Whats the Big Deal? The Big Deal is Governance

What’s the Big Deal?

The Big Deal is Governance

By Jennifer Chandler Hauge

 width=Whoa! What’s happening? The IRS has just thrown its biggest punch in over 30 years. Is your nonprofit ready to take the hit?

With a quick one-two punch, the IRS has just stepped into the ring. Egged on by Congress, amidst a media-fueled public outcry, the IRS has acknowledged that the enforcement efforts of the past have simply not been sufficient to keep wayward nonprofits and self-serving board members in line. As a result, the IRS is mixing up its punches. First, the IRS has completely revised the annual financial reporting form. The new IRS Form 990, complete with its proposed instructions demands a very detailed picture of, among other governance practices, a nonprofit’s compensation practices, board member relationships and how boards conduct themselves in conflict of interest situations. Next, the IRS released final regulations on intermediate sanctions, clarifying what it views as private benefit and the penalties imposed when excessive compensation is paid to CEOs and board members and also when charities allow individuals or for-profit entities to take advantage of their tax exempt status. And just to clarify that it is serious about enforcement, the IRS has announced a complaint process so that the public can report compliance concerns directly to the IRS. The IRS is sending a clear signal that nonprofit boards are being watched.

As boards are being challenged to rethink governance, every nonprofit board should be thinking, “How are we demonstrating good governance practices?” and “How are we communicating what we are doing so that donors and the public are reassured?”

Focusing on the second half of this query—how a nonprofit’s governance practices are communicated—is prudent risk management. At a recent gathering of lawyers who represent tax-exempt organizations, Steven T. Miller, Commissioner of the IRS’s tax-exempt and government-entities division, explained that IRS investigations generally stem from responses on the 990 annual returns. On the new IRS Form 990, if a nonprofit answers “no” in response to various questions in Part VI relating to whether the nonprofit has a certain governance policy or practice, that ‘no’ response will be a trigger for heightened scrutiny which could lead to an IRS “compliance check” investigation or an audit. Similarly, if the nonprofit answers ‘yes’ but does not adequately explain how the policy is put in practice, the nonprofit leaves itself open not only for public questioning, but also for further scrutiny by the IRS. To many reading the form, the explanation of these governance practices will be as important as the numbers and names, and description of the nonprofit’s mission and its charitable activities.

What Governance Practices Should Be Clearly Communicated?

Enlightened boards recognize that risk management runs through everything they do, from approving next year’s budget to identifying future board leaders. They also realize that sound risk management starts with good governance practices. So for those boards that are seeking enlightenment, what should be on the ‘to do’ list?

Your Board’s ‘To Do’ List Should Include These Governance Practices:

