John Templeton

Three Critical Privacy Issues Every Nonprofit Entity Should Consider

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By Deena Coffman, GSEC, CIPP/US, CIPP/E, CIPM, FIP

Most nonprofit organizations collect, use and store “personal information” of donors and staff. There are well over 200 laws, just in the United States, that mandate protections of this information and apply, in whole or in part, to nonprofits. All nonprofit entities should understand the requirements that TCPA, GDPR and U.S. state data breach/protection laws impose upon their organizations.

Just a few years ago, many entities were largely unaware of the impact data privacy and cybersecurity could have on their organization overall. Most categorized these issues as belonging to the IT or HR departments. Now, data-privacy class-action litigation has erupted and data breach announcements dominate the headlines. Currently, in almost every survey conducted of boards and senior management, data issues rank as one of their three top concerns, if not their single greatest concern. Nonprofit entities would be well advised to tend to this important area which is often overlooked until it becomes a crisis.

TCPA

The Telephone Consumer Protection Act of 1991 (TCPA) was introduced in response to consumer sentiment toward unwanted telephone solicitations. Telemarketers calling during all hours—particularly the dinner hour—became a punchline and an irritant. TCPA has been updated several times over the years, and the most recent update tightens restrictions on calling without written permission, even if a “prior business relationship” existed. Nonprofit organizations are exempt from some, but not all, requirements under TCPA. For example, the “abandonment rules” are an exemption for nonprofits, and requirements for auto-dialers and prerecorded calls are different for nonprofit organizations than for commercial entities. While the requirements are less restrictive, nonprofit organizations still can’t afford to completely ignore TCPA, because some requirements do still apply, and the cost for getting this incorrect can be enormous.

The recent changes give the TCPA “teeth” by providing for a private right of action, effectively inviting consumers, the FCC and states’ attorneys general to join in enforcement efforts. Plaintiffs are able to recover the higher of their actual loss or $500 for each violation. And, if the court finds that the defendant acted willfully or knowingly, the court has discretion to triple the amount to $1,500 for each violation.

Organizations that conduct telemarketing should be tuned to recent changes in the TCPA. Professional plaintiffs are causing a rise in TCPA enforcement and there have been no shortage of multimillion dollar settlements. Interline Brands agreed to pay $40 million to Craftwood Lumber to settle a suit alleging a TCPA violation by sending over 1,500 advertisements via fax. And, Bank of America agreed to pay $32 million for violating TCPA through its use of auto-dialing technology and prerecorded voice messages without prior written consent.

TCPA has no cap on total damages—making it easy to imagine that an organization with a large roster of donors or potential donors could quickly expose itself to losses in the range of multiple millions of dollars.

How do you protect yourself from this exposure? Simple—get written consent from individuals before marketing to them via phone or fax.

State Data Breach Laws

Almost every U.S. state and territory has enacted laws requiring entities to protect sensitive consumer and employee information in their possession and, if that protection fails, to provide notification to the individuals so she or he is able to be alert to identity theft and fraud. These laws vary, but it is important to note that an entity must be informed of the evolving state laws that apply where their employees, customers and prospects reside and not just where the entity is located. These requirements were initiated in 2003 with California’s law with other states following suit. Some states have also already updated their original laws to keep up with current technology standards and consumer expectations. With identity theft continuing to rise and awareness increasing, the trend will certainly continue.

Increasingly, state laws address issues beyond breach notification. Some states require specific security measures such as a written information security plan or encryption. At last count, four states had specific requirements for a written information security plan, three states require a dedicated employee responsible for information security and seven states require security provisions in supplier contracts. Penalties for violations can range up to $500,000.

Some states require privacy policies to be posted. For example, since 2003 the California Online Privacy Protection Act (CalOPPA) has required that all websites that collect personal information about state residents post an online privacy policy if the information is collected for the purpose of providing goods or services for personal, family or household purposes. Most websites, even if not required, post privacy policies. Ensuring the privacy policy complies with applicable laws is a critical first step. It is important then to align technology and operations with the public-facing statements and to maintain that alignment as new systems and processes are adopted and the business grows. Some state laws even address internal privacy policies. In 2005, Michigan began requiring employers to publish internal privacy policies to address the proper handling of employee sensitive information. New York has adopted a similar statute as has Connecticut, Massachusetts, and Texas. As mentioned, states are working to keep pace with technology changes and evolving standards, which makes it important for entities to remain alert to developments.

General Data Protection Regulation (GDPR)

U.S. entities may, understandably, not be aware of developments in European privacy law. But, Europe recently made dramatic changes to its data privacy laws which will impact the way many U.S. entities do business. U.S. entities doing business with or within Europe (EU) or marketing goods and services (even if unpaid) to EU residents must update how they collect, handle and secure information that identifies a natural person, such as name, address or email address, or they risk facing heavy fines and penalties. Even entities that are not located in the EU may be impacted as their EU clients and suppliers may require compliance as a condition of continued business. This new regulation goes into effect on May 25, 2018, and contains important new operational requirements concerning data minimization, accuracy, accountability, purpose and storage limitations, and data protection that will require impacted organizations to begin making technology and administrative changes far in advance of the deadline.

