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NONPROFIT GOVERNANCE: INTERMEDIATE SANCTIONS, PROHIBITED TRANSACTIONS,

AND THE IMPLICATIONS OF SARBANES-OXLEY

KATHERINE E. DAVID, J.D. Oppenheimer Blend Harrison and Tate Inc.

711 Navarro, Sixth Floor San Antonio, Texas 78205

State Bar of Texas 24TH ANNUAL ADVANCED TAX LAW COURSE

September 28-29, 2006 Dallas

CHAPTER 16.1

Nonprofit Governance: Intermediate Sanctions, Prohibited Transactions, and the Implications of Sarbanes-Oxley Chapter 16.1

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TABLE OF CONTENTS

I. INTRODUCTION................................................................................................................................................... 1

II. EXEGESIS: THE DISTINCTION BETWEEN “CHARITABLE,” “NONPROFIT,” AND “TAX-EXEMPT”... 1

III. CURRENT LAW: PRIVATE INUREMENT, PRIVATE BENEFIT, EXCESS BENEFIT, AND PROHIBITED TRANSACTIONS .................................................................................................................................................. 2 A. Private Inurement ............................................................................................................................................ 2

1. Private Inurement Insiders....................................................................................................................... 2 2. Private Inurement Rule............................................................................................................................ 3 3. Private Inurement and Private Benefit..................................................................................................... 4 4. Private Inurement Consequences............................................................................................................. 5 5. Problems with the Revocation Penalty .................................................................................................... 5

B. Excess Benefit Transactions and Intermediate Sanctions ............................................................................... 5 1. Disqualified Persons ................................................................................................................................ 6 2. Excess Benefit Transaction Consequences.............................................................................................. 7 3. Correcting an Excess Benefit Transaction............................................................................................... 8 4. Penalty Abatement................................................................................................................................... 9

C. Prohibited Transactions ................................................................................................................................. 10 1. Private Foundations ............................................................................................................................... 10 2. Disqualified Persons .............................................................................................................................. 10 3. Prohibited Self-dealing .......................................................................................................................... 11 4. Self-dealing Consequences.................................................................................................................... 12

IV. THE SARBANNES-OXLEY ACT ...................................................................................................................... 14 A. Audit Committee Requirements .................................................................................................................... 15 B. Auditor Provisions......................................................................................................................................... 15 C. Document Destruction................................................................................................................................... 16 D. Whistle-blower Provisions ............................................................................................................................ 16 E. Indirect Application of Sarbanes-Oxley........................................................................................................ 16

V. EXEMPT-ORGANIZATION-SPECIFIC LEGISLATION.................................................................................. 16

VI. CURRENT RECOMMENDATIONS................................................................................................................... 18

VII. CONCLUSION ..................................................................................................................................................... 20


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INTERMEDIATE SANCTIONS AND SARBANES OXLEY

“We will discourage and deter noncompliance

within tax-exempt and government entities, and the misuse of such entities by third parties for tax avoidance or other unintended purposes. Non- compliance involving tax-exempt entities is especially disturbing because it involves organizations that are supposed to be carrying out some special or beneficial public purpose... If we don’t act to guarantee the integrity of our charities, there is a risk that Americans will lose faith in and reduce their support more broadly for charitable organizations, damaging a unique and vital part of our nation’s social fabric.”

Mark W. Everson Commissioner Internal Revenue Service March 15, 2004

I. INTRODUCTION

The quote above is foreboding, suggesting that untold numbers of exempt organizations, cloaked in shrouds of munificence, are fleecing the American public. Although some exempt organizations and their leaders do engage in egregious acts of selfishness at the expense of their missions, a large percentage of noncompliance is unintentional, the result of exempt organization leaders being overworked or under- informed. This article aims to address the second of those factors, by familiarizing those who represent exempt organizations with applicable provisions of the Internal Revenue Code (“I.R.C.”).

This article will explain four established concepts that apply to exempt organizations: the long-standing restrictions on private inurement, private benefit and prohibited transactions, and the relatively new system of intermediate sanctions on excess benefit transactions. The article also will discuss the Sarbanes-Oxley Act of 2002, which, though designed to promote transparency and accountability among publicly-traded companies, contains provisions that apply to exempt organizations and could have indirect effects on the nonprofit sector. Finally, the article will explore some current legislative efforts to promote transparency and accountability specifically among exempt organizations.

The purpose of this article is to lay out for practitioners current and proposed enforcement mechanisms that pose hazards for well-intentioned, but perhaps uninformed, exempt organizations.

II. EXEGESIS: THE DISTINCTION BETWEEN “CHARITABLE,” “NONPROFIT,” AND “TAX-EXEMPT” A not uncommon misconception is that the terms

“charitable,” “nonprofit,” and “tax-exempt” are synonymous. Nonprofit corporations may or may not be charitable, and may or may not be tax-exempt.1 Whether an organization is classified under federal tax law as a Sec. 501(c)(3) organization2 will directly impact what the organization and its managers may or may not do. For example, a Sec. 501(c)(4) social welfare organization may participate to some extent in political campaigns, but a Sec. 501(c)(3) organization that can accept tax-deductible contributions may not.3

