Bishop Estate to Pay IRS $9-Million but Retain Its Tax-Exempt Status

Hawaii’s wealthiest charity has agreed to pay more than $9-million to settle its tax-liability dispute with the Internal Revenue Service.

Under an agreement approved this month by a probate court in Honolulu, the Bernice Pauahi Bishop Estate will be permitted to retain its tax-exempt status. But the court-appointed interim trustees have ceded to the service an extraordinary degree of oversight for the next five years.

The I.R.S. had threatened to revoke the charity’s exemption, retroactive to 1990, contending that the five former trustees had mismanaged its assets, improperly enriched themselves at its expense, and engaged in non-exempt activities while neglecting its core educational mission.

The Bishop Estate, which runs the Kamehameha Schools in Honolulu, also oversees real-estate holdings and far-flung business ventures estimated to be worth more than $5-billion — all of which is supposed to support its charitable purpose of educating Hawaiian children.

The service had argued that the former trustees were much more active in managing the estate’s commercial affairs than in supervising education.

The agreement, which Probate Judge Kevin S. C. Chang approved December 1, requires that the five former trustees be permanently removed from office. Judge Chang ousted four of the trustees temporarily in May and accepted the temporary resignation of the fifth (The Chronicle, May 20).

Since then, three of those trustees — Oswald K. Stender, Gerard A. Jervis, and Richard S. H. Wong, the chairman — have submitted their permanent resignations. A fourth, Lokelani Lindsey, was removed permanently in May by a different judge, though she is appealing that decision.

Probate Judge Colleen Hirai is scheduled to preside over a trial this week on the question of whether Ms. Lindsey and the fifth former trustee — Henry H. Peters — should be permanently barred from regaining that office. Since the former trustees’ provisional ouster in May, the estate has been controlled by the five interim trustees whom the judge appointed at that time. It is with them that the service reached its agreement, which closes the book on its four-year audit of the charity and settles a tax bill that initially was calculated to be $65-million.

In Judge Chang’s recent order, he said that although he did not agree with every aspect of the settlement, it was “reasonable and in the best interests of the Trust Estate.” Not only does it preserve the charity’s exempt status, he said, but it also “avoids costly and lengthy administrative appeals and litigation” in which the estate would be unlikely to prevail.

The Bishop Estate has been in turmoil for much of the past three years as students, parents, alumni, and staff members of the Kamehameha Schools voiced strong objections to the management practices of the former trustees. Attention focused initially on what critics described as the autocratic, secretive, and vindictive style of some trustees, which created what they called a climate of mistrust and intimidation. But the focus later broadened to include what critics said was excessive trustee compensation (averaging more than $800,000 apiece annually for the past decade), favoritism in hiring and in contracting services, and a spotty record of financial investments.

The 33-page agreement requires that the interim trustees take steps to remedy those concerns. The result will be a reorganization of the estate’s management structure and policies, and the installation of checks and balances intended to limit the trustees’ power and to insure that they are accountable to the I.R.S., the probate court, and the school community.

Perhaps the biggest change stipulated by the agreement is that the trustees will no longer be involved in managing the estate’s day-to-day operations. Instead, they will establish overall policies and provide fiduciary oversight — a role much closer to that played by most charities’ trustees.

The former trustees had adopted what they called a “lead trustee” system, in which each of them had primary responsibility for a particular area: educational policy, investment management, legal affairs, or government relations. They contended that those full-time responsibilities entitled them to executive-level salaries — and consequently awarded themselves annual compensation that last year topped $1-million apiece.

With the trustees now limited to a policy-making and oversight role, the settlement requires them to hire a chief executive officer to manage the estate’s affairs. The former trustees had agreed more than a year ago to hire such an administrator — a move recommended by a court-appointed special master — but had not done so before they were ousted.

As a further safeguard, the I.R.S. stipulates that an independent auditor be hired to monitor the charity’s compliance with the so-called closing agreement and all court orders, as well as its adherence to the conflict-of-interest policy that the estate has adopted as a result of the settlement. The auditor, who is to have unrestricted access to all people and documents, may not be dismissed arbitrarily.

The I.R.S. also seeks to crack down on the cronyism that critics say permeated the estate’s hiring and contracting practices under the former trustees. Under terms of the settlement, the estate must review existing contracts and job classifications to insure that it is getting good value for necessary services and that contracts are obtained through open and competitive bidding.

