Lawyers on Board

Principles of Nonprofit Governance for Attorneys Serving on and Counseling Charity Boards

Because you're a lawyer, you've been asked to serve on the board of a local charity, and you're happy to help. But are you prepared for the legal issues involved? Are you aware of the governance issues facing nonprofits and the governance principles nonprofits should follow? This article will help.

Tennessee has long prided itself as the Volunteer State, and Tennessee lawyers uphold that tradition admirably. Through pro bono service to indigent clients and the under-represented, hours devoted to bar and community service projects, and tireless contributions to local bar associations and the TBA,[1] Tennessee lawyers embody the Volunteer spirit.

Tennessee lawyers regularly volunteer by serving on and counseling the boards of nonprofit organizations, to give a lawyer's perspective on how the board and the charity should operate. In these roles, it is critical that lawyers be aware of the rules governing nonprofit organizations and the management issues that come into play.

Most of the charities lawyers serve are nonprofit corporations under the Tennessee Nonprofit Corporation Act, exempt from taxation under Internal Revenue Code (IRC) Section 501(c)(3) and classified as "public charities" for tax purposes.[2] This decade has seen increased scrutiny of these tax-exempt (TE) organizations on the heels of well-publicized charity missteps and the resulting public perception that many charities are not managed properly.[3] The federal government has taken a particular interest in the governance of TEs, spearheaded by the Senate Finance Committee under chair Max Baucus (D-Montana) and ranking member Chuck Grassley (R-Iowa). The IRS first weighed in by releasing a nonprofit management guide, Governance and Related Topics " 501(c)(3) Organizations, issued February 2008.[4] This increased scrutiny recently culminated in the IRS issuing a revised Form 990, Return of Organization Exempt from Income Tax, the annual return that most 501(c)(3) organizations file.[5] The redesigned form focuses attention squarely on the governance of TEs by adding numerous questions addressing TE governance, including a new section devoted exclusively to TE governance.

This article surveys TE governance issues of particular importance in light of the revised Form 990 and Congress's increased scrutiny of TEs. Most of the policies and procedures discussed are not required under state or federal law, but TE boards will do well to consider all and to adopt many.

Executive Compensation and Expense Reimbursement Policies. Compensation of TE insiders and related expense reimbursement issues might be the area of greatest concern for Congress and the IRS. Many of the questions in Form 990 and Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, address compensation of insiders. Part VI of Form 990 asks whether the process for determining compensation of the organization's top management officials and key employees included review and approval by independent persons, use of comparability data, and contemporaneous substantiation of the deliberation and decision, and Schedule O requires the organization to describe the process. Being able to answer these questions in the affirmative will reduce further scrutiny of the organization.

Adopting and maintaining good executive compensation policies also helps individuals avoid IRC Section 4958 excise taxes for excess benefit transactions. An excess benefit transaction generally is a transaction in which a TE provides to a "disqualified person"[6] a benefit, the value of which exceeds any return value given to the TE by the disqualified person (including performance of services).[7] If a TE engages in an excess benefit transaction, excise taxes are imposed upon the disqualified person and upon any "organization manager" who knowingly participated.[8]

The excess benefit transaction regulations include a rebuttable presumption that compensation is reasonable if an authorized body, composed of disinterested members of the governing body (or other authorized persons), approves the compensation in advance, relying upon comparability data, and adequately documents the basis for its decision.[9] A properly drafted and implemented executive compensation policy can establish the elements of the rebuttable presumption, and the IRS can rebut the presumption only by successfully invalidating the comparability data relied upon by the TE.[10] Such a procedure should outline the process for establishing compensation and document the deliberations and decisions regarding compensation arrangements.

Schedule J of Form 990 asks various questions regarding expenses of board members, officers and key employees. If the TE provided certain fringe benefits, including first-class or charter travel, travel for companions, gross-up tax payments, discretionary spending accounts, and other personal services, Schedule J asks whether the organization followed a written policy regarding payment, reimbursement, or provision of all of the expenses. If not, the organization is required to explain. Schedule J also asks whether the organization requires substantiation prior to reimbursing or allowing expenses. The Schedule J questions provide a road map for a proper expense reimbursement policy, including requiring substantiation and approval by the governing body (directly or indirectly) that such expenses are necessary for the organization's tax-exempt purposes.

