More and more, “governance” crops up in discussions about the nonprofit sector. So, why is the spotlight shining on how nonprofits govern, or manage, themselves — as opposed to, say, what they do for their communities? And what does this mean for your organization?

Reform Changed the Focus

This is a relatively recent development. In the late 1980s, a nonprofit board’s responsibility to its constituency became better defined. In the 1990s and early 2000s, several high-profile scandals involving accusations of misspent funds, fraud and other wrongdoings led to demands for greater accountability and transparency.

Organizations and businesses whose purpose is to assist nonprofits in defining good management practices developed more tools to help boards implement good governance. Among these were guides outlining board, chief executive and staff responsibility for establishing policies. Organizations such as boardsource were founded to help build effective nonprofit boards by providing relevant information to the nonprofits and their boards.

Such efforts were capped last year when the IRS issued revised Form 990, which places significant focus on governance issues through the questions that nonprofits are required to answer. For example, Part VI of the core form is exclusively devoted to governance and policy questions. Many other areas of the form require policy-related information such as procedures for setting compensation levels, gift acceptance policies, procedures for tracking the use of grants, and much more.

Accountability

Donors want to know that the contributions they make are used appropriately. They assume that, if an organization is well governed, it’s also handling its resources responsibly. Donors, thus, are paying more attention to how the nonprofits they support are managed, as are lenders.

This has led states and the federal government to pay more attention to how organizations govern themselves. In 2004, the panel on the nonprofit sector was formed by independent sector, a nonpartisan leadership forum for charities, foundations and corporate giving programs.

The panel was created at the encouragement of the U.S. senate finance committee so that it could make recommendations to congress to improve the oversight of charitable organizations. Through the efforts of 24 nonprofit and philanthropic leaders, as well as several advisory groups, the panel has produced a series of recommendations for congress to improve the oversight and governance of charitable organizations.

Strong Governance

In response to the added stress on governance, some organizations have taken measures to strengthen management by their boards, staffs and others. For example, in 2001 the Red Cross formed a Governance Task Force composed of board members, management and outside experts to review that organization’s governance practices.

The resulting report, American Red Cross Governance for the 21st Century, asserted that a nonprofit’s governance must be considered in light of its mission, size, operation and culture, among other factors. The report recommended that nonprofits:

• Strengthen their board’s focus on strategy, policy, resources and general oversight,
• Place more detailed oversight responsibility on the executive committee,
• Put greater emphasis on skills and experience when selecting new board members, and
• Establish a governance committee.

The Red Cross defines “governance committee” as one that is responsible for overseeing executive compensation and board leadership. The board’s responsibility for governance is “to provide objective oversight of operations, set policy, monitor the organization’s plans, and delegate to management responsibility for running operations and executing policies and plans.”

Governance vs. Fundraising

This level of responsibility may be different from the duties many nonprofit board members are accustomed to — in particular, fundraising. As organizations establish separate governance committees, many are finding that board members with fundraising talents may lack governance skills. If this is true of your organization, consider establishing committees to address governance and fundraising separately. Some nonprofits establish fundraising advisory committees made up of nonboard members. This allows the board to maintain more independent oversight of fundraising activities because it’s not directly involved with them.

Board Responsibility

As a result of the increased emphasis on governance, nonprofit boards can no longer be just a “rubber stamp” for the decisions of the organization. Board members need to understand good governance and take the responsibility to ensure that their organization is adhering to best governance practices. This also may mean reorganizing the board so that representatives have the expertise to make sure good governance is in place. As an alternative, the board can engage outside experts to advise them in this area.

Thomas Schulte
Partner-in-Charge
Nonprofit Services Group

For more information about this article, click here to send Tom an email.

Excess Benefit Transactions

Don't let these happen to you!

By Michael Cantrill

One way to lose your nonprofit’s tax-exempt status (or for the individuals who control your organization to rack up excise tax penalties) is to ignore the private benefit and private inurement — ie., excess benefit — provisions of the Internal Revenue Code (IRC). These rules prohibit an individual inside or outside a nonprofit organization from reaping an excess benefit from a transaction involving the nonprofit organization. Excess benefits can take many forms, such as excessive compensation, favorable sales of assets, below-market property rental and lending money.

What’s at Risk

The official IRS stance is that any amount of private benefit or inurement in your organization is enough to cause the loss of your tax-exempt status. Although in practice the agency doesn’t strictly enforce this position, it’s important to remember that it can do so at any time. In practice, since 1994, Congress has provided the IRS with a series of ‘intermediate sanctions,’ penalties which the IRS can assess in lieu of the hammer blow of loss of exemption.

Those receiving an excess benefit — and any of the nonprofit organization’s managers and board members who willingly participated in the transaction — may be subject to intermediate sanction penalties. These penalties range from a minimum of 10% of the excess benefit for managers who knowingly participate (maximum of $20,000) up to 200% for the person receiving the benefit.

