Once we have completed the charity formation process our nonprofit clients come to us and ask, now what? Obtaining IRS and FTB approval for tax-exempt status is just the tip of the iceberg, and we believe that the key to successfully maintaining favorable tax-exempt status is to ensure that proper written governance policies and procedures are adopted and followed from the get go. These policies and procedures provide for the segregation of duties, control of personnel and assets, execution of transactions, and record keeping requirements. Having these internal oversight procedures in place is important for two main reasons:

1)  When governance issues and problems arise (as they inevitably do), the procedures can help the charity deal with the problem so that the chances of it escalating and rising to the level of an investigation by the IRS, the Attorney General (“AG”), or other governmental agencies are reduced, and

2)  If a government agency such as the IRS or the AG initiates an audit or investigation of the charity, and the charity is able to demonstrate that it adopted well written governance policies and procedures far in advance of the problem and that the Board of Directors and officers have made a good faith effort to comply with them, then the organization’s chances of coming out of the investigation with it’s tax-exempt status in tact are increased.

And if these reasons are not enough, in many states (including California), having certain written governance policies in place is required by law! Whistle blower protection and prohibitions on document destruction are required under the federal Sarbanes-Oxley Act of 2002, and in California, the establishment of governance policies is required under the California Nonprofit Integrity Act of 2004.

In subsequent blogs we will describe what policies the IRS and the AG requires charities to adopt in connection with the following governance issues:

1. Good record keeping
2. Due diligence
3. Duties of loyalty and conflicts of interest
4. Private inurement
5. Private benefit
6. Code of ethics
7. Whistleblower policy
8. Compensation practices
9. Transparency
10. Disclosure statements

Stay tuned for our upcoming blogs on these and other subjects of interest to all charities, and as always, feel free to contact us for further information regarding these topics.

The Requirement

All tax-exempt organizations must file Form 990, 990-EZ, 990-N or 990-PF with the IRS annually.  If the nonprofit organization is other than a church, or certain other excepted entity, and normally has gross receipts of $25,000 or less, it must electronically file Form 990-N, Return of Organization Exempt From Income Tax.  If an organization has gross receipts less than $1,000,000 and total assets at the end of the year less than $2,500,000, it may choose to file Form 990-EZ, Short Form Return of Organization Exempt From Income Tax, instead of Form 990.  For exempt organizations having gross receipts more than $1,000,000 and total assets more than $2,500,000, Form 990 (as revised for 2008) must be filed.  The deadline for filing Form 990 (or one of its versions) is the 15th day of the 5th month after the organization’s accounting period ends (i.e., May 15 for calendar year filer).

The Consequence of Not Fulfilling The Requirement

Tax-exempt organizations that do not satisfy annual 990 filing requirements for three consecutive years automatically lose their tax-exempt status.  If an organization loses its exemption, it will have to reapply to regain its tax-exempt status.  Any income received between the revocation date and renewed exemption may be taxable.

The Relief – For Small Organizations Only

The IRS announced on July 26, 2010 that it is providing one-time relief for small organizations (i.e. organizations with gross receipts less than $1,000,000 and total assets at the end of the year are less than $2,500,000) that have filing due dates on or after May 17, 2010 and before October 15, 2010 to return to compliance and retain their tax-exempt status even though they failed to file for three consecutive years.  This one-time relief benefits only Form 990-N (e-Postcard) and Form 990-EZ filers.  Tax-exempt organizations required to file Form 990 or Form 990-PF are ineligible and their exempt status is automatically revoked if they fail to file for 3 consecutive years.

Small organizations required to file Form 990-N simply need to go to the IRS website, supply the eight information items called for on the form, and electronically file it by October 15, 2010.  Tax-exempt organizations eligible to file Form 990-EZ must file their delinquent annual information returns by October 15, 2010 and pay a compliance fee.

