CharityLawyer

Ripples from the Zambezi – Economic Development from the Bottom Up

2009-11-24T10:39:00.000-08:00

This post is the first in a series of book reviews designed to share some of my better finds with readers (and motivate me to reflect on some of the books I have read and to read the ones that have been languishing on my book shelf!). I bought Ripples from the Zambezi thinking it would be about development in Africa. It’s not.
In Ripples from the Zambezi, the author, Ernesto Sirolli, turns the top down model of grand economic development on its head. Instead, his focus is on nurturing the passion and creativity of individuals.

The title comes from Sirolli’s early experiments in economic development in rural Africa, where he worked as a foreign aid worker for the Italian government. The beginning of the book details his experiences in Africa and the ideas that those failed experiments planted in his mind.

From that experience, he learned firsthand the damage traditional top down development models could do and made it his life’s work to find a better way to build local economies. He later discovered that the ideas that germinated in Africa applied to Western economies too.

Sirolli’s approach builds on the theories of E.F. Schumacher, A.H. Maslow, Carl Rogers and others. The fundamental concepts underpinning Sirolli’s work include:

A belief in the intrinsic goodness of human nature.
If people don’t ask for help, leave them alone.
There is no good or bad technology to carry out a task – only an appropriate or inappropriate one. Something big, modern, and expensive is not necessarily best; it all depends on the circumstances.

However, this is not just a book of theory. Sirolli goes on to tell stories about the enterprises he ‘facilitated’ under austere economic conditions. Sirolli’s first success came in a small rural community called Esperance in Western Australia. In Esperance, Sirolli helped fishermen sell fish to the Japanese sushi market for six times what the local cannery was paying for their catch. Another business was started smoking the fish for gourmet markets. Another new business made quality sandals from local kangaroo hides. Sheep farmers developed a processing business that turned worthless old ewes into valuable hides, wool and mutton kebabs.

In rural Minnesota, Sirolli was hired to work in one of the poorest counties in the state with a workforce of only 3,000. Within four years, his effort had resulted in 30 new businesses, assisted 127 existing ones, retained 55 jobs and created 71 new ones.

In rural South Dakota, a penniless cattleman developed a welding repair business in a small town. Within two years, it employed 27 people who processed $90,000 worth of orders a month.

The success of Sirolli’s model depends upon empowering people rather planners and policy makers. “The future of every community,” Sirolli writes, “lies in capturing the energy, imagination, intelligence, and passion of its people.”

For more information on Sirolli’s methods, check out the Sirolli Institute’s website at http://www.sirolli.com/.

Change of Address!

2009-11-08T21:21:00.000-08:00

Please note CharityLawyer Blog is moving to a new address: www.charitylawyerblog.com . Hope to see you there!

Best,

Ellis

Nonprofit Law Urban Legends

2009-11-02T07:53:00.000-08:00

I recently contacted Gene Takagi, a noted California nonprofit lawyer, to confirm or deny an assertion regarding California nonprofit law that was made to one of our clients. He was kind enough to clarify the matter. We discussed that there are many such “nonprofit law urban legends” and he suggested that would be a good topic for a blog post! So, here is my list of popular “nonprofit law urban legends.” Please feel free to add a few of your own.

1.   Nonprofits Can’t Make Money. I covered this surprisingly persistent legend in a related post, but it bears repeating. The designation of an organization as “non-profit” or “tax-exempt” does not mean that the organization can’t have money left over in its bank accounts at the end of the year. Money that is not required to meet current expenses should be used to further the organization’s mission or can be set-aside as a reserve to cover future expenses.

2.   Nonprofits Can’t Lobby. This legend is actively harming the sector. Most nonprofits can actively lobby. While there are some restrictions on 501(c)(3)’s lobbying activities, only private foundations are prohibited from lobbying. Public charities may lobby within limits that can be quite generous. For excellent resources on this topic, visit http://www.afj.org/.

3.   Grant makers Can’t Fund Organizations That Lobby. Another harmful legend. Grant makers that are private foundations cannot earmark funds for lobbying. Grant makers that are public charities may make grants specifically to fund lobbying so long as they count such grants within their own lobbying limits. There are specific steps both types of grant makers may take to protect themselves from having a grantee's lobbying activities attributed to them. Grants from either type of grant maker are not flatly prohibited merely because the grantee is engaged in lobbying activities.

4.   Nonprofits Must Follow Roberts Rules of Order. Not only is following Roberts Rules of Order, Sturgis, or any other parliamentary procedure not legally required, its a bad idea to require Roberts Rules of Order in the organization’s governing documents. See Jack Siegal’s blog post on his Good Governance blog. Enough said.

5.   Nonprofit Staff Can’t Participate In Political Campaigns. Everyone, even a staff member or even a CEO or founder of a nonprofit has a first amendment right to engage in political speech in his or her individual capacity. Staff of 501(c)(3)s should, however, take care to restrict campaign activities to their personal time and avoid any impression of organizational support.

6.   Nonprofits Have To Make Their Books, Financial Statements, Board Minutes, etc. Public. In most states, nonprofits do not need to make documents other than their Form 1023, Application for Exemption and past three Forms 990, 990-EZ, and/or 990-T available for public inspection. There is an exception for organizations with voting members. Voting members may have broader state law rights to examine the organization’s books and records.

7.   Nonprofits Must Adopt All the Governance Policies Mentioned on the New Form 990. This is a fast growing legend. The IRS has indicated their belief that weak governance is a strong indicator of weak tax-compliance. None, I repeat, none, of the policies are legally required to be adopted, although many could be said to be a good idea for most nonprofits. Our approach is to recommend a conflict of interest, whistleblower, and document retention and destruction policy for nearly every tax-exempt client. We consider the necessity of the other policies on a case by case basis.

8.   They IRS Won’t Really Levy Penalties on Nonprofits. “I know our Form 990 is a year late and we didn’t extend it, but we only have a budget of 1.2 million and a staff of 12? They won’t really charge us a $50,000 late fee will they?” They will if you don’t have reasonable cause for being late. Being a nonprofit is not reasonable cause.

9. Nonprofits Can Hold Meetings and Vote by E-mail. Many states, including Arizona, require meetings to occur in a format where all parties can simultaneously hear each other. This means telephonic meetings are okay, but e-mail meetings are not. An alternative is to vote by written consent resolution and have each board member reply to the consent resolution by e-mail using a digital signature.  This will work in states where electronic signatures are accepted. However, in most states board votes by consent resolution must be unanimous to be effective. For more information regarding e-mail votes, see http://is.gd/4L9zf.

Even with the wealth of information floating around on the Internet, there are and always will be urban legends that laypersons (and even some lawyers!) will insist must be adhered to, often in support of an agenda. Be prepared to do your due diligence to find out what is required, what is a best practice, and what is just plain made-up.

Arizona Corporation Commission Changes Impacting Nonprofit Corporations - Good News and Bad News

2009-10-29T17:12:00.000-07:00

First, the Bad News

Recent reductions in the Arizona Corporation Commission's budget are impacting nonprofit corporations doing business in Arizona in the following ways:

Increased Turn-around Time. The turn-around time for filings will likely increase over the next six to twelve months, with regular filings taking as much as 250 days to be processed and expedited filings taking as much as 50 days to process. While there may be some consideration given when a document needs to be filed on an emergency basis (for example, to complete a transaction), the Arizona Corporation Commission will likely not be staffed to handle "emergency" filings on a regular basis.

No Notice of Annual Reports. Nonprofit corporations doing business in Arizona are required to file an annual report with the Arizona Corporation Commission. In the past, the Arizona Corporation Commission sent postcards to corporations reminding them when their annual report was coming due. As of October 1, 2009, those postcards will no longer be sent. Each corporation is responsible for knowing when its annual report is due. If the annual report is not timely filed, the Arizona Corporation Commission may proceed with administrative dissolution of the corporation. Corporation's can check their due date for filing the annual return and obtain a copy of the form online.

Now for the Good News

Financial Statements. As a result of legislation that passed last year, nonprofit corporations are no longer required to file a financial statement with the annual report. Annual reports will continue to be accepted if a financial statement is included, but nonprofit corporations do not need to expend the time or resources to complete a financial statement for the annual report.

