The IRS 1023

Section V of the IRS Form 1023: Compensation and Transactions with Related Parties

Overall, Section V of Form 1023 is about compensation and transactions with related parties. The questions in this section are meant to ensure that the organization has appropriate policies and practices in place to prevent conflicts of interest and to ensure that any transactions with related parties are conducted at arm's length and at fair market value.

Line 1 asks if the organization compensates or will compensate officers, directors, trustees, highest compensated employees, or highest compensated independent contractors, which, if answered yes, is followed by a series of follow-up questions (1a – 1g) about compensation practices, including whether the individuals who approve compensation arrangements follow a conflict of interest policy, whether compensation arrangements are approved in advance, and whether the organization uses external data to determine reasonable compensation. It is important to note that answering “No” to 1a through 1g, could potentially raise concerns about whether the organization is following best practices in establishing reasonable compensation and avoiding conflicts of interest, which could result in the IRS scrutinizing the organization's application and potentially denying it if there are significant issues. As such, Line 1’s subsections provide a sort of framework for compliant compensation arrangements and conflict of interest policies that would be advisable for an organization to establish if it has not already done so.

Line 2 asks if the organization has adopted a conflict of interest policy consistent with the sample policy provided in the instructions. It is not technically required to use the exact policy example they provide, however, it may be in the organization’s best interests not to attempt to ‘re-invent’ the wheel when an already acceptable policy is provided. That said, a word-for-word copy of the example may not fit the organization’s precise needs, so it is also important to ensure that the policy ultimately makes sense for the organization.

If a substantially different policy is already in place, or the example is otherwise undesirable to the organization, then the organization must explain how it does or will prevent persons with conflicts of interest from having influence over the outcome of such interests. This option is certainly permissible, but it is worth noting that the IRS will likely scrutinize the policy more heavily if it is unfamiliar to them. Essentially, it is a “this better be good” situation.

In either case, it is important for the organization to have a clear understanding of what constitutes a conflict of interest, how conflicts will be identified and managed, and how the policy will be enforced. The organization should also ensure that all relevant parties are aware of the policy and understand their obligations under it.

Line 3 asks if any of the individuals detailed in Line 1 will be compensated through non-fixed payments, such as bonuses. If yes, then the method for determining these payments must be explained. Essentially, this question wants to ensure that no one in the organization is able to grant themselves a bonus, and more specifically that no one is receiving more than “reasonable compensation”. 

In this context, "reasonable compensation" generally means the amount of compensation that would be paid for similar services by similar organizations in similar circumstances, considering factors such as the employee's duties and responsibilities, the organization's size and complexity, and the local labor market. Please note that failing to satisfy this reasonable standard could result in penalties and/or revocation of tax-exempt status.

Lines 4 and 5 ask about transactions with related parties, including purchases or sales of goods, services, or assets, and leases, contracts, loans, or other agreements. The organization must describe any such transactions it has made or intends to make, identify the parties involved, and explain how it ensures that the terms are negotiated at arm's length and at fair market value. Determining fair market value may involve conducting research on the prices charged for similar transactions in the market or obtaining independent appraisals or valuations of assets.

Please note that if any of these arrangements are not negotiated at arm's length or if the organization is not paying or receiving fair market value, it could be seen as a potential conflict of interest or a violation of IRS rules. Therefore, it's important to be transparent and accurate in answering this question.

Lines 6 and 7 ask about relationships with third-party contractors or managers who develop, build, market, finance, or manage the organization's facilities or activities. The organization must describe these relationships and explain how it ensures that it pays no more than fair market value for services. The organization must also explain how the other entity was selected and how the terms of any contract(s) were negotiated at arm's length. The organization should also disclose and provide information about any business or family relationship between the two entities, the outside managers and/or the organization’s officers, directors, or trustees, including the names of the outside managers along with any relevant information about their qualifications and experience.

To best answer these questions, the organization should provide a clear and detailed description of the activities or facilities being managed, including the scope and duration of the management arrangement the organization, and the role of the other organization in developing, building, marketing, or financing it. The response should also explain how the outside managers were selected and how the terms of any contracts or agreements were negotiated. This should include information about the process used to solicit bids or proposals, any evaluation criteria used to select the outside managers, and any negotiations that took place to finalize the terms of the arrangement.

Line 8 asks if the organization participates in any joint ventures with other partners where they share profits and losses. The organization needs to describe each joint venture, including its ownership percentage, investment, tax status of other participants, how the organization exercises control, and how the joint venture furthers the organization's exempt purposes as this will help the IRS determine whether the joint venture is consistent with your tax-exempt status.

When answering this question, it is important to be specific and provide detailed information about each joint venture. If the organization's involvement in these ventures is not consistent with its exempt purposes, or if the venture is not operated in a manner that furthers exempt purposes, it could result in a denial of tax-exempt status.

In conclusion, it's important to note that answering any particular question incorrectly does not automatically result in a denial of tax-exempt status. However, it could trigger further scrutiny from the IRS and require additional information or clarification to be provided. The most important thing an organization filing this application can do is to provide entirely honest and transparent information that is as specific and detailed as possible. This is not a form that should be hastily prepared and any questions or concerns that persist should be raised to a legal and/or tax exemption professional that is familiar with the Form 1023 Application.