Private foundations provide benefits to donors and society alike, but are subject to a bewildering set of highly technical federal tax rules that hold many traps for the unwary. This article will discuss how some of these rules apply in connection with a private foundation’s payment or reimbursement of the travel expenses of its board members and their families.
Let’s assume a hypothetical charitable foundation, the Smith Family Foundation, that is described in section 501(c)(3) of the Internal Revenue Code, and is a private foundation under section 509(a) of the Code. The foundation was formed by a husband and wife, Mr. and Mrs. Smith, to support various educational programs for young people. The foundation’s board includes Mr. and Mrs. Smith, their two grown children, John and Jill, and Jill’s husband, Bob (who also provides accounting services to the foundation).
The board holds its annual meeting at Disney World, in Orlando, Florida. The board chose Disney World because of the availability of meeting space and amenities, and also because of its recreational and entertainment opportunities for the other family members who come along. John and Jill bring their spouses and children, and generally stay a few extra days beyond the day of the actual meeting to enjoy a vacation. In addition to the annual meetings, the board of directors meets quarterly to review investment activity.
The foundation reimburses the directors for the costs of their travel, lodging and meals. It also pays each board member $2,000 for attending each of the board meetings.
Several times a year, Mr. Smith and his son John travel to various locations to meet with educational groups to investigate and evaluate the programs supported by the foundation. In addition, Bob attends an annual conference on private foundation management issues, which is held in different locations each year. Depending on the location, Jill may come along, but Jill does not attend the conference. The foundation pays Jill’s expenses on these trips as well.
Mr. and Mrs. Smith want to make sure that the foundation’s policies regarding payment or reimbursement of travel and other expenses of family members do not violate the technical rules applicable to private foundations. In particular, they are concerned about the application of the self-dealing rules.
The Self-Dealing Rules
It is important to avoid violations of the self-dealing rules, because even a relatively minor technical violation of these rules can result in the imposition of harsh excise taxes on foundation managers and other “disqualified persons,” personally. In addition, self-dealing transactions must be “corrected” (generally, undone to the extent possible) in a timely manner in order to avoid the imposition of additional, even harsher, taxes.
Mr. and Mrs. Smith are disqualified persons with respect to the foundation because they are substantial contributors. That is, they contributed more than $5,000, and their gift constituted more than 2 percent of the total amount of gifts received by the foundation at the time of the gift. John, Jill, and Bob are disqualified persons for a different reason—because they are family members of substantial contributors. (For this purpose, family members include spouses, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren.) In addition, all of these individuals are disqualified persons once over because they are foundation managers (i.e., officers, directors or trustees) of the foundation.
Generally, any payment (or reimbursement of expenses) by a private foundation to a disqualified person constitutes self-dealing, unless the transaction falls within one of the narrow exceptions to self-dealing provided in the Internal Revenue Code and the regulations. For instance, if a private foundation pays the personal living expenses of its trustees, it generally will be self-dealing, even when the foundation’s trustees are otherwise not compensated for their services.
Reasonable Compensation Exception
Fortunately, an exception to self-dealing is provided for the payment of “reasonable” compensation, including reimbursement of expenses, to a disqualified person (other than a government official) for personal services that are reasonable and necessary to the foundation’s charitable operations. Although there is no precise definition of the types of personal services that are included within this exception, it generally has been interpreted to apply to services that are essentially professional and managerial in nature, such as legal, accounting, tax, investment advisory, investment management, and banking services. The compensation may be paid in the form of salaries, wages, fees, bonuses, fringe benefits, and retirement benefits, as long as the total compensation paid does not exceed reasonable compensation for the services rendered.
Generally, compensation is “reasonable” if it is the amount that would ordinarily be paid for similar services by similar organizations under similar circumstances. In one case, the IRS determined whether the compensation a private foundation paid to its directors was reasonable by comparing it to data in a published report on compensation paid by private foundations. The IRS concluded that the directors’ compensation was not reasonable—and was therefore self-dealing—because it was 75 percent higher than the average compensation paid by private foundations of the same size, according to the report.
In order for the reasonable compensation exception to apply, the compensation must in fact be purely in the form of payments for services—not for property or for a distribution of the organization’s earnings and profits. For instance, the IRS ruled that a private foundation’s payment or reimbursement of the personal vacation and travel expenses of the foundation’s directors and their families was self-dealing when the payments were not intended to be compensation and were not treated as compensation when paid.
Accordingly, the directors of the Smith Family Foundation may be paid a reasonable fee for attending board meetings, and son-in-law Bob may be paid a reasonable fee for his accounting services. Of course, this compensation generally would be taxable income to Bob and the other directors for federal income tax purposes, and must be properly reported as such.