1 I.R.C. §501(c)(3) requires that no part of the net earnings of the organization inure to the benefit of any private shareholder or individual. Thus, only nonprofit (and not for-profit) corporations are eligible for tax exemption under I.R.C. §501(c)(3). At the same time, the mere fact that an organization is a nonprofit corporation is not sufficient to support a exemption under I.R.C. §501(c)(3). For example, at least under Texas law, the purposes for which a nonprofit corporation may be incorporated are broader than the permissible purposes under I.R.C. §501(c)(3). A Texas nonprofit corporation may be formed for “charitable, benevolent, religious, eleemosynary, patriotic, civic, missionary, educational, scientific, social, fraternal, athletic, aesthetic, agricultural and horticultural purposes, and for the conduct of professional, commercial, industrial, or trade associations; animal husbandry; and operating on a nonprofit cooperative basis for the benefit of members.” Texas Business Organizations Code §2.002. A Texas nonprofit corporation organized for the purpose of conducting a trade association would not qualify for exemption under I.R.C. §501(c)(3), although it might qualify under I.R.C. §501(c)(4) or (6). Also, the dissolution provision required under I.R.C. §501(c)(3) is different from the one required by the Texas Business Organizations Code. To avoid the unfortunate result where a properly-formed Texas nonprofit corporation has its exemption application denied because of impermissible or lacking provisions in its Articles of Incorporation (necessitating time-consuming amendments to the Articles before the exemption process can resume), prudent organizers should track the language of I.R.C. §501(c)(3) and the applicable regulations, not the language of the Texas Business Organizations Code (and promulgated forms) in the Articles of Incorporation. Organizers also should avoid organizing a planned exempt organization for “all permissible purposes under the Code.”

2 The term “Sec. 501(c)(3) organization” is used to refer to an organization that is exempt from tax under I.R.C. §501(c)(3).

3 I.R.C. §501(c)(3) provides an exemption for “charitable” organizations, and I.R.C. §501(c)(4) provides an exemption for “social welfare” organizations. The concepts of charity


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Nonprofit corporations are subject to certain restrictions under state law. Nonprofit corporations that apply for and receive tax-exempt status are subject to federal restrictions. This article explores certain federal restrictions imposed on all Sec. 501(c)(3) organizations, whether public charities, private foundations, or private operating foundations, and explains how the restrictions are applied depending on the status—public charity or private (operating) foundation—of the organization.

III. CURRENT LAW: PRIVATE INUREMENT,

PRIVATE BENEFIT, EXCESS BENEFIT, AND PROHIBITED TRANSACTIONS The doctrines of private inurement, private

benefit, excess benefit, and prohibited transactions are four overlapping and mutually complementary concepts. These four sets of rules come from the Internal Revenue Code and are part of the regulatory structure that our federal tax laws place on charitable organizations that also want to be tax-exempt.

To apply these rules, one must find the persons to whom they apply (commonly referred to as “insiders”), determine the rule, and then identify the consequence of failure to follow the rule. This section will attempt these steps in a brief manner.

A. Private Inurement

The doctrine of private inurement derives from the language of I.R.C. §501(c)(3), which states as a requirement of a Sec. 501(c)(3) organization that “no part of the net earnings of which inures to the benefit

and social welfare are sufficiently similar that the same organization might qualify for exemption under both subsections of I.R.C. 501(c). E.g., Rev. Rul. 74-361, 1974-2 C.B. 159; Treas. Reg. §1.501(c)(4)-1(a)(2)(i). For federal tax law purposes, the primary difference between the two types of organizations is that Sec. 501(c)(3) organizations are prohibited from “carrying on propaganda or otherwise attempting to influence legislation” as a substantial part of their activities while Sec. 501(c)(4) organizations can be “action organizations”—drafting legislation, presenting petitions for the purpose of having legislation introduced, and circulate speeches, reprints, and other materials concerning legislation. Rev. Rul. 68-656, 1968-2 C.B. 216. Sec. 501(c)(4) organizations also may appear before legislative bodies, may encourage members of the community to contact legislative representatives in support of particular initiatives (Rev. Rul. 67-6, 1967-1 C.B. 135.) and may advocate particular viewpoints on controversial subjects (Rev. Rul. 68-656, 1968-2 C.B. 216.). Thus, for many organizations, the decision whether to seek exemption under I.R.C. §501(c)(3) or under I.R.C. §501(c)(4) will turn on whether it is more important that the organization be able to influence legislation or be able to attract donors with the promise of tax-deductible contributions.

of any private shareholder or individual.”4 The prohibition on private inurement distinguishes a nonprofit charitable organization from a for-profit organization.

A for-profit entity may provide returns on the investment to the investors that in the classic case are dividends to shareholders. Under Texas law, a nonprofit corporation cannot pay dividends to its members, directors, or officers.5 Tax-exempt charitable organizations serve public, not private interests. A condition of its tax exemption is that a Sec. 501(c)(3) organization be organized and operated for exempt purposes and not the benefit of private interests of its insiders. The private inurement doctrine was designed to ensure that exempt organizations serve exempt rather than private interests. In order to qualify for federal tax exemption, charitable organizations must comply with federal tax law prohibiting private inurement.6

1. Private Inurement Insiders

The “private shareholder and individual” mentioned in the statute frequently are referred to by the term “insiders.” Generally, an “insider” is a person who has a unique relationship with the exempt organization involved, through which that person can cause application of the organization’s funds or assets for the person’s private purposes by reason of the

4 This language in I.R.C. §501(c)(3) is the federal counterpart to Texas Business Organizations Code §22.053. The terms “shareholder” and “individual” are misleading. Though a few states allow nonprofit corporations to issue shares, most do not, making the term “shareholder” seem irrelevant. Furthermore, the private inurement doctrine can be triggered by the involvement of persons who are not individuals (corporations, partnerships, limited liability companies, estates, and trusts). Bruce Hopkins, The Law of Tax Exempt Organizations 484 (John Wiley & Sons, Inc. 2003). The term “private shareholder or individual,” as used in I.R.C. §501 refers to a person having a personal and private interest in the activities of the organization. Treas. Reg. §1.501(a)-1(c).

