This is Your Final Notice
Fiduciary responsibility includes seemingly routine areas where neglect can cause serious and expensive problems. Here are four cautionary tales for foundation trustees.
Most individuals would leap at the opportunity to serve on a foundation board. The idea of doing good by directing dollars to worthy causes is rewarding stuff.
Typically foundation trustees are well-prepared to assume their role of overseeing the foundation's grantmaking, governance and investment management. Many take advantage of the abundant educational opportunities by studying the foundation's mission statement, grant history and guidelines. They learn quickly about the "do's and don'ts" in such areas as good grantmaking, sound succession planning and investment manager selection.
But these same individuals are sometimes unaware that their fiduciary responsibilities extend beyond best practices in grantmaking, governance and investing to seemingly routine areas, such as good financial recordkeeping and timely and accurate tax preparation and filing. And it's often here, in these neglected areas, that serious and expensive problems can arise.
Beyond "First Things First"
When you became a trustee and were introduced to the foundation's purposes and priorities, did anyone provide a copy of the foundation's tax return? It's all too easy to assume that someone else is taking care of those mattersan experienced bookkeeper, an accountant or a trusted lawyer friend of the foundation.
The reality is that more foundations need to establish audit committees to meet regularly with the auditor and the tax preparer and review the foundation's financial practices. Not enough trustees are given a copy of the tax return and have a chance to learn about, let alone understand, its inner workings. Experience suggests that audits and taxes are an important area requiring trustee attention.
For the past 20 years, Grants Management Associates (GMA) [www.grantsmanagement.com] has provided grantmaking, consulting and office administration to a range of foundations. About five years ago, the company began to realize how regularly clients asked GMA staff to work with trustees, lawyers and accountants to address other kinds of concerns. More often than not, those concerns were financial or had financial consequences. Four cases drawn from recent experience illustrate what can go wrong and how, with knowledgeable trustees and timely and informed intervention, the situations could have been prevented, corrected or improved.
Keeping Good Records
The Shoebox Foundation was funded in 1999 with proceeds from the sale of a chain of nonprofit nursing homes in Nevada and New Jersey. The longtime president of the chain had managed the homes for 50 years with her husband as a board of two. After his death, she was thrilled at the opportunity to perpetuate, through grantmaking, her passionate interest in addressing the healthcare needs of elders.
As a first step, she turned to a retired associate in New Mexicowho for more than 30 years had served as the nursing home's legal counselto take care of the paperwork in setting up the new foundation. Then she quickly assembled an 11-member board of busy eldercare and medical practitioners from across the country. While none had prior foundation experience, all were honored to accept her invitation. Unfortunately for the Shoebox Foundation, in early 2000, in the middle of the transition, its founder died unexpectedly.
During the following years, it became increasingly clear that the transition was not going well. The friend in New Mexico did not seem up to the task that he had assumed. Finally, the board decided to hire staff to pull together the foundation's records and to oversee its grantmaking and administration. The foundation's financial records, which its founder had stored in shoeboxes, were in disarray and incomplete. In one stash of unopened mail, staff found recent warning notices from the Internal Revenue Service (IRS) and state agencies in Nevada and New Mexico. Phone calls were placed to try to determine what had gone wrong, but with its founder's death, the foundation had lost its institutional memory.
Through a process of forensic accounting, staff determined that the foundation had missed filing deadlines with the federal government and Nevada and New Mexico state agencies. Once the trustees recognized the gravity of the problem, they approved the formation of an action team made up of a lawyer and an accountant to work with the staff. After almost a year, the reconstruction process is still incomplete; certain questions in Nevada remain unresolved. Although some forgiveness was negotiated with the IRS, to date there have been substantial penalties for nonfilings and late filings. The foundation has also incurred legal, accounting and extra staffing costs. On the bright side, on one long- distance phone call during the search for missing information, staff discovered a sizeable forgotten bank account that significantly improved the foundation's depleted cash position.
Understanding the Tax Return
During 1999 and 2000, the Maxamillion Foundation's astute investments in real estate achieved outstanding results, driving the foundation's portfolio value to new heights. The three trustees cheered when the foundation's income passed the $1 million mark for the first time. However, the cheers became muffled when the trustees learned that, as a direct consequence of their accomplishments, the foundation faced a substantial penalty for underpayment of estimated taxes.
The Maxamillion Foundation trustees were famous in local circles for their frugality and their commitment to conserving as much of the foundation's resources as possible for grantmaking. Year after year, the foundation's operating expenses were among the lowest in the state. The three trustees managed the assets on their own and served without compensation. As a further cost saver, the trustees cut a deal with an experienced accountant who prepared the foundation's taxes at cost, in recognition of other business relationships they had with him.
Unfortunately, neither the accountant nor the trustees were aware that once the foundation's income exceeded $1 million, the IRS would treat it as a "large corporation." After the end of the fiscal year, the foundation calculated its excise tax and, using the "pay safe" method as it had always done, made four quarterly payments, each equal to one-quarter of the prior year's total tax liability. What the trustees did not realize is that with its new "large corporation" status, the foundation was now required to make estimated excise tax payments based on the actual income earned in each quarter of its fiscal year. It was no longer eligible to use the "pay safe" method.