Affidavits of Publication. As a result of legislation that passed earlier this year, affidavits of publication for any type of document are no longer required to be filed with the Arizona Corporation Commission. The Arizona Corporation Commission will accept an affidavit of publication for filing, but there will be no associated filing fee. Publication requirements remain unchanged and, therefore, corporations should continue to publish documents as necessary, obtain affidavits of publication and maintain the affidavits in their corporate records if they choose not to file them with the Arizona Corporation Commission.

Nonprofit Law Jargon Buster - Public Support Test

2009-10-28T02:14:00.000-07:00

Today’s Nonprofit Law Jargon Buster is a doozy so keep your hat on.

In the last Nonprofit Law Jargon Buster, we looked at the difference between a private foundation and a public charity. The default rule is that all 501(c)(3) organizations are private foundations unless they qualify as public charities. Private foundations are subject to more restrictions than public charities and have to pay a tax on investment income so qualifying as a “public” charity is usually considered a pretty darn good thing.

We sometimes get panicked calls from public charities that have been informed that they have “failed their public support test” and must now operate as a private foundation. What does it mean when your lawyer or accountant says your organization has failed its “public support test”?

As discussed in last week's Nonprofit Law Jargon Buster, there are some organizations that are, by their very nature, considered “public.” These include churches, schools, and hospitals. Other types of charitable organizations must pass one of two mathematical tests calculated on a four year rolling average to qualify is public.

For ease of reference, I refer to the two alternative tests as the “donative charity test” and the “gross receipts charity test.”

Donative Charity Test. To satisfy this test, the charity must normally receive at least 1/3 of its total income from government grants, grants from other public charities, and from members of the public. However, there is a 2% limit on the amount of funding from any one donor, foundation, or corporate funder that can be counted in the numerator. Therefore, only 2% of a gift from any one donor, foundation, or corporate funder will be counted in the numerator while the entire amount of the gift will be included in the denominator, making it harder to pass the 1/3 test.

For charities trying to meet this test, the proportion of public support can drop as low as 10% if the charity meets a facts-and-circumstances test that indicates it is working to attract public support.

Gross Receipts Charity Test. A charity can pass this test if it normally receives at least 1/3 of its total income from government grants, grants from other public charities, from members of the public, or from revenues generated by activities within the organization’s exempt purpose. Charities relying on this test are also subject to a different limit on the amount of funding from any one individual, foundation, or corporate funder that can be counted in the numerator. For such charities, only the greater of 1% of the charity’s total income or $5,000, whichever is less, will be counted in the numerator while the entire amount of the gift will be included in the denominator.

This test also places a limit on the amount of investment income that the organization can earn. To meet this test, no more than 1/3 of the organization’s total income can come from investments.

Unusual Grant Exception. Under some circumstances, an unusually large and unexpected grant can be excluded from both the numerator and the denominator in calculating the public support tests. Unusual grants are essentially grants from disinterested persons that are unusual or unexpected and that, due to their size, would adversely impact the organization’s public support test.

These explanations do not begin to do the complexity of these tests justice. As with most tax law concepts, there are exceptions, exclusions, exceptions to the exceptions and so on. Upon careful analysis, we often find that contributions have been misclassified or that there are other strategies we can recommend to preserve the organization’s public charity status.

Top 10 Smart Moves Great Nonprofit CEOs Make (From a Lawyer’s Perspective)

2009-10-23T10:01:00.000-07:00

In addition to the governance and tax issues we deal with on a daily basis, there are a number of governance and legal distractions we tend to see repeated over and over again in the nonprofit community. The following list of smart moves are traits that CEOs of clients who successfully avoid these distractions tend to share:

1. Asks Forgiveness, Not Permission. I receive calls from nonprofit CEOs who are struggling with their boards. I am also asked by boards to intervene when there is a an issue with the CEO. What I have learned is that great CEOs do not overly confer with the Board. Instead, great CEOs understand that it is their job to implement the Board’s strategy within the scope of the strategy, policies, and budget the Board has set. Too much “checking-in” can have the unintended consequence of inviting the board to micro-manage. Conversely, scribbling too far outside the lines of the board approved strategy, policies, and budget can get a CEO fired.

2. Assembles a Trusted Team of Professional Advisors. Great CEOs form long-term relationships with a banker, an insurance broker, a lawyer, and an accountant who understand non-profits. Its best to form these relationships when the organization is doing well so that the organization will have strong relationships to fall back on when problems arise.

3. Understands Legal and Compliance Duties are Not Aspirational. Great nonprofit CEOs take their legal, tax, contractual, and other duties seriously. Legal and tax problems are not only expensive to correct, but can be particularly devastating to nonprofits that rely on donor goodwill. Unlike for-profits that can usually correct compliance problems by writing a check, compliance issues for tax-exempt organizations can lead to revocation of tax-exempt status which usually spells the end of the organization.

4. Uses a Professional Employer Organization (“PEO”). Employment practices liability is the leading risk for nonprofits. PEOs enable nonprofits to cost-effectively outsource the management of human resources, employee benefits, payroll and workers' compensation to human resource professionals. Great CEOs know that outsourcing high risk functions reduces risk and helps the organization focus on its mission.

5. Protects Trade name/Trademark/Donor Lists. All successful organizations have valuable intangible assets. Nonprofits trade on their reputation and public goodwill. A nonprofit that is appealing to donors likely has a distinctive trade name and trademark as well as valuable donor information. Great CEOs know that failure to protect these assets can be devastating to a nonprofit.

6. Expects/Asks for a Reasonable Salary. Great nonprofit CEOs know that if they don’t take care of themselves, they can’t take care of the nonprofit’s business. Many nonprofit executives work for very little early on and hope to receive a severance payment to make up for it when they retire. If the nonprofit is a charity, paying an insider money the nonprofit does not legally owe for services already rendered raises private inurement and excess benefit issues. Great CEOs build a reasonable salary for their services into their budget.

7. Trusts, but Verifies. Great CEOs implement checks and balances that secure and protect the nonprofit’s funds and other resources. They know that just because they are working in the nonprofit sector, they still need to conduct business on behalf of the organization with the same level of diligence and care they would use if they were running their own business. Dishonesty, sadly, is not limited to any particular sector.

8. Creates a Sound Succession Plan. Great CEOs do not leave a leadership gap in their wake. They know that to be sustainable, the organization needs to develop talent that can pinch hit and take over if necessary. Great CEOs identify and nurture potential leaders within their organization.

9. Selects Professional Statutory Agent. Great CEOs know that a statutory agent receives crucial documents such as service of lawsuits and court filings as well as notices of potential problems with a nonprofit’s corporate status. These matters are simply too important to delegate to a volunteer.

10. Doesn’t Over-rely on Pro Bono Services. Great CEOs know that you get what you pay for. Even if that lawyer or accountant who serves on the nonprofit’s board has a great reputation, that does not mean the board member has the specific expertise required or the time to work on the organization’s matters for free. Shop around for professional service providers and don’t be afraid to ask for alternative fee arrangements. Many professionals will offer more favorable fee arrangements for long-term clients.

Nonprofit Law Jargon Buster: Private Foundation v. Public Charity

2009-10-19T01:59:00.001-07:00

Generally, ever since 1968, Section 501(c)(3) organizations have been divided into two categories for tax purposes: public charities and private foundations.

Public Charities. Public charities generally depend on outside funding. Some organizations, including churches, schools, and hospitals, are, by their very nature, considered "publicly supported." Other organizations must pass one of two mathematical public support tests to qualify as a public charity. These tests require charities to obtain funding from many sources rather than one funding source or a small group of related funders. This requires public charities to conduct their affairs in a manner that attracts donor support.

Private Foundations. In contrast, private foundations are usually privately created and funded by an individual, a family, a company, or a small group. As a result, private foundations are generally not dependent upon the support of outside donors. For this reason, private foundations are not subject to the same degree of scrutiny from the public as public charities that depend on donor support for their survival.

Private foundations are subject to a more strict regulatory regime than public charities. There are penalties for "self-dealing" transactions, failure to distribute sufficient income for charitable purposes, holding concentrated interests in business enterprises, making risky investments, and for making certain types of expenditures. Public charities are exempt from these penalty regimes, however, public charities are prohibited from conferring excessive benefits on private interests.