5 Texas Business Organizations Code 22.053.

6 The prohibition on private inurement also applies to social welfare organizations, associations and other business leagues, social clubs, voluntary employees’ beneficiary associations, teachers’ retirement fund associations, cemetery companies, veterans’ organizations, and state-sponsored organizations providing health care to high-risk individuals. Despite the fact that the law applies to multiple categories of exempt organizations, the vast majority of the law dealing with private inurement has been developed in the context of charitable organizations.


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person’s exercise of control or influence over the organization.7 Insiders typically are an organization’s founders, trustees, directors, officers, key employees, members of the families of these individuals, and certain entities controlled by them. Putting it bluntly, the Internal Revenue Service (“Service”) has stated that the prohibition on private inurement prevents “anyone in a position to do so from siphoning off any of an [organization’s] income or assets for personal use.”8

In United Cancer Council, Inc. v. Comm,. 165 F.3d 1173 (7th Cir. 1999), the court rejected the Service’s expansive definition of “insiders” that included all persons performing services for an organization. The Service argued that these persons had a personal and private interest in the activities of that organization, and thus were insiders subject to the private inurement doctrine. The court rejected the Service’s position and returned to the historical definition included above.

2. Private Inurement Rule

The private inurement doctrine can be stated as, “Income or assets of a public charitable organization cannot flow away from the organization to insiders for nonexempt purposes.” The prohibition on private inurement applies to several types of tax-exempt organizations, in addition to Sec. 501(c)(3) charitable organizations, but this articles limits itself to private inurement as it relates to Sec. 501(c)(3) organizations.

The private inurement doctrine applies far more strictly to private foundations than it does to public charities. While transactions between public charities and their insiders are subject to a reasonableness test, transactions between private foundations (including private operating foundations) and their insiders (“disqualified persons”) are prohibited (referred to as “prohibited transactions”) and subject the participants to self-dealing excise taxes under I.R.C. §4941. Unreasonable private inurement in the public charity context may result in intermediate sanctions under I.R.C. §4958. Both self-dealing excise taxes and intermediate sanctions are discussed more fully below.

The private inurement doctrine applies to “net earnings,” but the term “net earnings” may not be limited to its strict accounting definition.9 It also may include income and assets. A wide variety of

7 American Campaign Academy v. Comm’r, 92 T.C. 1053 (1989).

8 Gen. Couns. Mem. 39862.

9 See Virginia Mason Hospital Association v. Larson, 114 P.2d 978, 983 (Wash 1941).

transactions will be included in the concept, and this partial list of example illustrates what constitutes private inurement.

• Unreasonable or excessive compensation10 • Unreasonable or unfair (to the organization) rental

arrangements11 • Unreasonable or unfair (to the organization)

lending arrangements12 • Provision of services to persons in their private

capacities13

10 While reasonableness is a question of fact, the amount of compensation paid to an individual or person is not limited to formal salary or wage. All types of compensation—bonuses, commissions, royalties, fringe benefits, retirement and pension benefits, expense accounts, insurance coverage, etc. are aggregated for purposes of applying the reasonableness test. E.g., P.L.R. 9539016.

11 While an exempt organization may rent space to or from an insider, the arrangement must not involve a deflated or inflated rent amount favoring the insider at the expense of the organization. E.g., Founding Church of Scientology v. United States, 412 F.2d 1197 (Ct. Cl. 1969), cert. den., 397 U.S. 1009 (1970). While the rule is clear-cut, the application can become complicated where an insider uses an exempt organization’s facility for his appointed duties and private activities (i.e., a physician using his office and staff time for exempt hospital activities and private practice). The hospital audit guidelines provide that a physician may use an exempt organization’s facility for private practice, but the time and use of the office must be apportioned between exempt and private activities with a reasonable rent being charged for the latter. Hospital Audit Guidelines §333.2(1), 333.3(1). Though private inurement can be avoided in this situation, avoidance requires what could be cumbersome administrative requirements.

12 Thus, for example, loans to insiders should provide for security, adequate interest, reasonable repayment terms, and should be repaid on a timely basis. Loans also should be commensurate with the organization’s purposes. Griswold v.Comm’r, 39 T.C. 620 (1962).

13 For example, although furtherance of the arts is a charitable activity, a cooperative art gallery that exhibited and sold only its members’ works was deemed to be service their private ends and thus was not tax-exempt. Rev. Rul. 71-395, 1971-2 C.B. 228. An organization formed to provide bus transportation for children to a tax-exempt private school was ruled not to be eligible for exemption. Rev. Rul. 69-175, 1969-1 C.B. 149. According to the Service, the organization served the private purpose of relieving parents of their responsibility to transport their children to school, and when a group of individuals associates to provide a cooperative service for themselves, they are serving a private interest.