Excess Benefit Transactions

The concept of private benefit is easy to understand: It’s any payment or transfer of assets made (directly or indirectly) by your nonprofit that is beyond reasonable compensation for the services provided or the goods sold to your organization. It also includes compensation for services or products that don’t further the tax-exempt purpose of the nonprofit organization. If any of your net earnings inure to the benefit of any individual, the IRS won’t view your nonprofit as operating primarily to further its tax-exempt purpose.

The private inurement rules take the excess benefit transaction concept and extend it to all “insiders” of the organization. The term “insider” or “disqualified person” generally refers to any officer, director, individual or organization that is in a unique position to be able to exert significant influence over the nonprofit’s activities and finances. A violation happens when the approval of a transaction ultimately benefits the insider. An insider could include an insider’s family members or any organizations or businesses they control.

Of course, the rules do not prohibit all payments, such as salaries and wages, to an insider. They simply require that a payment be reasonable in relation to the services provided or the goods received — and that it be made with the nonprofit’s tax-exempt purpose in mind.

As a result, your organization should document its practices and procedures relating to any payments being made to insiders. This is to ensure that, upon an audit or inquiry, you would be able to show that there was a reasonable and valid exempt purpose for the transaction to have taken place.

Duty of Care

Duty of care is a related concept that requires board member understanding. It refers to a board member’s responsibility to act in good faith, in the nonprofit organization’s best interest, and with such care that proper inquiry, skill and diligence has been exercised in the performance of duties.

Remember, nonprofits are essentially stewards of the public’s money. So, board members carry a fiduciary responsibility to act with due care to safeguard assets until they can be spent for the organization’s tax-exempt purpose. This concept extends to all facets of the nonprofit and includes ensuring there are proper procedures in place to receive, hold and, ultimately, expend the assets for their proper purpose.

Clear Consequences

It is the duty of nonprofits and their boards to ensure their organizations’ resources are properly spent and safeguarded. A violation of this duty is most evident when an organization enters into an excess benefit transaction with an insider or an individual or organization outside of it.

The consequences of such a transaction can be devastating to the nonprofit, which may lose its tax-exempt status, to the individuals involved, who may be subject to significant excise tax penalties, and to everyone involved with the organization to the extent negative publicity enters the public awareness.

Because any violation of the excess benefit rules — no matter how small — can be enforced by the IRS, everyone in your organization needs to be intimately familiar with them.

Michael Cantrill
Director
Nonprofit Services Group

For more information about this article, click here to send Michael an email.

Excise Tax to Follow Madoff Ponzi Scheme?

More than 150 private foundations invested with Bernard Madoff, and their losses have forced several charities to close. But the effects of this investment travesty could live on.

The IRS is looking into whether excise taxes apply to private foundations and their board members who placed up to 100% of their portfolio assets with Madoff. These taxes would be based upon the Internal Revenue Code provision that excise taxes can be assessed on a private foundation and its board for making investments that jeopardize the charitable purpose.

William Josephson, former head of New York State’s Charities Bureau, told the U.S. Senate Finance Committee that it would make public policy sense to apply to public charities some of the additional restraints that already are on private foundations. This pertains to activities such as self-dealing, excess business holdings and jeopardy investments.

Similar discussions have come up in the Senate Finance Committee in the past. And in light of the recent scandal, greater regulation of charitable organizations’ investments is likely.

Selling Taxable Products

Does your charity sell products on an ongoing basis and, if so, does this create unrelated business income tax (UBIT) liability for your organization? As nonprofits increasingly search for extra revenue, this question becomes more relevant.

If the products you sell are created by the individuals that your organization serves, they generally are exempt from UBIT. For example, a nonprofit serves emotionally disabled children and, as part of their therapy, they create artwork that is sold. The sales proceeds are not taxable.

But if the product isn’t sold in substantially the same form as originally created, it could be subject to UBIT. For instance, if the artwork is used to make salable greeting cards, that income would be subject to the tax.

Generally, UBIT applies when the activity meets three conditions: 1) It’s a trade or business, 2) it’s regularly carried on, and 3) it doesn’t further the organization’s exempt purpose.

Employment Tax Warning

As nonprofits face budget crunches, some are trying to save payroll taxes and benefits expenses by treating individuals as independent contractors rather than employees. In light of large federal budget deficits, the IRS is looking more closely at this area to ensure that earnings are not escaping income and payroll taxes through underreporting.

In her remarks at the 2009 Georgetown Law CLE “Representing & Managing Tax-Exempt Organizations” conference in April, IRS counsel Catherine Livingston reminded participants that nonprofits are still required to withhold employment tax on pay to employees. You’ll “hear more from the Service on this issue,” she warned.