In essence, when a charity passes one of the public support tests, it is demonstrating to the IRS that a sufficiently broad segment of the general public (non-insiders) have evaluated the charity’s performance and found it worthy of their support. As a result, Congress treats such charities as having received the public’s stamp of approval, reducing the need for the strict IRS scrutiny applied to private foundations.

IRS Releases New Video Series to Help Exempt Organizations Understand Redesigned Form 990 Requirements

2009-10-14T10:02:00.000-07:00

The Internal Revenue Service has launched a new case study and video series to help exempt organizations and their tax preparers better understand the newly revised Form 990 series which must be filed for the 2008 tax year.

The revised Form 990, redesigned for the first time in nearly 30 years, requires significantly more disclosure and transparency by exempt organizations. Most organizations that are exempt from federal taxation under Code Section 501(c) are required to file Form 990. The additional information captured on the revised Form 990 will give the IRS and the public a better view of how exempt organizations operate including a more detailed look at expenditures and executive compensation.

To help illustrate key points and answer important questions about the new Form 990, the IRS' Exempt Organizations Division developed "The New Form 990: Getting Started," a case study about a hypothetical organization - Exempt Organization for Disaster Relief (EODR). The hypothetical case study includes a set of facts describing organizational and financial aspects of EODR, and a completed Form 990 based on those facts. A video series walks viewers through common Form 990 reporting issues. The series includes the following segments:

Overview - This video is a good place to start for people who have questions about the redesigned Form 990. It reviews some of the key things to consider about the Form 990 and the various schedules that may need to be completed, particularly Schedule R.
Revenue and Expenses - This segment covers two of the financial statement portions: Part VIII, Statement of Revenue, and Part IX, Statement of Functional Expenses. It looks at how to fill out the required columns of information for revenue and expenses
Balance Sheet, Supplemental Financial Statements, and Schedule D - In this video, the IRS reviews Part X of the Form 990, the Balance Sheet, and Part XI, which covers Financial Statements and Reporting. Some of the differences from the prior version of Form 990 are explained. This segment also focuses on parts of Schedule D, Supplemental Financial Statements.
Program Services, Other IRS Filings and Tax Compliance - This video focuses on Part III, which allows an organization to “tell its story” and describe its program services, and Part V, which covers other IRS filings and areas of tax compliance. Part V will alert exempt organizations whether they have other filing obligations besides the Form 990 and will help exempt organizations determine whether they engage in activities that raise tax compliance concerns.
Compensation - In this segment , the IRS focuses on Form 990 compensation reporting in Part VII. There is an explaination regarding who needs to be listed in Part VII and explaination of the three types of compensation to report. The segment also highlights Schedule J, the compensation continuation schedule.
Governance - In this segment, the IRS describes how to complete Part VI of the redesigned Form 990, which requests information about the organization’s governing body, management, policies and procedures, and disclosure practices. The segment also focuses on Schedule L, which requests information on transactions with interested persons, such as directors, officers, key employees, and their family members.
Summary, Schedules, Signatures - This segment covers Parts I, II and IV of the Form 990—Summary, Signature Block and Checklist of Required Schedules. It also provides an overview of several new schedules to the Form 990.

Nonprofit and Charity Law Jargon Buster - Non-profit vs. Tax-exempt.

2009-10-11T01:59:00.000-07:00

When you visit your lawyer or C.P.A, do you feel like you have entered a foreign land where people speak in ambiguous terms and obscure numerical references? If so, you have experienced the mind numbing qualities of non-profit and charity law jargon. Those of us who practice non-profit law are all guilty of it. To pay my debt to society, I will attempt to demystify a bit of non-profit law jargon each week. I welcome feedback regarding the clarity of the explanation.

Non-profit vs. Tax-exempt.

Non-profit. The designation of an organization as “non-profit” or “for-profit” is a concept of state law. Under state law, for-profit organizations are created to make money for their owners and investors. Designating an organization as "non-profit" only means that the organization is created for some purpose other than making a profit for owners or investors, but not necessarily for a purpose that would qualify it for exemption from taxes. For more about how to form a non-profit under state law, see my earlier post on starting a non-profit.

Tax-Exempt. Designation of an organization as "nonprofit" under state law does not mean the organization is also "tax-exempt". With few exceptions, organizations must apply to the IRS for a determination of tax-exempt status. There are numerous types of organizations that qualify for various tax exemptions including exemptions from tax on income that is earned in the course of conducting activities related to the organization's tax-exempt purpose. The most common type of tax-exempt organization is a 501(c)(3) organization. To qualify as a 501(c)(3) organization, the organization must apply to the IRS on Form 1023. Some states also require non-profits to submit an application to the state to qualify for exemption from state income tax as well as various other state taxes. For more information about the process of applying for tax-exempt status, see my earlier post on applying for tax-exempt status.

Both Nonprofits and Tax-Exempts Can Make Money.

This seems so obvious, but I get at least one call a year to settle an argument about whether all the organization's money has to be spent by the end of the year. Really! So, just to be clear, the designation of an organization as "non-profit" or "tax-exempt" does not mean that the organization can't have money left over in its bank accounts at the end of the year. Money that is not required to meet current expenses should be used to further the organization's mission or can be set-aside as a reserve to cover future expenses.

Charity Raffles - Tread Carefully

2009-10-07T01:16:00.000-07:00

As the recession deepens, we get more and more creative ideas from people wanting to conduct complex raffles. The most popular questions this year involve raffles of real estate. While raffles can be great revenue generators for charitable organizations, many charities do not realize that in most states, including Arizona, raffles are illegal gambling. Cautionary tales abound. Most states have specific exceptions for charitable raffles but require the charity and the raffle to meet specific criteria to qualify. For example, a raffle is not gambling in Arizona if:

it is sponsored by a nonprofit that has been in existence for 5 years;
no insider receives a direct or indirect pecuniary benefit other than participation on an equal basis with all other participants; and
no person participates directly or indirectly in the management, sales or operation of the raffle other than the non-profit's employees and agents.

Many juridictions require non-profits to obtain a permit to conduct a raffle. Permits can take weeks or even months to process. In addition, there are number of tax issues that must be considered when planning a raffle. Tax issues include the following:

Deductibility of Ticket Price. A ticket purchaser has not made a deductible gift. The consideration pid is considered equal to the "chance" to win a prize therefore there is no disinterested gift and therefore no contribution deduction.

Deductibility of Prizes Contributed. Those contributing prizes to the raffle may be entitled to a deduction depending upon whether the contribution is an interest in property (as opposed to a non-deductible service or right to use property). The charitable deduction for in-kind contributions that are raffled off in support of a charity are generally going to be limited to the taxpayer's basis in the property (rather than fair market value).

Non-profit's Obligation to Report Prize Income. The prizes are taxable income to the winners so the non-profit must ensure it properly reports the raffle prizes to the I.R.S. Generally, raffle prizes must be reported on Form W-2G with a copy to the winner if a) the amount paid, reduced by the amount the person paid for the chance to win a prize, is $600 or more; and b) the payout is at least 300 times the amount of the wager.

Non-profit's Obligation to Withhold from Prize Income. If the fair market value of winnings amount to more than $5,000, the non-profit must withhold taxes from the winnings and report this amount to the I.R.S. on Form W-2G. The non-profit is liable for any tax it fails to correctly withhold.

Back-up Witholding. If the prize is reportable (the amount paid, reduced by the amount the person paid for the chance to win a prize, is $600 or more; and b) the payout is at least 300 times the amount of the wager) and the winner fails to supply a taxpayer identification number, then the Foundation must withhold 31% of the total proceeds.

Federal Laws. Federal law strictly limits non-profits from conducting multi-state raffles. If the non-profit plans to use the U.S. mails for any part of the raffle – e.g. for mailing entry cards or raffle tickets – there are federal laws and regulations that bear consideration. Also, the FTC is empowered to regulated certain types of sweepstakes and contests.

Non-profits sponsoring raffles should consider creating raffle rules and treating them as contracts. Drafting detailed rules permits the non-profit to set defined limits on the giveaway – who may participate, what laws apply, warranty and liability disclaimers, etc. Raffle rules also provide a way for non-profits to cancel or modify their obligations in the event that too few tickets are purchased or there are other technical problems. We have also advised non-profits running raffles to have the raffle winner (or winners) sign an affidavit of eligibility and a release of liability. This is a good place to ensure the winner understands his or her tax reporting obligations and is eligible to accept the prize.