  • Review of Mission. According to the instructions to the New 990, (Part 1, Line 1) the organization’s reported “mission statement” should establish “why the organization exists, what it hopes to accomplish, who it intends to serve, and what activities it will undertake and where.” Does your nonprofit’s current mission statement communicate all those elements? If not, make sure that the mission and purpose reflected on the new 990 is expansive enough to answer the questions above.
  • Review of Executive Compensation. Steve Miller, the IRS Commissioner with oversight for exempt organizations and government entities, likes to use the phrase, “climate of transparency” when speaking of executive compensation. The New 990 requires full disclosure of the process the nonprofit uses to determine appropriate compensation. The instructions to Part VI, Line 15 of the New 990 outline the three critical steps boards are expected to take when reviewing and approving compensation for senior staff and any insiders (such as board members) who are compensated. Those steps are: (1) review and approval by the governing body or compensation committee of the compensation for any person who is a top manager of the nonprofit (and arguably any outside contractor or vendor who is paid significant compensation); (2) review of “comparable compensation” data for “similarly qualified persons in functionally comparable positions” at “similarly situated organizations”; and (3) “contemporaneous documentation and recordkeeping with respect to the deliberations and decisions regarding the compensation arrangement.” These three steps are the procedures the IRS will expect all boards to follow whenever compensation to senior managers or board members is approved.
  • Review of the Annual Form 990. The New 990, (Part VI, Line 10) expects nonprofits to disclose whether or not the board reviewed the 990 prior to filing, and to describe in Schedule O the procedure that the board follows to review the IRS Form 990, regardless of whether the board reviewed the 990 before or after filing. The instructions clarify that the description should include who reviewed the form, when it was reviewed, and “the extent” of any review. Note that if no review by the board was conducted, a big fat “No” will dance across the page, calling into question the board’s involvement (or lack of) in financial oversight of the nonprofit.
  • Review of Board Composition and Board Relationships. In a clear effort to increase the transparency of board operations, the New 990 ventures into territory that was previously uncharted by requiring nonprofits to disclose business and family relationships among and between members of the organization’s governing body. If such relationships exist, the nonprofit must respond, “Yes” in Part VI, Line 2, and then explain the details of the relationship on Schedule O. The instructions to Line 2 permit the nonprofit to disclose merely “family relationship” or “business relationship” without any more detail. However to answer this question nonprofits will have to become more conscious of relationships between trustees/directors and the disclosure of such relationships may result in challenges to the objectivity of the board’s operations.
  • Adoption of a Conflict of Interest Policy and Active Review of All Conflict Situations. In addition to disclosing whether or not the nonprofit has a written conflict of interest policy, the instructions to the New 990 (Part VI, Line 12c) direct nonprofits to explain in Schedule O how the organization monitors conflict situations and the process used to determine who may have a conflict. The description of how the nonprofit manages conflicts should include an explanation of how recent conflicts were disclosed at board meetings and what happened, such as whether the person with the conflict participated in any discussions or decisions about the transaction in question. This reporting requirement mandates that all boards become more diligent about recording the details of conflict discussions in board meeting minutes. Complete disclosure on the 990 will require such details as who had the conflict, who recused themselves and who voted. As a result, just reading Schedule O will provide a succinct testimonial of whether a nonprofit is handling conflicts of interest appropriately.
  • Confirm Compliance with Public Disclosure Requirements. Tax-exempt organizations are required to publicly disclose, upon request, their three most recently filed Form 990s and 990-Ts and the organization’s application for tax-exemption, with related correspondence. The New 990 asks not only whether the nonprofit has complied with this requirement but also whether the nonprofit makes other documents, such as the organization’s financial statements and conflict of interest policy, publicly available. The instructions to Part VI, Line 18 and 19 acknowledge that not all these documents are required to be disclosed, but directs nonprofits to explain on Schedule O whether and how such documents are made available to the public. If the nonprofit reports that such documents are not made publicly available, that may irritate some watchdogs and put pressure on the nonprofit to be more transparent.

The governance practices described above are only some of the prudent risk management steps that compliance with the new 990 will encourage, if not require. Others include:

  • Adoption of a whistleblower protection policy;
  • Adoption of a document retention and destruction policy;
  • Adoption of a gift acceptance policy;
  • Review of contracts or agreements with independent contractors, consultants and affiliated organizations (such as chapters).
May file 990-EZ for: If gross receipts are: If assets are:
2008 tax year (filed in 2009) > $25,000 and < $1 million < $2.5 million
2009 tax year (filed in 2010) > $25,000 and < $500,000 < $1.25 million
2010 and later tax years > $50,000 and < $200,000 < $500,000

If your nonprofit is not quite readsy to take a hit from the IRS on any of these practices, there is still time to get your governance practices in shape. Exempt organizations will begin using the new 990 for the 2008 tax year (which will be filed in 2009), however, use of the new form will be phased in over the next three years. Smaller organizations will be able to file either the new 990 or the current 990-EZ (see chart).

Congratulations if your organization is ready to rumble with the new 990, but don’t despair if it’s not. The Nonprofit Risk Management Center offers consulting services, including affordable and customized policy development assistance on all of the governance practices mentioned in this article. Feel free to give us a call to discuss how a risk assessment and recommendations by the Center can ensure that your governance practices won’t raise a red flag on the new 990.

1 Even the States are beginning to step up to the plate to respond to abuse and neglect in the board room. The Supreme Court for the State of Montana recently found that the board of the Bair Museum violated its fiduciary duty in closing down the museum in 2002. The State Attorney General argued successfully that the board did not spend enough money to maintain the museum and the Court ordered that the museum elect a new board and reconvene the board to make more appropriate judgments about the museum within six months.

2 Note that in several states, including Washington, New Jersey and Minnesota, review of the 990 by the board or officers of the organization is either explicitly or implicitly required since the 990 is often attached to financial reports that are filed with the state.

Have a question? This article was prepared by Jennifer Chandler Hauge. For more information about the Center’s recommendations for governance practices, give Melanie a call at (202) 785-3891 or e-mail.

May/June 2008 Risk Management Essentials