Reimbursement of Travel Expenses
Noncompensatory Travel Expense Reimbursements: The Smith Family Foundation generally may pay or reimburse its directors’ reasonable expenses incurred directly in connection with their personal services rendered to the foundation. This would include reimbursement of the directors’ expenses incurred in connection with their attendance at the annual board meeting in Orlando, the expenses of Mr. Smith and son John in investigating and evaluating programs supported by the foundation, and son-in-law Bob’s expenses to attend conferences that are directly related to the foundation’s operations. The payment or reimbursement of these travel expenses is directly related to the carrying on of the foundation’s operations, and the value of the payment or reimbursement of these travel expenses generally would be excluded from the directors’ income for federal income tax purposes under the fringe benefit rules.
Compensatory Travel Expense Reimbursements: The Smith Family Foundation may also pay or reimburse the travel expenses of family members who accompany the foundation’s directors when they travel on foundation business, but only if it is intended as compensation and treated accordingly, and only if it does not result in more than reasonable compensation to the directors. In one situation considered by the IRS, a foundation’s trustees and their spouses traveled to a foreign country to gather information about programs of interest to the foundation in that country. The IRS approved the foundation’s reimbursement of the travel expenses of the trustees and their spouses, even though the presence of the spouses was not necessary to the carrying out of the foundation’s purposes. The IRS noted that the reimbursement of the spouses’ expenses, if treated as compensation to the trustees, did not exceed reasonable compensation.
In another instance, a private foundation reimbursed its trustees for the travel expenses of the trustees’ spouses to accompany the trustees to meetings of the foundation’s board and committees. The foundation reported the reimbursement of spouses’ transportation, meals, and lodging expenses as additional compensation paid to the trustees. The IRS approved the reimbursement, provided that the amount of the reimbursement, when added to the other compensation received by the trustees, was reasonable compensation for the services rendered by the trustees to the foundation.
Thus, assuming that the foundation properly treats it as compensation to the directors, the Smith Family Foundation may pay or reimburse the expenses of the family members who accompany the directors to Disney World, as long as doing so does not result in the total compensation paid to the directors exceeding reasonable compensation for their personal services to the foundation. Likewise, the foundation may pay or reimburse John and Jill’s expenses attributable to the extra days they stay at Disney World, and Jill’s expenses when she accompanies Bob to conferences. As these expenses are not incurred directly in connection with rendering services to the foundation, the payment or reimbursement of these expenses generally would be taxable to the directors. Note, however, that the rules governing the income taxation of individuals for the payment or reimbursement of mixed business and personal travel, and spousal travel, are too complex to address in this article. Moreover, when travel outside the United States is involved, special rules apply.
A Compensation Checklist
In order to avoid any question in regard to any of the above payments or reimbursements, it would be advisable for the Smith Family Foundation to take the following steps:
- Document that the compensation, in whatever form, paid to its directors is intended as reasonable compensation for the directors’ personal services to the foundation. Formal policies and procedures should be adopted and implemented for this purpose, including policies concerning directors’ fees and expense reimbursements (including business travel), and the payment or reimbursement of the travel expenses of directors’ family members.
- When appropriate, treat payments or reimbursements as compensation to the director for personal services to the foundation. Maintain proper records and report all payments for tax purposes as appropriate. For instance, the reimbursement of the travel expenses of family members who are not traveling on foundation business should be treated as compensation to the director who is traveling on foundation business.
- Obtain and rely on appropriate comparability data to establish the total amount of compensation that is reasonable for the foundation’s directors. The amount of compensation that is reasonable must be determined for each director in light of the personal services rendered by that director to the foundation.
- Adopt a formal policy that the foundation will not pay or reimburse any expenses that would cause the total amount of compensation paid to a director to exceed reasonable compensation levels to that director for personal services to the foundation.
- Monitor all compensatory payments and expense reimbursements to directors and family members to make sure that, when added to the value of all other compensation paid to each director, the total does not exceed reasonable compensation for the director’s personal services to the foundation.
- Maintain records of the total compensation paid to each director, including any compensatory payments or reimbursement of the travel expenses of the foundation’s director and family members.
- Once this checklist has been completed it quickly becomes obvious that reasonable compensation is a zero sum game. That is, the more the Smith Family Foundation pays its directors in salaries and fees, the less it can pay them in compensatory travel reimbursements.
It follows that the foundation’s travel reimbursement policies must be coordinated with its salary or fee structure to make sure the total compensation paid is not unreasonable. For instance, the board may decide to forego directors’ fees entirely in return for the opportunity to hold their meetings in a nicer location. This should be kept in mind when planning the foundation’s annual meeting.
Richard Speizman is a partner, and V. Moore is a senior manager in the Exempt Organizations Tax Practice of KPMG LLP. For more information on the contents of this article or the services KPMG provides to private foundations, please contact Mr. Speizman at (202) 533-3084.