Constructing a legal and compliant raffle takes time and may require the advice of a professional. Non-profits that take care to do it right will avoid embarrassing and costly legal mistakes and have a model that they can use to raise funds again and again.

Top 15 Non-profit Board Governance Mistakes (From a Legal Perspective)

2009-10-04T14:08:00.000-07:00

This list was started as the inaugural post to CharityLawyer Blog. The post struck a nerve, was mentioned by the Chronicle of Philanthropy, the Nonprofit Quarterly, and numerous bloggers and twitter users. San Francisco tax-exempt organizations lawyer and publisher of the Nonprofit Law Blog, Gene Takagi, reviewed the list and added five more governance mistakes from his own experience. The expanded list is instructive and therefore I have posted it in its entirety here.

1.    Failing to Understand Fiduciary Duties. When you volunteer to serve as a director or officer of a non-profit, you accept the responsibility to act with the duties of good faith, due care and loyalty. You also accept the potential liability for failing to fulfill those duties. Increased scrutiny from the I.R.S., Congress, state attorneys general, the Department of Justice, donors and the media require vigilance at every step. It is no longer sufficient to rubber stamp committee or staff recommendations or to simply “abstain” from dicey decisions. Today, board service comes with real responsibilities and real consequences for those that fail to live up to them.

2.     Failing to Provide Effective Oversight. Boards are entitled to delegate tasks to committees, officers, staff, or in certain cases, professionals, but only if they perform sufficient oversight. Oversight is commonly exercised through policies and procedures so long as the board ensures that the policies and procedures are actually followed. Common oversight mechanisms include review of financial statements and the annual Form 990 as well as the implementation of various governance policies. Popular governance policies for nonprofits include conflict of interest policies, executive compensation policies, travel and expense reimbursement policies, whistleblower policies, etc. Difficult tasks that require more time and focused attention can be delegated to committees. Common governance committees include those designed to oversee finances, investments, audits, and compensation.

3.    Deference to the Executive Committee, Board Chair or the Organization’s Founder. No one owns a tax-exempt non-profit. No one committee, director, or individual can control the organization. The executive committee, if one exists, is typically charged with acting on behalf of the board when the board is not in session and cannot be easily convened. It is, however, accountable to the full board and should not be permitted to operate as a “mini-board.” The chair’s primary duty is typically to preside over board meetings and to act as a liaison between the board and the chief executive. The chair does not have the power to override decisions of the board. Similarly, the founder may act as the chief executive and run the day to day affairs of the organization. The founder may also sit on the board, but even founders serve at the pleasure of the board. The board has a duty to review the performance and set compensation for the chief executive and if necessary, censure or even terminate the chief executive.

4.    Micro-managing Staff. For a non-profit organization with paid staff, once board members demand keys to the organization’s offices and start making direct demands on staff that report to the chief executive, the board has crossed the line. The board’s key duties are to provide oversight and strategic direction, not to meddle in the organization’s day to day affairs. Board members who cross this line are undermining the authority of the chief executive to their own detriment and should be prepared to quit their day jobs. Similarly, staff should not invite micromanagement by asking the board to take on day-to-day tasks that the staff should be handling. The size and budget of smaller organizations necessitates some blurring of these lines, but board members and staff should know their roles and attempt to adhere to them as much as possible.

5.    Avoiding The Hard Questions. It is can be uncomfortable to ask tough questions or to disagree with one’s fellow board members. However, group think rarely leads to sound decision-making. Often, the most valuable board members are the ones who, calmly and respectfully, speak their mind. It is important to set a tone that encourages a free exchange of ideas, both good and bad. Open, vigorous discussions about key issues should be encouraged. A board that passes every resolution “unanimously” should evaluate whether it needs to do more to encourage a thoughtful and open discussion.

6.    Insufficient Conflict Management. If a conflict of interest is with an insider, their family member or business, its not enough to simply disclose the conflict and have the disinterested directors approve the transaction. In such cases, the disinterested members of the board need to consider alternate arrangements that do not give rise to a conflict of interest. If after considering alternatives, the board still finds the transaction with the insider is in the best interest of the organization, then the board should carefully document the basis for the decision and the fact that the interested director did not participate in the deliberations or vote. The best practice is to follow the procedures outlined in the intermediate sanctions regulations to properly analyze and document the proposed transaction.

7.    Lack of Awareness of Laws Governing Tax-Exempts. Directors that hail from the for-profit world often assume nonprofits operate in a less-regulated environment. In reality, the opposite is true. Tax-exempt organizations enjoy an array of tax and other benefits. To ensure those benefits are not exploited, Congress and local governments have imposed additional legal requirements that tax-exempts must follow. It is essential that directors of tax-exempt entities be aware of the various federal, state, and local laws that apply to the organization. Many directors are unaware whether they are governing a private foundation, a public charity, a supporting organization, or another form of tax-exempt entity, all of which are subject to different limits on their activities. Board members should understand, at a minimum, the penalties they face for overpaying key employees or other insiders, for engaging in excessive lobbying or political activities, for accommodating tax shelter transactions, for making egregious bad bargains on behalf of the organization, the impact of failing to pass the public support test, etc. Ongoing board training and orientation for new board members is often the best solution.

8.    Operating with Outdated, Inconsistent Governing Documents. Over time, many organizations change their mission and purpose without updating their governing documents. Similarly, many organizations develop governance practices that do not comply with their original governing documents. For example, it is not uncommon to see bylaws that call for voting members although no member votes have ever taken place or bylaws with a term that calls for the cessation of the organization on a date that has long since passed. Frequently, these issues stem from copying another institution’s bylaws without regard to the distinctions between the organizations or current law. Encourage compliance by conducting regular reviews of the governing documents and checking the bylaws before electing additional officers or directors, creating additional committees, adopting amendments, etc.

9.    Airing Disagreements Outside the Boardroom. Every board’s motto should be “what happens in the boardroom stays in the boardroom.” Inherent in the duty of loyalty that all board members must adhere to, is an implied duty of confidentiality. Once an issue is settled by board vote, the board members who voted against the majority must present a united front. If a vote is so disagreeable that a board member cannot carry on in this manner, the board member should consider resigning. In extreme cases, if the board member believes the corporation’s rights are being violated, the board member could join together with other like-minded board members to bring a derivative suit to enforce the organization’s rights.

10.    Failure to Cultivate Board Diversity. The initial board is typically made up of friends and advisors of the organization’s founder. Over time, the initial board may reach out to their trusted friends and advisors to fill vacancies. This approach to board recruitment can lead to the “usual suspect” syndrome. This is where the same individuals who went to the same schools, belong to the same clubs, and hail from the same neighborhoods and professions are institutionalized onto an organization’s board. If your organization is run by a group of “usual suspects,” consider mixing it up by creating a matrix of skills, experiences, and backgrounds that would add valuable perspectives to the board. Those with law, accounting, and fundraising skills are obvious choices. Substantive mission- related skills are also important. For example, an educational organization may want to recruit a retired teacher or school administrator; whereas, a domestic violence shelter may want to include a policy expert, social worker, or someone who has been a victim of abuse.

Plus, Gene Takagi’s excellent additions:

11.    Recruiting and Selecting Board Members Without Due Care. We sometimes select friends, relatives, and business associates often because we believe that they will share our vision, support our views, and make meetings pleasant. And sometimes because we can't find anyone else. We sometimes select influential and wealthy individuals because they will contribute substantial sums to the organization and connect us to their network of other influential and wealthy persons. All of this may be well and good, but only if we make sure that we select directors who are going to attend meetings, provide real oversight, and govern using their independent judgment.