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http://www.TexasBarCLE.com/CLE/PMCasemaker.asp?table=US_supremeopinions&volume=397&edition=U.S.&page=1009&id=109735_01


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• Certain assumptions of liability14 • Certain sales to or purchases by insiders15 • Certain percentage payment agreements16 • Varieties of tax-avoidance schemes.17

In the public charity context, a reasonable transaction will not violate the private inurement doctrine.18 Generally, a public charity may deal on an arm’s length, fair market value basis with its insiders. For example, sale of real property by an insider to the public charitable organization at a value determined by an appraisal will not be private inurement. As the Service has stated, “there is no absolute prohibition against an exempt section 501(c)(3) organization dealing with its founders, members, or officers in conducting its economic affairs.”19

Some transactions, however, may be unreasonable per se because they violate state law.20 Such

14 Where the purchase price for an asset acquired from an insider is more than the property’s fair market value (whether debt-financed or not), private inurement may result. E.g., Kolkey v. Comm’r, 27 T.C. 37 (1956), aff’d, 254 F.2d 51 (7TH Cir. 1958).

15 The Service has not mandated a particular valuation method but has suggested a preference for appraisals that consider and apply a variety of approaches in reaching the “bottom line.” See P.L.R. 9130002.

16 The Service likely will scrutinize compensation plans based on an incentive feature whereby compensation is a percentage of revenue received over a set level. However, the Service has concluded that these sorts of “garnishing arrangements,” common in the health care context, do not constitute private inurement where they are not devices to distribute earnings and profits and are the result of arms’ length bargaining. Gen. Couns. Mem. 39674.

17 Exempt organizations cannot be used to avoid income taxation. For example, a physician cannot transfer his medical practice and related assets to a controlled organization that hires him to do “research”—the ongoing examination and treatment of patients. Rev. Rul. 69-66, 1969-1 C.B. 151.

18 Such a transaction by a private foundation or a private operating foundation is not termed “private inurement” because it is usually a prohibited transaction, discussed below.

19 P.L.R. 9130002.

20 For example, Texas law prohibits a nonprofit corporation from lending funds to a director. Texas Business Organizations Code §22.225. The prohibition is absolute

transactions therefore violate the private inurement doctrine even if they otherwise appear fair or beneficial to the organization

3. Private Inurement and Private Benefit

The private benefit doctrine, differs from the private inurement doctrine in that the private benefit doctrine is not limited to insiders. The private benefit doctrine derives from the operational test that requires that an organization conduct programs in furtherance of a tax-exempt public purpose rather than a private interest. This doctrine prevents a charitable organization from benefiting private interests in any way other than to an insubstantial extent.

An incidental amount of private benefit is permissible, as it must be, because in benefiting the public, an organization must of necessity benefit individuals or other private interests. A scholarship benefits the public in general and the scholarship recipient in particular and is a permissible incidental private benefit, as is the American Red Cross’s provision of disaster relied to the victims of a natural disaster. The ultimate form of private benefit that is not incidental may be the conversion of a nonprofit, tax-exempt organization to a for-profit corporation.

In order to avoid jeopardizing an organization’s exempt status, private benefits conferred must be both quantitatively and qualitatively incidental in relation to the furthering of the organization’s exempt purpose. To be quantitatively incidental, the private benefit must be insubstantial measured against the overall exempt benefit produced by the activity.21 To be qualitatively incidental, the private benefit must be a necessary concomitant of the exempt activity, such that the exempt objectives cannot be achieved without benefiting certain individuals privately.22

and applies even if the loan is made at market rates. Loans to officers are allowed in limited circumstances and must meet certain requirements. The requirements are set forth in the Texas Business Organizations Code §22.055 and include that the loan must reasonably be expected to benefit, directly or indirectly, the corporation providing it and must be 1) made for the purpose of financing the principal residence of the officer; 2) made during the first year of that officer's employment, in which case the original principal amount may not exceed 100 percent of the officer's annual salary; or 3) made in any subsequent year, in which case the original principal amount may not exceed 50 percent of the officer's annual salary.

21 E.g., Ginsburg v. Comm’r, 46 T.C. 47 (1966).

22 Rev. Rul. 70-186, 1970-1 C.B. 128.




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4. Private Inurement Consequences What is the consequence of violating the private

inurement doctrine? If the violation will be inherent in the organizational documents, then the organization probably will not be given Sec. 501(c)(3) status.23 If the violation occurs after the status is given and the transaction is not undone, then Sec. 501(c)(3) status is revoked. The Service can use the threat of revocation to force an organization to undo a problematic transaction.

5. Problems with the Revocation Penalty

Until the advent of the excess benefit transaction doctrine and intermediate sanctions in 1996, revocation of exemption was the Service’s only enforcement mechanism. The revocation penalty carries several problems. First, it punishes the erstwhile exempt organization, not the “insider” who was responsible for—and who benefited from—the improper transaction. Second, where the organization generally operated for charitable purposes, the revocation penalty could result in otherwise unnecessary and far-reaching consequences to innocent third parties and, sometimes, the entire community.24 For example, a hospital that engaged in a single act of private inurement (perhaps the payment of excessive compensation to the CEO) could have its exempt status revoked. The loss of exemption would create significant tax liability for the hospital as well as the loss of charitable contributions. The hospital’s financial viability and ability to provide healthcare would suffer.25 If the hospital were forced to close, employees would loose their jobs, and the

23 In most cases, where a substantial private inurement violation is evident in the exemption application, the Service will issue a negative determination letter. However, Proposed Regulations issued on September 9, 2005 clarify that the Service “has discretion to refuse to issue a ruling recognizing under [I.R.C §501(c)(3)] to any applicant whose purpose or activities violate any provision of [I.R.C §501(c)(3)], including the inurement prohibition and the limitation on private benefit, even though such violation could serve as grounds for imposing [I.R.C §4958 ]excise taxes if the applicant’s tax-exempt status were recognized.” REG-111257-05. The author knows of at least one case where, in reliance on the Proposed Regulations, the Internal Revenue Service declined to revoke an organization’s exempt status to the date of formation and instead took the position that the organization was an “applicable tax-exempt organization” for a moment in time (i.e., just long enough for the I.R.C. §4958 excise tax penalties to apply).

