The introduction of new federal exempt organization oversight legislation took a step closer to reality with the June 22, 2005 release of a Final Report presented by the Panel on the Nonprofit Sector ("the Panel") to the U.S. Senate Finance Committee. Entitled "Strengthening Transparency, Governance and Accountability of Charitable Organizations," the Report contains 15 categories of oversight recommendations for the Finance Committee's consideration.
The Panel is an independent effort by charities and foundations that was formed by the Independent Sector in October 2004 at the encouragement of the Senate Finance Committee. The role of the Panel is to prepare recommendations for Congress to improve the oversight and governance of exempt organizations. The recommendations of the Panel are, of course, non-binding upon the Committee, but Chairman Sen. Charles F. Grassley has indicated that the Committee will closely consider the Panel's work as it crafts a related legislative proposal, which he expects to introduce later this summer.
The recommendations contained in the Final Report are likely of significance to most exempt organizations in that they address many fundamental governance and operational issues. If converted into legislation, the recommendations have great potential for influencing the manner in which exempt organizations govern themselves and preserve their federal tax-exempt status. In its recommendations, the Final Report addresses suggestions set forth in the Senate Finance Committee staff discussion draft released last year. The topics covered in the Final Report, and highlights of the specific recommendations, are set forth below:
1. Federal and State Enforcement
- Resources allocated to the IRS for tax enforcement and exempt organization oversight should be increased.
- A federally funded program should be created to help states increase oversight and education of exempt organizations.
- The IRS should be permitted to share information on exempt organization investigations with state officials.
2. IRS Reporting
- The IRS should revise the Form 990 and Form 990-PF to provide additional information concerning such matters as independence of board members, identity of grantees, conflict of interest policies, travel policies, and if applicable, type of supporting organization. More specific recommendations on form revisions will be presented in coming months.
- An exempt organization's highest ranking officer should be required to sign the organization's Form 990 or 990-PF and certify its correctness and completeness under penalties of perjury. The organization's board or appropriate committee should also review the Form 990 or 990-PF annually.
- Exempt organizations with annual gross receipts of $25,000 or less, which do not now need to file a Form 990, should be required to file a brief annual report with the IRS and should have their exempt status suspended if they do not file the required report for three consecutive years.
- An organization that does not correct inaccurate or incomplete returns for two consecutive years should have its exempt status suspended.
3. Periodic Review of Tax-exempt Status
- Contrary to the suggestion set forth in the Senate Finance Committee staff discussion draft, exempt organizations should not be required to have the IRS review their exempt status every five years. However, boards of exempt organizations should be encouraged to fully review their governing documents, key financial transactions, programmatic activities, and compensation and conflict of interest policies at least every five years.
4. Financial Audits and Reviews
- Financial statements of exempt organizations should be prepared in accordance with GAAP.
- Exempt organizations with at least $1 million in annual revenues should conduct an audit with audited financial statements attached to the Form 990 series return.
- Audited financial statements should be made available to the public in the same way they are filed with the IRS.
5. Disclosure of Performance Data
- As a best practice, exempt organizations should provide detailed information about their programs, including methods used to evaluate outcomes.
- Annual Reports, websites and other means are possible sources for providing such information.
6. Donor-Advised Funds (DAFs)
- "Donor-advised fund" should be defined by law.
- A sponsoring charity should have to distribute annually (across all its DAFs) 5% of the assets it holds in all DAFs at the end of the prior year.
- If a DAF is dormant for 3 years (no advice is received and no distributions are made), the sponsoring charity should have to distribute 20% of that DAF to its own unrestricted account or to other charities. After five years of inactivity, the sponsoring charity should be required to terminate advisory privileges for that DAF.
- Sponsoring charities should be required to disclose on Form 990 the total number of DAFs owned as well as the total value of the DAFs and the total contributions to and grants from the DAFs for the year.
- Grants from DAFs to private non-operating foundations or to organizations controlled by the donor should be prohibited.
- Donors should be prohibited from receiving any substantial benefit in connection with a grant recommendation, and grants, loans or other payments from a DAF that would benefit a donor or related parties should be prohibited. Excise taxes should be imposed on donors and the managers of sponsoring charities for violations of these prohibitions.
- A written agreement between the donor and the sponsoring charity confirming the charity’s legal control and the prohibition on benefits to the donor should be required in order for the donor to receive a charitable deduction. Further, donors and grant recipients should have to certify in writing each time a recommended distribution is made that the donor received no benefit.
7. Type III Supporting Organizations
- Contrary to the position the Senate Finance Committee staff took in its discussion draft, the Nonprofit Panel does not recommend eliminating Type III SOs.
- Instead, a Type III SO should be required to make annual distributions to its supported organizations equal to 5% of its net assets and to give its supported organizations copies of its governing documents, Form 990s and an annual report of its activities (including a description of the support provided, how it was calculated and a projection of support for the next year).