12.    Failing to Educate and Motivate Board Members. If we're not in startup mode, we may be stuck, at least temporarily, with a number of directors who regularly fail to meet their legal duties of care and loyalty. Amidst all the media attention on cases involving intentional misconduct, we should recognize that the vast majority of directors simply don't understand what they are supposed to be doing and believe that they will not be held accountable for their inaction. It's up to the president, chair, executive director, and really each board member to correct this lack of understanding. While this may be an ongoing (and seemingly Sisyphean) process, we can make some quick fixes. Set up a basic orientation process. Invite a nonprofit-exempt organizations lawyer to present to the board (directors' ears tend to perk up when they hear the word "liability"). Regularly send out information to the board about the organization's major issues (it's okay to be repetitive if the issues remain outstanding) and how board members might help. Have the board conduct a SWOT (strengths, weaknesses, opportunities, threats) analysis on itself (not just the organization) and create an action plan based on the analysis.

13.    Failing to Document Actions Appropriately. Some of us adopt minutes that are virtual transcripts of board meetings. Others adopt minutes that only document actions without any mention of the process or deliberations. What's proper? Well, it depends. But often what's most appropriate lies somewhere between these two extremes. Documenting every discussion could create greater exposure for liability and makes it unlikely that minutes will be reviewed except in cases where we are looking for something specific. On the other hand, documenting only actions can result in a loss of institutional knowledge about why certain decisions were made and provide less evidentiary support of a board's due care in making decisions. Documenting nothing is not an acceptable alternative, but it's a common problem. Do we incorporate minutes of board committee meetings into our minute books? Do we even have minute books?

14.    Failing to Review Program Effectiveness and Efficiency and Take Appropriate Follow-Up Actions. Many of us board members understand that we are fiduciaries and have a responsibility to provide financial oversight. And we "know" that our charities are doing great work because the executive tells us so. But how do we really know this? And if charities exist to provide some sort of public good, and not to maximize profits, isn't programmatic oversight just as, if not more, important than financial oversight?

15.    Failing to Hold Executives (and Nonparticipating Directors) Accountable. This one earned a retweet from NY Times philanthropy correspondent Stephanie Strom. How many of us give regular performance reviews to our executives? Do we just give pats on the back (which we should do whenever deserved) or do we also take a hard look at deficiencies and take corrective actions? Many nonprofits are transitioning to younger, less experienced leaders as the boomers start to retire or move to other positions. Mistakes happen and may happen more often with new leaders. How do we respond to this? Do we document errors in judgment, complaints, abuses of authority? Are we prepared to fire an executive even without malfeasance where he or she is just not getting the job done? And what about removing directors who don't show up at meetings or otherwise fail to fulfill their governance responsibilities? Tricky stuff, but don't we need to deal with it?

Part III: Starting a Non-profit in Arizona - Applying for Tax-Exempt Status

2009-10-02T01:14:00.000-07:00

Having a nonprofit corporation is not the same as being tax-exempt. To obtain 501(c)(3) status, newly formed entities must apply to the IRS for a formal determination of exemption. Entities seeking 501(c)(3) status apply by filing Form 1023. (Entities seeking exemption under other sections of 501(c) file Form 1024.)

Newly formed organizations applying for exemption face a chicken and egg dilemma. Form 1023 requests considerable detail regarding the charity’s planned programs and activities. The attitude of the IRS is that requiring applicants to articulate detailed plans is a small price to pay for the significant tax benefits associated with 501(c)(3) status.

1.   Narrative Statement. Newly formed organizations often struggle to articulate their plans with the level of specificity the IRS demands. We generally try to provide at least a paragraph describing the who, what, when, where and how of each of the entity’s separately identifiable programs. Narratives statements that are very brief tend to elicit additional questions from the IRS. Narrative statements that go on for pages create an impression of trying too hard. We generally try to provide a 1-2 page narrative description.

2.   Language Matters. Many applicants unknowingly use language that has a specific meaning in tax-exempt organizations parlance. This can confuse the IRS and generate long lists of questions that may not apply, but nevertheless must be responded to. For example, there are strict rules that govern whether scientific research is “in the public interest” or “commercial.” Statements that the organization conducts “research” are likely to trigger a list of questions pertaining to scientific research. The terms “advocacy,” “partnership,” “political,” and “publishing” can cause similar confusion.

3.   Ancillary Documents. Often, the IRS will ask applicants to provide various contracts, grant applications and agreements, scholarship applications and guidelines, cost sharing agreements, and other evidence supporting the applicant’s plans. We have found that preparing and submitting drafts of the documents the planned activities call for can streamline the process significantly.

4.   Timing. The IRS has a process to screen applications. Applications the screener finds raise no issues are processed within a few weeks to a few months. If the IRS screener has any issues or concerns, the application is assigned to a specialist for review. It typically takes 4 to 5 months for the file to be assigned to a specialist. Once a file has been assigned, we usually receive follow-up questions within a few weeks. The time required to resolve follow-up questions depends upon the complexity of the issues and the experience and training of the specialist.

5.   Expedited Processing. It is possible to request expedited processing of the application in cases where the applicant has been offered a grant that will lapse if the entity does provide the funder with a favorable determination letter by a specific date.

6.   Interim Fundraising. Until the new charity receives its determination letter, it should disclose to potential donors that an application for 501(c)(3) status is pending. If the application is filed within 27 months of the date of incorporation and is ultimately approved, the entity’s 501(c)(3) status will be retroactive to the date of incorporation. Donors who claim a charitable deduction before IRS issues its determination letter assume the risk that application will not be approved. Many non-profits work with a fiscal sponsor during its start-up period to ensure their donors that their contributions will be deductible.

7.   Cyber Assistant. The IRS has announced its plan to unveil a new Form 1023 preparation program called “Cyber Assistant” some time during 2010. This new tool will guide applicants through the Form 1023, providing cover sheets for attachments, continuation sheets for lengthy responses, and relevant taxpayer education.

8.   User Fees. The IRS charges user fees to file an application for exemption. These fees are scheduled to increase on January 3, 2010. Organizations whose gross receipts average less than $10,000 per year currently pay $350. This fee will increase to $400. All others pay $850. This fee will increase to $850. When the Cyber Assistant becomes available later in 2010, applicants who use it will be eligible for a reduced user fee of only $200.

Part II – Starting a Non-profit in Arizona – Forming the Entity

2009-09-30T01:02:00.000-07:00

Once a non-profit founder has surveyed the non-profit landscape and found a legitimate need, recruited an initial board, created business and fundraising plans, and scraped together some start-up funding, he or she is ready to proceed. In Arizona, it usually makes the most sense to form the entity as an Arizona non-profit corporation. Very generally, the steps to creating a new non-profit corporation in Arizona are as follows:

1.   Prepare and File Articles of Incorporation. The filing of the articles of incorporation begins the organization’s legal existence. To qualify for tax-exemption, the articles must limit the corporation’s activities to tax-exempt purposes. The purpose statement should be broad and flexible enough to give the organization room to evolve, without being so all encompassing that it would permit it to engage in non-exempt activities. The articles must permanently dedicate the corporations’s assets to tax-exempt purposes and must not permit distribution of profits to private individuals. If the Articles do not meet these basic IRS requirements, the IRS will require amendments and may only grant exemption from the date of the amendment rather than retroactive to the date of incorporation.

2.   Prepare the Bylaws. The articles and bylaws collectively form the governance structure for the corporation. Perhaps most importantly, they prescribe how the board of directors is selected. In Arizona, directors can be selected by board vote, by designation of a third-party, by one or more members or delegates, or through a combination of these methods.

3.   Prepare Governance Policies. We recommend that newly formed corporations adopt certain key governance policies. Arizona law requires certain Arizona non-profits to have a Conflict of Interest Policy. Whistleblower and Document Retention and Destruction Policies help the corporation avoid violations of Sarbanes Oxley’s criminal provisions. Other governance policies that are typically considered at this stage include Gift Acceptance Policies, Compensation Policies, Travel and Expense Reimbursement Policies, and Joint Venture Policies.

4.   Hold Organizational Meeting. At the organizational meeting, the directors will approve the corporation’s articles and bylaws, elect directors and officers not identified in the Articles, adopt governance policies, pass a banking resolution authorizing the opening of a bank account, authorize the hiring of the chief executive and any conduct other initial corporate business.

5.   Obtain Tax Identification Number. In order to open bank accounts, the corporation will need to obtain a tax identification number from the IRS. It is very important that the number not be obtained before the organization is formed because the identification number cannot attach to a corporate entity that does not yet exist.

