In a March 1 report, the Panel on the Nonprofit Sector made recommendations to the Senate Finance Committee for strengthening charities by enacting a variety of measures to improve governance and financial disclosure and the panel also suggested that the government improve oversight of charities and other nonprofit organizations.
Full Text: Co-Conveners
Paul Brest, President,
William and Flora Hewlett Foundation, Menlo Park,
California
M. Cass Wheeler, Chief Executive Officer,
American Heart Association, Dallas, Texas
Executive Director
Diana Aviv, President and CEO,
INDEPENDENT SECTOR, Washington, D.C.
Members
Susan Berresford, President and CEO,
Ford Foundation, New York, New York
Linda Perryman Evans, President and CEO,
The Meadows Foundation, Dallas, Texas
Marsha Johnson Evans, President and CEO,
American Red Cross, Washington, D.C.
Brian Gallagher, President and CEO,
United Way of America, Alexandria, Virginia
Kenneth L. Gladish, Chief Executive
Officer, YMCA of the USA, Chicago, Illinois
Robert Greenstein, Executive Director,
Center on Budget and Policy Priorities, Washington, D.C.
Stephen B. Heintz, President and CEO,
Rockefeller Brothers Fund, New York, New York
Wade Henderson, Executive Director,
Leadership Conference on Civil Rights, Washington, D.C.
Dorothy Johnson, President Emeritus,
Council on Michigan Foundations, Grand Haven, Michigan
Paul Nelson, President,
Evangelical Council for Financial Accountability,
Winchester, Virginia
Jon Pratt, Executive Director,
Minnesota Council of Nonprofits, St. Paul, Minnesota
William C. Richardson, President and CEO,
W.K. Kellogg Foundation, Battle Creek, Michigan
Dorothy S. Ridings, President and CEO,
Council on Foundations, Washington, D.C.
John R. Seffrin, President and CEO,
American Cancer Society, Atlanta, Georgia
Sam Singh, President and CEO,
Michigan Nonprofit Association, Lansing, Michigan
Edward Skloot, Executive Director,
Surdna Foundation, New York, New York
Lorie A. Slutsky, President, New York
Community Trust, New York, New York
William E. Trueheart, President and CEO,
The Pittsburgh Foundation, Pittsburgh, Pennsylvania
William S. White, President,
Charles Stewart Mott Foundation, Flint, Michigan
Timothy E. Wirth, President,
United Nations Foundation, Washington, D.C.
Gary L. Yates, President and CEO,
The California Wellness Foundation, Woodland Hills,
California
Raul Yzaguirre, Immediate Past President and CEO,
National Council of La Raza, Washington, D.C.
PAUL BREST
President
William and Flora Hewlett
Foundation
M. CASS WHEELER
Chief Executive Officer
American Heart Association
Co-Conveners, Panel on the
Nonprofit Sector
PREFACE
Nonprofit organizations are an indispensable part of American society. The country's network of nearly 1.3 million charitable and philanthropic organizations offers relief in times of disaster, nurtures our spiritual and creative aspirations, cares for vulnerable people, and finds solutions to medical, scientific and environmental challenges. Charitable organizations occupy a central place in every community, drawing upon the talents and generosity of and providing service to an enormously diverse group of people.
The Panel on the Nonprofit Sector is dedicated to ensuring that charities and foundations remain a vital and responsive force in America and around the globe. Convened at the encouragement of the U.S. Senate Finance Committee in October 2004, the Panel seeks to help the nonprofit sector meet the highest ethical standards in governance, fundraising and overall operations. Participating in the Panel's work are more than 175 experts and leaders drawn from across the country and reflecting a wide spectrum of experience in the sector. The Panel also has sought input from hundreds of other interested nonprofit organizations to inform its work. These efforts highlight two of the defining characteristics of the nonprofit community: its willingness to take initiative to make improvements, and its commitment to collaboration.
The following report sets forth the Panel's initial recommendations for strengthening the accountability of charities and foundations. The report begins by describing the composition, reach and accomplishments of the sector, background that is essential to understanding the Panel's recommendations and reasoning, and by explaining the process by which the Panel drew upon the expertise of practitioners and scholars throughout the nonprofit community. It then lays out the overarching principles that guided the Panel's analysis. The main section of the report provides recommendations for specific rules and practices intended to strengthen the sector today and in the years to come. The report concludes with a summary of the areas of study that will be the basis for the second phase of the Panel's deliberations.
Paul Brest
President
William and Flora Hewlett
Foundation
M. Cass Wheeler
Chief Executive Officer
American Heart Association
Table of Contents
Executive Summary
SECTION I Introduction
Dimensions of the Nonprofit Sector
The Panel on the Nonprofit Sector
Factors that Led to the Creation of the Panel on the
Nonprofit Sector
Convening of the Panel on the Nonprofit Sector
Report Timetable
Panel Work Groups
Panel Advisory Groups
Panel Research
Staff Support and Funding
About the Process
SECTION II Principles to Guide Improving the Accountability and
Governance of Charitable Organizations
SECTION III Recommendations of the Panel on the Nonprofit Sector
Recommendations to Improve Transparency in Charitable
Organizations
1: Internal Revenue Service Information Returns
2: Financial Audits and Reviews
3: Annual Notification Requirement for Organizations Not
Filing Information Returns
Recommendations to Enhance Governance of Charitable
Organizations
4: Conflict of Interest Policy Disclosure
5: Audit Committees
6: Reporting of Suspected Misconduct or Malfeasance
Recommendations to Strengthen Government Oversight of Charitable
Organizations
7: Donor-Advised Funds
8: Rules for Valuation of Property Contributions
9: Penalty Taxes on Self-Dealing and Other Violations
10: Type III Supporting Organizations
11: Tax Shelters
12: State Enforcement of Federal Laws
13: Funding for Federal and State Enforcement
14: Information Sharing Between Federal and State Officials
15: Public Disclosure of IRS Determinations
SECTION IV ISSUES THE PANEL WILL CONSIDER FOR ITS FINAL REPORT
Issues Continued from the Interim Report
Additional Issues for Examination
Transparency
Governance
Accreditation and Standard-Setting
Government Oversight
SECTION V APPENDIX
Citizens Advisory Group
Expert Advisory Group
Governance and Fiduciary Responsibility Work Group
Government Oversight and Self-Regulation Work Group
Legal Framework Work Group
Transparency and Financial Accountability Work Group
Small Organizations Work Group
Funding the Work of the Panel on the Nonprofit Sector
Letter from the Senate Finance Committee Leadership to
INDEPENDENT SECTOR, September 22, 2004
Letter from INDEPENDENT SECTOR to the Senate Finance Committee
Leadership, October 12, 2004
PRINCIPLES TO GUIDE IMPROVING THE ACCOUNTABILITY AND GOVERNANCE OF CHARITABLE ORGANIZATIONS
In developing its recommendations, the Panel on the Nonprofit Sector's work was guided by the following eight overarching principles:
RECOMMENDATIONS
This interim report includes recommendations to improve governance and oversight of the charitable sector that call for action by the sector, by individual charitable organizations, by the Internal Revenue Service, and by Congress. The following recommendations have been abbreviated to facilitate quick review; the full recommendations corresponding to the recommendation numbers below are provided in Section III of this report.
