Ordinarily, established private foundations and public charity grantmakers would ignore the IRS's revision of Form 1023, Application for Recognition of Exemption from Federal Income Tax. After all, these groups have already received their determination letters. But the revised Form 1023 and the accompanying instructions that the IRS issued on November 1, 2004, merit grantmakers' attention.
Form 1023 is in the vanguard of IRS forms that are designed to educate tax-exempt organizations and help halt abusive transactions. In addition, the form and instructions contain questions and information about conflicts of interest that all grantmakers should consider.
The new Form 1023 focuses on policies and processes that charities can use to safeguard against abuses in areas such as compensation and self-dealing. Parts of the form set out a listing of what the IRS apparently deems best practices; if applicants indicate that they are not following these recommended steps, they must explain how they intend to achieve compliance with the law. The IRS has already stated that it plans to incorporate questions like these into Form 990 and Form 990-PF, the annual information and tax forms that public charities and private foundations file.
It asks applicants whether they have adopted a conflict of interest policy that is consistent with a sample included in the instructions. If the answer is "yes," applicants must include a copy of the policy; if the answer is "no," applicants must answer further questions on the subject: "What procedures will you follow to assure that persons who have a conflict of interest will not have influence over you for setting their own compensation?" and "What procedures will you follow to assure that persons who have a conflict of interest will not have influence over you regarding business deals with themselves?" The form notes that a conflict of interest policy is recommended but not required for exemption.
So what does the IRS think a conflict of interest policy should look like, and does the IRS model work for grantmakers? The IRS's sample policy was drafted back in the late 1990s as a guide for healthcare organizations. It was developed with public charities in mind and with a particular focus on financial conflicts of interest between a charity and directors and officers. Private foundations may want to evaluate whether the sample policy is a good fit for them, and all grantmakers may wish to include statements about non-economic conflicts of interest. Following is a summary of some of the document's provisions, with comments on how grantmakers might consider revising the policy.
The IRS's policy states that it is meant to protect a charity's interests when it is contemplating transactions that may benefit the private interests of officers or directors or that might result in excess benefits to foundation insiders.
Comment: Public charity grantmakers' conflicts policies often cite a desire to maintain public trust. Private foundations may cite the importance of exhibiting fairness or integrity or upholding the values of a founding family.
The policy defines an "interested person" as "any director, principal officer, or member of a committee with governing board delegated powers, who has a direct or indirect financial interest." A person has a "financial interest," directly or indirectly, through business, investment, or family, if the person has an actual or potential ownership or investment interest in any entity with which the charity has or is negotiating a transaction or arrangement, or has a compensation arrangement with the charity or with any entity or individual with which the charity has a transaction or arrangement. The policy clarifies that not every financial interest is a conflict of interest.
Comment: Grantmakers often have all manner of established advisory committees in operation; the policy should clearly show how it applies to members of those groups. Grantmakers' policies may also cover staff members and should probably define who constitutes a member of an interested person's family. Grantmakers may also wish to note that not every conflict of interest is financial; directors and staff members may have personal or political involvements that may cause them to have dual and conflicting loyalties in connection with a grant or other foundation expenditure. Private foundations must keep in mind that the definition of "interested persons" is different from, and less inclusive than, the tax code's definition of "disqualified persons," that group of donors, directors and their family members and business interests with which the foundation is barred from entering into an array of financial transactions.
The IRS's sample policy provides that an interested person must disclose any actual or possible conflict of interest and all material facts relevant to the conflict. After disclosure to the board or appropriate committee, the interested person must leave the meeting room. The board or committee will then discuss the matter and vote on whether a conflict of interest exists. If a conflict of interest exists, the board or committee shall, if appropriate, determine whether the charity can obtain a more advantageous arrangement that would not pose a conflict of interest. If an alternative arrangement is not possible, the board or committee shall determine by a majority vote of disinterested directors whether the transaction is in the charity's "best interest, for its own benefit, and whether it is fair and reasonable."
Comment: This procedure tracks many states' laws on how to deal with conflicts of interest. Where a vote of disinterested directors is not possible, an outside authority such as a court may validate a transaction if it can be shown to be fair and reasonable. No amount of disclosure or independent ratification can correct an act of self-dealing that occurs between a private foundation and a disqualified person.
The sample policy also states that a voting member of a board or committee who receives compensation for services from the charity is prohibited from voting on matters related to his or her compensation arrangement.
Comment: Both private foundation and public charity grantmakers should exercise great caution when they hire foundation insiders, family members or board or committee members, to perform professional services.
Annual Statements & Periodic Reviews
To ensure compliance, the conflicts policy requires that directors and officers annually sign a statement declaring that they have received, read, understood and intend to comply with the policy. The charity is obligated to carry out periodic reviews to ensure that the organization does not serve private interests at the expense of its charitable mission. The periodic compliance check will include, at a minimum, a review of whether "compensation arrangements and benefits are reasonable, based on competent survey information, and the result of arm's length bargaining," and whether transactions with management organizations are reasonable and do not result in impermissible private benefit.
Comment: This provision requires only an annual certification that the directors and officers have read and understood the policy and agree to comply with it; some foundations require periodic statements from individuals covered by conflicts of interest policies that disclose the financial, vocational and charitable ties that may give rise to conflicts.
The key features that appear in most conflicts of interest policies can be reduced to a few simple (and alliterative) ideas: disclose, discuss, decide (by disinterested directors whenever possible) and document. The IRS's sample policy requires all of those actions. With a little tweaking, this policy can help grant-makers ensure that their assets are being used for charitable, not private, ends.
Form 1023, Application for Recognition of Exemption