24 Roady, 884 T.M. Intermediate Sanctions.

25 Id.

community served by the hospital would loose a valuable source of health care.

Because of its severity, the revocation penalty typically was used only against the worst offenders,26 leaving low- and mid-level misfeasors free to engage in private inurement.

B. Excess Benefit Transactions and Intermediate

Sanctions On July 30, 1996, the Taxpayer Bill of Rights 2

(P.L. 104-168) was signed into law. The act contained long-awaited “intermediate sanctions” provisions imposing excise tax penalties on “disqualified persons” who engage in “excess benefit transactions” with “applicable tax-exempt organizations”—specifically, public charities or social welfare organizations.27 The penalties for excess benefit transactions are referred to as “intermediate sanctions” in contrast to the ultimate sanction of exemption revocation. Intermediate sanctions enable the Service to address mild to moderate cases of private inurement by punishing the individuals involved and without jeopardizing the interests of the organization or the community. Intermediate sanctions are used where the excess benefit does not rise to a level where it “calls into question whether, on the whole, the organization functions as a charitable or other tax-exempt organization.”28 Intermediate sanctions may be imposed in addition to (not just in lieu of) revocation.29

The prohibited transaction rules applicable to private foundations (discussed below) served as a template for the intermediate sanctions rules. However, unlike prohibited transactions with private foundations, which are prohibited absolutely, transactions by disqualified persons with public charities (and social welfare organizations) are subject to a rule of reason. A reasonable transaction does not result in an excess benefit.

An “excess benefit transaction” is defined as:

[A]ny transaction in which an economic benefit is provided by a [public charity or social welfare organization] directly or indirectly to or for the use of any disqualified

26 James J. Fishman & Stephen Schwarz, Nonprofit Organizations 495 (2d ed. 2000) (1995).

27 I.R.C. §4958(e)(1), Treas. Reg. §53.4958-2(a)(1).

28 H.R. Rep. No. 104-506 at 59 n. 15.

29 Id.


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person30 if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.31

I.R.C. §4958, dealing with intermediate sanctions, imposes excise taxes on disqualified persons who improperly benefit from an “excess benefit transaction” and on organization managers who participate in such a transaction knowing32 that it is improper.33

1. Disqualified Persons

“Disqualified person” is the special term for an insider in the intermediate sanctions area.34 The term includes:35

1) Any person who was, at any time during the

5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization;36

30 The term “disqualified person,” as used in the excess benefit context, is discussed in the following subsection.

31 I.R.C. §4958(c)(1).

32 There is no “knowing” requirement with respect to the excise tax on disqualified persons. Thus, a disqualified person could, in theory, be subject to excess benefit penalties even where he or she believed the transaction to be reasonable and without excess benefit.

33 The intermediate sanction rules apply to public charities as opposed to private foundations or private operating foundations. The rules on excess benefit transactions for public charities are substantially parallel to the prohibited transaction rules applicable to private foundations discussed below.

34 Although the same term applies to insiders as to prohibited transactions by private foundations, the term has a slightly different definition in the latter context. Regardless of the technical differences between them, both definitions seek to encompass those in a position to “siphon off the organization’s income or assets for personal use.”

35 I.R.C. §4958(f); Treas. Reg. §53.4958-3(a),(b).

36 The five year “look back” rule prevents and individual from doing an end-run around I.R.C. §4958 by resigning from a position immediately before engaging in a potential excess benefit transaction.

2) A member of the family of an individual described in paragraph 1). Members of the family are limited to spouse, ancestors, children, grandchildren, great-grandchildren; the spouses of children, grandchildren, and great-grandchildren; and brothers and sisters, of whole or half- blood, and their spouses. Not included are nieces and nephews and spouses of ancestors;

3) A 35% controlled entity, which means (i) a corporation in which persons described in 1) or 2) own more than 35% of the total combined voting power, (ii) a partnership in which such persons own more than 35% of the profits interest, and (iii) a trust or estate in which such persons own more than 35% of the beneficial interest.

The definition is important because if a person is not a “disqualified person,” then no excess benefit transaction with that person can exist. Even an unreasonable transaction with that person will not trigger intermediate sanctions.37

The difficulty with drawing bright-line distinctions comes from determining who is “in a position to exercise substantial influence over the affairs of the organization” (as stated in 1), above). The statute does not define what this means, and the regulations say it includes a person who has the powers or responsibilities, or holds the type of interest, described in one of these categories.38

• Voting members of the governing body; • Presidents, chief executive officers, or chief

operating officers, regardless of title, who have or share ultimate responsibility for implementing the decisions of the governing body or supervising the management, administration, or operation of the applicable organization;

• Treasurers and chief financial officers, regardless of title, who have or share ultimate responsibility for managing the organizations’ financial assets or have or share authority to sign drafts or direct the signing of drafts, or authorize electronic transfer of funds, from organization bank accounts; or

• Persons with a material financial interest in a provider-sponsored organization.

