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Growing Scrutiny in the Nonprofit Sector

By Tom Watson on July 18, 2007No Comment

Growing Scrutiny in the Nonprofit Sector
Growing Scrutiny in the Nonprofit Sector
By Josh Moore, 7/18/07

With increasing reports of scandal and inefficiency within the nonprofit sector – a sector which now accounts for 8.5% of our national income – it is no wonder that donors, Congress, and the IRS are applying ever greater scrutiny to the practice and governance of nonprofit organizations.

Currently, a bitter lawsuit rages between Princeton University and the children of Charles and Marie Robertson, founders of the Robertson Foundation, over Princeton’s alleged wrongful spending of more than $207 million in restricted funds.  This lawsuit, originally filed in 2002, is expected to be a defining case in donor intent.  If the Foundation wins, it will, as a columnist from the New York Sun commenting on the case put it, send a clear message to nonprofits: “Don’t accept money unless you plan to use it for the designated purpose.”

While the Robertson v. Princeton University case is one example of the changes underway in the nonprofit sector, other examples, already in place, such as legislative and reporting changes by the IRS and Congress, have far more immediate implications.  These changes, almost certainly the result of nonprofit growth and, to some degree, scandal, were one of the topics discussed at a conference at Fordham Law School entitled “Nonprofit Law, Economic Challenges, and the Future of Charities.” 

The conference, itself indicative of the growing scrutiny to the field, brought together nonprofit leaders and legal academics to discuss changes in nonprofit governance, proposed and current legislation, changing financial structures, and the implications of these issues for the nonprofit community.  Of particular interest to the topic of changing legislation and increasing government scrutiny was the presentation by Marion Fremont-Smith, a Lecturer in Public Policy at the Harvard Kennedy School of Government, on her working paper, The Search for Greater Accountability of Nonprofit Organizations: Recent Legal Developments and Proposals for Change.  Outlining this paper, Ms. Fremont-Smith provided a comprehensive overview of the ways in which state and federal government bodies have tightened (or plan to tighten) the reins on nonprofit institutions.
In further indications of the direction such oversight is taking, two key legal changes have been enacted by the IRS and Congress in recent years.

Pension Protection Act

The Pension Protection Act, signed into law a little under one year ago, is one of the most sweeping reforms of America’s pension laws in over 30 years.  Though seemingly unrelated to nonprofit law, this act has great implications for the nonprofit sector, some positive and some negative.  The act contains a package of charitable giving incentives such as tax-free distributions from IRAs for charitable purposes, charitable deduction for contributions of food and book inventories, and the easing of unrelated business income tax on certain income.

In all, some 17 reforms were passed with the bill.  Under the Act, all charitable contributions must be substantiated by either a bank record or written acknowledgment from the recipient organization (placing a greater administrative burden on the nonprofit), compared to the past when only gifts of $250 or more needed to be substantiated.  Deductions for contributions of clothing and household items are no longer allowed unless the property is “good or better,” again placing a burden on the nonprofit to define the goods as such.  To promote state oversight, the Act encourages IRS information sharing with state charity officials.

Also, and of significant importance to tax-exempt organizations with gross incomes of less than $25,000 (a large percentage of the sector), there are changes in filing requirements.  Prior to the Act, these organizations were not required to file annually with the IRS. Now these organizations must file an e-Postcard Form 990-N annually.

The Act also impacts foundations with the first complete regulations on donor-advised funds and the commission of a Treasury Department study on donor-advised funds and supporting organizations.  Among other provisions, the Act defines a donor-advised fund and places an excise tax on organizations that do not follow proper procedures to ensure that distributions and receipt of monies for donor-advised funds meet certain procedural requirements.  Further, contributions to these funds are no longer treated like tax-deductible donations to other charities but now require more stringent documentation to receive tax-deduction.

Additional information on how the Act affects tax-exempt organizations can be found through the Association of Fundraising Professionals, through the Committee on Ways and Means, and through the Council on Foundations.

New Form 990

Another area of added and — as expressed in Susan Raymond’s most recent article on the topic — welcome scrutiny is an overhaul of the IRS Form 990.  Although only a draft (available here) and open to public comment until September 14th 2007, the form will be implemented for the 2008 tax year and contains a ten-page core section to be completed by all nonprofit organizations with up to 15 schedules.  The primary modifications to the document have to do with governance and accountability reporting. 

Although controversial, the form includes a new section requiring disclosure of all financial and/or familial relationships between board members and the organization. There is also increased scrutiny of governance, as seen by questions on the number of independent members of the governing body, and on policies regarding conflict of interest, whistle blowers, and document retention. 

Regarding financial transparency, the proposed form requires the reporting and itemization of all non-cash contributions.  Given the growth in micro-finance and venture-philanthropy, an additional reporting line for investment income generated through program services is provided.  Miscellaneous expenses are now not allowed to exceed 5% of total expenses, and compensation of key officers is required to be reported as a percentage of total program service expenses. 

Also, the new form includes a line item report of all grants and assistance overseas.  Though seemingly simple, in some cases the IRS actually categorizes some domestic grants as grants outside the United States. Included in this line item are grants to organizations abroad, but also grants going to a domestic charities’ foreign branch office, grants to U.S. charities with more than 60% of their expenditures overseas, grants that will benefit foreign persons (such as grants to the American Red Cross to benefit tsunami victims), grants to U.S. residents overseas, and grants to U.S. citizens for work, study, or research abroad.

For a more comprehensive overview of proposed changes to the Form, please visit the Council on Foundations, to hear an audio update on proposed changes click here, or to make comments visit the IRS website.   

What is Next?

As this article is published, there is less than a week until the July 24th, 2007 Ways and Means Oversight Subcommittee overview hearing on tax-exempt organizations, which will focus on charities and foundations.  For anyone who is unconvinced of the growing federal interest in nonprofits, the purpose of this meeting, as described by the subcommittee, is to “review the overall state of this sector, including activities and measures for ensuring public accountability and good governance.”
Though the Pension Protection Act and the modification of the Form 990 are only two examples of increasing standards for the nonprofit sector, and have focused primarily on required public disclosure of data rather than direct enforcement, recent proposals by the Finance Committee allow for the latter.  One such proposal would put a condition for tax exemption on a set of best practices through a certification system and would increase IRS and federal enforcement power.  Regarding donor enforcement, the outcome of the Robertson v. Princeton University, if ruled in favor of the Robertson family, would strengthen the ability of donors to enforce the terms of a gift. Yet, as discussed in the Fordham conference, the trend has been toward expanding and enforcing the rights of donors for some time now.

Perhaps the most important message of the Fordham conference (or at least for one concerned more with nonprofit mission than law) is that change is upon us and it is imperative.  The role of nonprofit institutions, to both serve the needs and be an expression of society, cannot exist without social support.  Therefore, heightened requirements for transparency and accountability, if not a burden to mission and resources, should be a welcome change.  After all, it is only through trust that the sector can survive.

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