Senate Finance Considers Far-Reaching Changes in Tax Exempt Laws

Senate Finance Considers Far-Reaching Changes in Tax Exempt Laws

Staff Proposes New Taxes, Filings, Fees and Prohibitions
Article posted in Legislative on 30 June 2004| 4 comments
audience: National Publication | last updated: 18 May 2011


In response to the Senate Finance Committee's staff draft report and hearing last week regarding charity abuse, Washington, D.C. attorneys Mark B. Weinberg and Barnaby Zall have responded point-by-point with their opinions regarding proposals that would affect nonprofits of all categories and further urge organizations to contact their counsel so "reason prevails."

by Mark B. Weinberg and Barnaby Zall

The Senate Finance Committee, which oversees the Internal Revenue Service's regulation of tax-exempt organizations, has released a staff draft report suggesting many dramatic changes in laws governing charities and other exempt organizations. Sen. Charles Grassley (R-Iowa), Chairman of the Committee, announced that he intends to introduce bipartisan legislation this fall to incorporate at least some of these changes.

The staff draft document and IRS Commissioner Mark Everson's testimony at the hearing can be found at the conclusion of the news story entitled, Senate Finance Hears Testimony on Nonprofit Abuses, published by the PGDC on June 23, 2004.

In addition, a RealPlayer webcast of the June 22, 2004 hearing on the staff draft can be viewed at:

Some of the most important proposals in the staff draft include:

Federalizing Control of Nonprofit Organizations:

Traditionally, control over nonprofit organizations has been shared between the states and the federal government. The states have generally controlled the corporate aspects of exempt organizations (such as incorporation, governance, and registration); the federal role was only to ensure that requirements for federal tax-exemption were met.   Since 1950, and with increasing frequency, the federal government has intruded on a number of corporate areas traditionally reserved to the states, including conflicts of interest and financial transactions; even these federal incursions, however, were couched in terms of taxes and penalties, rather than direct control.

The new staff draft goes much further than prior federal regulation, however, in proposing specific federal control over essentially all aspects of tax-exempt organizations. The IRS and the federal Tax Court would be given the same powers traditionally exercised by the states over organizations' Boards of Directors, operational decisions, and budgets. The staff draft, for example, not only permits the IRS and the Tax Court to remove directors from exempt organizations' boards, but removed persons may be barred from working with other organizations in the future.

In addition, "Federal liability for breach" of Director's duties "would be established." It is unclear what this means, but it could mean that directors who fail to use ordinary care would be subject to federal prosecution. The staff draft notes that persons with "special skills or expertise" would have to use those in the service of the exempt organization; presumably this would mean that an attorney, banker, or accountant serving as a director would face possible federal prosecution for failure to utilize appropriate professional skills on behalf of the organization.

Given the U.S. Supreme Court's recent decisions on whether federal laws can pre-empt areas traditionally governed by state laws, it is unclear whether this type of direct federalizing of regulation of exempt organizations would be constitutional. Nor is it clear how the already-under-funded and overworked IRS would be able to handle an expected new flood of obligations and demands.

On the other hand, the staff draft also proposes that state officials could also "pursue certain Federal tax law violations by exempt organizations, with the approval of the IRS." The staff also envisions increased communication and cooperation between state and federal officials, as well as federal payments for states to cooperate.

New Fees for Routine and Required Reporting:

Many observers believe the IRS currently has sufficient legal authority to correct any of the concerns addressed by recent congressional hearings, but that it doesn't have the personnel or financial resources to enforce the law. Thus, one of the most effective "reforms" would be simply adequately funding the IRS oversight and enforcement initiatives that are already in place. Unfortunately, the Senate Finance Committee does not have jurisdiction to provide more funding; only the Appropriations Committee can provide actual dollars for more resources.

The Finance Committee can, however, institute various fees and financing methods to encourage congressional appropriators to provide more money for IRS enforcement and regulation. The staff draft document proposes to reinstate a recently-repealed requirement that excise fees collected on certain private foundation transactions be used to bolster IRS enforcement; although the requirement was enacted in the 1960's, it was never respected by appropriators, who simply took the money for the general treasury funds.

