Related-Party Transactions: The Dangers of Mixing Business with Charity
It could be a board member who urges you to purchase insurance coverage through a firm controlled by his spouse. Or maybe it’s a major donor who promises future gifts only if the organization conducts business with a particular company.
In the end, mixing business with charity can be a dangerous combination. This makes understanding how to properly handle so-called “related-party transactions” critical.
What Are Related-Party Transactions?
At its most basic, a related party is one that is either directly or indirectly able to significantly influence or control another party. Thus, a related-party transaction is a transaction that occurs between two or more parties (individuals, businesses, organizations, etc.) with inter-linking relationships.
Sometimes these transactions can be benign: An organization buys a computer from a company that employs the wife of a staff member who has no decision-making ability regarding the purchase. But that benign transaction can quickly turn problematic if the proper steps are not followed — for example, if the computers were not purchased at the best possible price and the transaction was not appropriately reviewed and approved.
Before undertaking a related-party transaction, make sure it meets all of the following criteria:
- Full disclosure is made. Related-party transactions should be disclosed to all decision makers as well as executive staff and the governing board. Typically, related-party transactions are disclosed on Schedule R of IRS Form 990, as well as via the organization’s financial statements. The key is to provide a specific description of the relationship and how it arises (e.g., through representation on the board of directors).
- Related parties are excluded. A fair and objective decision also re-quires that related parties be excluded from the discussion and approval of related-party transactions. The related party should not only avoid discussing and voting on the matters, but should also be absent from the meeting to avoid even the appearance of a conflict of interest.
- Costs and benefits are analyzed. Clearly outline the evidence that the goods or services being procured through the transaction are the best that can be obtained for the money. Commonly, this is established via competitive bids.
- The best interest of the organization is honored. Once the board has discussed a proposed transaction openly and without bias, evaluated costs vs. benefits, and disclosed all relationships that could lead to a conflict of interest, it still needs to evaluate the overall wisdom of entering into the transaction.
For example, will the transaction, when properly disclosed, raise more questions with constituents or regulatory groups than the board can adequately answer? Will it set a precedent, making it difficult to respond negatively to future situations? Does this decision ultimately have the best long-term interests of the organization at heart, or will it provide short-term gains only?
Practical Steps to Take
- Adopt a conflict of interest policy. The IRS has included a suggested conflict of interest policy in the instructions for completing Form 1023, Application for Exemption under Section 501(c)(3). This detailed and comprehensive policy is published starting on page 25 of Form 1023, available at http://www.irs.gov/pub/irs-pdf/i1023.pdf.
- Use your audit committee. An audit committee made up of financially knowledgeable board members should evaluate any transaction with the potential for conflict of interest. Consider adding a paid or unpaid CPA if expertise isn’t already available from within the board.
- Create a conflict list. At least annually, have board members and staff in decision-making roles complete a questionnaire designed to disclose their connections with groups or individuals doing business with the organization. Ditto for any individual nominated to stand for election as a director.
- Document the decision and evidence. Make sure to document your organization’s decision as well as the evidence used to support the reasonableness of the related-party transaction. Up-to-date minutes are crucial. This means they are written in the proper format, signed and approved.
Related-party transactions should be disclosed to all decision makers as well as executive staff and the governing board.
Who's In Control?
According to the IRS, control of a nonprofit organization is determined based on whether one or more persons (individuals or organizations) has 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.
Source: IRS Form 990, Schedule R
To learn more, please contact:Lori A. Sheets, CPA
Senior manager and practice leader