The regulation also mandates that entities demonstrate compliance, which will require the creation of policies, procedures and documentation mechanisms. If your entity possesses data on EU residents, you are positioned to be impacted by this new regulation. If you market to or solicit donations from the EU market, you’ll want to stay tuned to updates to the ePrivacy Directive (this is also called the “Cookie” Directive) which is expected to create as much disruption for U.S. entities.

The GDPR authorizes regulators to levy remarkably steep fines in amounts exceeding €20 million or 4 percent of annual global revenue, whichever is higher. Germany and Spain have stated openly that they may move against U.S. entities quickly. France has mentioned codifying parts of GDPR earlier than 2018. Some example requirements likely to be of interest to nonprofit entities include the following:

  • Consent must be “freely given, specific, informed and unambiguous.” Silence, pre-ticked boxes or inactivity is not sufficient to provide consent. Much of the data currently in use was collected using “opt out” mechanisms. This will need to be remediated if the information is going to continue to be retained and used.
  • If the data is being used because consent has been given, then that consent must be able to be withdrawn at any time and withdrawn “as easily as it was given.” This will necessitate changes in processes and quite possibly technology in order to accommodate. This also means that the data belonging to that individual not only cannot be used going forward but must be erased.
  • For data being used based on consent, the data subject has the right to request an inventory of all of the information an entity possesses on that individual. Accommodating these requests will require entities to establish mechanisms for receiving the requests, verifying the identity of the requestor, accurately and completely finding all relevant information to respond to requests and a documentation mechanism.
  • A new “accountability principle” makes those that collect and use data responsible for demonstrating compliance with the general principles outlined in the regulation. (Demonstrating compliance is in the form of policies, procedures, impact assessments, documentation of consent, inquiry handling, responses and decisions, etc.)

Interpreting GDPR requirements strictly is likely to lead entities to incorrect conclusions. Special provisions for nonprofit organizations are present in the GDPR, but they are limited, so most of the regulation still applies to nonprofit entities just as it does for for-profit companies. Privacy rights are not absolute, and a balancing decision must be made by legal counsel familiar with EU privacy laws. The GDPR contains many different requirements and the requirements may or may not apply to all entities depending on various factors. To make correct decisions, counsel must know details on what data is processed, the circumstances around the original collection, what is done during processing, retention/disposition, access, security controls and onward transfers.

Data privacy is increasingly important and can, if ignored, have tremendous impact on a nonprofit. An annual privacy assessment is recommended to see that your technology, policies and operations are aligned with current applicable requirements.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

IRS “Snapshots” Providing Technical Guidance

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By Joyce Underwood, CPA

The IRS has recently added new issue-specific guidance regarding charities and nonprofits in the form of “Snapshots.”

The guidance is a result of internal collaboration and provides fresh insight and perspective to agents on compliance areas to help them effectively and efficiently perform their work. These IRS employee job aids are public documents and provide insight to nonprofits and other outsiders on how the IRS is thinking and responding to issues.

For each issue, the guidance provides lists of relevant law and resources, analysis and background on the issue, and tips to help the agent recognize if an organization has an issue in the area. The concise format allows the reader to focus on the definitions, law and facts, and hopefully to efficiently and effectively form a conclusion.

The following is a summary of topics for charities and nonprofits included in the Snapshots issued to date:

If an organization is determined to be Lessening the Burdens of Government it can qualify as an Internal Revenue Code (IRC) Section 501(c)(3) charitable organization. The guidance, with the application of facts and circumstances criteria, helps clarify if the activities represent a burden of government and if the organization by its activities lessens that burden.

Electronic Health Records (EHRs) or Regional Health Information Organizations (RHIOs) have been formed to facilitate the electronic use and exchange of health-related information in response to incentives and appropriations for health information technology provided by the American Recovery and Reinvestment Act of 2009 (ARRA). The IRS’ concern is to ensure organizations are organized for an exempt purpose, lessen the burden of government, and act in a manner consistent with Health and Human Services (HHS) standards.

Taxable unrelated trade or business activity does not include sponsorships, so determining if an activity is Advertising or Qualified Sponsorship Payments is important to many nonprofits. Review of sponsorship arrangements includes an assessment of any substantial return benefit, payments contingent on attendance, use or acknowledgment of a name or logo, and connections to a qualified convention or trade show or exclusive provider arrangements. Certain language is provided which, if used in an acknowledgment, is an indication of a taxable advertisement.

Definition of a Disqualified Person: The term “disqualified person” is critical to private foundations to analyze whether various Chapter 42 excise taxes apply, and in determining whether an organization qualifies for public charity status as a supporting organization or meets the public support test for IRC Section 509(a)(2). It is important to identify relationships and transactions between the organization and private individuals, corporations, partnerships and other potential disqualified persons.

Taxes on Failure to Distribute Income —Carryover: Private foundations with mandatory distribution requirements that carry over excess distributions from earlier years can correct their distributable amounts and the amounts of qualifying distributions in order to determine the correct excess or deficient distribution carryovers. They are not barred by the statute of limitations on changing the carryover, however, they can only correct Section 4942 excise tax for years open by the period of limitations on assessment.