Staying the Course
Venerable was the first word that came to mind when anyone mentioned the Finest Hour Foundation. Observers respected the foundation's deliberate approach to grantmaking, careful avoidance of any impropriety and strict adherence to a demanding governance practice of rotating trustees after two three-year terms of service. For those reasons, no one was more surprised than the trustees when they learned they had made two mistakes in the same year, either of which might undo the foundation.
The Finest Hour Foundation was established by trust in 1949, with the language of the trust instrument very clear in requiring that the foundation be perpetual. It also was clear in instructing that all income should be used "to relieve the pain and suffering of new immigrant families." Some of the trustees had sought ways of circumventing the perpetuity requirement, when Baltimore's influx of refugees and immigrants peaked. In the words of one trustee, "It seemed like the right thing to do when by spending down the assets, one could address needs which were not likely to ever again be so great." The exploration was quickly abandoned when the foundation's counsel advised that the trust instrument's perpetuity requirement was "ironclad."
In early 2002, while reviewing the foundation's 2001 tax return, a staff member discovered that several practices of the foundation, if looked at together by an IRS auditor or the Maryland attorney general, might be construed as a renewed effort to gradually liquidate the foundation. For years, the trustees had maintained a very high payout in order to qualify for the 1 percent excise tax rate, believing it was the responsible thing to do. The trustees had maintained a payout level well in excess of the minimum required, even in the face of a portfolio value that had declined with the stock market, which would have required a draw on principal to meet the minimum payout requirement.
When the chairman looked into the tax return, he was surprised to find that the foundation had recorded five years of very large excess payouts. These "carryovers" were available to the trustees as an easy way to meet its distribution requirements without drawing further funds from the foundation's assets. The chairman realized that, as a matter of commonsense investing, they should have used carryovers. He also began to question the practice of regular trustee rotation, suspecting that breaks in continuity may have had something to do with the oversight.
About a month later, the foundation faced another disturbing situation. A representative of the state attorney general's office called to ask for information about a major grant the trustees had made the previous year to a respected university. The grant, for an endowment of a center that specialized in refugee studies, was made in honor of a trustee who was rotating off the board. Thus, the attorney general was investigating how the grant was justified under the restricted purpose of the foundation, requiring that funds be used to provide direct support for immigrant families.
Misplacing Your Trust
The Gathering Storm Fund was one of the oldest independent foundations in Massachusetts. For almost 100 years, the low-key foundation had uneventfully and successfully provided modest start-up grants and expansion support for small arts programs. In the mid-1990s, with the retirement of the accountant who had served the foundation for more than half its life, the seven members of the board knew it was important that they hire a qualified successor. They believed they had done so when they retained the services of an individual with more than 20 years of experience who had recently left his large firm to practice on his own.
The next few years seemed to go well. The audits were completed professionally and the tax returns arrived on time for the trustees to review, sign and return to the accountant for filing. In 1999, with the retirement of one trustee and the closing of his office in the western part of the state where the grantmaking records were stored, the foundation moved its place of business to Boston. After the IRS and the Commonwealth of Massachusetts were duly notified of the change of address, all communications came to the Boston office, including, somewhat inadvertently, copies of tax and accounting-related communications, which had previously gone exclusively to the accountant.
A month after the transition, staff was rather stunned to open a letter from the IRS that stated clearly that this was a final notice. It was obvious from the context that the letter was the latest in what had been a long series of communications. For two prior tax years, the accountant had failed to file the signed tax returns and to withhold and pay the excise taxes due. No fraud had been committed, but inaction or inattention had created an obligation of $93,091 in back taxes and penalties.
What's a Foundation to Do?
Although the events that unfolded for the trustees of the Shoebox, Maxamillion, Finest Hour and Gathering Storm foundations were unusual and involved a certain amount of bad luck, the kinds of mistakes that were madeand others like themare generally preventable. At GMA, we've handled a wide range of foundation fiscal situations. One foundation fell short of meeting its payout requirement. At another, we discouraged a trustee from filing a foundation meeting reimbursement claim that included expenses for family members.
Perhaps busy individuals who are volunteering their time should know better, should understand their vulnerabilities and should take steps to protect themselves at the outset. The incentives for doing so are considerable. As the lawyer who is helping the Shoebox Foundation work out its difficulties commented, "The agent assigned to cases like this is usually not from the IRS's customer-friendly division."
While the consequences of really bad grants or a series of poor investments can be much more devastating, those four foundations have learned the hard way that mistakes create major headaches. Beyond the costs of fines, penalties and back taxes, errors drained time and energy away from their other duties. Indeed, in one way or another, all four have adopted as their new operating mantra, "Little things can mean a lot and cost a lot, if neglected."
While it would be unrealistic for any foundation to expect it can avoid all possible mistakes, here are six steps trustees can take to help themselves:
1. Find good orientation and training for new trustees.
2. Encourage colleagues to attend conferences and workshops.
3. Commit to regularly scheduled meetings with advisors.
4. Review the foundation's tax return annually.
5. Appoint a committee to oversee the work of the advisors.
6. Don't delegate trustee responsibilities to advisors.
And when in doubt, don't hesitate to seek legal and/or financial counsel from dedicated expertsthose experienced in foundation law and management.
Illustrations by George Schill
Pamela Labonte Maksy (firstname.lastname@example.org) is a partner and financial manager at GMA, and coordinates financial services for foundations.
Newell Flather (email@example.com) is president of both Grants Management Associates, Inc. (GMA) and the Theodore Edson Parker Foundation. (Both are Boston-based organizations.)