Recommendations to Improve Transparency of Charitable Organizations
Recommendations to Enhance Governance in Charitable Organizations
To improve governance practices, every charitable organization should:
The charitable sector should implement vigorous sector-wide efforts to educate and encourage all charitable organizations to implement these recommendations.
The IRS should require all charitable organizations to disclose whether they have a conflict of interest policy on their annual information return.
Recommendations to Strengthen Government Oversight of Charitable Organizations
To improve enforcement of charitable regulations at the state and federal level, Congress should:
* The Panel plans to provide model policies in its final report.
** The Panel plans to provide specific recommendations on these issues in its final report.
Next Steps
A large part of the Panel on the Nonprofit Sector's work lies ahead. Additional concerns related to strengthening the governance, ethics and accountability of charitable organizations will be addressed in the Panel's final report to be released in the spring. A detailed list of issues the Panel plans to address in its second phase of work appears in Section IV of this interim report.
America's philanthropic and charitable organizations play a distinctive role in American society and around the globe.1 These approximately 1.3 million public charities, private foundations and religious congregations commit their resources and efforts to enriching life in communities worldwide. The nonprofit sector encompasses organizations involved in virtually every aspect of human endeavor. Whether dedicated to the advancement of knowledge and creative expression, the support of free speech, or the protection of vulnerable people, nonprofit organizations fulfill their missions with the help of millions of volunteers and professionals.
Among the great accomplishments of this sector:
DIMENSIONS OF THE NONPROFIT SECTOR
The number of public charities and private foundations in America has nearly doubled over the last twenty years. Designated by the Internal Revenue Service as section 501(c)(3) organizations, they currently employ approximately 11.5 million people. The sector is predominately composed of small organizations, with 64 percent of all 501(c)(3) nonprofits operating with budgets of under $500,000 per year. Only 6 percent of nonprofit organizations have annual budgets larger than $10 million, though this group accounts for a considerably larger portion of the sector's overall activity. The American people contribute approximately $201 billion annually directly to charitable institutions, and the country's 65,000 private foundations and corporate giving programs provide an additional $40 billion toward charitable endeavors. A number of nonprofits also serve as the instruments through which government discharges some of its obligations, and are partially funded through public dollars.
To encourage widespread philanthropic giving and enable nonprofits to fulfill their missions, federal and state governments have provided the incentive of tax deductions to encourage donors to increase their gifts and have exempted nonprofits from paying most taxes. This special status is based on the expectation that the activities of nonprofit organizations serve the common good and are not conducted for private gain.
THE PANEL ON THE NONPROFIT SECTOR
Factors that Led to the Creation of the Panel on the Nonprofit Sector
The vast majority of charitable organizations2 conduct their work in an ethical, responsible and legal manner. As in the commercial and public sectors, a small number of individuals and organizations have abused the public trust placed in them by engaging in unlawful or unethical conduct. Particularly after the corporate governance scandals that marked 2002, the national media has reported on allegations of questionable conduct by trustees and executives of public charities and private foundations. In some instances, the alleged abuses were clear violations of the law. In other cases, questions were raised about whether the practices at issue met the high ethical standards expected of the charitable sector.
While recognizing that only a small number of charitable organizations engaged in such conduct, leaders of the U.S. Senate Finance Committee and state legislators across the country asserted that further legislative and regulatory action might be necessary if illegal and excessive practices continued. Their concern resulted in a hearing convened by the Senate Finance Committee in June 2004, which was followed in July by a Committee staff-led roundtable at which sector leaders responded to a Senate Finance Committee staff discussion draft3 of possible remedies to the problems that had emerged. Many national and local organizations had long shared the concerns of the Senate Finance Committee leadership that unethical actions of even a few bad actors had the potential to undermine the good work of the entire sector. As a result, the nonprofit community recognized the need to come together to find ways to better address these issues.
Convening of the Panel on the Nonprofit Sector
On September 22, 2004, the chairman of the Senate Finance Committee, Senator Charles Grassley (R-IA), and the ranking member, Senator Max Baucus (D-MT), sent a letter to INDEPENDENT SECTOR4 encouraging it to assemble an independent group of leaders from the nonprofit charitable sector to consider and recommend actions to strengthen governance, ethical conduct, and accountability within public charities and private foundations. In response, on October 12, 2004, INDEPENDENT SECTOR announced the Panel on the Nonprofit Sector, naming 24 distinguished leaders from public charities and private foundations as its members.
Panel members represent large and small nonprofit organizations, community foundations and membership associations, organizations that operate worldwide or in a single state. The missions of these organizations encompass a broad spectrum of causes, all of which promote the public good.
Report Timetable
The Senate Finance Committee leadership requested an interim report from the Panel by February 2005 and a final report by the spring of 2005. Anticipating that there may be additional concerns requiring further consideration following the final report, the members of the Panel plan to continue to meet through the fall of 2005 and may offer additional comments.
Panel Work Groups
In order to benefit from the immense expertise within the sector, the Panel convened five Work Groups to address many of the issues identified by lawmakers:
In total, the five Work Groups include over 100 professionals and other experts from the nonprofit sector who have agreed to volunteer their time and talent to support the Panel's work. Work Group members are leaders drawn from a diverse array of national, regional and local organizations. They include noted academics and practioners, state oversight officials and executives of public charities, foundations and corporate giving programs.
Panel Advisory Groups
As part of an effort to compile and utilize the knowledge and perspectives of as many individuals as possible, the Panel on the Nonprofit Sector created two Advisory Groups. The Expert Advisory Group is drawn from the ranks of academia, law and nonprofit oversight, and brings particular expertise to the issues being considered by the Panel. The Citizens Advisory Group is comprised of leaders of America's business, educational, media, political, cultural and religious institutions who provide a broad perspective on how these issues affect the public at large.
Panel Research
So that it can make informed recommendations during the forthcoming phase of its work, the Panel is initiating a series of research projects. These studies will analyze:
Staff Support and Funding
The work of the Panel on the Nonprofit Sector in this initial phase has been supported by staff under the leadership of the Panel's executive director5 and a team from a law firm that specializes in the law of exempt organizations.6 The Panel staff is also working closely with other consultants and experts.
Already, more than 80 organizations, including private foundations, community foundations, public charities, and corporate giving programs, have made financial commitments to support the work of the Panel. These contributions reflect the sector's widespread commitment to supporting the work of the Panel by ensuring it has the funds necessary to achieve the goals set forth by the Senate Finance Committee leadership. The Panel also has benefited from invaluable pro-bono contributions of time and expertise by individuals throughout the sector and the community at large.
About the Process
To advance the Panel's work, its staff and legal team analyzed the issues raised in the Senate Finance Committee staff discussion draft on governance, fiscal management and ethical practice within the nonprofit sector. Upon receipt of the resulting materials, the Work Groups developed recommendations for inclusion in the Panel's interim report through a series of conference calls and the use of listservs. The Expert Advisory Group reviewed the analysis and conclusions of the Work Groups and added its own recommendations.
Given the unparalleled assembly of talented individuals working on this project, there was the desire by some to expand the agenda to address an even broader range of issues of concern to the sector. Though many issues were thought to be worthy of consideration at some future date, they were not included as part of these initial deliberations in the interest of meeting the timetable set forth by the Senate Finance Committee leadership.