In Arizona, the time required to accomplish these steps depends on how complex the governance structure is, how quickly the founders can make the necessary decisions, and how quickly the Arizona Corporation Commission can process the articles. If the articles are filed on an expedited basis, a new Arizona non-profit corporation can usually be formed in a few days. Once the entity is formed, the next step is to apply for tax-exempt status which will discussed in Part III of this post.

Part I – Starting a Non-profit in Arizona – Laying the Groundwork

2009-09-27T17:41:00.000-07:00

I receive several calls a week from people who want to start a new non-profit. Looking back on my legal career, I realize that many of the tax-exempt organizations I helped to create early on never got off the ground. Today, I consider it part of my responsibility to the potential new client and to the sector to educate would be founders on the realities of the marketplace. What follows is a walk through the typical discussion that I have with potential founders.

1.   Does the Idea Have an Exempt Purpose? Not every good idea is something that will qualify for tax-exempt status. Examples include: making investments in start-up companies; providing benefits limited to a relatively small and defined class; and ideas for businesses that are indistinguishable from for-profits except that they commit to contribute profits to charity, just to name a few.

2. Running a Charity is a Competitive Business. Starting a nonprofit is a lot like starting a business. Rather than looking to access investors in the capital markets, charity start-ups are looking to access donors in the philanthropic markets. Would be founders need to know that there are already 1.4 million charities in the United States and competition for philanthropic dollars is fierce and grants are the smallest and most competitive piece of the philanthropic funding pie.

3.   Survey the Landscape. Today’s funders strongly discourage duplication of services. To get a realistic idea of your chances of attracting funding, research other non-profit organizations that are similar to the organization you propose. If there are others filling the niche and filling it well, do you have a plan to deliver the service in a new, innovative way? If you can’t differentiate your organization, it is going to be very difficult to attract philanthropic support.

4.   Do Your Homework. To obtain 501(c)(3) status, non-profits have to present the IRS with a detailed business plan. A business plan is not a mission statement. It is a statement that answers what you plan to do, when, where, how, by whom, for how much and with what funding. The IRS will also want to see a qualified and mostly independent board of directors. This can present a frustrating chicken and egg problem for many would be founders. If you can’t answer these questions in detail, consider whether you are really ready to start a non-profit.

5. Consider Alternatives. The cost in both time and resources to create and maintain a new non-profit can be daunting. Alternatives to creating a new entity include:
• partnering with an existing organization as a volunteer or fundraiser;
• creating a donor advised fund;
• finding an established charity with a related purpose to act as a “fiscal sponsor” of the project; or
• starting a chapter of an established national organization.

After discussing the above, if the potential founder is still ready to proceed, the next step is to review the actual mechanics of creating the organization and applying for tax-exempt status. This is the topic of Parts II and III.

In Honor of the Weekend - Recommended Foreign Film List

2009-09-24T20:37:00.000-07:00

In honor of the weekend, I thought I would post a list of foreign films of the last few years recommended to me by my friend Claudia Work. Claudia is a fellow lawyer and an organizer of the Scottsdale International Film Festival, so she knows what she's talking about. The festival is October 2-6. Hope to see some of you there!

The lives of others
I’ve loved you so long
Tell no one (ne le dis a personne)
Persepolis
Goodbye Lenin
Downfall
Indigenes (Days of Glory)
Joyeux noel (merry Christmas)
La vie en rose
Diving bell and the butterfly
Mongol
Volver
Pan’s Labyrinth
Tsotsi
A very long engagement
Les Choristes (the Chorus)
Once
Elsa and Fred
Rudo y cursi
The Queen
Ben X
OSS 117: Cairo, nest of spies
Balzac and the Little Chinese Seamstress
Osama
Caramel
Man on wire (documentary)
Rape of Europa (documentary)

And one recommendation of my own:

Before the Rain

Please contribute your own additions in the comments section. Have a great weekend!

Gift Restrictions - Permanent Endowment = Infinity and Beyond

2009-09-23T09:12:00.000-07:00

Most non-profits understand that if a fund is a permanent endowment, the principal must be preserved in perpetuity. Still, in my practice and in the ASU Lodestar Center course I teach on non-profit law, I am often surprised by how little some fundraising professionals understand about the mechanics of gift restrictions - particularly the implications of permanent restrictions and legal meaning of the term “endowment.”

Forever is a Really Long Time. The maintenance of permanent endowment funds is usually unquestioned until the organization is being acquired by another organization or the donor’s intent for which the funds are to be used is impracticable, impossible, wasteful, or otherwise impairs the management of the fund. Non-profits are sometimes surprised that they can’t simply transfer endowment funds to another charitable institution without permission from the original donor or the courts.

The Default Rules. The default law that governs endowment spending in most states, including Arizona, is the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA is a relatively new development that replaces the similarly named previous uniform act, known as UMIFA. UPMIFA’s more flexible spending rules permit spending based on a prudence standard that takes seven factors into consideration.

Understand the Meaning of the Message. Most fundraisers know that the use of the term “endowment” without any reference to a limited term creates a perpetual fund under UPMIFA. Fundraisers should also be aware that any words indicating the funds are not expendable on a current basis can override the favorable spending rules in UPMIFA. For example, any reference to “historic dollar value” or a direction to spend only “income”, “interest”, “dividends”, or “rents, issues, or profits”, or “to preserve the principal intact”, or will result in a fund with less flexible spending rules than UPMIFA’s prudence standard. UPMIFA’s favorable spending rules can be overridden by any “gift instrument” so it is important for non-profits to understand what a gift instrument is.

What are Gift Instruments? Under UPMIFA, virtually any record can serve as a “gift instrument” that legally restricts the gift. For example, an e-mail, a jotted down note clipped to the check, a statement in the memo portion of the check or even the text of the solicitation letter can serve as part of a gift instrument that will override UPMIFA.

Consistency is Key. When communicating with donors about a fundraising campaign, consistency is key. It is not uncommon for a fundraising campaign to span several years and for each solicitation to have different wording regarding what the funds will be used for. We have had cases where we struggled mightily to track the various restrictions that emerged from numerous inconsistent solicitation letters. It’s important to choose your messaging carefully at the beginning of a campaign and to be consistent.

Modification of Restrictions. If unforeseen circumstances cause the non-profit to be unable to live up to its side of the bargain (that is, maintaining the restricted funds forever) there is a process for modifying the restrictions. UPMIFA permits the non-profit to obtain written agreements from the original donors modifying the restrictions so long as the funds will be used for another charitable purpose. Alternatively, the non-profit may request a court order releasing or modifying the restrictions under certain circumstances. In states that have adopted UPMIFA, there is a new process for releasing small, old funds without going to court by giving notice to the state Attorney General.

Proposal to Abolish the Rebuttable Presumption

2009-09-22T01:52:00.000-07:00

The Chronicle of Philanthropy reports that Sen. Grassley is once again attempting to change the rules that impact how certain exempt organizations set executive compensation. This time, Sen. Grassley wants to do away with the “rebuttable presumption process” that exempt entities have been relying on to provide some measure of assurance that their compensation decisions will not trigger intermediate sanctions.

Intermediate Sanctions. The intermediate sanctions rules directly penalize insiders that are paid excessive compensation. The law also penalizes directors and others that “knowingly” approve the excessive compensation. The potential penalties are significant and should serve as a powerful deterrent to abuse.

The burden of proof is generally on the exempt entity to prove that its compensation decisions are reasonable. However, the law includes a process known as the “rebuttable presumption process” that exempt entities can follow to shift the burden of proof to the IRS. This process requires a review by disinterested members of the governing body of appropriate comparability data and adequate documentation of the decision.

Appropriate comparability data includes compensation levels paid by by similarly situated organizations, both tax-exempt and taxable, for functionally comparable positions. The location of the organization, including the availability of similar specialities in the geographical area, independent compensation surveys by nationally recognized independent firms, and written offers from similar institutions competing for the services of the individual are all appropriate comparabiltiy data. Essentially, the rebuttable presumption process requires an objective investigation into how the relevant labor market values the knowledge, skills and talent of the individual whose compensation is under review.

Proposal to Remove the Rebuttable . . . Safe Harbor? According to the amendment's official description, Grassley’s proposal is:

"[to] remove the safe harbor available to tax-exempt organizations with respect to reasonable compensation of executives."

