Operational Risk – Risk of Nonpayment

OnRiske way to think about contract risk is that there are two veins: the likelihood of a breach and the impact of a breach. When a breach of contract occurs, it often requires significant of time, information-gathering, and negotiations in order to prosecute or defend the action.  The lost opportunity cost associated with a breach of contract dispute is in addition to actual costs due to lawyer fees, court cost and other litigation related expenses.  Therefore, it is to entities advantage to minimize the risk and costs associated with breach of contract.

There are risks involved in every agreement for performance of services.  On the buyer’s side there is the risk of nonperformance – meaning the buyer does not receive the services bargained for under the contract.  On the seller’s side there is a risk of nonpayment – meaning the seller does not receive payment for services rendered.  This article focuses on the risk of nonpayment and how to most effectively minimize such risks.

Unless the agreement you have with the other party requires all payment upfront – the contractor accepts some form a credit risks when he or she agrees to provide services to the buyer.  Credit risks is defined as the probability that a party will fail to meet his or her obligations in accordance with the agreed upon terms.  The level of inherent risk (level of risk before considering controls) that a service provider faces with respect to nonpayment for services may depend on a number of factors – but the largest factor will be the parties involved.

Inherent Risks – First step is to identify what is the inherent risk involved when you are contemplating entering into a relationship with the other party. What can go wrong with this relationship?  What could impede your business objectives if you engage with this entity or organization? You need to go through this exercise to better appreciate the risk involved.  Without acknowledging the inherent risk  it is difficult to create effective controls to mitigate risks.  Again, inherent risks is the level of risk prior to assessing the effectiveness of controls. It shows the level of risk that exists if no controls are present.

It is impossible to control for every risk, especially since certain risk remain unknown.  Therefore,  after we assess the risk – we may skew our controls toward those risks that are most probable and with the potential for the greatest lost.  The greater the risk- the more controls that may need to be implemented.

What is Unrelated Business Income?

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A 501(c)(3) organization can lose its tax exempt status if earns excessive income from a regularly carried on trade or business that is not substantially related to its tax exempt purpose.   The controlling law for this is found under IRC Sections 511 through 515 and the applicable treasury regulations.  The treasury regulations provide good context regarding the primary objective of the applicable statutes and the definition of “trade or business”.

The primary objective of the unrelated business income tax is to eliminate a source of unfair competition by requiring the same tax basis as nonexempt businesses whenever a tax exempt entity engages in business activity defined under IRC Section 162. For purposes of IRC 513, the term “trade or business” has the same meaning it has in IRC 162.  “Trade or business” generally means any activity carried on for the production of income from (i) selling goods or (ii) performing services.

More simply, a tax exempt organization would be unfairly advantaged if it could engage in business activity and not be taxed in the same manner as a commercial business. Therefore a tax is imposed under IRC 513 when a nonprofit engages in commercial activity. There are also two IRS publications concerning the unrelated tax provisions.  Publication 598 discusses the applicable statutes on unrelated business tax and Publication 1018 provides guidance on how the unrelated business tax applies to churches and church organizations.

To determine whether a tax exempt organization is subject to the unrelated business income tax UBIT, a three part test is first applied.  Three conditions must be met before the tax exempt organization’s activity will be construed as unrelated business activity under IRC 513.

  • The activity must be a trade or business;
  • The trade or business must be regularly carried on; and
  • The trade or business must substantially unrelated to the entity’s tax exempt purpose.

If all three conditions are present, then under IRC 513(a) (1) we look to see an exception to the rule applies:

One exception involves volunteer labor. An unrelated trade or business does not include any trade or business where substantially all the work is performed for the organization by unpaid volunteers.  For example, in St. Joseph Farms of Indiana v. Commissioner, 85 T.C. 9 (1985), a religious organization operated a farm and sold the food commercially.  The farm was operated entirely by unpaid volunteers.  The court ruled that the farming operation was an unrelated trade or business, but because the farm was operated by persons who received no compensation for their farming services, there was no unrelated business tax liability.

Other exceptions to the rule include the “convenience exception” under IRC 513(a)(2) and Regs. 1.513-1(e)(2) which provides that any trade or business carried on by a 501(c)(3) organization for the convenience of its members is not an unrelated trade or business and donated merchandise that is sold by the tax exempt organization is another exception.

It is important that any organization that needs assistance on UBIT issues consult with a lawyer, accounting professional or tax advisor.  This information is not legal advice.  Please, contact our office at info@scottpractice.com if you request assistance.

Should We Outsource Our Healthcare Compliance Program?