Gift Acceptance Policy. Congress and the IRS are also concerned about TEs' acceptance and management of in-kind gifts, such as real estate, closely held business interests and art. Such gifts are particularly ripe for income tax abuse by donors, by overvaluation of the gifts for charitable deduction purposes and through restrictions on the charity's use or sale of the donated item. Schedule M of Form 990, required to be completed by any organization that received certain types or a threshold amount of non-cash contributions for the year, requires an accounting of such donated items.[11] Schedule M also asks whether the organization has a gift acceptance policy that requires a review of any non-standard contributions.

Beyond IRS scrutiny of donors' income tax charitable deductions, charities should have a gift acceptance policy to ensure that all required substantiation and documentation for charitable deduction purposes has been completed, to ensure compliance with state charitable solicitations laws, and to guard against acceptance of troublesome assets.

Conflict of Interest Policy for Board Members, Officers and Key Employees. All organization boards, whether for-profit organizations or TEs, must be vigilant to identify and address any potential conflicts of interest between the organization and its leadership. If a person of influence in the organization might benefit financially from a decision the individual or the board makes, a potential conflict of interest arises. Under the Tennessee Nonprofit Corporation Act, if a TE engages in a conflict of interest transaction, the transaction was not fair at the time it was entered into, and it was not approved by the board, a committee of the board, the members of the TE, the state attorney general, or a court of equity jurisdiction pursuant to the act, then the transaction is voidable.[12] In addition, if the transaction results in "private inurement" under federal tax law,[13] the transaction can cause loss of the organization's tax-exempt status or imposition of excise taxes under the excess benefit transaction rules. Finally, conflict of interest transactions can become public relations disasters.

Part VI of Form 990 asks whether the organization has a written conflict of interest policy; whether officers, directors, and key employees are required to disclose any interest that could give rise to conflicts; and whether the organization consistently monitors and enforces compliance with the policy. The appendix to the instructions for Form 1023 includes a sample conflict of interest policy, which may be adopted without modification or tailored to the TE's particular circumstances. Schedule L of Form 990 requires disclosures related to certain "interested persons,"[14] in order to gather information about potential excess benefit transactions, loans to and from interested persons, grants or assistance to them, and business transactions involving them. Accordingly, the TE's conflict of interest policy could be drafted to require production of the information required for those disclosures.

The conflict of interest policy should define the procedures to determine whether a conflict exists and the appropriate responses when the conflict is identified, including complete disclosure to the board of the potential conflict and recusal of the conflicted board member from any votes related to the potential conflict of interest transaction.

Board Review of Form 990 Prior to Filing with the IRS. Part VI of Form 990 asks whether a copy of the Form 990 was provided to the organization's governing body before the form was filed, and requires the organization to describe in Schedule O the process, if any, the organization uses to review the Form 990. Presumably, a board member is not required to review the Form 990 prior to submission in order to carry out the board member's fiduciary duties,[15] but every TE should have some procedure in place whereby the board or a committee to which the task is delegated reviews the Form 990 prior to its submission. Each board member should have an opportunity to review the form.

Contemporaneous Documentation of Board and Committee Meetings and Actions. Part VI of Form 990 asks whether the organization contemporaneously documented the meetings held or written actions undertaken during the year by the governing body and each committee with authority to act on behalf of the governing body. As lawyers know, proper documentation of any action is critical to defending the action, and TE boards are encouraged to keep proper minutes of all meetings and written actions taken.

Document Retention and Destruction Policy. Part VI of Form 990 asks whether the organization has a written document retention and destruction policy. Every organization needs to ensure that it both maintains necessary and helpful records and reduces clutter by destroying extraneous documents. TEs should consider document retention and destruction policies that give guidelines for maintaining, storing, and destroying electronic and paper copies of documents. In addition, as anyone who has suffered through a computer data malfunction can attest, wise document retention policies address backup and archiving procedures to reduce the likelihood of losing key documents.

Whistleblower Policy. Federal law imposes criminal liability on TEs for retaliation against whistleblowers.[16] Part VI of Form 990 asks whether the organization has a written whistleblower policy. Such a policy should establish procedures for the communication of and response to employee complaints regarding any misuse of the organization's resources or violation of federal or state law or the organization's internal rules for operation.
Required Public Availability of Documents. All TEs are required to make certain documents available to the public, including the TE's Form 1023, Form 990 (with names of individual donors redacted out), and the organization's governing documents (charter, bylaws, trust agreement, etc.). A written policy to which the TE unfailingly adheres will avoid trouble with the IRS and the state.