Penalty Abatement due to Reasonable Cause is permitted for private foundation first-tier taxes under Chapter 42 of the Internal Revenue Code, except for penalties assessed for self-dealing. Since there is no definition of “reasonable cause,” the determination of whether a taxpayer’s actions were due to reasonable cause under Section 4962 and in good faith is made on a case-by-case basis. Examples of court cases and legislative history provide perspective on how to assess the facts and circumstances.

For private foundations with distribution requirements, Administrative Expenses Treated as Qualifying Distributions are allowed. Qualifying distributions include that portion of reasonable and necessary expenses, direct and indirect, that a foundation incurs in implementing exempt purposes. Direct expenses are those which can be specifically identified with a particular activity. Indirect (overhead) expenses are not specifically identifiable with a particular activity. Neither the Internal Revenue Code nor the Treasury regulations set any limits on the amount of administrative expenses that may be used as qualifying distributions as long as they are reasonable and necessary for the accomplishment of the private foundation’s exempt purposes.

Private Operating Foundation under IRC 4942(j)(3) discusses the advantages to having private operating foundation status as opposed to that of a private non-operating foundation, and reviews the annual tests (Income, Assets, Endowment and Support) for qualification based on an organization’s qualifying distributions, income and assets. An organization that fails to qualify as an operating foundation in a given year may have to distribute additional amounts to other charities in order to avoid excise taxes on failure to make sufficient qualifying distributions.

The release of the Snapshots is a welcome educational resource. Knowing the guidance and resources recommended by the IRS when evaluating a tax position, and the steps they take in their analysis can be helpful in responding to inquiries or avoiding potential compliance and exemption issues. The full list of Snapshots, which also includes topics for retirement plans, federal, state and local governments, and tax-exempt bonds, can be found at https://www.irs.gov/government-entities/tax-exempt-and-government-entities-issue-snapshots. The IRS plans to add and update Snapshots periodically in the future.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

Perspective in Real Estate

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A feature examining the role of private equity in the real estate sector.

Brick & Mortar Retailer Woes Raise Concerns Despite Spiking M&A Activity

The retail model is undergoing a transformation that presents opportunities and risks for the real estate industry. Driven by changing consumer expectations about brand experience and convenience, traditional retailers are scrambling to expand their online and omnichannel offerings, while online retailers are laying down their first bricks and mortar. And despite recent headlines touting retail’s demise off the back of Q1 earnings, there’s been a sustained spike in e-commerce deal activity among strategic and financial buyers that suggest interest in transforming the current retail model is rapidly growing.

REITs operating in the retail industry are keeping a close eye on the sector’s fiscal health—which has a direct impact on their bottom line. While the retail industry is sending investors somewhat mixed signals, the future of retail will likely be less dependent on growing brick-and-mortar footprints and more focused on developing the right balance of consumer channels. Embracing e-commerce is not synonymous with shuttering physical locations, as storefronts remain an integral element of the retail mix. Retailers that take active steps to grow their multichannel offering while right-sizing their in-store footprint look to be better positioned than competitors who have yet to take steps to address the rise of e-commerce.

The Good

General retail e-commerce M&A activity topped out at $17 billion in 2016, representing about an eightfold increase from 2014’s $2.36 billion in M&A activity, according to BDO & Pitchbook’s Current State of E-Commerce, which was published in May and outlines strategic and financial deal activity across the sector. Furthermore, retailers expect deal activity to continue to rise in 2017. Nearly half (46 percent) of retail CFOs surveyed in BDO’s 2017 BDO Retail Compass Survey of CFOs forecast an uptick in retail M&A activity this year. More than two-thirds (38 percent) of these CFOs cite competition and consolidation as the driving factors for deals.

Strategic buyers account for the bulk of the increased deal activity in recent years. In fact, more than half of retail CFOs (56 percent) anticipate M&A activity will continue to be driven by strategic buyers in 2017, with an estimated average EBITDA multiple of 7.0, the highest in the Compass Survey’s history.

That means the retail industry is likely to see more deals: first, Walmart’s acquisition of Jet.com last year, then Amazon’s announcement in June of a $13.1 billion bid to acquire Whole Foods. Grocery has been a retail sector arguably more insulated from e-commerce disruption than others, as customers largely still prefer grocery shopping in stores. Bloomberg reported that Amazon focused heavily on Whole Foods’ distribution technology in negotiations, and experts say immediate cost reduction opportunities could be seen in warehouses. Walmart’s acquisition was made to immediately bolster its e-commerce presence and to compete with Amazon. Walmart paid a premium ($3.3 billion) compared to Jet.com’s valuation ($1.35 billion), but it appears to have paid off: The company’s global e-commerce sales for 2016 increased 15 percent from the previous year, and its U.S. e-commerce sales gained 36 percent.

The Not So Good

At the same time, there have been recent strategic acquisitions that have delivered less clear results. Look to examples like the 2015 flash-sale startup Gilt Groupe’s sale to Hudson’s Bay Co. for $250 million or Bed Bath & Beyond’s $100 million acquisition of One Kings Lane. Both deals enabled the buyers to enter the flash-sale space at a discounted rate, but the market ultimately slowed. Gilt Groupe’s sale now seems like a win; however, the brand was previously valued at $1 billion before losing steam as the flash-sale trend has slowed. A similar story was told for One Kings Lane. The total acquisition amount was never released, but estimates put the deal around $150 million, a far cry from the company’s previous valuation of $900 million.