As part of its effort to ensure that its processes were open, inclusive, transparent, and strengthened by the experience of many groups around the country, the Panel posted the draft recommendations of the Work Groups and Expert Advisory Group on its website at www.NonprofitPanel.org and encouraged nonprofit organizations to comment on them. In addition, the Panel convened two national conference calls to discuss both the draft recommendations and the process through which they were developed, and to invite further input from all those interested in the Panel's work. The Panel also benefited from the broad experience of the members of the Citizens Advisory Group.
1 The scope of this report is intended to address public charities, private foundations and religious congregations -- those nonprofit organizations that fall under IRS section 501(c)(3).
2 Throughout this report, the term "charitable organizations" is used to refer to public charities, private foundations and religious congregations, unless otherwise specified.
3 See Senate Finance Committee staff discussion draft, 108th Cong. (2004).
4 INDEPENDENT SECTOR is a nonprofit, nonpartisan coalition of approximately 500 national public charities, private foundations, and corporate philanthropy programs, collectively representing tens of thousands of charitable groups in every state across the nation.
5 The Panel's executive director is Diana Aviv, president and CEO, INDEPENDENT SECTOR, Washington, D.C.
6 Leading the legal team from Caplin & Drysdale, Chartered is Robert Boisture, member and group leader of the firm's exempt organizations practice.
The following principles have guided the recommendations of the Panel on the Nonprofit Sector:
1. A VIBRANT NONPROFIT SECTOR IS ESSENTIAL FOR A VITAL AMERICA
America's voluntary spirit has shaped the history and character of our country since its inception. The 19th century French visitor and scholar Alexis de Tocqueville noted that, from their colonial days, Americans have come together voluntarily to improve the common good. He remarked that this was a distinctive quality of American life, to which there was no parallel in any European society. That great tradition of collaboration, generosity and participation continues today in the form of nonprofit public charities and private foundations.
Our country's expansive network of charitable organizations enriches America's communities by providing vital services in such fields as health, education, social assistance, community development and the arts. The voluntary nonprofit sector provides the means for Americans to engage collectively and collaboratively in critical research, community-building and advocacy efforts that strengthen American democracy, advance freedom of expression, and add richness and diversity to American life. U.S. nonprofit organizations assist victims of disasters, provide educational and economic opportunities, alleviate poverty and suffering at home and abroad, and foster worldwide appreciation for democratic values of justice and individual liberty.
Today, the nonprofit sector remains a creative, vibrant and unique feature of American life, with thousands of organizations, both large and small, working together to create a better world. Unlike its commercial for-profit counterpart, the public good, rather than personal gain, is at the core of its activities. Any effort to address issues within the nonprofit sector must take into account the sector's diversity and complexity and avoid the unintended consequence of stifling its vitality. Further, any policy changes must be aimed at strengthening the great American traditions of giving to, volunteering in, and serving as leaders, directors and trustees of our charitable organizations.
2. THE NONPROFIT SECTOR'S EFFECTIVENESS DEPENDS ON ITS INDEPENDENCE
At the heart of the nonprofit sector is its power to bring people together who are committed to solving problems and enhancing the public good. Among the nonprofit sector's great strengths is its ability to pilot new ideas, to respond to needs without delay, to hold government accountable, and to encourage all efforts, both large and small, that will improve the quality of life for people across the country and abroad. Our country must continue to encourage such independent innovation and creativity by allowing charitable organizations the freedom, within a broad range of public purposes viewed by the law as charitable, to define and pursue their mission as they deem best. Government appropriately sets the rules for the use of government funds by nonprofits, but should resist inappropriate intrusion into policy and program matters best determined by the charitable organizations themselves.
3. THE NONPROFIT SECTOR'S SUCCESS DEPENDS ON ITS INTEGRITY AND CREDIBILITY
Public trust is essential to a viable nonprofit sector. The sector's value to society depends on the extent to which its organizations use their assets exclusively and effectively to advance public purposes. Federal and state laws recognize the value of nonprofit organizations by providing tax exemption and other privileges unavailable to for-profit entities. Americans contribute their resources and time to nonprofit organizations and work through these organizations to serve the common good. Donors, volunteers, consumers of services, and public officials have a right to expect nonprofit organizations to conduct themselves in a manner that will earn and sustain the public trust. To retain and strengthen this trust, nonprofit organizations have an obligation to operate in an open and transparent manner, prevent fraud and the enrichment of insiders and other abuses, and serve the purposes for which they have been created. Board members should ensure these obligations are being met through proper governance and oversight.
4. COMPREHENSIVE AND ACCURATE INFORMATION ABOUT THE NONPROFIT SECTOR MUST BE AVAILABLE TO THE PUBLIC
To enable and support the public's participation in the nonprofit sector and assure ongoing confidence in the sector, the public must have access to accurate, clear, timely, and adequate information about the programs, activities and finances of all charitable organizations. Government regulation should promote such transparency while providing sufficient flexibility to accommodate the wide range of resources and capabilities of nonprofit organizations, particularly of small organizations.
5. A VIABLE SYSTEM OF SELF-REGULATION IS NEEDED FOR THE NONPROFIT SECTOR
The vast majority of charitable organizations are committed to ethical conduct and responsible governance and are willing to conform to commonly accepted standards of practice. Such practices are an important component of the effort by the charitable sector to encourage all nonprofit organizations to embrace the highest possible standards of conduct. Whether it be peer review and feedback, coupled with transparency in practice or more complex systems of accreditation, such initiatives, if actively embraced by the sector, are likely to bring about positive change.
Although self-regulation is unlikely to work with those who deliberately and cavalierly violate standards of ethical practice and are immune to peer pressure, the charitable sector nonetheless must be actively involved in identifying and promoting best practices and strongly encouraging compliance within relevant subsectors. The sector must offer educational programs that reach the entire sector, especially the board members and professional leaders who may not otherwise be aware of the expectations and requirements imposed on them. Both the sector and government should provide the resources necessary to disseminate best practices and to develop and sustain ongoing education efforts to help board trustees to govern and CEOs to operate in a responsible, transparent and accountable manner.
6. GOVERNMENT SHOULD ENSURE EFFECTIVE ENFORCEMENT OF THE LAW
Abuse of the privileges granted nonprofit organizations, while perpetrated by a small number of individuals and organizations, threatens the work of the entire sector and may diminish the generosity of donors. Accordingly, government should authorize and appropriate sufficient resources to facilitate full implementation of the law designed to prevent such abuses. There also should be greater coordination between federal and state oversight officials in order to make best use of limited resources and avoid duplication of work. In addition, government should support sound educational and technical assistance programs to ensure that all nonprofit organizations are familiar with the law and appropriate standards of practice.
7. GOVERNMENT REGULATION SHOULD DETER ABUSE WITHOUT DISCOURAGING LEGITIMATE CHARITABLE ACTIVITIES
Regulation is necessary to address instances in which the sector cannot reasonably be expected to deal with those who deliberately abuse the public trust and exploit nonprofit organizations for personal gain. New regulation may be needed where current legal standards have proven inadequate. However, regulation that is not responsive to the diversity of the nonprofit sector has the potential to increase the administrative and financial obligations of compliance to a level that will force some organizations to curtail or even cease their legitimate charitable activities. Particular care should be given to any actions that might deter new donors or discourage responsible volunteers from serving on boards.
