DATELINE: January 8, 2009, Chicago
Any lawyer whose law practice focuses on business corporations knows that business corporations effectively subject to different regulatory regimes. Closely-held corporations are subject to minimal regulation under state business corporation laws. The owners can select directors, make major decisions, and pay compensation largely as they see fit. On the other hand, large publicly-traded corporation are subject to lots of regulation and disclosure requirements thanks to federal securities laws.
By and large, state nonprofit laws and regulation of charity do not draw a distinction between private foundations—the equivalent of closely-held business corporations—and the large brand-name charities. Federal tax law, however, does draw a sharp distinction, but one that is far different than the one drawn between closely-held and publicly-traded business corporations. Under Chapter 42 of the Internal Revenue Code, private foundations (including family foundations) are subject to far...
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more stringent restrictions than the large well-known charities. Although Chapter 42 is part of the Internal Revenue Code, its purpose is not to raise revenue, although it relies on punitive excise taxes to achieve Congress’ purpose of making sure that family and other foundations further charitable purposes rather than the interests of the family or others funding the foundation. In theory, Section 4944 should be making some of those who manage family foundations very nervous if the foundations invested with Madoff. It imposes a two-tier tax on foundations and their managers on investments that jeopardize the foundation’s charitable purposes. Plain and simple, back in 1969, Congress did not want family or other foundations to invest in risky assets. That is what Section 4944 is all about. Section 4944 in essence can be viewed as a restatement of the state law duty of care imposed on directors, but with one important difference. There is no shield from liability and the statute offers no defense to directors based on good faith--although it does offer several more limited defenses, including reliance on an opinion of counsel. Treasury Regulation Section 53.4944-1(a)(2) defines a jeopardy investment as follows: An investment shall be considered to jeopardize the carrying out of the exempt purposes of a private foundation if it is determined that the foundation managers, in making such investment, have failed to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long- and short-term financial needs of the foundation to carry out its exempt purposes. In the exercise of the requisite standard of care and prudence the foundation managers may take into account the expected return (including both income and appreciation of capital), the risks of rising and falling price levels, and the need for diversification within the investment portfolio (for example, with respect to type of security, type of industry, maturity of company, degree of risk and potential for return). The determination whether the investment of a particular amount jeopardizes the carrying out of the exempt purposes of a foundation shall be made on an investment by investment basis, in each case taking into account the foundation's portfolio as a whole. No category of investments shall be treated as a per se violation of section 4944. However, the following are examples of types or methods of investment which will be closely scrutinized to determine whether the foundation managers have met the requisite standard of care and prudence: Trading in securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, the purchase of "puts," "calls," and "straddles," the purchase of warrants, and selling short. The determination whether the investment of any amount jeopardizes the carrying out of a foundation's exempt purposes is to be made as of the time that the foundation makes the investment and not subsequently on the basis of hindsight. Therefore, once it has been ascertained that an investment does not jeopardize the carrying out of a foundation's exempt purposes, the investment shall never be considered to jeopardize the carrying out of such purposes, even though, as a result of such investment, the foundation subsequently realizes a loss. The provisions of section 4944 and the regulations thereunder shall not exempt or relieve any person from compliance with any Federal or State law imposing any obligation, duty, responsibility, or other standard of conduct with respect to the operation or administration of an organization or trust to which section 4944 applies. Nor shall any State law exempt or relieve any person from any obligation, duty, responsibility, or other standard of conduct provided in section 4944 and the regulations thereunder. This regulation, which was promulgated in 1972, is clearly out of date with current investment practices. It does, however, reflect two important principles which are timeless. First, it requires diversification. Second, it requires that foundation managers (including directors and trustees) exercise due care and prudence, which suggests to us that some level of due diligence in selecting investment assets is required. Unfortunately there is virtually no case law addressing what constitutes due care and prudence within the context of Section 4944. Our review of a database of tax case law only revealed two cases which specifically addressed issues under Section 4944. Neither focuses specifically on what constitutes a jeopardy investment. The more relevant of the two is John E. Thorne, 99 TC 67 (1992). The parties conceded that there was a jeopardy investment. The question before the court was whether the IRS had taken sufficient action to be able to assert the second-tier tax. The facts do suggest that an apparent lack of due diligence on the part of the foundation and a trustee probably served as the basis for the imposition of the first-tier tax. The court, in describing the investment, states: On August 1, 1976, petitioner, as a trustee of the Trust, executed an agreement with the Aruba Bonaire Curacao Trust Co., Ltd. (ABC), a Bahamian corporation. The agreement referred to, and sought to affirm, a prior agreement entered into by the Trust and ABC on or about October 9, 1973. Under the August 1, 1976, agreement, ABC acknowledged that it received $508,502.40 from the Trust on or about October 9, 1973. This amount constituted the entire corpus of the Trust. ABC further acknowledged that it received two additional deposits of $250,000 each from the Trust on January 14, 1974. The Trust acknowledged that it had received certain sums of interest and principal from ABC through August 1, 1976. The agreed annual rate of interest on the deposits under both agreements was 5 percent. The initial sum of $508,502.40 transferred by the Trust to ABC in 1973 was a demand deposit. The two subsequent transfers of $250,000 were each time deposits. The time deposits were subsequently modified and terminated, and $194,000 was returned to the Trust by ABC on or about June 10, 1975. As of August 1, 1976, the balance of the Trust's remaining demand deposit with ABC was $677,942.40. As of December 31, 1977, the balance of the account was $674,942. Petitioner entered into the original agreement with ABC based, at least in part, on the advice of his friend and attorney, Mr. Harry Margolis. Several of Mr. Margolis' other clients had deposits with ABC. Mr. Margolis assured petitioner that ABC was a good place to deposit money because it would pay a higher rate of interest than domestic banks and the funds would be available whenever needed. Mr. Margolis did not provide petitioner with a written legal opinion to this effect. Petitioner did not make personal inquiries into ABC's integrity. Consequently, it was not until sometime in 1988 that he discovered that ABC's license to do business had been revoked in June of 1973 and its charter had been struck from the register of Bahamian companies in September of 1973. None of the other trustees voiced any objections to petitioner with regard to the agreements with ABC. Nor did any of them request, at least prior to May 15, 1980, that petitioner agree to remove the Trust's funds from deposit with ABC. The opinion never says whether the money was lost, but the quoted description of the facts certainly brings to mind some of the accounts about how and why some people and foundations invested with Madoff. The investment was recommended by an advisor because it offered higher returns than couldn't be obtained elsewhere. The trustee followed the advice without any other inquiries. All of the trust’s assets were invested with ABC so there was no diversification. Given the apparent similarities between the ABC investment and the ones with Madoff leads us to conclude that the IRS should be investigating whether any of the private foundations (and their directors and other foundation managers)that invested directly with Madoff or who failed to diversify in selecting feeder funds should be held liable for taxes under Section 4944. We, however, are pragmatists. We therefore suspect that the IRS won't even consider invoking Section 4944. From a ground-level perspective, inaction on the part of the IRS is justifiable given the IRS's limited resources. The IRS has the power to proceed against both the foundations and the directors, but there is not much point in proceeding against a foundation that has lost all or substantially all of its assets. Proceeding against the directors and other foundation managers makes more sense because they are the ones who made or abdicated from making the decisions. A 10% (tier 1) and 5% (tier 2) tax on these individuals could amount to a lot of money when millions of dollars are involved. Unfortunately, the total that amount that the IRS can be assess with respect on any one investment is capped under tier 1 at $10,000 and under tier 2 at $20.000. IRC Section 4944(d). The IRS’s potential haul in excise taxes doesn’t make an investigation worthwhile if the focus is limited to merely how much can be collected. Moreover, any taxes collected would not necessarily be returned to the charitable sector or used to bolster enforcement of the tax law provisions pertaining to exempt organizations. That brings us to the bird’s eye view. The IRS, like state charity regulators, make it difficult for good lawyers to impress on their clients the importance of adopting sound investment and other governance practices to assure that the organization’s charitable assets aren’t wasted or misused. We have experienced what good lawyers experience when we have responded to press inquiries. We have already received the question from the media in the Madoff context: Can the directors of the foundations be held monetarily liable? Can you point to cases where directors have been held liable? Sure, there is the famous Sibley Hospital case. Stern v. Lucy Webb Hayes National Training School for Deaconesses and Missionaries, 381 F. Supp. 1003 (D.D.C. 1974). The court found mismanagement, no management, and self dealing. The court’s penalty: The directors were required to read the court’s opinion. Death by boredom, but no monetary liability. It is hard to find many reported state law cases where directors have been held monetarily liable. It also hard to find cases where directors have been held liable under Section 4944. Creating duties and obligations without enforcement makes a lawyer’s job impossible. Lawyers can cajole all they want, but the client who is hell bent on doing what he wants to do is going to keep saying, “Show me the case where somebody got into trouble.” Inaction by regulators turns provisions like Section 4944 into recommended best practices rather than laws that regulate behavior. We believe the IRS should at least open audits of the foundations that invested in Madoff to determine whether those investments constituted jeopardy investments under Section 4944. Although the IRS is prohibited from revealing who it is auditing and why, attorneys will undoubtedly reveal that they are handling a Madoff-related audit at bar and other professional meetings--although they would probably not reveal their clients' names. In short, word would spread within the regulated community. Even if not a nickel of tax were ever collected, the signal would result in improved foundation investment practices. If the IRS chooses not to at least open audits under these circumstances, then it should ask Congress to repeal Section 4944 as deadwood, particularly in the absence of any meaningful litigation under the provision during the last 29 years. Both the IRS and state regulators should recognize that public enforcement of laws helps attorneys who counsel clients, particularly when it comes to protecting charitable assets and seeing that those assets are used efficiently. Lawyers can talk themselves blue in the face about what the law requires, but if there is no visible evidence that the law has ever been enforced, few clients will listen. In this same vein, state charity regulators should start releasing detailed press releases and the underlying documents when they enter into settlements with boards that keeps potential violations of the law out of the courtroom and the public limelight. Many regulators are reluctant to do this because they fear the publicity will hurt the charity. What they fail to recognize is that not publicizing these settlements hurts many other charities. In short, if regulators want the private bar to effectively enforce the rules by drawing clear lines when advising clients, the regulators occassionally must send some signals that the private bar can point to.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
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THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL.