The Ugly

The first quarter of 2017 saw the highest number of bankruptcy declarations by retailers since 2009, during the height of the Great Recession. The number of retailers that have filed for Chapter 11 bankruptcy protection so far this year has already surpassed the total 2016 number, according to reports by CNBC and USA Today. Financial challenges seem to be hitting mall clothing chains especially hard as consumers shift their spending to more agile online sellers. Of note, roughly half of retailers that have filed for Chapter 11 protection year-to-date were previously purchased by private equity firms, according to CNBC. And the number of retailers on Moody’s distressed list is also surpassing Great Recession levels. If this trend accelerates, REITs operating in the retail sector could be impacted by tenant loss or defaults and falling or flat lease values.

Still, surging M&A appetite and a determination by the majority of retailers to transform their business model to meet new customer preferences should provide an opportunity for evolution—for the better, ultimately—for REITs operating in the sector.  Retail as we know it is rapidly changing. Just as the industry is different today from what it was 50 years ago, it will be totally transformed by 2067. And our bet is that transformation will come relatively quickly, so there is a good opportunity for disruptors and innovators in the sector to shape what the future model of retail will look like. Identifying, courting and partnering with those disruptors would be a solid strategy for REIT executives.

Future PErspectives: What’s Next for Real Estate Investors?

The real estate industry, and particularly retail U.S. REITs are bracing for a bumpy road ahead. In fact, REITs’ concerns over foreclosure and bankruptcy have jumped in the last year, according to the 2017 BDO RiskFactor Report for REITs, which examines the risk factors in the most recent 10-K filings of the largest 100 publicly traded U.S. REITs. This year’s report reveals that 86 percent of REITs are concerned about the risk of foreclosure and bankruptcy, up from 80 percent in 2016. Roughly the same amount (84 percent) said falling or flat real estate values are a risk in the year ahead, up from 79 percent in 2016. Meanwhile, three out of four (76 percent) retail REITs point to the growth of e-commerce, specifically as a threat.

To reposition their model in light of the rise of retail e-commerce, some REITs have already begun to take active steps to redefine the consumer in-store experience across their properties. High-end mall REITs have found some success in moving up-market to fill vacancies created when struggling retail chains have moved out, as well as by cultivating a differentiated shopper experience by incorporating more entertainment, activity and dining venues.

The implication is that, while consumers are increasingly seeking to purchase a larger share of their goods online, they remain drawn to brands that deliver a consumer experience before, during and after the transaction. While there may be some right-sizing of retail brick-and-mortar footprints still left to be done, REITs should take comfort in the fact that a new retail model—one that focuses more on brand experience—has started to take shape across the sector. That model will be dependent on a well-defined and prominent in-store component.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

Another Year Wiser: Takeaways from REITWise 2017

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By Brandon Landas and Jan Herringer

In mid-March, leaders throughout the industry gathered in sunny California for NAREIT’s annual Law, Accounting & Finance Conference. Presentations spanned financial, accounting, tax, legal and political issues for REITs and real estate companies. Here are some of the event’s top takeaways from REITWise 2017.

Accounting for New Standards: Lease Accounting & Revenue Recognition

Throughout the conference, the Financial Accounting Standards Board’s (FASB) new Lease Accounting Standard, ASC 842, was a key topic of discussion. While the lease accounting guidance will have a more direct impact on REITs’ tenants, the industry is closely monitoring how their tenants are adjusting to the new standard. That said, REITs with ground and equipment leases will be directly impacted by the new standard. The changing guidance around revenue recognition under ASC Topic 606: Revenue from Contracts with Customers was also discussed at length. The new revenue recognition accounting standard takes effect in 2018, and the new lease accounting standard will become effective for public companies in 2019. That means now is the time for REITs to adopt an implementation plan and assess each standard’s impact to their operations and bottom line.

Dusting up Disclosure Requirements:

As part of the SEC’s Disclosure Effectiveness initiative, designed to improve the disclosure regime for both companies and investors, the SEC issued a Disclosure Update and Simplification Release (DUSTER) proposed rule in July 2016. While the SEC is deliberating how to move forward with the disclosure requirements, there are voluntary steps companies can and should take. Proactive measures REITs can adopt now include eliminating some archaic information in filings and streamlining repetitive and complex document language. REITs would also be wise to closely review existing disclosures and take proactive measures to improve their effectiveness—with an eye toward making them easier for shareholders to read.

Going Concern Update – Implications for Management and Auditors:

Accounting Standards Update 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40) Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, became effective at the end of 2016, specifically, for annual periods ending after December 15, 2016, and for annual and interim periods thereafter. This update, among other matters, includes a new requirement for management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued (or within one year after the date that the financial statements are available to be issued, when applicable) and to provide certain related disclosures. Previously, there was no guidance in generally accepted accounting standards (GAAS) about management’s responsibility with respect to going concern.

In September 2014, the PCAOB issued Staff Audit Practice Alert (Staff Alert) No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern. This Staff Alert reminded auditors of public entities to continue to look to the existing requirements of PCAOB AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern, when separately evaluating whether substantial doubt regarding the company’s ability to continue as a going concern exists for purposes of determining whether the auditor’s report should be modified.