The agreement also seeks to revise the estate’s investment practices. Critics say the former trustees diverted into the estate’s investment portfolio some $350-million in revenue that should have been spent on educational programs. And various critics have alleged that the former trustees’ investments were often haphazard, high-risk, and otherwise ill-advised, resulting in some massive losses that the trustees tried to conceal through a maze of subsidiary organizations.

The I.R.S. agreement requires the estate to adopt clear policies on spending and investment, and to insure that the charity’s investments are handled in a way that supports its educational mission.

Other clauses in the agreement seem designed to attack what some critics say was at the heart of the problems at the Bishop Estate: the pervasive influence of politics. In recent decades, appointment to the Bishop Estate board has been seen as a political plum for Democratic officials in Hawaii. The ousted board members, for example, included a former Senate president (Mr. Wong) and a former speaker of the House of Representatives (Mr. Peters), and the estate has hired or retained other current or former legislators as well.

Such appointments would be unlikely to take place in the future. The estate has agreed not to hire as employees or retain as consultants elected or appointed members of the legislative, judicial, or executive branches of any government — local, state, or federal. Former officials may not work for the Bishop Estate for three years after they leave office, without approval from the probate court.

The estate agrees not to engage in any “prohibited political intervention,” such as campaigning or polling that benefit political candidates, and further agrees to adopt a lobbying policy that will include requirements for documenting all communication with state and federal legislators.

Many Hawaiians have welcomed the closing agreement as a major step toward returning the estate to relative tranquility. But not everyone agrees.

“The I.R.S. settlement has put a corporate foundation structure on something that was very unique to Hawaiian history,” says Renee Yuen, a lawyer for Mr. Peters. “I’ve been told that it’s unprecedented for the I.R.S. to come in and dictate this kind of radical restructuring.”

But while settlement agreements with the service ordinarily are not made public, experts say that the I.R.S. has wide latitude in deciding what conditions to require.

“Closing agreements can contain just about anything the parties agree to,” notes Daniel L. Kurtz, an authority on trustee-liability issues. The only provision that strikes him as unusual, he says, is the one that bars current or recent government officials from employment by the estate. But the reason for that provision is clear, he says, given the estate’s recent history of political entanglements.

“Somebody would have been looking into the Bishop Estate years ago had the holders of office there not been so politically connected and powerful,” Mr. Kurtz says. “There was so much venal behavior and so much abuse of power, where the people running [the charity] thought they could laugh at the law.”

If the Bishop Estate had lost its tax-exempt status, retroactive to 1990, it would have faced a tax bill of more than $750-million, according to an analysis commissioned by the interim trustees.

The total financial settlement of about $13-million ($9-million in taxes, plus interest) is well below the $65-million figure that the I.R.S. had initially sought — a sum that it said represented the estate’s total tax liability from fiscal 1992 to 1996.

Ironically, the former trustees had considered voluntarily giving up the organization’s tax exemption, which saves the estate tens of millions of dollars in taxes every year.

In court papers filed earlier this fall, the interim trustees allege that their predecessors had directed legal counsel to explore ways of converting the estate to a for-profit organization and moving its corporate headquarters to another state. Both steps were intended to put an end to state and federal scrutiny of the estate’s affairs, the interim trustees contend — and to make the trustees immune from any attempt to limit their compensation.

The December 1 agreement puts to rest only one of many legal actions facing the Bishop Estate and its former trustees. It does not cover the tax liabilities of any of the estate’s for-profit subsidiaries, for example. Nor does it include any sanctions the I.R.S. may choose to invoke against the former trustees, which may include taxes and surcharges levied under the “intermediate-sanctions” legislation passed in 1995, which permits the service to penalize officials who receive excessive compensation or other benefits from non-profit organizations.

Critics say that it was fear of having the government lower their compensation that prompted the trustees to spend some $1-million of estate funds on lobbying against — and later, on trying to modify — the intermediate-sanctions legislation.

On the matter of compensation, the agreement defers to the determination of the probate court. A court-appointed compensation committee has recommended that annual trustee compensation be capped at $97,500 — and $120,000 for the chairman. Judge Chang, meanwhile, has authorized the interim trustees to receive $180,000 a year because of the amount of work involved in correcting past practices. The matter will be reviewed in two years.

For now, many observers are relieved that the estate has avoided the potential devastation of losing its exemption.

“Assuming the former trustees are all permanently removed, this guarantees that the estate will keep its tax-exempt status,” says Randall W. Roth, a University of Hawaii law professor. “Given the level of abuse over the years, that’s a major accomplishment. Obviously, the I.R.S. doesn’t like to take away a viable charity’s tax-exempt status, but it would be hard to imagine a more egregious situation than this one.”