8. DEMONSTRATIONS OF COMPLIANCE WITH HIGH STANDARDS OF ETHICAL CONDUCT SHOULD BE COMMENSURATE WITH THE SIZE, SCALE AND RESOURCES OF THE ORGANIZATION
All organizations should be expected to operate ethically and serve as worthy stewards of the public and private resources entrusted to them. Fraud or abuse cannot be condoned in any organization for any reason. A breach of the public trust by any organization, large or small, damages the reputation of the entire sector. At the same time, it may not be possible or desirable for small organizations, given their limited human, technical and financial resources, to demonstrate their ethical and accountable operation by complying with some of the more complex legal requirements appropriate for larger charitable organizations. Lawmakers must consider the range of organizations to which regulations may apply, and must refrain from adopting regulations where the costs of demonstrating compliance outweigh the benefits gained.
Maintaining public trust in the nonprofit sector requires a balance of vigorous government enforcement, and effective governance of charitable organizations through a viable system of management and governance standards and proactive educational programs that are part of a self regulatory system. The recommendations offered in this interim report include some recommendations for actions by the charitable sector and by charitable organizations and their boards of directors, recommendations for action by the Internal Revenue Service, and recommendations for legislative action to improve governance and oversight of the sector.
These recommendations, while drawing upon the wisdom and expertise of hundreds of organizations and individuals, are those of the Panel on the Nonprofit Sector. Organizations associated with this process as well as others will be encouraged to endorse the recommendations once they have been shared with the Senate Finance Committee.
1. INTERNAL REVENUE SERVICE INFORMATION RETURNS
Issue
Organizations exempt from federal income tax are required to file an annual information return (Form 990, 990-EZ, or 990-PF) with the Internal Revenue Service.1 For charitable organizations,2 this annual information return serves as the primary document providing information about the organization's finances, governance, operations and programs for federal regulators, the public, and many state charity officials.
Current IRS regulations permit any authorized officer of the organization3 to sign Form 990 returns certifying, under penalty of perjury, that the return and accompanying schedules and statements are true, correct and complete. Exempt organizations may receive an automatic threemonth extension to file their Form 990 returns by filing a request on Form 8868, and the IRS has the discretion to grant an additional three-month extension upon a showing of reasonable cause.
The IRS may impose penalties for failure to file a required return or to include required information on Form 990 series returns. These penalties may reach up to $10,000 or 5 percent of gross receipts per return for organizations with annual receipts of $1 million or less, and $50,000 per return for organizations with over $1 million in annual gross receipts. Although the majority of Form 990 series returns are prepared by professional tax personnel who certify the form under penalty of perjury,4 current preparer penalties imposed for filing false tax returns do not apply to the preparation of Form 990 information returns.
As a result, too many Form 990 series returns provide inaccurate or incomplete information. Current information often is not available to the public and government officials because of delays in filing and processing the returns. Enforcement is hampered by the high costs of processing paper returns.
Recommendation for Charitable Organization Action5
Charitable organizations should encourage their boards or an appropriate board committee to review the Form 990 or 990-PF. Board members should be familiar with their organization's Form 990 or 990-PF return as it is a central public document about the organization. Depending on the knowledge and expertise of its members, a board may choose to delegate this responsibility to an appropriate committee of the board. This recommendation should be adopted as a "best practice" by all charitable organizations.
Recommendations for Internal Revenue Service Action
Other Considerations
The Panel discussed proposals to reduce the time period for extensions to file returns, which is currently set at three months for the first extension and an additional three months for a second extension. Charitable organizations may require additional time to obtain the necessary information from third parties to file a complete and accurate return. Generally, charitable organizations do not file their Form 990 or 990-PF returns until they have audited financial statements and they may encounter significant delays in having audits completed, particularly in areas of the country where there are a limited number of accountants with expertise in nonprofit accounting rules. Given the financial challenges that so many charitable organizations face on a daily basis, some organizations find that it is more cost effective to have returns prepared during the accounting "off season." The Panel will be studying other proposals to increase the timeliness of filing Form 990 series returns to include further recommendations in its final report.
There is a need for revision and reform of the Form 990 series returns to ensure accurate, complete, timely, consistent and informative reporting. The Panel intends to offer recommendations for revising the form and substance of Form 990 series returns in its final report.
2. FINANCIAL AUDITS AND REVIEWS
Issue
Concerns have been raised about the quality of financial information on charitable organizations available to boards of directors, regulators and the public. Having financial statements prepared and audited in accordance with generally accepted accounting principles and auditing standards improves the quality of financial information available. A number of states require charitable organizations that meet certain financial criteria and/or that solicit contributions from the public to prepare audited financial statements. Under the Office of Management and Budget Circular No. A-133, the federal government currently requires non-federal organizations that receive federal awards of $500,000 or more per year to perform an audit of the federal funds received and expended and the programs for which the funds were received. There is currently no other federal requirement for financial audits of charitable organizations.
Recommendations for Legislative Action
Rationale
Financial audits can be a substantial expense for many charitable organizations, depending on the size, scale and complexity of the organization's operations. Thresholds for various state requirements for audited financial statements by charitable organizations were reviewed, as were requirements of some accreditation agencies for audits or reviews of participating organizations based on specific financial criteria.6 While national data was not available about specific audit costs, the Panel determined that the threshold of $2 million or more in total annual revenues would require most charitable organizations to spend less than 1 percent of their annual budget to obtain an audit.7 For smaller organizations with at least $500,000 and under $2 million in total annual revenues, a financial statement review by an independent accountant offers a less expensive option while still providing the board, regulators and the public with some assurance of the accuracy of the organization's financial records.
This recommendation is limited to 501(c)(3) organizations that are currently required to file an annual information return with the IRS, thereby excluding houses of worship and their affiliated organizations, governmental units and their affiliates, and other specific organizations.
Charitable organizations are currently required to make their annual information returns (the Form 990 series) available to the public for a period of three years at the organization's principal and regional or district offices during regular business hours; and by mail upon personal or written request, or by posting on the organization's own website or on the Internet. Requiring organizations to make their audited financial statements available on the same basis will provide the public with additional, reliable information by which to monitor such organizations.
The Panel recognizes that there may be some discrepancies between information in the audited financial statements and information provided on the Form 990 returns, particularly for organizations that have consolidated financial statements but must file independent information returns for each of the related entities covered in the consolidated statements. Provisions must be made for organizations to explain discrepancies and, where appropriate, to file both the consolidated statements for the parent organization and appendices detailing financial information for the related entity.
Other Considerations
The Panel noted that in some cases, changing audit firms on a regular basis (every five years or more) can be beneficial and recommends that large organizations, as a best practice, consider rotation of audit firms or partners as appropriate. However, the availability of auditors with the appropriate expertise can be quite limited based on where the organization is located and the size and complexity of its operations. The cost of audits and the willingness of some auditors to perform all or part of the audit on a pro bono basis can also determine the practicality of rotating audit firms or partners. Therefore, the Panel does not believe it would be appropriate for the federal government to require the rotation of auditors for charitable organizations.
The Panel discussed concerns raised by a number of scholars and accounting practitioners that some standards established by the Financial Accounting Standards Board (FASB) may be inappropriate for charitable organizations.8 The Panel also examined the need for greater definition and understanding of the standards and requirements for auditors regarding reportable events discovered in the course of a financial audit or review. The Panel intends to examine these issues more closely in the months ahead in order to make more informed recommendations in its final report to the Senate Finance Committee.