More recently, in February 2017, the Auditing Standards Board of the AICPA issued Statement on Auditing Standards (SAS) No. 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (SAS 132). This SAS will be effective for audits of statements of nonissuers for periods ending on or after December 15, 2017, and reviews of interim financial information for interim periods beginning after fiscal years ending on or after December 15, 2017. SAS 132 clarifies that the auditor’s objectives with respect to going concern matters include separate determinations and conclusions from management regarding (1) the appropriateness of management’s use of the going concern basis of accounting, when relevant, in the preparation of the financial statements, and (2) whether substantial doubt about an entity’s ability to continue as a going concern exists, based on the evidence obtained, for a reasonable period of time as defined in the applicable financial reporting framework.

Don’t Bet All Your Marbles on Infrastructure Investment:

A big topic of discussion throughout the conference was the much-lauded trillion-dollar investment in infrastructure candidate Donald Trump discussed last year on the campaign trail. Enthusiasm has waned, however, since the White House published its preliminary budget blueprint. The proposal includes a $2.4 billion, or 13 percent, cut to the Department of Transportation’s budget, raising alarm bells for the sector. Earlier this year, REITs and real estate companies were bullish on infrastructure development and public-private partnerships (P3s). In light of the recent developments, though, infrastructure investment is less of a surefire win, leading many REITs to reevaluate their next moves.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

Best Practices for an Effective Investment Committee

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By Lee Klumpp, CPA CGMA

Most nonprofits rely on an investment committee to oversee their investment portfolios. This oversight group can have a big impact on real long-term wealth preservation and ensuring resources are available to realize organizational goals and aspirations.

These best practices are consistent with the fiduciary duties of care, loyalty and obedience, and include:

  1. Form a strong investment committee that embraces the “commit” in committee.
  2. Ensure diversity and experience in committee composition.
  3. Set a strong Investment Governance and Operational Framework that establishes an Investment Policy Statement—including asset allocation, risk constraints, performance metrics and pay-out. It should be consistent with furthering the organization’s objectives and realistic given its resources.
  4. Refresh the organizational Investment Policy Statement on a regular basis to make sure that it continues to articulate the organization’s long-term objectives and unique needs.
  5. Define a realistic target for investment success that is consistent with the organization’s resources, and focus on the implementation.
  6. Be strategic in asset and investment manager selection and perform regular evaluations.
  7. Find an appropriate person or organization that can act as the organization’s Chief Investment Officer (CIO), to manage its investment portfolio, be held accountable to the committee and regularly review its performance.
  8. Monitor results and make changes as needed.
  9. Have regularly structured investment committee meetings and draft minutes from these meetings.

Above all, these best practices, which are fundamental regardless of the nature or size of the organization, can be boiled down to five C’s: commitment, coordination, communication, continuity and completion.

While an investment committee can operate successfully with a variety of structures and approaches, these best practices can make any investment committee more efficient and effective. This should lead to improved long-term portfolio operation—ultimately benefiting grantees, beneficiaries and stakeholders.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

Making Real Estate Investments Attractive To Tax-Exempt Organizations

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By David Patch

Organizations described in sections 401(a) and 501 are generally exempt from federal income tax, except with respect to income from businesses that are unrelated to their tax-exempt purpose, known as unrelated business taxable income (UBTI).[1]

Rents from real property are specifically excluded from UBTI, making rental real estate partnerships a potentially attractive investment for many exempt entities. Otherwise excluded rental income, however, becomes taxable UBTI to the extent the property is funded with debt.[2]  Given that leverage is ubiquitous in real estate investments, this presents a problem for exempt entities except in those rare situations where the real estate is entirely funded with equity.

Some types of exempt entities can avoid UBTI on debt-financed real estate investments if certain requirements are met. In order to attract such investors, many real estate funds carefully structure the terms of their operating agreements to meet these requirements and advertise their compliance in offering documents. This opens up a new source of funding for syndicated real estate investment partnerships that might otherwise have appealed mainly to taxable investors.

The types of tax-exempt entities to which these rules apply include educational organizations and their affiliated support organizations, qualified trusts under section 401 (pension, profit sharing and stock bonus plans), certain title holding companies, [3] and retirement income accounts of churches (collectively, Qualified Organizations or QOs).

In order for a QO’s investment in a real estate rental partnership to qualify for the exclusion, the partnership must meet one of the following requirements:

  1. All the partners of the partnership must be QOs;
  2. Each QO’s distributive share of each item of income, gain, loss, deduction, credit and basis of the partnership must be the same and must remain constant during the entire period the entity is a partner in the partnership; or
  3. Each partnership allocation must have substantial economic effect and satisfy the “fractions rule.”[4]

Partnerships in which all the partners are QO’s are rare, so the first requirement would not generally be met by a syndicated real estate fund. The second requirement is extremely restrictive and could limit the ability to structure deals in a way that will be of broad appeal. Therefore, real estate funds hoping to attract QOs as investors will generally want to meet the third test.

