Good Governance Practices & 501(c)(3) Organizations by Jon Austin

The Internal Revenue Service has expressed concern in recent years about the growing trend of abuse within the non-profit sector and, in particular, with 501(c)(3) organizations (e.g., public charities and private foundations). Areas of concern include excessive compensation awarded to executives of these charitable organizations, as well as the use of charities for various means of tax avoidance (e.g., through self-dealing transactions between officers and/or directors and the charity). The privilege bestowed upon 501(c)(3) organizations to avoid paying certain taxes has unfortunately tempted some to use these organizations for their personal and private benefit.

An unfortunate, recent example involves one of the more noted tax-exempt organizations, the Smithsonian. This past spring, Lawrence M. Small, former chief executive of the Smithsonian, resigned amidst controversy over revelations as to his housing allowance, office and travel expenditures, and excessive compensation. In addition to a compensation package reportedly totaling in excess of $900,000 in 2007, Mr. Small reportedly spent over a hundred thousand dollars redecorating his office within the Smithsonian, in addition to having the Smithsonian routinely pay for his lavish perks such as chauffeurs, private jets and top-rated hotels. While it may be easy to point fingers at Mr. Small, ultimately the corporation's board of directors must be held accountable for their oversight, or lack thereof, as to the corporation's operations. Subsequent to Mr. Small's resignation, it was determined the Smithsonian's governing board failed to provide the necessary oversight both as to Mr. Small and the entire Smithsonian. In short, it was agreed steps would be implemented to ensure greater accountability by the board of directors, as well as various sub-committees, as to the Smithsonian's operations. Although it may seem extreme, this incident with the Smithsonian is but an example of this growing trend of abuse among tax-exempt organizations.

In light of this trend, the IRS will continue increasing its enforcement efforts concerning tax-exempt organizations and, in particular, 501(c)(3) organizations. As part of this effort, the IRS recently issued a set of voluntary guidelines known as "Good Governance Practices for 501(c)(3) Organizations." Although the IRS lacks the authority to impose mandatory governance standards, the "strongly recommended" guidelines are meant to "help ensure that directors [of charitable organizations] understand their roles and responsibilities and actively promote good governance practices." The IRS reminds us that merely adopting these policies, in part or in whole, is not a requirement for obtaining exemption. However, "an organization that adopts some or all of these practices is more likely to be successful in pursuing its exempt purposes and earning public support." In addition, any decision by the IRS to review the operations of a charity "will be influenced by whether [the] organization has voluntarily adopted good governance practices."

The practices a tax-exempt organization implements will depend on its size as well as the composition of the board of directors. However, the IRS recommends each organization reviews and considers adopting the following good governance practices. To read the actual suggested policies, please go to http://www.irs.gov/pub/irs-tege/good_governance_practices.pdf.

Mission Statement. This is more than what is in the organization's governing documents, such as the certificate of incorporation and/or bylaws. Rather, the organization should consider adopting a mission statement that clearly articulates its purpose and which will serve as a guide for its work. In short, it should show "why the charity exists, what it hopes to accomplish, and what activities it will undertake, where, and for whom." Among other things, one of the benefits of having a mission statement is that it gives the board a standard with which to compare the charity's actual practices on a regular basis. The board can then ask itself if the charity's practices need to change to conform to the mission statement or if the statement needs to be revisited.

Code of Ethics. Charities are expected to promote the public good and part of that includes maintaining high ethical standards throughout the organization. As such, the board should consider adopting a policy which promotes a "strong culture of legal compliance and ethical integrity." Part of this should include the adoption of a "whistleblower policy." A proper whistleblower policy should address how to handle employee complaints, as well as "procedures for employees to report in confidence suspected financial impropriety or misuse of charity's resources." As a note of caution, a policy is generally only worthwhile if it is enforced. In fact, to have a policy and not follow it could possibly be more problematic than not having one at all, which is an admonition for adoption and faithful enforcement and not an excuse for declining to adopt this or any other policy.

Due Diligence. The board of directors has a duty of care to act "in good faith; with the care an ordinarily prudent person in a like position would exercise under similar circumstances; [and] in a manner the director reasonably believes to be in the charity's best interest." This includes, among other things, ensuring the directors are "familiar with the charity's activities and knows whether those activities promote the charity's mission." It also means the directors have sufficient and accurate knowledge to make informed decisions, and are fully informed regarding the charity's financial status.

Duty of Loyalty. In short, the directors must "act in the [best] interest of the charity rather than in the personal interest of the director or some other person or organization." More specifically, directors should avoid conflicts of interest with the charity they serve. A practical means of ensuring compliance is the adoption of a conflict of interest policy. As previously noted, however, if the board adopts a conflict of interest policy, the board must diligently follow it. A conflict of interest policy also aids in ensuring compliance with the "code of ethics" discussed above.