Summary. While many of the policies and procedures described above are not required under federal or state law, most are helpful and TEs should evaluate the appropriateness and applicability of each one. All policies should be in writing and widely communicated among the board, officers, and employees. Any adopted policies should be reviewed for proper implementation and revision over time, where appropriate. Lawyers serving on TE boards are particularly well positioned, and probably expected, to evaluate which policies to adopt, to tailor the policies to the particular organization, and to monitor proper administration and enforcement of the policies.[17]

Notes

  1. Those lawyers reporting pro bono hours to the TBA contributed an average of 72 hours per lawyer in 2006 (the most recent statistics available).
  2. Organizations exempt from taxation under IRC Section 501(c)(3) are divided into two broad categories, "public charities" and "private foundations." Private foundations are generally funded by a small number of donors, typically an individual or a family, who maintain a broad degree of control over the operations of the organization. Public charities, which are the large majority of charities familiar to the public and on whose boards Tennessee lawyers serve, generally have a broader base of supporters and board members. Several tax advantages flow from public charity status, both to donors and to the organization.
  3. Recent examples include the National Heritage Foundation, based in Falls Church, Virginia, which filed for bankruptcy, leaving creditors, including charitable gift annuity donors, scrambling. Among the improprieties alleged against NHF are misleading donors (resulting in a $6 million civil verdict against NHF, which it is appealing), transferring $1 million to a related charity two days before the bankruptcy filing, and improper payments exceeding $100,000. See "Charity Moved $1 Million Before Bankruptcy Filing," Forbes, March 2, 2009; "Bankrupt Charity Calls in the Cops," Forbes, March 5, 2009. In Tennessee, the Pigeon Forge-based American Eagle Foundation reportedly lost $500,000 in Dennis Bolze's alleged Ponzi scheme. See "Eagle Rescuers Banked on Bolze," Knoxville News Sentinel, April 2, 2009. While AEF was the victim in the scheme, the story illustrates the importance of due diligence on the part of the board regarding the choice of investment professionals.
  4. Available at www.irs.gov/pub/irs-tege/ governance_practices.pdf.
  5. Available at www.irs.gov. The new form applies to tax years that began on or after Jan. 1, 2008. Private foundations must file Form 990-PF and public charities with income and assets below certain threshold amounts may file the simplified Form 990-EZ. The IRS Web site includes a simple table to show which form to file, plus numerous other resources helpful for completing Form 990.
  6. See IRC  § 4958(c). A "disqualified person" generally is any person in a position to exercise substantial influence over the organization. IRC  §4958(f)(l). Special rules apply for 509(a)(3) supporting organizations and donor advised funds.
  7. IRC  § 4958(c).
  8. IRC  § 4958. An "organization manager" is any officer, director, trustee, or anyone with similar powers or responsibilities. IRC  § 4958(f)(2).
  9. Treas. Reg.  § 53.4958-6(a).
  10. Treas. Reg.  § 53.4958-6(b).
  11. Schedule M also asks whether the organization received any contribution not required to be used for exempt purposes during the holding period where the donor requested or required that the TE hold the contribution for at least three years. If the TE sells the donated property within three years, it must file an IRS Form 8282 showing the sales price obtained by the charity, which might call into question a higher value reported by the donor for income tax charitable deduction purposes. Form 990 requires the charity to report any attempts by the donor to get the charity to delay sale of the donated property.
  12. Tenn. Code Ann.  § 48-58-302.
  13. See IRC  § 501(c)(3).
  14. "Interested persons" are generally directors, officers, key employees, "substantial contributors," and persons and entities related to them. See instructions to Schedule L of Form 990.
  15. Under the Tennessee Nonprofit Corporation Act, directors have duties of good faith, prudence, and loyalty. See Tenn. Code Ann.  § 48-58-301.
  16. 18 USC  § 1513(2008).
  17. For further reading, see "Principles of Good Governance and Ethical Practices " a Guide for Charities and Foundations," The Panel on the Nonprofit Sector, available at www.nonprofitpanel.org/report/principles/
    Principles_Guide.pdf. Sample governance policies are available at the following Web sites:
    - http://cof.org;
    - www.boardsource.org/epolicy;
    - www.achsnatl.org/ASAE_Jacobs.doc;
    - www.michaelmalamut.com/articles/Guide_Form_990_Nonprofit_Governance_Poli...
    - www.charitygovernance.com/charity_governance/2008/06/governance-poli.html.

Eddy R. Smith ED SMITH is a principal of the Knoxville law firm of Holbrook Peterson & Smith PLLC, past chair and current member of the Executive Council of the Tennessee Bar Association Estate Planning and Probate Section, a fellow of The American College of Trust and Estate Counsel, and a member of the Tennessee Probate Study Group.