37 However, the transaction still would constitute private inurement and could jeopardize the organization’s exemption.

38 Treas. Reg. §53.4958-3(c).


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There is also a facts-and-circumstances-tending-to-show-substantial-influence test, including whether the person39: • Founded the organization; • Is a substantial contributor (i.e., has given more

than 2% of the total contributions received by the organization) to the organization taking into account only contributions received by the organization during the current and four preceding fiscal years;40

• Has compensation based on revenue derived from activities of the organization that the person controls;

• Has or shares authority to control or determine a substantial portion of the organization’s capital

39 Treas. Reg. §53.4958-3(e)(2).

40 The use of one’s status as a substantial contributor as a factor tending to establish the contributor as a disqualified person is problematic. The regulations provide an example wherein a substantial contributor is held not to be a disqualified person because the benefits received were available to all donors at the same level. Treas. Reg. §53.4958-3(g), Ex. 13. However, the suggestion is that where a major donor receives some special treatment, he or she is more likely to be considered a disqualified person. This interpretation limits the flexibility of organizations making special arrangements with potential major donors. It is particularly burdensome to small and mid-sized organizations where substantial donors are more likely to satisfy the definition of “substantial contributor.” One might argue that where benefits conferred on an individual are tied directly to the individual’s making a contribution, the benefits returning to the individual should operate to reduce the amount of his or her charitable contribution deduction, that they should not be considered “excess benefits” under I.R.C. §4958. Roady, 884 T.M. Intermediate Sanctions. Where a quid pro quo contribution causes a donor to become a substantial contributor, is the contribution subject to scrutiny under I.R.C. §4958? The Service maintains (in the private foundation context) that the term “self-dealing” does not include a transaction between a private foundation and a disqualified person where the disqualified person’s status arises only as a result of such transaction. Treas. Reg. §53.4941(d)-1(a). However, the regulations under I.R.C. §4958 do not contain a similar carve-out, and Treas. Reg. §53.4958-3(g), Ex. 13 suggests (be negative inference) that the result in the public charity/social welfare organization context might be different. In the example, a donor whose contribution causes her to become a substantial contributor is deemed not to have substantial influence over the organization because she receives only the same benefits as other similarly-situated donors. The question remains whether, had she received disparate benefits, she would have been treated as a disqualified person for purposes of I.R.C. §4948.

expenditures, operating budget, or compensation for employees; and

• Owns a controlling interest in a corporation, partnership, or trust that is a disqualified person.

Again, it is difficult to draw bright-line distinctions and to determine if a person meets the test or not.

The regulations also set forth persons deemed not to have substantial influence, including the tax-exempt organization itself and employees receiving economic benefits of less than specified amounts.41 The facts-and-circumstances test for a person not having substantial influence over the affairs of the organization includes whether the person has taken a bona fide vow of poverty as an employee, agent, or on behalf of a religious organization; whether the person is an independent contractor; whether the direct supervisor of the individual is not a disqualified person; and whether any preferential treatment a person receives based on the size of that person’s donation is ordered to others making comparable donations.42

2. Excess Benefit Transaction Consequences

The consequences of a violation already have been stated: an excise tax. If the excess benefit transaction is not timely corrected, a more punitive excise tax is imposed.43

The disqualified person pays a tax of 25% of the excess benefit.44 If the disqualified person does not correct the excess benefit transaction, a tax of 200% of the excess benefit is imposed.45

41 Treas. Reg. §53.4958-3(d).

42 Treas. Reg. §53.4958-3(e)(3).

43 A person liable for the excise tax under I.R.C. §4958 also may be liable for penalties. If the act (or failure to act) was not due to reasonable cause and either 1) the person has theretofore been liable for tax under chapter 42 or 2) the act (or failure to act) was both willful and flagrant, then such person is liable to a penalty equal to the amount of the tax. I.R.C. §6684.

44 I.R.C. §4958(a)(1); Treas. Reg. §53.4958-1(a).

45 I.R.C. §4958(b); Treas. Reg. §53.4958-1(c)(2).


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The organization manager46 who knowingly47 participates in an excess benefit transaction (unless such participation is not willful and is based on reasonable cause) pays an “organization manager tax” of 10% of the excess benefit.48 The amount of the tax cannot exceed $20,000,49 but if the manager receives an excess benefit, then he may be subject to both the organization manager tax and the disqualified person tax.50 Silence can constitute participation if the manager is under a duty to speak, and an objection to the transaction can constitute non-participation. Also, a legal opinion that sets forth the facts and the applicable law and concludes that the transaction is permissible may make the manager’s participation “unknowing”51 and avoid the organization manager tax.

46 An “organization manager” is any officer, director, or trustee of such organization (or any individual having powers or responsibilities similar to those of officers, directors, or trustees of the organization). I.R.C. §4958(f)(2); Treas. Reg. §53.4958-1(d)(2). The regulations state that an officer is one specifically designated under the certificate of incorporation, bylaws, or other constitutive documents or any person who regularly exercises general authority to make administrative or policy decisions on behalf of the organizations. Persons not considered officers are independent contractors such as attorneys, accountants, and investment managers and advisors, as well as a person who has authority merely to recommend administrative policy decisions, but not to implement them without approval of a supervisor. Treas. Reg. §53.4958-1(d)(2). A committee member of the governing body of an organization invoking the rebuttable presumption of reasonableness based on the committee’s actions is an organization manager. Id.

