Last month, two of Paul Newman’s daughters, Susan Newman and Elinor “Nell” Newman, filed a lawsuit against the Newman’s Own Foundation, a tax-exempt organization established by their actor and philanthropist father.
While the parties are uniquely well known, the allegations in the case are common to hijacked estates everywhere—a wealthy individual ages, opportunist business associates move closer to the individual when they’re vulnerable, the family is kept at arm’s length from the business, new counsel is retained, and then the estate and business succession plans are amended.
The interesting wrinkle here, however, is that Paul Newman aged in an era of excessive litigation. He was aware of it, and his longtime attorney, Leo Nevas, designed and executed the original plan with an eye toward specifically avoiding a lawsuit. In fact, according to the complaint, the successor CEO to the foundation, Robert “Bob” Forrester, told Newman:
“I think it would be wise for you to have a personal message describing your intentions. There is no better way to help the future figure out your intentions than by saying it yourself in your own words, as opposed to future lawyers and judges trying to interpret legal documents. This is something many in the foundation world wish they had. In your case, it might be fun to do it in a video form. It is a great legacy.”
The complaint alleges that Newman did exactly as Forrester recommended. However, while he was thorough in expressing his wishes, he didn’t provide his estate with the tools to properly secure their realization. In fact, while he was focused on expressing estate aspirations, he allowed foxes to guard the hen house of the foundation’s operations. With its new authority, the foundation’s succeeding board of directors was able to amend expenditures and direct cash flows in ways that benefited them.
Private Inurement Test
A private foundation must satisfy six tests under Internal Revenue Code Section 501(c)(3) to qualify for and maintain tax-exempt status. Failing any of the six tests places the foundation at risk of losing that status. One of the tests is the private inurement test, which requires that the foundation refrain from distributing any part of its net income to any member, shareholder, or other individual.
Paragraphs 63 and 64 of the complaint specifically identify the following benefits inured to Forrester:
- Forrester’s requirement that donee charities use his consulting firm;
- More than half of foundation donations went to less than 1% of the recipients, many of whom had close relationships with members of the foundation’s board;
- Forrester also consistently traveled first class, often accompanied by his wife, staying in expensive hotels and having their trips fully funded by the foundation; and
- Forrester also employed a personal driver, paid for by the foundation.
The complaint also alleges that these benefits are in addition to salaries that Forrester and Brian Murphy, Newman’s longtime business manager, were already receiving from the foundation and other Newman entities.
Payment of salaries is not entirely prohibited. The prohibition against providing any kind of benefit to a private individual has been defined as excessive compensation for goods and services, unreasonable rents, loans, purchase of an insider’s assets by the exempt organization for more than a fair price, use of the organization to further an insider’s business, and commingling of organizational and personal funds.
With respect to whether the foundation has exposure to IRS examination and enforcement, the question in the Newman case will turn on whether those benefits alleged in the complaint improperly inured to the benefit of Forrester. Thus, the analysis here is whether the compensation was excessive and whether the foundation was used to further Forrester’s business.
With respect to compensation directly from the foundation, the 2018 Form 990-PF states that Forrester was compensated $262,180, plus an additional deferred compensation contribution of $76,689. This salary was in exchange for roughly 17 hours of work per week. Added to the compensation would be the first-class travel, travel for Forrester’s wife, and his personal driver.
Whether this total amount is reasonable considers a number of factors under the IRC Section 162 test for reasonable compensation. In this analysis, courts have examined the type and extent of services rendered, the scarcity of qualified employees, the qualifications and prior earning capacity of the employee, and the contributions of the employee to the business venture, market compensation of comparable positions.
As president and CEO of a highly profitable and complex foundation, Forrester’s compensation possibly was reasonable, low hours notwithstanding. Executives of tax-exempt organizations often have permissible compensation packages that include perks and deferred compensation. However, tilting the balance against the foundation here is that Newman consistently required that his daughters be compensated “up to $100,000 of market-based compensation for each daughter’s work” for their respective foundations. Newman specifically directed that the daughters’ compensation be considered against fair market value. In the complaint, discovery is yet to be conducted, but there is no indication that a similar survey occurred for Forrester.
Where a private foundation runs afoul of the private inurement prohibition, the event isn’t necessarily a death knell for the organization. The IRS has a spectrum of penalties at its disposal, ranging from monetary payments up to revocation of its tax-exempt status. Naturally, the severity of the penalty runs parallel to the negligence, gross negligence, recklessness, or intent of the parties in establishing the compensation. In the Newman case, the IRS will undertake this process if it takes notice and sees a favorable outcome as a result of the litigation.
Even if it’s proven that the benefits improperly inured to Forrester, the substance of the suit still turns on whether the daughters’ foundations are to continue receiving the $400,000 annual donation originally envisioned by Newman before Forrester’s modification.
While the complaint looks to Newman’s living trust, it doesn’t cite to the foundation’s governing documents, which would detail whether the foundation is mandated to distribute $400,000 to the daughters annually. Granted, those documents may not be readily available to the daughters at the time of filing and could have been amended by the board of directors to delete or reduce such a requirement. To avoid this type of conflict, Newman should have named his daughters to the foundation’s board of directors and specified their allocation amounts in the foundation’s bylaws.
Finally, it’s worth noting that only two of Newman’s four daughters have initiated this lawsuit, vividly illustrating the suit’s 50-50 chances of success.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jared Johnson is a partner in the Philadelphia office of White and Williams LLP, where he provides tax representation and guidance on complex tax laws and disputes, corporate transactions, reporting, asset protection, and cross-border issues.
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