In addition, however, the staff draft proposes new fees for many of its proposals, including for required filings such as annual tax information returns (Form 990), and the proposed five-year renewal of tax-exemption (see below). In other words, organizations would not only be required to file tax returns, but would pay a fee to file them. Such fees would obviously fall more heavily on smaller organizations, and the staff suggests that such fees be enacted on a sliding-scale to minimize the burden.

Periodic Review of Tax-Exemption:

The staff draft proposes that every five years, tax-exempt organizations would have to submit detailed information justifying their continued tax-exemption. In addition to the material already required to be submitted with an organization's Form 990 annual information tax return, an exempt organization would also have to submit conflicts of interest policies, "a detailed narrative about the organization's practices," and other information.

It is unclear how the already overwhelmed IRS would handle such a flood of new applications and reviews. The staff draft appears to recognize this problem by providing that the organization's tax exemption is retained automatically unless the IRS decides to revoke it (assuming the organization actually files the required information).

Restrictions on Donor-Advised Funds:

Donor-advised funds accept gifts from donors and then consider the donor's suggestions on later grants of the funds. In the 1980's, some in the private foundation world viewed DAFs as a threat, since there would be little incentive to establish a foundation if a DAF could do the same thing without all the restrictions on foundations, yet private foundations have continued to thrive while billions of dollars flowed into DAFs in the intervening years. The staff draft would provide new limits on DAF operations, including prohibitions on grants to private foundations or individuals, and the imposition of several restrictions on use of DAF funds for purposes which might benefit the donor.

Elimination of Supporting Organizations:

Following complaints that some donors establish a particular type of "supporting organization" and then borrow back their donation, the staff draft proposes the elimination of the "type III" supporting organization. The staff propose that donors could use donor-advised funds instead. 

The proposal is unclear as to how nonprofits, such as other charities, social action groups, unions, agricultural groups, and trade and professional associations, that conduct activities through such support groups that could not qualify under Code Section 501(c)(3) standing on their own, would operate under this new system.  This suggests that insufficient thought has been given to the tidal (as opposed to ripple) effects some of the draft proposals would have well beyond the areas in which abuse has been documented.

 Eliminate Many Credit Counseling Agencies:

 Again, following much media coverage about consumer credit counseling organizations, the staff draft proposes far-reaching restrictions on credit counseling agencies. Some of these proposals, such as a requirement for individual counseling, follow recent IRS rulings; other proposals, such as a requirement that no more than 20% of a CCA's board be employees or persons who will benefit from the organization's activities, are new. The proposals would essentially eliminate many of the more modern CCAs, including those who have helped millions of Americans lower their credit card penalties and interest payments through Debt Management Plans. The proposals would limit debt management services only to low-income persons, and prohibit the solicitation of voluntary contributions to the agency from those who receive services from it.

 Penalize Individuals and Charities Involved in Tax Shelters:

 Recently, some financial planners have used charities as "tax accommodation parties" to facilitate tax shelter schemes. The IRS has cracked down on these practices, and the staff draft proposes a variety of penalties to be levied on the charities and individuals involved in such schemes. The penalties include loss of exemption for the charities and repayments of the tax savings from any such schemes by persons involved.

Apply Private Foundation Self-Dealing Rules to Charities and Raise Taxes:

Under current law, private foundations are subject to far greater restrictions on activities than are publicly-supported charities. For example, an insider cannot provide below-cost rental space to a private foundation, even if all of this benefit runs to the foundation; that would be prohibited "self-dealing." Public charities, on the other hand, can accept the benefit of this sort of bargain. The staff draft would impose the restrictive foundation rules on public charities. This is a sweeping change, and would negate the principal concepts embodied in the 1995 imposition of "intermediate sanctions" rules on public charities and social action groups (the intermediate sanctions rules for charities are a limited form of the foundation self-dealing rules that only prohibit "unreasonable" financial transactions, rather than an absolute bar on all such transactions).