3. ANNUAL NOTIFICATION REQUIREMENT FOR ORGANIZATIONS NOT FILING INFORMATION RETURNS
Issue
The Internal Revenue Service publishes a list of organizations eligible to receive tax-deductible contributions to assist taxpayers in making charitable giving decisions. However, this list (Publication 78) includes outdated contact information for many organizations and may include many organizations that have ceased operations or become inactive without notifying the IRS. The IRS currently has no mechanism for updating information for organizations that do not file an annual Form 990 series return because their annual receipts fall below the specified amount (generally, under $25,000) or because they meet other criteria for houses of worship and their affiliated organizations, governmental units and their affiliates, and other specific organizations. Consequently, taxpayers cannot rely on the IRS list for accurate information.
Recommendations
1. Legislation should be enacted requiring all organizations recognized under section 501(c)(3) of the Internal Revenue Code that are currently excused from filing an annual information return because their annual gross receipts fall below the specified amount (currently below $25,000) to file an annual notice with the IRS containing the following items:
This notification form should be incorporated in the Form 990 series and should be required to be made available to the public on the same basis as other Form 990 series returns. Further, the IRS should be directed to make this notice available for electronic filing and should require e-filing of this notice as soon as possible.
2. Charitable organizations should be required to notify the IRS if and when they cease operations and to file a final Form 990 series return within a specified period after termination.
3. The IRS should be required to suspend the tax-exempt status of organizations that fail to file the required notification form for three consecutive years. Because of the lack of current contact information for many of these organizations in the IRS databases, the Panel recommends that an appropriate phase-in period be provided before automatic suspension is enforced.
Rationale
This notification requirement would assist the IRS in providing for public use more accurate information on the charitable organizations that are exempt from federal income taxes and are eligible to receive taxdeductible contributions. It would also help to ensure that all organizations granted charitable tax-exempt status by the IRS can be notified of more detailed filing requirements should their annual gross receipts rise above the minimum filing thresholds.
Currently, organizations that are terminating operations are asked to send a letter to the Exempt Organization Customer Account Services at the IRS and, if they file an annual return (Form 990, 990-EZ or 990-PF), to check a "Final Return" box on the first page of the return. A formal requirement to provide notification of termination to the IRS would provide greater clarification regarding organizations involved in dissolution or termination procedures. This, coupled with the new annual notification requirement, should enable the IRS and the public to have more timely, accurate information on charities that are eligible to receive tax-deductible contributions.
The Panel believes that automatic suspension of tax-exempt status is a cost-effective remedy for both the IRS and organizations that are not in compliance. The IRS should be required to give prompt notice of the suspension. The organization's income would not be exempt from taxation and the organization would not be eligible to receive taxdeductible contributions if its status was suspended, but the status can be reinstated with relatively little impact and cost to the IRS when the error or offense is corrected.9
Other Considerations
The Panel discussed whether this notification form should include additional information, such as the names of the organization's board of directors, the source of the organization's funds, and disclosure of whether the organization currently engages in a limited number of governance and accountability best practices (based on questions included on the new Form 1023 Application for Recognition of Exemption) through a checklist-style series of yes/no questions. After careful consideration, the Panel determined that such additional information would unduly complicate and increase the cost of establishing and enforcing the new notification requirement and therefore did not include this in its recommendation.
1 Excluded from this requirement are organizations other than private foundations with annual gross receipts of $25,000 or less, houses of worship and specific related institutions, specified governmental instrumentalities and other organizations relieved of this requirement by authority of the IRS.
2 Throughout this report, the term "charitable organizations" is used to refer to public charities, private foundations and religious congregations, unless otherwise specified.
3 For a corporation or association, this officer may be the president, vice president, treasurer, assistant treasurer, chief accounting officer or other corporate or association officer, such as a tax officer. A receiver, trustee, or assignee must sign any return he or she files for a corporation or association. For a trust, the authorized trustee must sign.
4 Surveys conducted by the IRS and National Center for Charitable Statistics indicate that approximately 80 percent of all Forms 990 are prepared by professional tax personnel.
5 Recommendations for charitable organizations are intended to encourage voluntary charitable sector action and do not require government action.
6 For example, the Evangelical Council for Financial Accountability requires all participating agencies to obtain an annual audit performed by an independent certified public accounting firm in accordance with generally accepted auditing standards (GAAS) with financial statements prepared in accordance with generally accepted accounting principles (GAAP). Organizations with less than $500,000 in annual revenues may periodically obtain a compilation and review of financial statements in lieu of an audit.
7 The United Way of America is conducting a study of member audit costs that will be shared with the Panel. Preliminary data indicates that the average audit cost for agencies in United Way's Metro Area II (smaller urban areas) where annual revenues range from $4 million to $9 million were $15,795 or 0.26 percent of the annual revenue. For agencies in Metro Area III, where annual revenues range from $2 to $3.8 million, the average audit cost was $10,440 or 0.37 percent of the annual revenues. The smallest agencies, Metro Area VII, whose annual revenues are below $500,000, the average audit cost was $3,475 or 0.93 percent of the annual revenues.
8 For example, Robert N. Anthony, professor emeritus at Harvard University, has been sharply critical of the SFAS No. 116 and No. 117 issued by FASB in the mid-1990s and stated that "SFAS No. 117 challenges the accountant to find a sensible way of preparing an operating statement for nonprofit organizations that have contributed endowment, plant, or museum objects. The statement mixes operating transactions with nonoperating transactions and leads to what many believe to be a useless bottom line."
9 In its January 26, 2005, report, "Options to Improve Tax Compliance and Reform Tax Expenditures" (JCS-02-05), the Joint Committee on Taxation of the U.S. Congress calls for a similar annual notification requirement and suggests that an organization's tax-exempt status should be automatically revoked if the organization fails to provide the required annual notice for three consecutive years. The Panel believes that automatic revocation introduces unnecessary cost burdens for the IRS and the organization and suggests that the same results can be achieved more costeffectively through automatic suspension of taxexempt status.
4. CONFLICT OF INTEREST POLICY DISCLOSURE
Issue
There are instances in which board members and staff of charitable organizations have personal, business or other interests in transactions that the charitable organization undertakes. A conflict of interest arises in such situations when the board member or staff person's duty of loyalty to the charitable organization comes into conflict with the competing interest they may have in the proposed transaction. Some such transactions are illegal, some are unethical, and some may be undertaken in the best interest of the charitable organization as long as certain clear procedures are followed. A fundamental step in preventing abuse in and protecting the reputation of charitable organizations is the identification and appropriate management of apparent and actual conflicts of interest. Many charitable organizations neither understand what a conflict of interest entails, nor have policies to help guide board members, staff and volunteers in dealing with the apparent or actual conflicts that will inevitably arise.
A conflict of interest policy can help to ensure that a charitable organization, and its officers and directors, comply with federal and state legal obligations. Violations of section 4941 of the Internal Revenue Code (self-dealing transactions for private foundations) and section 4958 (excess benefit transactions for public charities) are triggered by transactions involving individuals who may have a conflict of interest with respect to the organization, as defined by the Code. All states mandate that directors and officers owe a duty of loyalty to the organization, and improperly benefiting from a transaction involving a conflict of interest more than likely involves a violation of the duty of loyalty. Some state statutes specifically penalize participation in transactions involving conflicts of interests unless the organization follows certain prescribed procedures.