Transparency. Tax-exempt organizations need to make full and accurate disclosure of all documents related to the charity's organization and operations. This can be accomplished by posting such documents on their website or making them readily available to the public upon request. Another alternative is to utilize a third party (such as Guidestar.org) to assist you in making your relevant information available to the public.

Fundraising Policy. Most charities derive their financial support through fundraising. As such, directors should consider adopting policies to "ensure that fundraising solicitations meet federal and state law requirements and solicitation materials are accurate, truthful, and candid." Unless they fall under a particular exemption, most states require charitable organizations to register with some state agency (e.g., the Secretary of State). Therefore, at a minimum, charitable organizations need to ensure they are properly registered in their state of organization. In addition, organizations soliciting in more than one state (for example, through the use of a website) may need to consider, although tedious, registering in every state, or at least checking on their particular requirements. Another important reminder is for organizations to indicate clearly how donated funds will be used and then ensure they actually use the funds as promised. In other words, do not indicate the funds will be used for X, but then turn around (whether purposefully or not) and use the funds to accomplish Y.

Financial Audits. Charitable organizations "should operate in accordance with an annual budget approved by the board of directors." As previously discussed, this requires the board of directors to be active in reviewing the organization's financial statements and ensuring the funds they have received are being used to further the charity's exempt purposes. For organizations with substantial assets or revenues, the IRS also suggests using an independent auditor to conduct annual audits. If possible, it is also recommended that the auditor is periodically changed to ensure a "fresh look at the financial statements." For smaller organizations, an independent certified public accountant should be used to conduct an annual audit.

Compensation Procedures. The IRS suggests board members should not be compensated for services, except "to reimburse direct expenses of such service." If they are compensated, their compensation should be determined by an independent committee who are not compensated and have no financial interest in the determination. Finally, and perhaps most importantly, charities may pay reasonable compensation to their officers and other staff. In short, reasonable compensation is an amount ordinarily paid for similar services by a similar enterprise and under similar circumstances. This can be accomplished, among other ways, by reviewing independent surveys of appropriate comparability data to determine salaries. An independent committee, which could be the board of directors or a separate sub-committee, with no conflicts of interest as to the outcome should review the data and make the determination for compensating officers.

Document Retention Policy. Last, but not least, charities need to consider "establishing standards for document integrity, retention, and destruction." This should include guidelines for handling electronic files. Again, having this policy and not following it, or following it intermittently, can be more problematic than not having one at all. From the top to the bottom, everyone associated with the charity should know the retention policy.

As previously noted, these good governance practices are not law, but rather suggestions. Although most are reasonable, some are more problematic in actual implementation. As noted on their website, the IRS does seem to acknowledge there are "no bright lines" and the "implementation of a particular practice must be tailored to the organization."4 In addition, it is unclear what will transpire if a charity does not follow these suggestions. It is important to note the IRS has recently revised both Form 1023, the charity's application for tax exemption, and Form 990, the charity's annual report, to include questions aimed at these suggested policies. Until it becomes clearer, it seems prudent for organizations to review and consider these policies to determine how they can be implemented to effectively accomplish their intended purposes within their organization.

Whether it is a public charity or a private foundation, 501(c)(3) organizations have a great privilege in not having to pay certain taxes; with that privilege comes great responsibility. Part of the responsibility of serving as a director of a charitable organization is understanding the money contributed to the charity you serve does not belong to you, but rather is now held in trust for the benefit of the public. With that perspective in mind, directors should take very seriously their obligation to the public to manage and expend the funds in their trust for truly charitable purposes. Adhering to these good governance practices is an important step in the right direction as charities fulfill their responsibility as stewards of the resources given them for the public good they accomplish.

1See, e.g., Jacqueline Prescott and James V. Grimaldi, Smithsonian's Small Quits in Wake of Inquiry, March 27, 2007 (last visited November 13, 2007) <http://www.washingtonpost.com...>; Elizabeth Sloan, Embattled Smithsonian Official Resigns, March 27, 2007 (last visited November 13, 2007) <http://www.nytimes.com/2007/03/27/arts/27museum.html?...>; Robin Pogrebin, Report Faults Oversight By Smithsonian Regents, June 19, 2007 (last visited November 13, 2007) <http://www.nytimes.com/2007/06/19/arts/design/19smit.html?...>.

2Internal Revenue Service, Good Governance Practices for 501(c)(3) Organizations [Draft], February 2, 2007 (last visited November 13, 2007) http://www.irs.gov/pub/irs-tege/good_governance_practices.pdf. Unless otherwise indicated, any quotes within this article are taken directly from here.

3For a sample conflict of interest policy, see Appendix A to the Form 1023 Instructions.

4See http://www.irs.gov/charities/charitable/article/0,,id=167626,00.html.