The IRS issued a list of organizations for which the IRS does not have a record of a required annual filing for 2007 and 2008, and whose 2009 return, due on or after May 17 and before October 15, 2010, has not yet been received.  In California alone, the list of nonprofit organizations at risk of losing their tax-exempt status because they failed to file for 2007, 2008, and 2009 is 1,162 pages long; with an average of 30 organizations per page, that means that approximately 35,860 California tax-exempt organizations may automatically lose their tax exempt status if they do not file From 990-EZ or Form 990N by October 15, 2010.  However, the list may also include organizations that were required to file Form 990 or Form 990-PF.  As stated above, these organizations are not eligible to take advantage of this one-time IRS filing relief to bring them into compliance.

Not included on the list but still at risk of automatically losing their tax exempt status?  Subordinates in group rulings for which the parent has not filed a required group return; very small section 501(c)(3) public charities not required to file an application for exemption; and other section 501(c) organizations not required to file an application for exemption.

The Lesson to be Learned

If you are a small tax-exempt organization (i.e. your gross receipts are less than $1,000,000 and total assets at the end of the year are less than $2,500,000), and you have not filed your 990-N or 990-EZ for the past 3consecutive years, you must file the applicable version of Form 990 by October 15, 2010 at the latest to avoid automatically losing your tax-exempt status.  For questions about annual filings for tax-exempt organizations, or nonprofits in general, please contact us.

A living trust is but the “tip of the iceberg” in estate plans prepared by our office.  We always include the following additional documents to our estate planning clients.  These documents help ensure that your estate will be distributed in accordance with your wishes, and that if you become ill you will be cared for in the manner directed by you.

New will: We will provide you (and your spouse, if applicable) with a new will, commonly referred to as a “pour over will”, the primary purposes of which are to (1) distribute any assets owned in your individual name to your trust, and (2) provide for burial or other instructions.  Of course, we will assist you in the transfer of your assets into your living trust (see Deeds and Transfers below), which should avoid the need for probate of your estate, and in many cases, the will should not have to be admitted into any court proceedings.  However, we prepare wills as a “fail safe” device to channel any assets not held in a living trust as of the time of death.  In order to avoid probate, we advise our clients to hold title to all of their assets in their living trust, with the exception of IRA, 401(k), pension and profit sharing plan and other retirement plan accounts, which for estate tax reasons are generally not held in a living trust (only a spouse may do a “roll-over” into an IRA account).

Advanced Health Care Directive: Many persons have made no provision for health care instructions if they become incapacitated, or have an outdated form that is no longer used in California.  We provide our clients with the current California statutory form of Advanced Health Care Directive (under California Probate Code Section 4701), which lets their physicians, family and friends know their health care and end of life decisions, organ donation preferences, and designated conservators. It also allows individuals to appoint agents who have power of attorney to make care and treatment decisions on their behalf, and give instructions about their health care wishes.

Durable Power of Attorney – Business Matters:
Generally, powers of attorney are effective only during times when the principal is competent and able to give instructions to the agent.  In situations where a person becomes unable to direct his or her own business affairs, Durable Powers of Attorney – Business Matters are very useful.  These documents become effective only upon a person becoming incapacitated and ceases to be effective when the person gets better or dies.

General Grant and Assignment: Living trusts are only effective in avoiding probate when funded with a person’s assets.  To the extent that assets are not held in the name of the living trust, a probate court proceeding may be needed in order to distribute those assets to the designated beneficiaries.  One of the documents included in our estate plans is a form of General Grant and Assignment, the purpose of which is to act as a “catch all” document that transfers all assets and properties (with the exceptions notes above regarding retirement plan accounts) into the living trust.  The General Grant and Assignment is not sufficient to transfer real estate, bank accounts, stock brokerage accounts, and certain other assets into a living trust.  Upon request, we assist our clients in moving all appropriate assets into their living trusts.

HIPAA Documents: This document authorizes persons designated in the form to receive your confidential health care information if you become incapacitated and unable to act for yourself.  “HIPAA” is short for the United States Health Insurance Portability and Accountability Act, which was enacted by Congress in 1996 and has revolutionized the way medical information can be disseminated in the U.S.

Deeds and Assignments: An Updated General Grant and Assignment (see above) is insufficient of itself to transfer title to real estate and bank and stock brokerage accounts to a living trust.  Upon request we assist our clients in preparing deeds that transfer their interests in real property to their living trusts, and we inform our clients how they may hold their bank accounts and stock brokerage accounts in their trusts.