The rebuttable presumption process is not a safe harbor. Rather, it’s a presumption of reasonableness that the IRS can, with sufficient evidence, rebut and overcome. The description of the amendment goes on to state that organizations are using these procedures to:

“. . . justify paying compensation comparable to executives in for-profit organizations, including comparables from for-profit entities that had nothing in common with the tax-exempt organization.” (Italics added)

Comparables from organizations that have nothing in common with the exempt entity are unlikely to be appropriate comparables. For example, comparing the head of a small local preschool's salary to the CEO of a large for-profit multistate college because both individuals are leading schools is clearly inappropriate. If the IRS can make a case that the comparables the exempt entity relied upon are inappropriate, then it can rebut the presumption of reasonableness and impose penalties. If the IRS cannot make its case, then the compensation is likely reasonable by market standards and should stand.

Impact of Proposed Amendment. The rebuttable presumption process has set the gold standard for determining executive compensation across the sector. We strongly recommend all of our clients follow it. Where there is abuse, the IRS has the ability to develop a strong case and rebut the presumption.

Removing the rebuttable presumption would permit the IRS to more easily attack compensation decisions without having to develop a strong case. It would also leave executives and boards of tax-exempt entities with significant concerns about their potential personal liability. Boards that are willing to follow the process should at least be rewarded with the knoweldge that the IRS will be forced to put together a strong case before challenging their decisions.

Sen. Grassley is also proposing legislation that would grant the IRS clear authority to require tax-exempt organizations to report certain governance practices, something they have already been doing without authority for over a year.

What is A Charity Lawyer Anyway?

2009-09-19T10:57:00.000-07:00

Since launching CharityLawyer, several of you have asked what, exactly, is charity law and what does a charity lawyer do? I’m glad you asked.

Non-profit and charity law is an astonishingly diverse and eclectic area of the law that touches on all aspects of general business law with a particular emphasis on the federal tax laws and state statutes that are exclusive to non-profits. Counter intuitively, tax-exempt organizations generally have more, rather than fewer, I.R.S. compliance issues. This is so because the I.R.S. must ensure that the valuable tax-exemptions, eligibility for deductible contributions, tax-exempt bond funding and other benefits are not exploited.

The practice is as diverse as the philanthropic sector itself. While charitable organizations make up the vast majority of the sector, there are actually over 27 categories of tax-exempt entities. The diversity of clients cover the whole spectrum of human interest and endeavor – from promoting arts and culture to religion/spirituality; from advancement in medicine and science to economic development; to protection of the environment, human rights, animal welfare and so on.

So, what does a charity lawyer do? At Fennemore Craig, where I am a director in the Non-profit and Tax-Exempt Organizations practice, we view ourselves as business and tax lawyers who specialize in representing charities and other non-profit and tax-exempt clients. We counsel clients at every stage of a non-profit's lifecycle from start-up, through operations, to dissolution. For example, we counsel clients with respect to I.R.S. and state law compliance, governance, joint ventures, mergers and acquisitions, restructuring, minimizing unrelated business income tax, lobbying and political activities, raffles and other fundraising activities, domestic and international grant-making, tax-exempt bond financing, tax-shelter law compliance, endowment management, negotiating complex naming rights and other major gift agreements, compliance with gift restrictions, advice regarding complex traditional and mission or program related investments, and the list goes on.

Non-profit clients also require assistance in the areas of employment, real estate, intellectual property, benefits, and occasionally litigation. We refer clients to specialists within the firm to handle these more typical business issues.

It is important to keep up with the fast developing areas of law impacting our clients, however, the most important characteristic for a charity and non-profit lawyer is a genuine passion for and interest in the philanthropic and community benefit sector. One of the most satisfying aspects of representing non-profit organizations is the opportunity to work with visionary clients. It is our privilege to help them achieve their vision of a better world.

Quick Tips for Setting Nonprofit Executive Compensation

2009-09-16T09:03:00.000-07:00

To ensure its decisions will stand up to the scrutiny of the media, regulators, and donors, and protect the employee as well as the board from personal liability, non-profits that employ executive staff should consider implementing practices and procedures that ensure its executive compensation procedures are thorough, well-documented, and conflict-free. Recommendations include the following:

1. Use the Rebuttable Presumption Procedures. Tax-exempt organizations must pay reasonable compensation. The Treasury Regulations outline a process for public charities and social welfare organizations that, if followed, shifts the burden of proof to the I.R.S. to prove that compensation is unreasonable. The I.R.S. has published a checklist that can be used for this purpose.

2. Create a Compensation Committee. A dedicated committee is often better able to devote the time and attention that executive compensation matters require. If a compensation committee is formed, it should operate pursuant to a formal delegation of authority from the board.

3. Adopt Comprehensive Conflicts of Interest Policy. A conflict of interest policy is strongly encouraged by the I.R.S. and is a legal requirement in some states. If followed, it can help protect directors and officers from liability stemming from transactions between the organizations and insiders.

4. Adopt a Compensation Policy. A compensation policy helps to create internal consistency by specifying comparable peer groups, target market position with respect to salary, long and short-term incentives that the foundation offers, total cash compensation, standard benefits, and any executive benefits and perquisites.

5. Use Appropriate Comparability Data. Reasonable compensation is the amount that would ordinarily be paid for similar services by similar enterprises, whether taxable or tax-exempt, under similar circumstances. To qualify for the rebuttable presumption, non-profits with annual gross receipts under $1 million must rely on at least 3 comparables. No threshold has been set for larger non-profits; however, the higher the proposed compensation, the more data the board should generally consider.

6. Assess All Components of Executive Compensation Relative to Comparable Organizations. It is important to ensure that total compensation is reasonable rather than comparing salary and various perquisites in isolation. All financial benefits (other than de minimus fringe benefits) must be included in the analysis and reported as compensation.

7. Have Full Board Approve Chief Executive’s Compensation. It is prudent to have the full board of directors approve the chief executive’s compensation package. Some boards approve other key executive’s compensation. Others delegate that task to the compensation committee or to the chief executive (within pre-established limits).

8. Have Full Board Approve Directors' Compensation. The full board of directors should approve any compensation paid to directors or trustees. This is a requirement under some state non-profit corporation laws. Due to the inherent conflict of interest, the board should base its decision on the certified opinion of an independent compensation consultant or recommendations from an independent ad hoc committee.

9. Adopt a Travel and Expense Reimbursement Policy. To ensure that travel and expense reimbursements are reasonable and necessary, non-profits should adopt a travel and expense reimbursement policy. This is a good place to memorialize the organization’s practices in areas of I.R.S. interest such as luxury travel and spousal travel.

10. Where The Stakes Are High, Obtain a Reasoned Opinion. A reasoned opinion from a lawyer, certified public accountant, or compensation expert protects the board from incurring penalties for “knowingly” paying unreasonable compensation to a key employee or other insider. The review can also serve as a valuable mechanism to discover and correct weaknesses in the analysis or documentation of the compensation process.

More Congressional Outrage Over Non-profit Executive Compensation

2009-09-15T02:43:00.000-07:00

As evidenced by the recent media coverage of the salaries paid to CEOs of four non-profits that contract with the government to deliver U.S. foreign aid, non-profit executive compensation continues to be an area of keen interest for the media and for key members of Congress. Each of the four executives earned over $500,000 in 2007 according to the organization's tax filings (Form 990). Both Sen. Chuck Grassley and Sen. Patrick Leahy made comments that the pay is excessive:

"It seems to me that these are salaries that are outrageous, particularly if they're government contractors," said Sen. Chuck Grassley of Iowa, the ranking Republican on the Finance Committee, which has jurisdiction over non-profit compensation.

"It conflicts with most people's notion of what a non-profit organization is about when they're paying themselves salaries that are several times higher than what a U.S. Cabinet secretary would earn," said Sen. Patrick Leahy, D-Vt., who chairs the subcommittee that funds foreign aid.

While it is true that these salaries are in excess of what a U.S. Cabinet secretary earns, that is not the standard. The standard is reasonable compensation in the amount that would ordinarily be paid for similar services by similar enterprises, whether taxable or tax-exempt, under similar circumstances. Based on this standard, it's not clear whether these executives are earning excessive compensation.