Recommendations for Charitable Organization Action
1. Every charitable organization, as a matter of best practice, should adopt and enforce a conflict of interest policy consistent with the laws of the state in which it is located and tailored to its specific organizational needs and characteristics. This policy should define conflict of interest, identify the classes of individuals within the organization covered by the policy, specify procedures to be followed in managing conflicts of interest and facilitate disclosure of information that may lead to conflicts of interest. Special attention should be paid to any transactions between board members and the organization.
2. There should be a vigorous sector-wide effort to encourage all charitable organizations, regardless of size, to adopt and enforce conflict of interest policies.
Recommendation for Internal Revenue Service Action
The Form 990 series (Form 990, Form 990-EZ, Form 990-PF) should be revised by the IRS to require all charitable organizations to disclose whether they have a conflict of interest policy. Beyond this new disclosure requirement, however, no new legal requirements are warranted. Because of the variability both in state laws and among charitable organizations, adoption and enforcement of conflict of interest policies should be a matter of recommended practice for the sector. The Panel expects to develop model conflict of interest policy provisions to assist charitable organizations in crafting policies tailored to their specific organizational needs.
Rationale
Establishing and enforcing a conflict of interest policy is an important part of safeguarding charitable organizations against engaging in unethical or illegal practices. A requirement to report annually whether or not an organization has adopted such a policy will remind organizations that have not yet done so that this is an important step to take and will likely result in more organizations adopting and enforcing such policies. The Panel notes with approval that the IRS has already added a question to the new Form 1023 asking organizations whether they have adopted a conflict of interest policy.
The Panel also notes that if an organization has a conflict of interest policy requiring signatures by board members and staff, and signed forms are missing, an outside auditor is required to report that fact in connection with its audit. This constitutes yet another means to ensure compliance with conflict of interest policies.
5. AUDIT COMMITTEES
Issue
One of the primary duties of the board of directors of a charitable organization is to ensure that all financial matters of the organization are conducted legally, ethically and in accordance with proper accounting rules. Depending on the size and scale of the organization, the board of directors may choose or be required by law1 to have the organization's financial statements audited or reviewed by an independent auditor. In overseeing the audit process, the full board of directors must have sufficient objectivity in assessing the financial controls, policies, procedures, and condition of the organization, and adequate oversight of the external auditor.
At issue is whether boards of directors should be required by law to establish a separate audit committee to review management's performance and the performance of external auditors hired to conduct audits, reviews and compilations.
Recommendation
Audit committees should not be defined or required by federal law. Oversight of the audit function is a critical responsibility of the board of directors, but boards of directors must have the independence to assess the most cost-effective methods for ensuring that the organization's financial resources are managed responsibly and effectively. Organizations with small boards of directors and limited organizational structures may not choose to delegate the audit oversight responsibility to a separate committee. This decision should be determined by the board of the organization and not be mandated by law. Further, audit committees may be inappropriate for charitable organizations that are organized as trusts rather than as corporations.
Recommendations for Charitable Organization Action
1. Charitable organizations should include individuals with some financial literacy on their board of directors in accordance with the laws of their state or as a matter of good practice. Every charitable organization that has its financial statements independently audited, whether legally required or not, should consider establishing a separate audit committee of the board. If the board does not have sufficient financial literacy, it may form an audit committee comprised of non-voting, non-staff advisors rather than board members if state law permits.
2. There should be a sector-wide effort to educate charitable organizations about the importance of the auditing function. Since so many organizational leaders, both professional and volunteer, come to the charitable sector motivated by the mission of the organization, they may not always have the requisite knowledge regarding governance and finance. However, they may be very responsive to improving practices once they are made aware of the process.
Other Considerations
Audit committees can help the board have greater assurance that audited financial statements are accurate and comprehensive by reducing possible conflicts of interest between outside auditors and the paid staff of the organization. It is important that the board or its audit committee, if it chooses or is required by state law to establish such a committee, include individuals with financial expertise. The board or its audit committee should not include paid staff of the organization in the audit review process.
The Panel discussed the board's responsibilities for overseeing the audit process and duties it should either perform itself or delegate to an audit committee. These include:
Education and technical assistance should be available to boards of directors to assist them in overseeing the audit process and deciding whether to establish audit committees, assess what the duties of the audit committee should be and hold external auditors accountable for conducting thorough audits. The Panel expects to make further recommendations on mechanisms for providing and funding such assistance and educational efforts in its final report.
6. REPORTING OF SUSPECTED MISCONDUCT OR MALFEASANCE
Issue
Employees and others affiliated with charitable organizations may be reluctant to come forward with information about suspected wrong-doing or questionable practices for fear of retaliation by their employers. Some state laws provide protections for employees who report misconduct under specific conditions. The Sarbanes-Oxley Act of 2002 prohibits employment-related retaliation (including by nonprofits) against whistleblowers who provide information on certain financial crimes delineated under federal law. Many within the charitable sector may not be aware that the whistleblower provision of the Sarbanes-Oxley Act applies to nonprofits as well.
Recommendation
Existing legal provisions protect individuals working in charitable organizations from retaliation for engaging in whistleblowing activities, and violation of these provisions will subject organizations and responsible individuals to civil and criminal sanctions. Because of the great diversity of organizational structure, governance, and capacity within the charitable sector, as well as the variability in state laws, whistleblower policies and procedures will be more effective if they are tailored to the needs of individual organizations. Therefore, no additional legislative action is required.
Recommendations for Charitable Organization Action
1. All charitable organizations should establish policies and procedures that encourage individuals to come forward with credible information on illegal practices or violations of adopted policies of the organization. These policies and procedures should specify the individual or individuals within the organization (both board and staff) or outside parties to whom such information can be reported, and should include at least one way to report such information that will protect the anonymity of the individual providing the information. The policy also should specify that the organization will protect the individual who makes such a report from retaliation.
2. To facilitate the establishment of these policies and procedures, a sector-wide education initiative should be undertaken to inform charitable organizations about establishing such policies and procedures. This initiative should develop model policies as well as notification and reporting procedures for use by charitable organizations. The Panel will review policies that have been implemented successfully by charitable organizations to provide recommendations in its final report.
1 See Issue #2, Financial Audits and Reviews, p. 23-25 of this report.
7. DONOR-ADVISED FUNDS
Issue
Over the past century, donor-advised funds have evolved as an important means of stimulating charitable contributions from a broad range of donors. Community foundations pioneered the development of donor-advised funds and such vehicles remain a vital means for donors to make philanthropic contributions today and to build endowments for long-term community needs. More recently, other types of charitable organizations -- including educational institutions, cultural organizations, federations and a new class of national charities that receive and distribute donor-advised funds -- have begun to make more extensive use of donor-advised funds.
There currently is no statutory definition of a donor-advised fund. However, a donor-advised fund is generally understood to be a fund maintained by a public charity,1 typically as a separately identified fund or account, though in some cases as a separate trust. The donor-advised fund is owned, controlled, and administered by the public charity, subject to an agreement under which the donor (or an advisor designated by the donor) has the right to make recommendations with respect to distributions and/or investments. As with its other assets, the administering public charity has a fiduciary obligation to ensure that donor-advised assets are used exclusively for charitable purposes.
