Answer an Important Question: Are Your Directors Independent?
Diane Glover
Sep 18, 2018

Not-for-profit organizations that file IRS Form 990 must indicate the number of independent voting members or directors of the governing body. (This is entered on Parts 1 and VI.) The IRS is not the only group interested in these facts. Two other groups also focus on the number of independent directors: state attorneys general and prospective donors. All three groups believe that independent directors are the cornerstone of good governance. In other words, they believe independent directors are less likely to cause the organization to violate prohibitions on private benefit and private inurement.
No Conflict of Interest
Independence generally requires that a director has no conflict of interest. A conflict arises when a director (or a family member) has an interest different from that of the exempt organization (EO). It may involve direct or indirect compensation from the EO, or involve a transaction between the director and the EO or a related organization.
Four Characteristics of Independence
A director is independent only if all four of the following criteria applied at all times during the year.
1. Employee Compensation. The director wasn’t compensated as an officer or other employee of the exempt organization or of a related organization. In addition, the director wasn’t compensated by an unrelated organization or individual for services to the organization or a related organization, if the compensation is required to be reported on Form 990 (in Part VII, Section A). However, reasonable compensation from the organization for services as a director doesn’t preclude independence.
2. Services as an Independent Contractor. The director didn’t receive more than $10,000 of total compensation or other payments as an independent contractor from exempt organization (or a related organization). The threshold of $10,000 is based on the organization’s tax year. Note: Expense reimbursements under an accountable plan aren’t included in calculating the limit of $10,000.
For example, during the exempt organization’s tax year, a director received $7,500 in fees for tax and accounting services provided to the exempt organization, $3,100 for out-of-pocket expenses, and a $7,300 fee (considered reasonable) for services as director. The director is independent since the accounting and tax service fees are under the $10,000 threshold and the other items are excluded.
3. Transactions with the Organization. The director (or one of his or her family members) wasn’t involved in a transaction with the exempt organization (directly or indirectly through an affiliated organization) , which is required to be reported on the organization’s Schedule L, Transactions with Interested Persons, for the current tax year.
4. Related-Party Transactions. The director (or one of his or her family members) wasn’t involved in a direct or indirect transaction with a taxable or tax-exempt organization, which is related to the organization — if that transaction is required to be reported on Schedule L filed by the related organization.
For example, a director is a voting member of the governing body of both Charity A and Charity B, which are related organizations. During A’s taxable year, the director’s daughter received $40,000 in taxable compensation as an employee of B. The director is not an independent member of A’s board because the daughter received compensation from an organization related to the director, and the compensation was of a type (compensation to a family member of a director of B) and amount (above $10,000) that would be reportable on Schedule L if B were required to file Schedule L.
Another example: A director is a voting member of Charity A’s governing body. In addition, the director is also a partner with a profits and capital interest greater than 5 percent in a law firm. During A’s taxable year, A paid the law firm $115,000 for litigation services. The transaction between A and the law firm must be reported on A’s Schedule L because it is a transaction between A and an entity in which the director is a more-than-5% owner, and because the payment by A exceeded $100,000. Therefore, the director is not independent because A’s payment of the legal fees is deemed an indirect business transaction with D.
A variation on the above example: If a director was an employee of the law firm (rather than a more-than-5-percent owner) and not an officer or director of the law firm, then A’s payment of legal fees would not affect the director’s status as an independent director of A.
Tax Court Rulings
The U.S. Tax Court has, in at least two cases, discussed the importance of an independent board to provide operational oversight to an exempt organization. In one case, an exemption was denied because a college scholarship fund organization couldn’t show it “was operated exclusively for exempt purposes.” The organization primarily raised money from the operation of bingo games at an Iowa for-profit lounge.
The organization’s board of directors was comprised of five members. The court noted the initial directors, named in the articles of incorporation, were two owners of the lounge; the lounge’s accountant and director, and two other persons, each described as a “bingo player.”
The court stated that it appeared “that more than an insubstantial purpose of the (organization’s) activities was to attract persons, by the way of the bingo games, onto the premises” of the lounge “expecting that they would purchase food and beverages while participating in the games.” The court added that the activities “were, in substantial part, designed to enhance the profitability” of the lounge. (P.L.L. Scholarship Fund v. Commissioner, 82 T.C. 196)
In another case, the court upheld the IRS’s determination that the organization was not tax-exempt because it did not, among other things, have an independent governing body. One individual was the organization’s president, secretary, sole officer, director and employee. (The Council for Education v. Commissioner, T.C. Memo 2013-283)
However, in both of these Tax Court cases described above, there were other factors that were prejudicial to an exemption under Internal Revenue Code Section 501(c)(3). So it’s not clear how much weight the court placed on the absence of an independent board.
Not All Activities Cause Problems
Certain transactions or activities specifically don’t compromise the independence of a director. A director does not give up independent status by making donations to the exempt organization, regardless of the contribution amount. In addition, directors don’t lack independence simply because they are part of the governing body of another charity that received funding from the exempt organization during the organization’s tax year.
Also, a director is permitted to receive financial benefits from the exempt organization solely by virtue of being a member of the class served by the organization in the exercise of its exempt purpose, provided the financial benefits comply with the terms of membership of the organization.
Finally, a director who has taken a bona fide vow of poverty isn’t considered to lack independence because he or she either:
• Receives compensation as an agent of a religious order or a Section 501(d) organization, provided the compensation is not taxable; or
• Belongs to a religious order that receives payments from the exempt organization that are not taxable income to the member.
Keep in mind: An organization must make a reasonable effort to determine the independence of its directors. One way to do this is to provide a questionnaire annually to each director and reasonably rely on each person’s responses. Of course, if your board knows facts that contradict a director’s response, it would preclude relying on the response.