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It is no longer sufficient to simply have a compliance program.  Today’s federal enforcement landscape places higher demands on Privacy and Compliance Officers not envisioned in years prior.  For example, a more expansive application of HIPPA now includes severe penalties of up to $1.5 million for violations of the same HIPPA provision within a calendar year.   Also, under the Omnibus Final Rule, covered health organizations can be liable for business associates that violate privacy rules under HIPPA or the HITECH ACT.  Increased responsibilities of Compliance Officers reasonably include:

  • Internal Audits of Privacy, Security and Data Transfer Policies and Procedures
  • Review of Potential Data Transmission Vulnerabilities
  • Oversight of Business Associate Relationships and Business Associate Agreements
  • Management of Training and Educational Programs on privacy and security requirements under HIPPA and HITECH
  • Overseeing Enforcement of HIPPA and HITECH policies and procedures

Unfortunately, the responsibilities resulting from the Final Rule under HIPPA are in addition to the time required for proper review, analysis and compliance enforcement of rules concerning EMTALA, Fraud, Waste and Abuse, the False Claims Act, Stark, the Anti-Kickback statute, Conflict of Interest policies and other regulatory requirements.   For this reason, health organizations should explore cost effective alternatives such as outsourcing compliance needs to legal consultants.  The advantage of outsourcing compliance not only includes cost efficiency benefits, but also the ability to protect sensitive client communications through the attorney/client privilege.  Legal compliance firms are better equipped to provide the evaluation and training required under constantly changing regulations such as HIPPA.  For more information regarding HIPPA and HITECH please contact our legal compliance firm at info@scottpractice.com.

Private Benefit and Nonprofit Executive Compensation

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We hope to have several segments which address Tax-Exempt Compliance with applicable IRS regulations and the Internal Revenue Code.

A 501(c )(3) public charity receives tax exempt status upon demonstrating that it is organized and operates for a public purpose under 501(c )(3) of the Internal Revenue Code.  To maintain tax exemption, tax-exempt organizations must follow all laws and regulations pertaining to tax-exempt organizations.  The law provides that engaging in certain activities will jeopardize a nonprofit organization’s tax exemption.  The focus of this article is on a salient issue concerning executive compensation.  Can a nonprofit organization lose its tax-exempt status due to unreasonable compensation?  The answer is yes.

Briefly, the law provides that no part of a tax-exempt organization’s net earnings may inure to the benefit of an insider. An insider is a person who has a personal or private interest in the activities of the organization such as an officer, director, or a key employee.  The key here is net earnings of the organization privately benefited a key employee of the nonprofit organization.  Authorizing key employees, such as an Executive Director, Chief Executive or other key officers, to receive unreasonable compensation put the nonprofit’s tax-exemption at risk.  In other words, if compensation is given to any officer, director or key employee it must be reasonable or it can be deemed to be a private inurement jeopardizing the organizations 501(c )(3) status.  What is reasonable compensation depends of the totality of the circumstances.  Comparability data is one means of substantiating the reasonableness of executive compensation.  However, there are caveats with respect to its use, such as whether the data provides an accurate comparison.  The Exempt Organization section of the IRS has two useful articles on its Website on nonprofit compensation.  If you have difficulty finding them, you can e-mail us at info@scottpractice.com and will be happy to assist you.

Thinking of Starting a Volunteer Program? Here Are 5 Things To Consider
Couple Working in Homeless Shelter
  1. Know what role your volunteers will have.    Even if your organization has numerous tasks that it just cannot get to, planning is essential to an effective volunteer program. As such, the first step is to think about what suitable tasks and responsibilities are needed that match the organization’s strategic goals.  In other words, is the work suitable for a volunteer and will it advance the organization’s strategic goals.
  2. Know compliance requirements and regulations applicable to your industry and be prepared to share your organization’s written policies and procedures with your volunteers.     If required by law or advised by legal counsel, have volunteers sign written acknowledgements.  Federal grants now require that nonprofit organizations protect personally identifiable information.  Check with a legal professional to find out:
    • If volunteers should adhere to your organization’s confidentiality agreements
    • Whether volunteers should receive training on applicable laws such as HIPPA or other privacy laws
    • Whether volunteers are covered by your organization’s insurance in the event of a claim of liability
    • Does the work require the volunteer to undergo a background check or health assessment
    • Answers to other compliance requirements under either state and federal laws or funding requirements that may impact the volunteer program
  1. Identify staff members with sufficient time to oversee the volunteer program. Don’t assume that HR or a program manager would be the obvious choice for oversight of any portion of the volunteer program.  A proper volunteer program will require time and effort to run properly. 
  2. Develop a framework for recruiting, training, promotion, recognition and retention.    It’s not enough to just seek out helpers and put them to work. An effective volunteer program requires cultivating if you want to retain volunteers.
  3. Select the best channels for recruiting potential volunteers.    The organization continues to brand itself even during the recruitment process.  Therefore, the organization should solicit volunteers that are consistent with the organization’s brand and mission.  Finding volunteers who match the mission and objectives is equally important.  Finally, the type of work involved, general timeframe for completion and any indirect costs to the organization are important considerations.