Government steps up regulation of groups with tax exemptions

The United States Congress and the Internal Revenue Service have expressed heightened interest in the regulation of tax-exempt organizations.

The IRS has taken action -- including revision of its Form 1023 ("Application for Recognition of Tax-Exemption") and its Form 990 (Annual Report) -- to include new disclosure requirements.

Congress has also passed legislation impacting organizations qualified under Section 501(c)(3) of the Internal Revenue Code (IRC), which deals with tax exemptions.

Recently, the IRS published a "draft" document entitled "Good Governance Practices for 501(c)(3) Organizations." That "draft" document "strongly recommends" adoption and implementation by 501(c)(3) organizations of several specific practices.

These practices, according to IRS officials' statements, are necessary for good governance and correlate to legal and regulatory compliance.

In addition to organizations applying for recognition of tax exemption, currently exempt organizations are well advised to act to adopt good governance practices.

The IRS has indicated that "any decision by the Service to conduct a review of the operations [of a tax-exempt organization] subsequent to exemption…will be influenced by whether an organization has voluntarily adopted good governance practices." The IRS "draft" document recommendations include:

1. Statement of purpose

Written statements of purpose and mission provided by a tax-exempt organization in its Application for Recognition of Tax-Exemption should be thoughtfully and clearly written.

This means, of course, that all submitted organizational documents including the Articles of Incorporation and Bylaws, the application's description of an organization's programs and activities, as well as attachments and appendixes to the application should be consistent in their description of purpose and mission.

The IRS will pay close attention to the information provided in the application in order to determine if the organization has been organized and is operated in furtherance of tax-exempt purposes, and to determine if a significant "public benefit" will be served. The IRS will also refer to it in subsequent examinations of organizational governance and activities.

2. Code of Ethics and 'whistle blower' policies

In general, the law known as Sarbanes-Oxley was not drafted to cover tax-exempt organizations. However, certain provisions within the law and its approach have found their way into IRS proposals and suggestions to ensure greater transparency and accountability for tax-exempt organizations.

The new IRS form Application for Recognition of Tax Exemption, for example, requests disclosures concerning an organization's written Code of Ethics and procedures for handling (and avoiding) conflicts of interest. Boards of directors are expected to review and assess this code and policy on a regular basis.

In addition, the IRS recommends that boards of directors adopt a specific policy for the handling of complaints by employees concerning possible financial impropriety or misuse of resources by a tax-exempt organization. These policies are sometimes referred to as "whistle blower" policies.

3. Duty of care

The IRS has indicated that in an examination of a tax-exempt organization, it will look for records indicating whether that organization's governing body has acted knowledgeably, reasonably and in good faith, with the care a prudent person in a like position would exercise in the same or similar circumstances, in carrying out its responsibilities.

This standard for governance action is not dissimilar from that embodied in state law pertaining to the fiduciary responsibility of members of boards of directors in carrying out their duties as directors.

The IRS has also stated that it will look to see if procedures are in place to ensure that:

• Members of the board of directors are in fact familiar with the charity's mission, finances and activities.
• That they understand the charity's financial status.
• And they are familiar with appropriate and sufficient information concerning the organization and its activities to ensure that it is acting in furtherance of its charitable purpose.

4. Duty of loyalty

A director must act in his or her capacity as a member of the board of directors for and in the interest of the tax-exempt organization. Directors are therefore to avoid conflicts of interest that may be detrimental to their organization and/or their duty.

For this purpose the IRS recommends that a formal Conflict of Interest policy be adopted, implemented and regularly assessed by the board.

In an examination of a tax-exempt organization, expect close scrutiny of records of action taken where a conflict of interest does or may exist.

5. Transparency

A tax-exempt organization's filings with the IRS are expected to be complete and accurate.

The IRS will look for evidence that an organization's board of directors has adopted and implemented procedures to ensure that.

In addition, in the interest of transparency, certain filings are to be posted on the organization's Web site or otherwise made available to the public upon request.

6. Fundraising

The IRS will pay closer attention to a tax-exempt organization's fundraising arrangements and activities.

While recognizing that fundraising is an important activity undertaken to support tax-exempt organizations and their missions, recent revelations and disclosures of abuse in this area have driven heightened scrutiny.

The IRS expects that boards of directors will regularly assess their organizations' fundraising and solicitation activities, and their compliance with federal and state requirements.

The IRS expects the board to act to ensure that solicitation materials are "accurate, truthful and candid".

In addition, the IRS will give increased attention to the percentage of costs incurred in fundraising activities in comparison to the funds actually raised.

Care should be taken in connection with retention of professional fundraising firms.

7. Stewardship

The IRS has restated a common law requirement that directors have a duty to protect a tax-exempt organization's resources from improper use, waste or loss.

The IRS will look for records that may show whether, and how, a charity's financial resources are used to further its tax-exempt purposes.

It will look for records indicating the board is familiar with the organization's financial status and activities, that it has adopted after appropriate deliberation annual budgets, and that an independent auditor conducts annual audits of finances of the organization.

It is recommended that boards establish an independent audit committee (with at least one member with pertinent expertise), to retain and review the work of the organization's independent auditor.

8. Compensation decisions

The IRS requires that compensation for services rendered by any individual to the tax-exempt organization be "reasonable" and appropriate.

In general, the IRS will view negatively decisions to pay individuals who provide services to the tax-exempt organization while also serving in a capacity that can influence that decision.

Compensation of directors and other "insiders" for services provided should be made after due and objective examination of the facts, without participation of individuals with a conflict of interest, and after consideration of "comparables." Records of the decisions and the decision making process should be kept.

9. Document retention policy

The IRS has recommended that a written document retention policy be adopted by a tax-exempt organization's board of directors.

That policy should contain protocols on document retention and destruction. The policy should also include provisions for the handling of electronic files, back-up procedures, and archiving of documents.

The IRS also suggests that the policy and its implementation be regularly reviewed and assessed.

Some of the above recommended practices may be new to some leaders of tax-exempt organizations. Leaders of such organizations, including those other than 501(c)(3) organizations, would do well to pay serious attention to them, and take action appropriate for their organizations.

Questions concerning these practices and their implementation should be discussed with legal counsel.

Saul N. Winsten is a shareholder in the law firm of DeWitt Ross & Stevens S.C. and works with tax-exempt organizations and their affiliates. He can be reached at 262-754-2852.