Running a large and diverse non-profit organization with a multi-million dollar budget and operations spread out across the globe does not require less skill because the organization is a non-profit. Non-profits compete with for-profits for executive talent, yet the Senators’ comments imply that executives who choose to run non-profit organizations should forgoe a significant portion of their earning potential for the privilege.

In my experience, most non-profits do pay reasonable salaries according to the reasonable compensation standard. Where many are coming up short is in adequately documenting the process in a manner that will substantiate and explain the compensation decision if questioned. More on that later.

IRS Issues Guidelines for Processing Exemption Applications

2009-09-13T20:05:00.000-07:00

The I.R.S. has made the guidelines it provides to its Exempt Organization determination specialists for processing tax exemption applications publicly available. The guidelines are organized by specific types of tax-exempt entities as follows:

• Donor Advised Funds
• Advance Approval of Individual Grant Procedures - Code Section 4945
• Charter Schools - Exemption Application Issues
• Government-Affiliated Organizations - Code Section 501(c)(3)
• Health Care Providers - Internal Revenue Code Section 501(c)(3)
• Hospitals Helping Staff Physicians Acquire Electronic Health Records Software
• Limited Liability Companies Associated with Tax-Exempt Organizations
• Low-Income Housing Tax Credit Partnerships
• Set-Asides - Code Section 4942(g)(2)
• Supporting Organizations - Code Section 509(a)(3)
• Voluntary Employee Beneficiary Associations - Code Section 501(c)(9)

These resources provide tax-exempt organizations and those hoping to qualify for exemption with valuable insight into the I.R.S.' current thinking on issues that impact their qualification for exemption.

Top 10 Non-profit Governance Mistakes (From a Lawyer’s Perspective)

2009-09-12T03:01:00.000-07:00

Lawyers who regularly represent tax-exempt and non-profit organizations are eventually solicited for advice regarding non-profit governance. Often these questions drift into management issues. While always quick to point out that my expertise is in non-profit law, not management, I have summarized some of the most common governance mistakes I have witnessed in my practice.

1. Failing to Understand Fiduciary Duties. When you volunteer to serve as a director or officer of a non-profit, you accept the responsibility to act with the duties of good faith, due care and loyalty. You also accept the potential liability for failing to fulfill those duties. Increased scrutiny from the I.R.S., Congress, state attorneys general, the Department of Justice, donors and the media require vigilance at every step. It is no longer sufficient to rubber stamp committee or staff recommendations or to simply “abstain” from dicey decisions. Today, board service comes with real responsibilities and real consequences for those that fail to live up to them.

2. Failing to Provide Effective Oversight. Boards are entitled to delegate tasks to committees, officers, staff, or in certain cases, professionals, but only if they perform sufficient oversight. Oversight is commonly exercised through policies and procedures so long as the board ensures that the policies and procedures are actually followed. Common oversight mechanisms include review of financial statements and the annual Form 990 as well as the implementation of various governance policies. Popular governance policies for nonprofits include conflict of interest policies, executive compensation policies, travel and expense reimbursement policies, whistleblower policies, etc. Difficult tasks that require more time and focused attention can be delegated to committees. Common governance committees include those designed to oversee finances, investments, audits, and compensation.

3. Deference to the Executive Committee, Board Chair or the Organization’s Founder. No one owns a tax-exempt non-profit. No one committee, director, or individual can control the organization. The executive committee, if one exists, is typically charged with acting on behalf of the board when the board is not in session and cannot be easily convened. It is, however, accountable to the full board and should not be permitted to operate as a “mini-board.” The chair’s primary duty is typically to preside over board meetings and to act as a liaison between the board and the chief executive. The chair does not have the power to override decisions of the board. Similarly, the founder may act as the chief executive and run the day to day affairs of the organization. The founder may also sit on the board, but even founders serve at the pleasure of the board. The board has a duty to review the performance and set compensation for the chief executive and if necessary, censure or even terminate the chief executive.

4.     Micro-managing Staff. For a non-profit organization with paid staff, once board members demand keys to the organization’s offices and start making direct demands on staff that report to the chief executive, the board has crossed the line. The board’s key duties are to provide oversight and strategic direction, not to meddle in the organization’s day to day affairs. Board members who cross this line are undermining the authority of the chief executive to their own detriment and should be prepared to quit their day jobs. Similarly, staff should not invite micromanagement by asking the board to take on day-to-day tasks that the staff should be handling. The size and budget of smaller organizations necessitates some blurring of these lines, but board members and staff should know their roles and attempt to adhere to them as much as possible.

5. Avoiding The Hard Questions. It is can be uncomfortable to ask tough questions or to disagree with one’s fellow board members. However, group think rarely leads to sound decision-making. Often, the most valuable board members are the ones who, calmly and respectfully, speak their mind. It is important to set a tone that encourages a free exchange of ideas, both good and bad. Open, vigorous discussions about key issues should be encouraged. A board that passes every resolution “unanimously” should evaluate whether it needs to do more to encourage a thoughtful and open discussion.

6.     Insufficient Conflict of Interest Management. If a conflict of interest is with an insider, their family member or business, its not enough to simply disclose the conflict and have the disinterested directors approve the transaction. In such cases, the disinterested members of the board need to consider alternate arrangements that do not give rise to a conflict of interest. If after considering alternatives, the board still finds the transaction with the insider is in the best interest of the organization, then the board should carefully document the basis for the decision and the fact that the interested director did not participate in the deliberations or vote. The best practice is to follow the procedures outlined in the intermediate sanctions regulations to properly analyze and document the proposed transaction.

7.     Lack of Awareness of Laws Governing Tax-Exempts. Directors that hail from the for-profit world often assume nonprofits operate in a less-regulated environment. In reality, the opposite is true. Tax-exempt organizations enjoy an array of tax and other benefits. To ensure those benefits are not exploited, Congress and local governments have imposed additional legal requirements that tax-exempts must follow. It is essential that directors of tax-exempt entities be aware of the various federal, state, and local laws that apply to the organization. Many directors are unaware whether they are governing a private foundation, a public charity, a supporting organization, or another form of tax-exempt entity, all of which are subject to different limits on their activities. Board members should understand, at a minimum, the penalties they face for overpaying key employees or other insiders, for engaging in excessive lobbying or political activities, for accommodating tax shelter transactions, for making egregious bad bargains on behalf of the organization, the impact of failing to pass the public support test, etc. Ongoing board training and orientation for new board members is often the best solution.

8.     Operating with Outdated, Inconsistent Governing Documents. Over time, many organizations change their mission and purpose without updating their governing documents. Similarly, many organizations develop governance practices that do not comply with their original governing documents. For example, it is not uncommon to see bylaws that call for voting members although no member votes have ever taken place or bylaws with a term that calls for the cessation of the organization on a date that has long since passed. Frequently, these issues stem from copying another institution’s bylaws without regard to the distinctions between the organizations or current law. Encourage compliance by conducting regular reviews of the governing documents and checking the bylaws before electing additional officers or directors, creating additional committees, adopting amendments, etc.

9.     Airing Disagreements Outside the Boardroom. Every board’s motto should be “what happens in the boardroom stays in the boardroom.” Inherent in the duty of loyalty that all board members must adhere to, is an implied duty of confidentiality. Once an issue is settled by board vote, the board members who voted against the majority must present a united front. If a vote is so disagreeable that a board member cannot carry on in this manner, the board member should consider resigning. In extreme cases, if the board member believes the corporation’s rights are being violated, the board member could join together with other like-minded board members to bring a derivative suit to enforce the organization’s rights.

10.     Failure to Cultivate Board Diversity. The initial board is typically made up of friends and advisors of the organization’s founder. Over time, the initial board may reach out to their trusted friends and advisors to fill vacancies. This approach to board recruitment can lead to the “usual suspect” syndrome. This is where the same individuals who went to the same schools, belong to the same clubs, and hail from the same neighborhoods and professions are institutionalized onto an organization’s board. If your organization is run by a group of “usual suspects,” consider mixing it up by creating a matrix of skills, experiences, and backgrounds that would add valuable perspectives to the board. Those with law, accounting, and fundraising skills are obvious choices. Substantive mission- related skills are also important. For example, an educational organization may want to recruit a retired teacher or school administrator; whereas, a domestic violence shelter may want to include a policy expert, social worker, or someone who has been a victim of abuse.