47 “Knowing” is defined as 1) having actual knowledge of sufficient facts so that, based solely on such facts, the transaction would be an excess benefit transaction; 2) being aware that the transaction might violate the prohibition on excess benefit transactions, and 3) negligently failing to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction or being aware that the transaction is an excess benefit transaction. Treas. Reg. §53.4958-1(d)(4)(i)(A)-(C).

48 I.R.C. §4958(a)(2); Treas. Reg. §53.4958-1(a).

49 I.R.C. §4958(d)(2), as modified by §1212 of The Pension Protection Act of 2006 (H.R. 4, Public Law 109-280) (“PPA”); Treas. Reg. §53.4958-1(d)(7) (not yet modified to reflect changes from the PPA. Prior to the enactment of the PPA, the organization manager tax was limited to $10,000.

50 Treas. Reg. §53.4958-1(a).

51 Treas. Reg. §53.4958-1(d).

Where multiple parties are liable for the excise tax with respect to a particular excess benefit transaction, they are jointly and severally liable.52 3. Correcting an Excess Benefit Transaction

An excess benefit transaction is corrected by undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the applicable tax-exempt organization involved in the excess benefit transaction in a financial position not worse than that in which it would be if the disqualified person had been dealing under the highest fiduciary standards.53

The correction amount is the sum of the excess benefit plus interest at the applicable federal rate, compounded annually.54 Correction generally must be made in the form of cash or cash equivalents and cannot, for example, be made in the form of a note.55 Where the excess benefit transaction involved the transfer of property to a disqualified person, the correction may—with the organization’s approval—involve the return of the property to the organization.56

The organization and the disqualified person can create a rebuttable presumption that a transaction is reasonable and not an excess benefit transaction by meeting certain conditions:57

• The compensation arrangement58 or the terms of

the property transfer were approved in advance by

52 I.R.C. §4958(d)(1); Treas. Reg. §53.4958-1(d)(8).

53 I.R.C. § 4858(f)(4); Treas. Reg. §53.4958-7(a).

54 Treas. Reg. §53.4958-7(c).

55 Treas. Reg. §53.4958-7(b)(1).

56 Treas. Reg. §53.4958-7(b)(4)(i). The disqualified person involved in the transaction cannot participate in the decision as to how correction should be effected. The correction payment is treated as the lesser of the fair market value of the property on the date it was returned or on the date of the excess benefit transaction. Id. Thus, if the property has declined in value since the date of the excess benefit transaction, the disqualified person will have to make an additional payment as well. On the other hand, if the value of the property exceeds the correction amount, the organization can make a cash payment to the disqualified person. Treas. Reg. §53.4958-7(b)(4)(ii).

57 Treas. Reg. §53.4958-6(a).

58 Economic benefits that are treated as compensation are not excess benefits if—all together—they are reasonable.


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an authorized body of the organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement or the property transfer;59

• The authorized body relied upon appropriate data60 as to comparability prior to making its determination; and

• The authorized body adequately documented the basis for its determination concurrently with making that determination.

If each of these conditions is met, the transaction is presumed to be at fair market value and not to have

According to Internal Revenue Service tax law specialist Larry Brauer, the idea is that all economic benefits that are treated as compensation are put on one basket. One must look at the total basket and ask whether the total benefits are equal to the value that the organization received in return. Economic benefits that are not treated as compensation do not go into this compensation basket for a reasonableness test and are treated as “automatic” excess benefits transactions. March 3, 2005 Remarks of Larry Brauer, Annual Washington Non-Profit Legal & Tax Conference; printed in EO Tax Journal (vol. 10, no. 2, March/April 2005). For good-faith organizations, problems develop with personal use of business equipment such as cell phones and Blackberries. According to Harvey Berger, national director of Grant Thornton’s not-for-profit tax services, exempt organizations risk excess benefit penalties if they have not build a case that their cell phone (and other equipment) use falls within the Service’s fringe benefit guidelines. If such organizations cannot document that 100% of the cell phone use is business use, and if they do not meet the requirement to show that they intended the personal use of the phone to be compensation, the automatic excess benefit rules kick in. BNA, Inc., Daily Tax Report No. 123, ISSN 1522-8800 (June 28, 2005). Solutions include to report the cell phones (or other equipment) on the Form W-2 or that organizations include them on Form 990; causing disqualified persons to sign statements that their cell phones (and other equipment) are used for business and not personal use; and automatically requiring employees to pay 15% of their cell phone bills under the presumption that personal use always will exist. Id.

59 Under the conflict of interest rule, disclosure is not enough. The interested person may participate only to answer questions, but must leave the meeting room and must not be present during debate and voting on the compensation arrangement or property transfer. Treas. Reg. §53.4958-6(c).

60 Appropriate data would include compensation studies (available through organizations such as the Association of Small Foundations, the Council on Foundations, and the United Way, among others); appraisals and comparability studies (in the case of real property); and appraisals and third-party pricing guides (such as the Blue Book, collector’s guides, etc.) for personal property.

generated excess benefit.61 In order to rebut the presumption, the Service must develop “sufficiently contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body.”62 The type of contrary evidence that will be considered is prescribed in the regulations and depends on the type of transaction at issue.