- Type III SOs should be prohibited from supporting more than 5 organizations or any organization that is controlled by the donor. Further, grants, loans or other payments from a Type III SO that benefit a donor or related parties should be prohibited.
- Type III SOs should be required to attach letters to Form 1023 and annual Form 990s from each supported organization verifying that the organization agrees to be supported and describing how it is supported.
8. Abusive Tax Shelters
- Congress and the IRS should provide guidance for exempt organizations intending to participate in reportable tax shelter transactions.
- Taxable participants and material advisors to a reportable transaction must notify exempt organization participants that they would be engaging in a reportable transaction.
- Exempt organizations participating in abusive tax shelters should be subject to sanctions.
9. Non-Cash Contributions
- Standards for "qualified appraisals" should be strengthened and penalties for improper valuations should be made tougher rather than limiting tax deductions to basis.
- A "qualified appraiser" should be defined as an individual who has earned an appraisal designation from a recognized professional organization, who regularly performs appraisals for compensation and who can verify experience in valuing the specific type of property being appraised.
- Qualified appraisals for real estate claimed to have a value over $100,000 should be prepared only by state general certified real estate appraisers in accordance with USPAP standards.
- If the claimed value of the donated property exceeds the correct value by 50% or more, new or expanded penalties should be imposed on both the taxpayer and the appraiser.
10. Board Compensation
- While board members should be encouraged to provide their services to exempt organizations on a volunteer basis, organizations should not be prohibited or restricted in their ability to provide reasonable compensation to board members.
- Board members who receive excessive compensation should be subject to the same penalties as apply to officers and other key employees who receive unreasonable compensation.
- The IRS should revise Form 990 to require more clearly the complete disclosure of all compensation paid to board members, together with a description of duties provided by compensated board members.
- Loans to board members should be prohibited.
11. Executive Compensation
- Board members who review and approve executive compensation should be liable for intermediate sanctions or self-dealing excise taxes if they "should have known" that the approved transaction was improper. One way to show the required diligence under this standard would be to satisfy all the steps necessary to qualify for the "rebuttable presumption of reasonableness" under the intermediate sanctions rules.
- The penalties on foundation executives who receive excessive compensation should be increased significantly.
- The cap on the excise tax applicable to board members (of a 501(c)(3) or 501(c)(4) organization) who approve an excess benefit transaction should be $20,000 rather than $10,000.
- The IRS should revise Form 990 to require more thorough descriptions of all forms of compensation and benefits provided to officers and key employees, as well as to disclose whether the organization followed the "rebuttable presumption of reasonableness" procedures in determining the reasonableness of the CEO's compensation.
- If the board relies on a compensation consultant to evaluate the CEO's compensation, the consultant should be independent and should be engaged by, and should report to, the board (or a committee of the board).
- Exempt organizations should continue to be permitted to rely on compensation data from comparable taxable organizations.
12. Travel Expenses
- Exempt organizations should establish travel expense policies that provide clear guidance on reimbursement of expenses, and the IRS should require organizations to disclose on the Form 990 whether they have a travel policy.
- With exceptions for de minimis expenses, spouse travel expenses should not be reimbursed or paid for by exempt organizations (even if they would be treated as taxable income to the employee or board member).
- While travel expenses must not be lavish or extravagant, the amounts reimbursed by exempt organizations also should not be limited to the federal government per diem rates.
- The IRS should provide guidelines on prohibited travel expenses and what should be reported as taxable income.
13. Structure, Size, Composition and Independence of Governing Boards
- A 501(c)(3) organization should have a minimum of three directors.
- At least one-third of the board members of a public charity should be "independent" according to a specific definition.
- The names of the independent board members must be disclosed on the Form 990 series return.
- Individuals barred from service on corporate boards or convicted of crimes related to breach of fiduciary duty should be barred from board service on charities.
- While there should be no legal maximum size of a governing board, each exempt organization should periodically review its board size for appropriateness.
- Exempt organizations should establish strong governance oversight and education practices.
14. Audit Committees
- The governing boards of exempt organizations should include individuals with some financial literacy.
- Every exempt organization with independently audited financial statements should consider establishing a separate audit committee.
- If the governing board lacks sufficient financial literacy it may form an audit committee comprised of non-staff advisors who are not board members.
15. Conflict of Interest and Misconduct
- IRS is encouraged to revise Form 990 to require disclosure of whether an exempt organization has a conflict of interest policy.
- As a best practice, exempt organizations should adopt a conflict of interest policy tailored to state law and their specific needs.
- Exempt organizations should adopt policies and procedures that encourage whistleblowers to report illegal practices and violations of conflict of interest policy.
McDermott attorneys Douglas M. Mancino and Michael W. Peregrine provided assistance to the Panel in the preparation of the Final Report.
For further information on the Phase II recommendations, or the work of the Panel generally, please go to the Panel's website at www.NonProfitpanel.org, or contact your regular McDermott Will & Emery LLP attorney or any of the attorneys listed.