The Difference Between a Will and a Living Trust: A will is merely a legal document with instructions for the disposition of one’s assets at death, and takes effect only upon the death of the testator, i.e. the person who created the will.  A living trust is more than just a document – it’s a form of legal entity that becomes effective when signed and upon the transfer of one or more assets into the trust.  These assets can be held for the benefit of the trustor, i.e. the person who created the trust, during his or her lifetime, and following that person’s death, distribution of the assets in the trust is made to designated persons or entities.

Avoiding Probate: All wills must be probated (except as noted below), which means lengthy and costly court proceedings.  Probate can be a very time consuming and expensive process — property transfer through probate can often take up to two or more years.  Probate is a public process, with court documents becoming part of the public record.  It can also be an expensive process, with substantial fees going to the executor and the probate administration attorney.  In California, an exception to probate may exist if the total value of the estate is less than $100,000.  But estates over that amount require probate if the decedent leaves only a will or unless the property is held in joint tenancy, with right of survivorship.  Often, ownership in joint tenancy may result in unfavorable tax consequences and, of course, joint tenancy only works to avoid probate when one spouse survives the other.  If both spouses die simultaneously, then instead of avoiding probate (or a proceeding in intestate succession) there will be two probates (or intestate proceedings if there were no wills) required, one for each spouse.  On the other hand, when individuals or couples have a living trust agreement that holds their assets and properties, then no court proceedings (i.e. probate) are required, and the beneficiaries receive the assets and properties without going to court, without lawyers, and without incurring great expense.

Tax Benefits: If you have been told that you must have a living trust in order to attain significant tax benefits, you were misinformed.  All tax advantages of living trusts can also be provided through a will.  These tax advantages include (1) maximizing tax exemptions that reduce or eliminate federal estate taxes, (2) attaining potentially favorable capital gains treatment on the eventual sale of assets by way of a stepped up basis adjustment upon death, and (3) in cases of marital estate plans, postponement of estate taxes until the surviving spouse dies.  The benefit of having a stepped up basis adjustment is that the assets receive a new value at the time of death, which value may in turn be used to eliminate or reduce the taxable gain on the sale of the assets.

Protect Your Children: We frequently create estate plans for families with young children. By establishing a living trust, parents are able to ensure that their children are financially secure in the event of unexpected death, and that minimal assets are lost to administrative expenses. By designating a guardian, parents can make their wishes for future care clear and legally enforceable.

Built-in Conservatorship Over Assets And Properties: Another difference between wills and living trusts, aside from the necessity for all wills to be probated (unless the estate is under $100,000, see above), only living trusts provide a form of built-in conservatorship over the assets and properties held in the estate.  This may be a significant difference because if an individual becomes unable to handle his or her own business affairs, there would be a need to establish a court ordered conservatorship over the person and his or her estate.  A conservatorship proceeding involves the appointment of a person to be in control of someone else and that person’s assets and properties.  In California, a court ordered conservatorship is expensive (usually costing $5,000 or more), time consuming, and requires an annual accounting made by the appointed conservator to the court, which further ads to the expense.  The conservatorship process can be avoided entirely by holding your assets and properties in a living trust, and designating persons who will be in control in the event that you become incapacitated and unable to handle your own affairs.

Protection Against Creditors: In California, it is generally considered against public policy to enforce your own trust agreement to defeat your creditors.  However, when a spouse dies, the deceased spouse’s assets held in the trust may be protected against the creditors of the surviving spouse.  Also, it is permissible to establish a living trust for the benefit of children or other persons that contains enforceable provisions protecting assets against your creditors.  These are known as “spendthrift trusts” and must be irrevocable, i.e. cannot be terminated or amended once established.  For additional information pertaining to the establishment of living trusts that provide protection against creditors, please contact our office.

Privacy: Because wills are subject to probate, which is a court proceeding open to the general public, and because all court files may also be inspected by the public (unless sealed by the court), only living trusts can effectively preserve privacy.  This is because living trusts are generally not recorded documents and are unavailable to the public at large.  Your wishes, and the disposition of your estate when you die, may remain totally private if your assets are held in a living trust.