For many donors, donor-advised funds are an attractive alternative to creating a private foundation. Because they are donations to a public charity, contributions to a donor-advised fund may qualify for more favorable charitable deduction treatment than contributions to a private foundation. Because they are assets of a public charity, donor-advised funds are not subject to the self-dealing, payout, and taxable expenditure rules applicable to private foundations. Finally, because the public charity owns and administers the fund, the donor is freed of the administrative burden of creating and maintaining a private foundation and also benefits from the philanthropic and substantive expertise of the public charity.
Most charities with donor-advised funds exercise the highest levels of fiduciary responsibility to ensure that donor-advised assets are used exclusively and appropriately to advance charitable purposes. However, donor-advised funds can be subject to a range of potential abuses if the administering public charity fails to exercise its fiduciary responsibility. Specific concerns include the following:
Recommendations for Internal Revenue Service Action
Public charities, in addition to identifying themselves as owners of donor-advised funds on the Form 990,2 should be required to disclose on their Form 990 aggregate financial information about donor-advised funds they hold. While there could be benefit to charities and the public from the disclosure of greater information about donor-advised funds, such as the names of advisors to the funds, such disclosure would compromise donor anonymity (where anonymity is desired) and deter some donors from giving. The Panel will make recommendations on the specific types of information that should be reported by public charities in its final report.
Recommendations for Legislative Action
1. The term "donor-advised fund" should be statutorily defined to provide a basis for targeted rules addressing potential abuses of donor-advised funds, without discouraging use of such funds by donors. The definition should make clear that a donor-advised fund is a separately identified fund or account consisting of assets owned by a public charity with respect to which there is an understanding between the donor and the charity that the charity will consider non-binding advice from the donor (or an advisor) regarding investments or distributions of the amount held in the fund. The definition explicitly should exclude specific arrangements in which advisory rights are substantially more limited than in the typical donor-advised fund, such as funds for which a majority of the advisors are appointed by a public charity or by a governmental entity and funds designated at the time of the gift to support a specific charitable purpose when specified conditions regarding the selection of fund advisors and/or grantees are met. The Panel is considering several definitions of "donor-advised fund" put forth by various experts and intends to make specific recommendations in its final report regarding the contours of a definition, including the types of funds that should be excluded from the definition and the appropriate section of the Internal Revenue Code for such a definition to appear.
2. Public charities should be prohibited from making grants to private non-operating foundations from assets held in donor-advised funds. While there may be some situations in which grants from assets held in donor-advised funds to private nonoperating foundations are desirable, attempts to draft or enforce a more targeted rule allowing these few instances while prohibiting other such distributions would be extremely difficult, if not impossible.
3. Public charities holding donor-advised funds should be subject to minimum activity rules to ensure that funds are not permitted to remain in inactive donor-advised fund accounts indefinitely. These minimum activity rules should require charitable organizations (a) to contact the donors/advisors of funds that have been inactive for a period of years to request advice and (b) to make distributions or revoke advisory privileges if there has been no activity in an individual donor-advised fund account for a specified time period. This recommendation addresses concerns about "parking" of assets over extended periods while preserving the ability of donors to use donor-advised funds legitimately to accrue assets for a specific intended charitable purpose, such as creating a field-of-interest fund, scholarship fund or an endowed faculty chair at a university. The Panel intends to make further recommendations for these minimum activity rules with specific time periods in its final report.
4. Public charities should be prohibited from knowingly using assets held in a donor-advised fund to:
This narrowly targeted prohibition on certain uses of donor-advised fund assets is an easily administrable standard that would prevent identified abuses.3
5. Public charities that own and administer donor-advised funds should be required to include on forms used to recommend potential grantees a donor certification that the grant will not provide any substantial benefit to, or relieve any obligation of, the donor, the advisor or any related party.
6. Public charities that own and administer a donor-advised fund should not be permitted knowingly to make grants from that fund to satisfy a legally binding charitable pledge of the donor/advisor. Assets of donor-advised funds belong to the charity that owns and administers the funds and allowing donors to make binding pledges on those assets would violate the prohibition on use of charitable assets for private benefit. The proposal in the Senate Finance Committee staff discussion draft to permit donor-advised funds to satisfy a donor's legally binding pledge would ease administration of donor-advised funds; however, the Panel believes that it is important to adhere strictly to the principle that assets in donor-advised funds may not be used in ways that confer substantial benefits on donor/advisors.
Other Considerations
The Panel is studying proposals requiring that donor-advised fund grantees acknowledge to the grantor public charity that the donor-advised grant will not result in any substantial benefit to the recommending donor/advisor.4 Such proposals must balance the benefit of the grantee's verification that no benefit has been provided to the donor/advisor with the anticipated administrative burdens of carrying out a grantee acknowledgement requirement and the need to respect the value of maintaining donor anonymity.
The Panel discussed how minimum payout requirements could be implemented for donor-advised funds and determined that subjecting assets held in donor-advised funds to the complex rules that govern distributions by private foundations would require public charities holding those assets to incur significant administrative costs without producing a corresponding public benefit, since most donor-advised fund programs pay out substantially more than 5 percent. The Panel therefore opposes establishing a minimum payout requirement for donor-advised funds.
8. RULES FOR VALUATION OF PROPERTY CONTRIBUTIONS
Issue
In its discussion draft, Senate Finance Committee staff recommended that contributions to donor-advised funds of assets other than cash or publicly traded securities be required to be sold within one year of the contribution (or that donor-advised funds be allowed to receive only contributions of cash or publicly traded securities).
The Senate Finance Committee staff discussion draft also proposed that a mandatory "baseball arbitration" (where the arbitrator must choose one side's valuation) procedure be instituted to assist in resolving federal tax valuation disputes regarding the value of property contributed to a charity (other than cash or publicly traded securities).
Recommendation
The appropriate valuation and disposition of non-cash contributions should be addressed in the context of all public charities, rather than developed for specific types of assets or funds that are held by charities. The Panel has instituted procedures to study these complex issues over the coming months in order to provide specific recommendations in its final report to the Senate Finance Committee.
Note: The Panel has deep reservations concerning the Joint Committee on Taxation recommendation in its January 27, 2005, report on "Options to Improve Tax Compliance and Reform Tax Expenditures" to limit deductions for contributions of property (other than publicly traded securities) to the donor's basis in the property or, if less, the fair market value of the property. The effect of this proposal could be to eliminate a significant source of contributions for charities.
Rationale
Federal law should provide adequate safeguards against abuse by charities or taxpayers in all areas, including valuation and disposition of non-cash contributions. At the same time, it is important to ensure that any changes to federal law do not unnecessarily discourage individuals or corporations from making valuable non-cash contributions to charity or force charities to dispose of donated property in a manner that would diminish its financial value to the charity. The Joint Committee on Taxation's argument that gifts of property other than publicly traded securities require significant diversion of resources from the mission of a charitable organization does not comport with sector experience and does not take into account the capacity of many charities like community foundations and institutions with major endowments to make effective use of gifts of real estate, closely held stock, limited partnership interests, and other securities in meeting their long-term financial goals to further their charitable missions, nor the importance to museums and other cultural organizations of donations of art and artifacts. The Joint Committee on Taxation raises a number of other possible approaches to valuation concerns related to donated property ranging from strengthening present-law appraiser and appraisal rules to eliminating, in whole or in part, the charitable contribution deduction for property. This is an area that deserves significant study and deliberation for the Panel to reach a meaningful recommendation for the Senate Finance Committee's consideration.
