A troubled recipe for nonprofits: equal parts Congress, Sarbanes-Oxley, U.S. Treasury Department, the IRS, and Bankruptcy

RMA Journal, The, March, 2007 by Gerald L. Blanchard

THE WORLD OF NONPROFITS, churches, and other faith-based organizations has come under a great deal of scrutiny by Congress, the IRS, and the U.S. Treasury Department for everything from abuse of tax-exempt status to issues of corporate governance, and anti-terrorist financing. Clearly, government entities have become more aware of just how large the nonprofit sector has become. More than 1.8 million tax-exempt organizations in the U.S. today control assets of more than $3 trillion and have expenditures of $1 billion. Over two-thirds of all 501(c)(3) organizations have less than $25,000 in gross receipts and represent everything from the school/parent/ teacher organizations to local sports leagues. Another, more visible reason for the scrutiny are several high-profile cases of executive mismanagement and alleged diversion of charitable donations to support terrorist activities.

Coporate Governance Issues

There was a great deal of speculation following the passage of the Sarbanes-Oxley Act (SOX) that Congress would move to push down the corporate governance reforms to the world of nonprofits. In fact, two SOX provisions--whistle-blower protection and the retention of documents--do apply to nonprofits. So far, Congress has not pushed down provisions dealing with independent audit committees, rotation of auditors, and other matters related to increased scrutiny of financial dealings, at least not in a direct fashion, as will be explained later.

Typically, industries that come under congressional scrutiny have a choice of approaches to countering potential governmental intrusion:

* The "burnt earth" approach--simply fight any possible regulation every step of the way, support sympathetic representatives and senators, and actively work for the defeat of those who support the regulations.

* Get there first--seek to control the debate by proposing reasonable regulations and generally show an active interest in self-policing the industry.

The Independent Sector, a coalition of over 500 nonprofit organizations, reacted to the increased scrutiny by issuing a report to Congress in 2005. Two key findings of the report are as follows:

* Independence is integral to the success of the nonprofit sector. People donate time and money to nonprofits because they are not government run and controlled.

* Integrity and credibility are essential to nonprofits' ability to continue to raise funds and successfully carry out their mandate.

To those ends, the Independent Sector recommended the following:

1. Every nonprofit board should regularly review the very reason for the nonprofit's existence.

2. Organizations with more than $1 million in revenue should have audited financial statements. An independent CPA should review financial statements of organizations with less than $1 million but more than $250,000.

3. Organizations should provide detailed information about their programs, including the methods used to evaluate their outcomes.

4. Board members of charitable organizations should generally not be paid. In those situations where compensation is awarded, the organization should review the salaries being paid by its peers.

5. Boards should review executive compensation annually.

6. Boards should have at least three members.

7. Boards should maintain a conflicts-of-interest policy.

8. Whether required by law or not, every nonprofit that has its financial statements independently audited should consider having a separate audit committee.

The Independent Sector also made numerous recommendations for changes to the tax code to address self-dealing abuses involving foundations.

Congress reacted by adopting most, if not all, of the recommended tax-code changes, discussed later in this article. What happened to the rest of the recommendations? Congress took no action on any of them. Instead, the U.S. Treasury came out with the "U.S. Treasury Anti-Terrorist Financing Guidelines: Voluntary Best Practices." While dealing with anti-terrorist financing might seem to be within the purview of the Treasury Department, the first several pages of the guidelines contain recommendations dealing with corporate governance for nonprofits. The guidelines first acknowledge that charities in the U.S. are fully independent of the government. They go on to recommend that nonprofits adopt practices over and above minimal legal requirements to assure their contributors that assets are being used for charitable purposes, and that boards should be independent and actively engaged in the oversight of the entity. The first draft of the guidelines suggested that boards have at least three members, but the final version did not include that recommendation.

The guidelines suggest the following additional financial accountability items:

* The board should appoint one individual to serve as the financial/accounting officer, who should be responsible for day-to-day control over the charity's assets.

* The charity should adopt a budget on an annual basis.

* If total gross income exceeds $250,000, the board should hire an independent CPA to audit the organization's finances and to publicly issue the audit on an annual basis.