One requirement of this test is that the allocations provided for by the partnership agreement have substantial economic effect.[5] Among other things, partnership agreements must generally provide for liquidating distributions in accordance with positive capital accounts in order to meet this requirement. Partnership agreements frequently define liquidating distribution rights in other ways, and such an agreement would generally fail this requirement.[6] A real estate partnership hoping to attract QOs would need to ensure that its partnership agreement is drafted in a way that causes its allocations to have substantial economic effect. Virtually any partnership’s economic arrangement can be defined in this manner so meeting this requirement should not be a particular hardship, but the desire to do so must be communicated to the drafting attorney.

The more difficult requirement is that the partnership’s allocations satisfy the fractions rule. The fractions rule is met only if “the allocation of items to any partner that is a qualified organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner’s share of the overall partnership loss for the taxable year for which such partner’s loss share will be the smallest.”[7]  Thus, for example, a QO could not generally be allocated 10 percent of the partnership’s loss in one year and 11 percent of the partnership’s income in another. This seemingly simple requirement may prove difficult to achieve in practice because most real estate funds have allocations that vary or have different classes of interests that cause allocations to change from year to year. The promoter’s interest will generally also vary depending on whether and when investment return hurdles are reached. In recognition of these common issues, the regulations provide a number of exceptions under which certain variances are ignored, including:

  1. Allocations reflecting a preferred return or guaranteed payments for capital computed at a commercially reasonable rate.
  2. Guaranteed payments to the tax-exempt member for services if reasonable in amount.
  3. Allocations of income made to reverse prior disproportionately large allocations of overall partnership loss or disproportionately small allocations of partnership income to a QO.
  4. Special allocations required by the Internal Revenue Code or regulations such as minimum gain chargebacks and qualified income offsets, as well as provisions that prevent allocations of loss to a QO if it would create a deficit capital account.
  5. Special allocations of certain partner-specific expenditures such as the costs of additional record-keeping and accounting incurred in connection with the transfer of a partnership interest, additional administrative costs that result from having a foreign partner or state and local taxes.
  6. Special allocations of certain unlikely losses, such as litigation costs or casualty losses.[8]

In addition, the regulations make the fractions rule inapplicable if (1) QOs do not collectively hold interests of greater than five percent in the capital or profits of the partnership; and (2) taxable partners own substantial interests in the partnership through which they participate in the partnership on substantially the same terms as the qualified organization partners.[9]

In 2016, regulations were proposed that would modify several of these exceptions in ways that should generally make them easier to satisfy and add additional exceptions. For example, the proposed regulations would:

  1. Remove a requirement in the existing regulations that preferred returns be distributed currently in favor of a requirement that unpaid amounts compound and be distributed first.
  2. Allow special allocations of management (and similar) fees to account for separately negotiated economic arrangements.
  3. Allow for special allocations intended to reverse prior special allocations of unlikely losses.
  4. Allow certain allocations to account for changes in ownership due to staged closings.
  5. Allow for changes in allocations due to unanticipated defaults on or reductions in capital contribution commitments.
  6. Clarify how allocations from lower-tier partnerships are taken into account.
  7. Add a de minimis exception for partnerships in which non-QO partners do not own in the aggregate interests of greater than five percent in capital or profits.

The proposed regulations will be effective when finalized, but partnerships may apply the rules for taxable years ending on or after November 23, 2016.

Conclusion

Syndicated real estate partnerships that fail to satisfy the fractions rule may be missing out on a valuable source of investment capital. By working closely with partnership specialists, syndicators can ensure that their funds meet the requirements for the exclusion of debt-financed income and present an attractive investment opportunity for QOs. Proposed regulations issued in 2016 will make it easier for real estate partnerships to satisfy the fractions rule, making this a great time to consider (or reconsider) taking the steps necessary to comply with the requirements.

[1]     Section 501(a), section 512.

[2]     Unrelated debt-financed income, Section 514.

[3]     As described in section 501(c)(25).

[4]     Section 514(c)(9)(B)(vi).

[5]     Section 514(c)(9)(E)(i).

[6]     Allocations provided by partnership agreements that do not call for liquidating distributions in accordance with positive capital accounts may meet this requirement only if they have substantial economic effect “equivalence.”  To qualify, the allocations must result in ending capital accounts that reflect liquidating distribution priorities at the end of the current and all future years.

[7]     Section 514(c)(9)(E)(i)(I).

[8]     See generally Treas. Reg. sections 1.514(c)-2(d) though (j).

[9]     Treas. Reg. section 1.514(c)-2(k)(2).

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

IRS Focuses on Employment Tax Issues During Tax-Exempt Organization Audits

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By Robert Kaelber, J.D.

With tax filing season well underway, organizations of all sizes are beginning to identify areas of potential noncompliance and, for nonprofits, a common culprit is employment tax issues.
The IRS has emphasized employment tax compliance during its tax-exempt audits for many years. As we’ve noted in multiple prior Nonprofit Standard blog posts (see “IRS Issues 2017 Work Plan for Tax Exempt Organizations” and “UBI Issues: Is Your Organization at Risk?”), the IRS has officially stated that this employment tax focus will continue into 2017. In the IRS’ Tax Exempt and Government Entities FY 2017 Work Plan, which details its priorities and mission for the coming year, the IRS disclosed that more than 25 percent of closed audits had a “primary issue” related to employment tax. At the end of June 2016, 1,323 audits involved primarily employment tax issues, out of a total 4,984 closed examinations. Further, the IRS continues to include employment tax issues within its list of high-risk areas of noncompliance.

