Quick Action Needed by Nonprofits to Answer IRS Good Governance Questions

May 7, 2008

The IRS is serious about good governance for nonprofits – especially Section 501(c)(3) charities. In late April, 2008, the head of the IRS division responsible for charities and nonprofits said the IRS will continue to “educate, engage and indeed irritate” in the area of governance. These comments follow a February, 2008 IRS Report outlining good governance policies and practices for Section 501(c)(3) charities. The IRS Report reflects a number of recommendations found in the October, 2007 Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations by the Panel on the Nonprofit Sector.

The IRS’ good governance recommendations have teeth. The new IRS Form 990 requires nonprofits (charities, trade associations, chambers of commerce and private clubs) filing that form to disclose governance practices. Most smaller nonprofits with under $1,000,000 of gross receipts and less than $2,500,000 in assets (and that file Form 990-EZ or 990-N) and private foundations (that file Form 990-PF) do not currently face these disclosure requirements.

Nonprofits that file a Form 990 showing weak governance practices will be more likely to face audits. And nonprofits (even those that do not have to disclose governance practices on a Form 990) with weak governance practices should, if audited, expect stricter scrutiny. In light of the IRS’ emphasis on governance, all nonprofits should review their governance policies and procedures. The IRS Report and the Nonprofit Panel’s Principles are excellent resources for governance best practices. The IRS Report can be found at http://www.irs.gov/pub/irs-tege/governance_practices.pdf. The Panel on the Nonprofit Sector’s Principles can be found at www.nonprofitpanel.org.

Following is a short summary of some of the governance practices (in the form of policies and procedures) identified on the new Form 990. Nonprofits that want their Form 990 to show these practices are in place will need to act soon. A nonprofit considering new governance practices should keep the following three points in mind. First, if a governance policy is adopted, it needs to be followed. More trouble will result from a policy that is not followed than from the lack of a policy. Second, nonprofit governance standards are rapidly evolving, so be prepared for further developments. Third, certain types of nonprofits (such as hospitals and schools) will need additional policies.

Governance Policies

Conflicts of Interest Policy. Nothing draws scrutiny like a conflict of interest. For over a decade, the IRS has encouraged charities to adopt a Conflicts of Interest Policy to assist in properly addressing conflicts of interest. The IRS has even published a model Conflicts of Interest Policy. The new Form 990 asks if nonprofits have adopted a Conflicts of Interest Policy. According to the IRS, a conflict of interest arises when a person in a position of authority (such as a director, officer or key employee) with respect to the nonprofit may benefit financially from a decision he or she could make, including indirect benefits to family members and businesses with which the person is closely associated. The new Form 990 also asks about family and business relationships among those in authority, the disclosure of potential conflicts of interest, and the enforcement of the Conflicts of Interest Policy.

To answer the new Form 990’s questions about conflicts of interest, nonprofits will need to annually distribute a Conflicts Questionnaire that reminds directors, officers and key employees about the Conflicts of Interest Policy and asks about business and family relationships that might give rise to a conflict of interest.

Whistleblower Policy. The new Form 990 asks if nonprofits have a written Whistleblower Policy. A Whistleblower Policy can help the Board and management proactively address problems and comply with legal protections for whistleblowers. A Whistleblower Policy encourages employees and volunteers to come forward with credible information on financial improprieties, illegal practices or violation of the nonprofit’s policies, specifies that the nonprofit will protect from retaliation those who make good-faith reports, and identifies how a whistleblower should report information. Nonprofits should also have procedures to investigate and take appropriate action in the event of a whistleblower report.

Document Retention Policy. A third policy identified by the new Form 990 is a written Document Retention and Destruction Policy. A Document Retention and Destruction Policy identifies the responsibilities of employees, volunteers, Board members, and outsiders to maintain and document the storage and destruction of the nonprofit’s documents and records. The Board, staff and volunteers should be familiar with the Document Retention and Destruction Policy. A Document Retention and Destruction Policy will assist in demonstrating compliance with the various rules governing the retention and destruction of business records.

Joint Venture Policy. The new Form 990 asks if a nonprofit that engages in joint ventures with individuals or for profit businesses has a policy to safeguard the nonprofit’s tax-exempt status. Examples of safeguards expected by the IRS include: control over the joint venture sufficient to assure that the venture furthers the exempt purpose of the nonprofit; requirements that the venture give priority to exempt purposes over maximizing profits for the other participants; that the venture not engage in activities that would jeopardize the nonprofit’s tax-exemption; and that all contracts entered into between the venture and the nonprofit be on terms that are at least arm’s length. These safeguards are of special importance for charities.

Other Policies. In addition to the policies specifically mentioned on the new Form 990, the IRS and the Nonprofit Panel recommend adoption of a number of policies such as an Ethics Policy, an Investment Policy, an Expense Reimbursement Policy and a Gift Acceptance Policy. Nonprofits should consider the need for these additional policies.

Governance Procedures

Governing Board Independence. The IRS views an engaged and independent Board as key to effective governance. The Form 990 asks about Board size and the number of Board members who are financially independent from the nonprofit. While there is no “correct” Board size, a Board that is too large or too small may raise a question about the Board’s ability to effectively govern the nonprofit.

A Board member is financially independent from the nonprofit if he or she, either directly or through a family member or a business, is not compensated by or does not receive material benefits from the nonprofit or a related organization. (The Nonprofit Panel recommends that at least two-thirds of a charity’s Board be independent.) Financial independence is not lost because a Board member receives reasonable Board fees and the reimbursement of expenses, receives a limited amount of compensation from the nonprofit as an independent contractor, is a major donor to the nonprofit, or receives benefits from the nonprofit on the same basis as the nonprofit generally provides to others.

Executive Compensation. For several years, the IRS has closely examined executive compensation. The IRS wants nonprofits to follow the process set out in the Intermediate Sanctions Rules when establishing compensation for directors, officers and key employees. This process involves a review and approval of the compensation by independent members of the Board or a Board committee, use of objective comparability data, and contemporaneous substantiation of the deliberations and decisions. The new Form 990 asks if this process was followed and for a narrative of the process. The new Form 990 also asks about arrangements with directors, officers and key employees that are likely to draw extra scrutiny, such as loans, grants, business transactions, and special perquisites.

Minutes. The new Form 990 asks if the nonprofit contemporaneously documents meetings of the Board and Board committees. According to the IRS, documentation can take the form of minutes, email strings or similar writings. The IRS says documentation should include the actions taken, when the actions were taken and who made the decision. The IRS views documentation as contemporaneous if it is drafted by the later of the next meeting or 60 days after the meeting. Well drafted minutes can provide a nonprofit with invaluable protection in the event of an audit. On the other hand, the absence of minutes or poorly drafted minutes can cause real problems.

Financial Transparency. The new Form 990 asks several questions about the nonprofit’s financial transparency. Some of the questions include whether financial statements are reviewed or audited by an independent auditor, whether independent Board members select and oversee the independent auditor, the review of the Form 990 by the Board or a Board committee prior to its filing, and the public disclosure of the Form 990 and financial statements.

The good governance standards identified by the IRS and the Nonprofit Panel represent best governance practices. These standards are likely to quickly move from “recommendations” to expectations. It is important to remember that the Form 990 is publicly available and easily accessible on Guidestar.org. Failure by nonprofits – especially charities – to follow best governance practices not only heightens the risk and severity of an IRS audit, but may also raise questions by regulators (such as the Ohio Attorney General), donors and the press.

Nonprofits should act this year to review current best governance practices and work with their professional advisers to determine appropriate governance practices for adoption. Action now will help avoid “irritating” attention later from the IRS and others.

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