating with “Clients”
&
Serving on “Client” Boards Community Relations

Charitable Mission Foundation Trustees Seminar

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 40th Annual Salk Institute's Private

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 40th Annual Salk Institute's Private

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 Avoid
1. Engage expert before 1. Hiring expert after audit
fixing compensation notice
2. Expert with Qualified 2. Algorithm-statistical
Appraiser character form studies
3. Experts relied on by 3. Hired guns who general
parties to transactions work in litigation context
4. Experts accepted by a 4. Academics with no court
variety of courts or deposition history
5. Experts who interview 5. Experts who decline site
trustees and managers visits and interviews
6. Solid credentials 6. Jacks of all trades

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Salk 2012- Compensating Trustees

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