About The Author
As the Manager of Practice Growth, Diane focuses on the market awareness and growth of Kirsch CPA Group…
Tags
Sign Up for Email Updates
Related Articles



Tax Treatment of Debt Forgiveness: Watch Out for Tax Bills Delivered COD
- 01-18-23
- Kirsch CPA Group












Manufacturers: Be Aware of These 3 Business Tax Provisions Currently in Limbo
- 01-18-23
- Kirsch CPA Group



The Tax Deductible Mileage Rate for Business Driving Increases for 2023
- 01-04-23
- Kirsch CPA Group









Succession Planning Considerations for Construction Business Owners
- 12-14-22
- Kirsch CPA Group






Prevent Fraud at Your Construction Company With a Holistic Approach
- 11-30-22
- Kirsch CPA Group









Manufacturers Must Act Now to Maximize Depreciation-Related Tax Breaks for 2022
- 11-09-22
- Kirsch CPA Group



It’s Time for Businesses to Rethink Their Working Capital Practices
- 11-09-22
- Kirsch CPA Group









Social Security Wage Base and Earnings Test Amounts Increase in 2023
- 10-27-22
- Kirsch CPA Group



New Law Enhances Payroll Tax Break for Small Manufacturers’ Research Expenses
- 10-13-22
- Kirsch CPA Group







































How Buy-Sell Agreements Factor into Business Owners’ Estate Plans
- 09-14-22
- Kirsch CPA Group









SALT Cap Workaround Law Could Save Ohio Business Owners Over $100 Million
- 08-31-22
- Kirsch CPA Group
























How Manufacturing Companies Can Benefit from the Section 179 Expensing Deduction
- 08-04-22
- Kirsch CPA Group



























Could the Work Opportunity Tax Credit Help Your Construction Company?
- 06-23-22
- Kirsch CPA Group






Good News: IRS Boosts Standard Mileage Rates for Second Half of 2022
- 06-23-22
- Kirsch CPA Group
























Education Benefits Can Help You Recruit and Retain Smart Employees
- 05-26-22
- Kirsch CPA Group









Ensure Your Construction Accounting System Has the Right Features
- 05-12-22
- Kirsch CPA Group





















John Kirsch Named to Greater Butler and Warren Counties Business Hall of Fame
- 03-25-22
- Diane Glover






Manufacturers Need to Act Soon to Take Advantage of 100% First-year Bonus Depreciation
- 03-17-22
- Kirsch CPA Group



























Commission Fraud: Salespeople Getting Paid More Than They’ve Earned
- 02-04-22
- Kirsch CPA Group
















































Consider a New Approach to Meeting Your Business Real Estate Need
- 09-17-21
- Kirsch CPA Group
























Beware: Teleworking Arrangements May Cause State Tax Withholding Issues
- 08-18-21
- Kirsch CPA Group
























5 Common Construction Accounting Risks — and How to Address Them
- 07-07-21
- Kirsch CPA Group















Supreme Court Finds No Standing to Challenge a Provision of the ACA
- 06-24-21
- Kirsch CPA Group






Labor Shortage: Unlock Solutions by Evaluating Your Employment Value Proposition
- 06-09-21
- Kirsch CPA Group









Material Participation Standard is the Key to Unlocking LLC Tax Losses
- 05-27-21
- Kirsch CPA Group









Know Your Legal Obligations Under the Americans with Disabilities Act
- 05-13-21
- Kirsch CPA Group



























PPP Loan Not Forgiven? There’s a Safe Harbor for Deducting Expenses
- 12-03-20
- Kirsch CPA Group












What You Need to Know About the Deferral of Payroll Tax Obligations
- 09-15-20
- Kirsch CPA Group


















PPP Loan Forgiveness – Significant Borrower Friendly Changes on the Horizon
- 06-04-20
- John Kirsch





















Tax Filing Deadline Remains April 15 – Payment Due Extended to July 15
- 03-19-20
- John Kirsch








































































Prepare to Receive a Social Security Administration No-Match Letter
- 10-15-19
- Kirsch CPA Group





















IRS Announces Changes for Personal Use of Employer-Provided Vehicles
- 06-10-19
- Diane Glover






























Watch Out for these Tax Issues When Planning for Your Business in 2018
- 06-26-18
- Diane Glover









What Image Does Your Organization Present to Large Contributors?
- 03-15-18
- Kirsch CPA Group



8 strategies to help you adapt to economic down turn without layoffs
- 02-24-18
- Diane Glover













































Remember To Take Required Minimum Distributions at Age 70 1/2 Or Face Penalties
- 02-17-17
- Sue Schloemer







































Time is Money: Don’t Spend Valuable Time Inputting Data into QuickBooks
- 06-18-22
- Diane Glover