The IRS states in its 2017 Work Plan that, “Employment Tax includes unreported compensation, tips, accountable plans, worker reclassifications and noncompliance with FICA, FUTA and backup withholding requirements.” While this definition covers a wide range of areas, our experience with IRS employment tax audits and associated information document requests (IDRs) indicates that likely issues for review may include, but are not limited to, the following:

• Expense reimbursements and accountable plan compliance;
• Fringe benefits (e.g., relocation/moving, automobiles, group term life, cell phone reimbursement, prizes/awards, spousal travel and education benefits);
• Independent contractor classification and income reporting;
• Supplemental pay reporting and processes, including timing of wage inclusion for various tax and wage types (including retirement pay and incentives);
• Form W-9 process, Form 1099 TIN matching procedures and backup withholding compliance;
• Forms W-2c and 941-X processes;
• International cross-border employment tax issues; and
• General compliance procedures for employment tax filing obligations.

The IRS appears to be trying to streamline its processes for audit target identification, focusing on increasing efficiency as it works with fewer resources. As such, the agency has implemented a “data-driven case selection process,” and is seeking new ways to identify data that can indicate patterns of noncompliance. Other 2017 IRS priorities include working to develop an employment tax knowledge database (the “Employment Tax K-Net”) to track and disseminate what is learned during audits, and to use it to further train employees in this area. It is likely that with enhanced training, IRS examiners will more readily identify more complex potential employment tax issues for review rather than merely focusing on the “low hanging fruit.”

Based upon the IRS’ continued focus on employment tax issues, it is imperative that tax exempt entities review their policies and processes and invest in initiatives and resources to ensure compliance. Organizations should also document all policies and processes so that they may readily demonstrate upon audit that IRS compliance protocols are followed. Being proactive and completing an internal employment tax process review or even a “mock audit” may help to identify issues and result in the early implementation of corrections before the IRS is involved. Failure to comply with employment tax reporting obligations can result in the imposition of significant tax, penalties and interest. Additional wage inclusion due to employment tax noncompliance could also trigger further questions from the IRS pertaining to inurement or private benefits.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

PropTech – Is 2017 The Year Things Change For The Property Industry?

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By Ian Shapiro

Technology has been a disruptive force in most industries and sectors over recent years. But in the real estate and construction (REC) sector, widespread adoption of new technologies has lagged somewhat. Indeed, the adoption of technology in property – or ‘PropTech’ – has fallen a little short of its anticipated take-up. For example, in the U.S., the construction industry is several years behind many other industries with regards to technology with many companies still using manual systems for project planning and management. That’s why construction remains far behind in reaping the benefits of advanced data and analytics, drones, automation and robotics.

However, 2017 is set to be the year the floodgates open for PropTech in the global REC sector, and we’ve looked at some key technologies you should be keeping an eye on in the industry this year.

The Widespread Use of Drones

Drones have been in the news for various reasons recently – both good and bad. Thankfully, they are being put to good use in the construction industry and we’re seeing things get far more efficient on projects because of them. They can be used during surveys to check the condition of hard to reach places and can be equipped with lenses that are able to read serial or model numbers, meaning that surveys can be performed in detail.

Drones not only save time (and therefore money!) but also improve safety for construction workers. For example, a roof survey would normally involve human workers climbing onto the roof, which naturally involves considerable risk. By using drones, construction companies are able to bypass this risk, without losing much, if anything, in the way of accuracy.

For this reason, we are now seeing a wider adoption of drones by construction companies. However, the popularity of this technology has had the knock-on effect of bringing in increased regulation: aviation authorities around the world have introduced regulations for drones because of perceived privacy and security concerns, with many countries now demanding licenses or permits to use drones for certain activities or around important landmarks.

Virtual Reality – From Gimmick to Legitimate Tool

The use of virtual reality (VR) in property is already a $1 billion global industry and Goldman Sachs estimates that it is set to treble by 2020. VR has its obvious uses in the real estate sector: for example, VR is used for sales and marketing in the prime residential market, where investors often live miles away from the properties they want to view.

VR is also viewed as the next phase of Building Information Modeling (BIM), and as an enhancement to computer-aided design (CAD): developers can use VR to create more realistic and detailed renderings, which are now transitioning into virtual reality walkthroughs.

Certainly, 2017 will see virtual reality transition from gimmick to a legitimate tool across the REC sector as the emergence of VR headsets, interactive hand controllers and movement sensors revolutionize how designers and contractors experience the construction process.

The Cloud and Real‑Time Data

Increasingly, supervisors are turning to the cloud and real-time data to stay abreast of construction jobs. With the help of smart devices, such as an iPad or an iPhone, foremen and supervisors can follow a project in real time and identify specific “milestones” that can be checked off as a job progresses, causing invoices and payments to vendors or subcontractors to automatically generate accordingly.

Smart Tech for Smart Buildings

The term “smart building” has been in use for some time but smart technology is now making a real impact on the real estate sector. Buildings are now designed to be “smart,” which is making tenants’ and property managers’ lives easier.

