Related Party Treatment
Written by: Jessica Cooper
It is obvious through the redesign of the Form 990 that the IRS is concerned about the involvement of nonprofit entities in organizational structures and the transactions going on within those structures. Schedule R is where related organizations and various related party transactions are required to be reported on Form 990. A great deal more information is now required on the Schedule R and it is important to understand what the IRS is looking for in order to meet their requirements.
The newly redesigned Form 990 has six parts. Parts I through IV require you to identify the following types of related parties: disregarded entities, tax-exempt organizations, partnerships and C or S corporations and trusts. Part V is for information on transactions with related organizations and part VI requires information on unrelated organizations that are taxed as partnerships through which the organization conducted more than five percent of its activities.
The first major hurdle in completing Schedule R is determining who is related to you! According to the Schedule R instructions, there are five types of relationships that can cause two organizations to be related. The first type of relationship is “parent,” which is an organization that controls the filing organization. The next type of relationship is “subsidiary,” which is an organization controlled by the filing organization. A third type of relationship in the same territory with parent and subsidiary relationships is “brother/sister” relationship, which is when two organizations are controlled by the same person(s). All three of these types of relationships are based on “control,” which is defined differently in the 990 instructions depending on what types of organizations are involved.
Control of a nonprofit organization is determined if one or more persons (individuals or organizations) have the power to remove and replace a majority of the nonprofit organization’s directors or trustees. Another way to be considered a controlling organization is if a majority of the members have the power to elect a majority of the nonprofit’s directors or trustees. There are two different ways this power can be exercised by an organization. If one or more of the parent organization’s officers, directors, trustees, or agents have such power over a nonprofit, then the parent organization is deemed to control the nonprofit. The other way an organization can be deemed to control a nonprofit is if a majority of the nonprofit’s directors or trustees are directors, trustees, officers, employees, or agents of the parent organization.
Control of a stock corporation is simply defined as one or more individuals or organizations owning more than 50% of the stock of the corporation. Control of a partnership or limited liability company is not quite as simple, but it does also include a comparable 50% rule. One or more persons control a partnership if they own more than 50% of the profits interest or capital interest in a partnership or limited liability company. A person can also be deemed to control a partnership or limited liability if they are a managing partner, managing member or general partner and that entity has three or less managing partners, managing members or general partners. This rule stands without regard to which partner or member actually has the most control.
Similar to partnerships and corporations, one or more persons control a trust if they own more than 50% of the beneficial interests in the trust. The control rules as they relate to the different types of entities also include indirect control, i.e. if organization A controls organization B and organization B controls organization C, then organization A also controls organization C. The Section 318 rules apply for determining constructive ownership of a corporation.
There are some different rules within the Schedule R instructions for exempt organizations that are involved in group exemptions. A group exemption is sometimes granted by the IRS for a group of organizations who are tax exempt if they are affiliated with a central organization, then each organization does not have to apply for exemptions individually. For Schedule R purposes, central organizations and subordinate organizations of a group exemption are not required to be listed as related organizations. For a group return, the central organization must attach a list of the subordinate organizations included in the group return. Also, the central organization must include in their Schedule R the related organizations of all the subordinate organizations except for organizations included within their group exemption or organizations that they know to be included in another group exemption. Similarly, an entity that is or is not part of a group exemption, is not required to list a related organization that is included in a group exemption.
In addition to parent, subsidiary and brother/sister relationships, there are two more types of relationships for Schedule R reporting purposes – supporting/supported and sponsoring organization of a voluntary employees beneficiary association (VEBA). Organizations treated as supporting or supported organizations under the section 509 Private Foundation rules must report each other as related organizations. An organization that contributes 10% or more of the contributions or payments made to a section 501(c)(9) VEBA during the tax year is considered to be a sponsoring organization of a VEBA and related.
After clearing the first hurdle of determining who is related to you and completing the first four parts of the Schedule R, then you have to determine what transactions you are required to report on part five. The first line of part five is relatively simple; it is the second line of part five that gets more complex. In line one, you are to check the box if the filing organization engaged in any of the listed transactions. The listed transactions encompass just about every type of transaction you could imagine. One of the listed transactions is transfer of cash or property to/from related organizations and this includes any conveyance of funds or property not already listed, whether or not for consideration.
Two types of transactions with a “controlled entity” are required to be listed on the second line of part five. For this part of Schedule R, the Section 512(b)(13) definition of a controlled entity is used. The first type of transaction that must be disclosed is the receipt or accrual of interest, annuities, royalties or rent from a controlled entity regardless of the amount. The second type of transaction required to be listed is any transaction described in lines 1b through 1r of part V (which is essentially any other type of transaction) with a controlled entity if the amounts between the filing entity and the controlled entity exceed $50,000. The IRS appears to be the most interested in the receipt of interest, annuities, royalties or rent because these are potential sources of unrelated business income. From the perspective of the affordable housing industry, it seems that part V of Schedule R would be the most cumbersome for management companies or any upper tier type of entity that would be considered to have controlled entities.
The Schedule R reporting requirements can be a large burden in the affordable housing industry. Not only do management companies and upper tier entities have a significant amount of responsibility in reporting related party transactions, but all entities in the industry have to be vigilant about identifying and reporting related entities.
Jessica Cooper is a tax manager at Dauby O’Connor & Zaleski, LLC