9. PENALTY TAXES ON SELF-DEALING AND OTHER VIOLATIONS
Issue
Foundation managers and disqualified persons are currently subject to first-tier excise taxes when they engage in self-dealing transactions.5 These excise taxes may be too low to deter the prohibited actions effectively. Although the Internal Revenue Code gives the Secretary the authority to abate first-tier excise taxes levied against foundation managers whose participation in other types of transactions was due to reasonable cause and not willful neglect,6 this authority does not currently extend to abatement of first-tier excise taxes imposed on disqualified persons or foundation managers involved in selfdealing transactions. The lack of protections for disqualified persons and managers inadvertently participating in self-dealing transactions where the foundation was not harmed and the individuals involved received no "excess benefit" (and thus would not have been subject to an excise tax at all if the organization involved had been a public charity) can lead to harsh and unjust results.
The Internal Revenue Service can also impose excise taxes on foundation managers who knowingly participate in jeopardizing investments and taxable expenditures and on managers of public charities who knowingly participate in excess benefit transactions,7 but these taxes rarely have been imposed. Treasury regulations currently stipulate a number of conditions for establishing whether a foundation or organization manager acted knowingly when he or she participated in an excess benefit transaction or other prohibited activity. This has created an extremely high burden of proof on the Secretary before taxes can be imposed.
Recommendations for Legislative Action
1. First-tier excise taxes imposed on foundation managers and disqualified persons who knowingly participate in self-dealing transactions should be increased. The Panel is currently studying various proposals regarding the taxes that should be imposed and expects to make a definitive recommendation in its final report.
2. The Secretary's authority to abate first-tier taxes on managers participating in selfdealing transactions should be extended to include abatement of taxes imposed on foundation managers and disqualified persons who have participated in a self-dealing transaction. Standards for abatement should be clarified, and the language of the abatement provision in Internal Revenue Code section 4962 should be revised to more closely coordinate with the language of the penalty provisions in sections 4941 through 4945 and 4958. The Panel expects to make specific recommendations on this matter in its final report.
3. The standard for imposition of first-tier excise taxes on organization managers should be modified to provide a realistic possibility that such penalty taxes will be imposed on managers who fail to meet their fiduciary duties in approving or failing to oppose a prohibited transaction. This standard must be tailored so as not to unnecessarily deter qualified individuals from serving as managers of charitable organizations for fear that penalty taxes would be imposed unfairly. The Panel is studying proposals to modify the standard and expects to make a recommendation in its final report.
Rationale
First-tier excise taxes and penalties imposed on managers and other individuals who improperly benefit from self-dealing or excess benefit transactions and other wrongdoing must be sufficient to create an effective deterrent. At the same time, provision must be made to abate penalty taxes for inadvertent violations where the individual did not receive an "excess benefit" and the foundation was not harmed. For example, a well-meaning board member may allow a foundation to rent space in a building he or she owns for less-than-market-value rent, not realizing that this would violate selfdealing rules. Extending abatement authority would also promote greater symmetry in the penalties imposed on disqualified persons and managers of private foundations (under section 4941) and of public charities (under section 4958), as penalties on charity managers and disqualified persons currently may be abated under section 4962.
Standards for imposition of penalties must provide sufficient latitude for the Secretary to impose penalties on managers who have participated in prohibited transactions, while preserving protections essential to the ability of organizations to recruit qualified individuals to serve on boards. Proposals to alter the current standard require careful study and analysis before the Panel is able to make specific recommendations to the Senate Finance Committee.
10. TYPE III SUPPORTING ORGANIZATIONS
Issue
A Type III supporting organization is a public charity that is organized and operated exclusively for the benefit of one or more other public charities. Supporting organizations allow a public charity to use separate entities to insulate assets from liability or to separate certain functions (such as investing or fundraising), without becoming subject to the more stringent rules covering private foundations relating to insider transactions, required distributions, business holdings, investments, and expenditures. Like other types of supporting organizations, there must be a close and continuous relationship between the Type III supporting organization and the supported organization, but the supported organization does not have legal control over the Type III supporting organization. Substantial contributors to a Type III supporting organization and their family members are prohibited from controlling the supporting organization.
Type III supporting organization rules allow for independent ownership and management of assets exclusively dedicated to the benefit of the supported charities, thus permitting the supported charities, donors, and government entities to address specific needs and circumstances such as those described in the examples provided later in this discussion.
The flexibility currently allowed in the use of Type III supporting organizations makes them uniquely suited to meet the needs of public charities, governmental entities, and donors in a variety of circumstances, but has also made these organizations targets for abuse. Some donors inappropriately maintain de facto control over assets contributed to Type III supporting organizations, using the Type III organization as the functional equivalent of a private foundation without effective oversight by the public charity that is the nominal "supported organization."
Recommendation
Targeted anti-abuse rules, accompanied by appropriate penalties, should be enacted to eliminate the inappropriate use of Type III supporting organizations while maintaining the availability of such organizations for legitimate charitable purposes. Because of the important role Type III supporting organizations may play in a wide range of legitimate charitable situations, at this time the Panel does not support proposals to eliminate Type III supporting organizations entirely. The Panel will include specific recommendations regarding anti-abuse rules in its final report.
Rationale
Careful study is required to develop measures that will prevent and punish abuses, while continuing to allow the proper use of Type III supporting organizations to further the charitable purposes of the supported charity. The Panel has identified the following examples where Type III supporting organizations are uniquely suited to address charitable purposes:
11. TAX SHELTERS
Issue
Some charitable organizations, as well as other tax neutral persons and entities, have been involved as accommodation parties in abusive tax avoidance transactions (i.e., tax shelters). The Senate Finance Committee staff discussion draft has proposed that charitable organizations that the Internal Revenue Service determines have accommodated "listed tax shelter transactions or reported transactions (with a significant purpose of tax avoidance)" without receiving an "affirmation that the transaction is not a listed or reported transaction" under existing federal tax law would have their section 170 status revoked for a year and be subject to a 100 percent tax on all accommodation fees or other direct benefits received. "Listed transactions" are those which the IRS has determined to be tax avoidance transactions and identified as such by notice or other published guidance.8 "Reportable transactions" include "listed transactions" as well as other types of transactions that must be disclosed to the IRS even though there has been no determination that such other transactions are abusive.9
Recommendation
Appropriate anti-abuse provisions must be developed and should be sufficient to deter charitable organizations from participating in a listed transaction. The IRS recently has released final regulations under Circular 230, which sets forth best practices for tax advisors as well as standards for covered opinions and other written advice. The Panel is studying the Circular 230 regulations, relevant code provisions and regulations, as amended by the American Jobs Creation Act of 2004, as well as proposals from the Senate Finance Committee staff discussion draft and the Joint Committee on Taxation, to make a specific recommendation regarding such provisions in its final report.
Rationale
The Panel is deeply troubled by the participation of some charitable organizations in abusive tax avoidance transactions but notes that such activity is a complex problem whose reach extends beyond charitable organizations. Even as remedies are considered for participation in abusive tax avoidance transactions, the charitable sector must do more