By using smart devices to control things like heating and lighting, residents can decrease their bills and energy waste. Similarly, elevators can be programmed to reduce usage and automatically tell building managers when they need to be serviced. Here, PropTech is not only improving efficiency but also safety.

Robots in Real Estate

The construction industry has yet to really adopt robotics although human-controlled machine equipment is widely used. The use of robots for high-precision activities is not new (consider welding or vehicle painting) but advances that allow robots to “see” via sensors mean that robots can now be used to perform previously human-only tasks, such as “couriering,” cleaning or gardening in hotels, warehouses or office buildings. I was recently given a coffee by a robot at a PropTech conference!

Cyber Attacks Drive Interest in Security

In construction, cybersecurity issues are only now making an impression but in real estate, it is a real issue, especially as buildings become increasingly “smart” and therefore vulnerable. Thanks to the Internet of Things, everything down to your Christmas tree lights can now be controlled electronically; thus, buildings are becoming the new target of cyber attacks.

The use of ransomware is increasing and becoming more targeted to property. In recent years, it was claimed hackers stole the blueprints to Australia’s secret service agency HQ, presenting obvious terrorist threat concerns. It is therefore understandable that landlords and building owners would be concerned for the security of their assets, and must work with cybersecurity experts to protect their business.

Given the REC industry’s poor track record on innovation and the adoption of new technologies, tools and approaches, governments, developers and deliverers need to invest collectively to achieve these shared goals and future-proof the industry. In order to achieve this, firms need to develop digital road maps, appoint dedicated staff to think boldly about the digital agenda and partner with technology firms. BDO recently took a huge step toward this by partnering with Microsoft (read press release here).

This is the digital age of collaboration, and the industry will soon come to realize that digital tools can be more powerful than the ones in a rusty toolbox. We all need to embrace this catalyst for change to attract a new generation of talent.

This article originally appeared in BDO USA, LLP’s “Construction Monitor Newsletter (Summer 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com

John Templeton

The Importance of Civic Reach

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By Lewis Sharpstone, CPA
Ensuring sustainability is a top priority for almost every nonprofit organization. But one sometimes overlooked piece of the sustainability puzzle is managing critical external relationships and ensuring their longevity. This is especially important in a climate characterized by pervasive change. As we’ve covered in our Nonprofit Standard blog posts, executive retirements are impacting nonprofits of all sizes as leaders age, many of whom have tenured long careers at their organizations. The industry is also seeing an uptick in merger and acquisition (M&A) activity aimed at consolidating costs, back-office and administrative functions, and building efficiencies to expand scope and reach. How new priorities in the executive branch will impact charitable organizations is also a big unknown.

Whether an organization is approaching succession planning, post-merger integration or other organizational transition, or simply examining its long-term sustainability, it’s important to invest in key relationships.

Paul Vandeventer, CEO of Community Partners, describes this concept especially well with what he’s coined “The Civic Power Grid.” He defines an organization’s civic reach as “the essential third leg of a nonprofit board’s sustainability platform,” with fundraising and governance as the first and second legs. As Paul explains, the term “civic reach” refers to an organization’s ability to develop, maintain and grow relationships with individuals who have influence over resources across the sectors in which it operates.

Most nonprofit executives can attest that a grant proposal is received differently when you have a relationship with the program officer who receives it. Similarly, consider how your views about a regulatory issue might be taken when you already have a relationship with the official listening to you. What about how an influential person might look at an invitation to join your board when the board is already home to well-connected and influential members?

While building civic reach may sound like mere networking, Vandeventer contends it’s much more important than that. It’s essential that every organization have a sustainability plan. See Laurie De Armond’s, partner and national co-leader of BDO’s Nonprofit & Education practice, article on page 1 discussing this topic in detail. Her advice was that “To prevent gaps in relationship management during an executive transition, organizations can encourage shared ownership and an open flow of information so that key relationships don’t become siloed with one individual.” Extending an organization’s civic reach is an often-forgotten, but essential, element of building a sustainable enterprise. In this article from Stanford Social Innovation Review’s archives, Vandeventer dives deeper into the concept of civic reach and gives plenty of examples illustrating how increasing civic reach led to great results.

Over the course of my career working with nonprofit organizations, I’ve met a host of inspiring and remarkable people. While they built well-respected organizations that carry on wonderful and impactful legacies in the communities they served, many didn’t devote resources to building ties with the wider community and may have been able to leverage their connections for even more meaningful results if they had invested in civic reach.

To illustrate what civic reach can do for an organization, let’s consider a nonprofit in my area that was facing foreclosure. When we were first engaged to work with them, we were able to stave off foreclosure on a temporary basis, buying the organization time. Three years later, though, when the financial issues bubbled up again, they had cultivated a strong civic reach. They engaged local and even some national politicians, businesspeople and community leaders to advocate against foreclosure—and it worked. A favorable long-term loan, a win-win for the organization and the bank, was put in place and the nonprofit is now moving from uncertainty to strength. I am convinced that leveraging the increased civic reach of this organization is the only thing that could have achieved this result.

Here you can find a self-assessment tool to identify gaps and target areas for growth, which will help you put in place a specific plan to increase your organization’s civic reach. Happy “reaching!”

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com