In addition, the staff draft would increase taxes on prohibited transactions, such as self-dealing, to an unknown amount (represented in the staff draft by "XX"). Since these new taxes would now be imposed on charities, they will penalize charities which otherwise avoid the prohibition on self-dealing. Note that some of these taxes are PERSONAL to the managers of the organization.

Prohibit Compensation for Foundation Trustees:

The staff draft contemplates that foundation trustees should serve without compensation, and would prohibit compensation.

Limit Compensation from Foundations:

The staff draft also would limit compensation by foundations to government rates. Any compensation above government rates would have to be reviewed by the IRS.

Limit Calculation of Administrative Costs by Foundations:

The staff draft would limit administrative costs of a foundation to 35% of total expenses. Expenses beyond that point would not count toward a foundation's required annual payout.

Limit Expenses by Public Charities:

The staff draft would limit charities from paying travel, meal or accommodation expenses greater than government rates. Excess payments would be taxed at 10 percent to the charity, and required to be repaid by the individual who received them. To avoid the limit, a charity's Board could approve an excess expense reimbursement and the excess could be shown on the charity's annual return (Form 990).

 Form 990 Changes:

The staff draft, taking cues from the recently-passed Sarbanes-Oxley financial accountability law, also proposes numerous changes in exempt organizations' annual tax information returns (Form 990). Some of the changes include: requiring the CEO to sign and certify the return, increased penalties for failing to file or filing an inaccurate or untimely Form 990, and requirements that independent auditors review the Form 990. In addition, the staff draft proposes that an organization attach additional information to a Form 990, including information about "insider deals" and affiliations between organizations. The staff draft also would require that all tax opinions and conflict of interest opinions be made public.  Finally, the staff draft contemplates disclosure of charities' investments, and a more detailed description of an organization's activities and goals. One of those reports, for example, would be how often the Board of Directors met during the year, and how often the CEO was not present during that meeting.

 Additional Public Disclosure:

The staff draft also proposes numerous changes in public disclosure requirements for tax-exempt organizations. Financial statements, final determinations, audit results, and unrelated business income returns would have to be made public and posted on the organization's web site.

Governance Proposals:

One of the most sweeping areas of the staff draft document is in Board Governance, which follows the Sarbanes-Oxley principles discussed above. As noted above, the staff draft would "establish" federal liability for breaches of directors' duties. In addition, independent compensation consultants would have to be hired for annual reviews of all management compensation. The Board would have specific federal obligations for organizational and operational policies, performance measures, financial and accounting measures, independent audits, regulatory compliance, business transactions, and so on. Although Boards generally have such responsibilities now, the staff draft seems to contemplate the establishment of specific federal requirements and guidelines which would be enforced by federal prosecution.

In addition, the staff draft proposes specific Board composition requirements, such as that one-fifth of the Board must be independent, and specific operational requirements, such as an IRS-approved "prudent investor" rule. The staff draft suggests that the IRS enter into contracts with outside organizations to encourage these "best practices" and "accreditation" of charities both nationwide and in "classes" of activity, such as "private foundations, land conservation, etc."

Private Right of Action:

Finally, the staff draft would authorize directors and outside individuals to sue for alleged violations. The IRS would have some role in pre-suit review, as would certain state officials. If a complaint is deemed "frivolous" at the conclusion of such a suit, the complainant could be assessed certain financial penalties.




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Draft regulations

Gee...thanks Enron.

Draft Congressional Report

"Don't spank the baby with an ax."

AICPA Comments on Grassley proposals

The Tax Analyst article failed to mention that the AICPA Exempt Organization Technical Resource Panel presented 14 pages of comments on the Finance Committee's staff draft report. If anyone would like to see the AICPA comments, they are posted on the website under the Not-For-Profit committee news, or I will send you a copy, if you email

AICPA Comments

AICPA's comments and white paper have been posted as news stories on 7/28 and 7/30.

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