The “rebuttable presumption of reasonableness” standard is based on the notion that transactions between disqualified persons and organizations should be considered carefully; where the organization can show that care was taken, the Service should bear the burden of showing unreasonableness. It would be impossible for the Service to audit all or even a fraction of organizations subject to the intermediate sanctions rules. By offering a measure of protection in exchange for following procedural and substantive standards, Congress leverages the sound judgment of boards of directors in seeing that the purposes of the statute are carried out.63

4. Penalty Abatement

The excise taxes imposed by I.R.C. §4958 may be abated in certain circumstances I.R.C. §4962(a) provides that the first-tier tax can be abated if the taxpayer (the disqualified person and/or the organizational manager) establish, to the Service’s satisfaction, that the excess benefit transaction was 1) due to reasonable cause and not to willful neglect; and 2) corrected within the applicable correction period.64 The second-tier tax can be abated by prompt correction.65

In order to encourage organizations and disqualified persons to identify and promptly correct

61 Treas. Reg. §53.4958-6(b).

62 Id.

63 Roady, 884 T.M. Intermediate Sanctions.

64 In this regard, I.R.C. §4958 is more generous to disqualified persons than the corresponding provisions in the private foundation context. I.R.C. §4962(b) expressly prohibits abatement of the first-tier excise tax imposed on self-dealers under I.R.C. §4941.

65 Specifically, if the transaction is corrected during the period beginning with the date of the transaction and ending with the earlier of a) the date of mailing of a notice of deficiency under I.R.C. §6212 with respect to the excise tax, or b) the date on which the excise tax imposed on the disqualified person is assessed, the second-tier tax is abated. I.R.C. §4961(a); I.R.C. §4958(f)(5); Treas. Reg. §53.4958-1(c)(2)(ii).


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excess benefit transactions, the Service has adopted two safe harbors under which the excise tax on the disqualified person will be abated. The first safe harbor applies where the disqualified person discovers or acquires knowledge of an excess benefit transaction before the organization receives notice of audit and before the disqualified person receives notice of an I.R.C. §4958 examination. If the disqualified person completes corrective actions within 30 days of the discovery or knowledge, the Service will treat the disqualified person as acting reasonably and not willfully and will abate the first tier tax.66

If the corrective action is taken more than 30 days after the discovery or knowledge, although abatement will not be automatic, the Service will examine all relevant facts and will consider abatement.

C. Prohibited Transactions

As discussed above, unreasonable private inurement in the public charity context can result in intermediate sanctions. While transactions between public charities and their insiders are subject to a reasonableness test, transactions between private foundations (including private operating foundations) and their insiders (“disqualified persons”), even transactions that seem innocuous—fair market purchases or sales of property and fair market loans—can be unlawful.67 Such transactions between a private foundation and certain “disqualified persons,” even if they are reasonable or even favorable to the foundation, are prohibited entirely.68 “Prohibited transactions” subject the participants to self-dealing excise taxes under I.R.C. §4941.

1. Private Foundations

A nonprofit organization that is charitable within the meaning of I.R.C. §501(c)(3) will be presumed to be a private foundation unless it can be shown to the Service that the charity is a “public charity” either due to the nature of the organization (for example, a church or a school) or due to the portion of financial support it receives from the general public.69 70 The distinction

66 IRS FY 2003 CPE Text.

67 For simplicity, hereinafter, the term “private foundation” should be read to include private operating foundations.

68 I.R.C. §4941(d)(1); Treas. Reg. §53.4941(d)-(2).

69 I.R.C. §509(a).

70 Private operating foundations may undertake charitable activities while private foundations make grants to public charities, but private operating foundations can be contrasted

between a private foundation and a public charity is extremely important, not only for determining the tax rules that to the nonprofit organization71, but also for determining whether certain transactions will be permitted (if reasonable) or prohibited.

Why do these prohibited transaction rules apply only to private foundations and not to public charities? The notion is that public charities are policed by the general public. An improper transaction could cause an organization to loose its public support (contributions), so a public charity will not engage in an improper transaction and jeopardize its support. Also, public charities are subject to more public scrutiny than are private foundations, and an improper transaction is likely to come to public attention in the public charity context. Private foundations are not dependent on contributions, so the loss of public support is not a realistic sanction. Also, private foundations, particularly the smaller ones, are less subject to public scrutiny, and hence, improper transactions are less likely to come to public attention than they are in the public charity context. The lack of an effective policing method to prevent improper transactions means that all transactions between certain parties and private foundations must be prohibited.

2. Disqualified Persons

For a private foundation to avoid a prohibited transaction, it must identify its “disqualified persons.” For any private foundation, a disqualified person is:72

• A substantial contributor to the foundation. A

“substantial contributor” is any person who gave a total of more than $5,000 to the foundation, and those contributions are more than 2% of all contributions and bequests received by the organization from the date it was created up to the end of the year in which the contributions by the substantial contributors were received;73

with public charities in that private operating foundations do not have a wide base of donors. For purposes of the prohibited transaction rules, private operating foundations are subject to the same rules as private foundations.

71 For example, the tax deductions available to donors to the organization, , the distribution requirements imposed on the organization, and the type of return the organization is required to file.

72 I.R.C. §4946(a)(1); Treas. Reg. §53.4946-1(a).

73 The term “substantial contributor” is defined in I.R.C. §507(d)(2) and the Regulations thereunder.


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• A foundation manager74 of the foundation; or • An owner of more than 20% of

o The total combined voting powers of a corporation;

o The profits interest of a partnership; o The beneficial interest of a trust or

unincorporated enterprise that is (during such ownership) a substantial contributor to the foundation; or

o A “member of the family” of any of the individuals just listed. A “member of the family” includes a spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren. (A brother, sister, uncle, aunt, nephew, or niece is not considered a “member of the family.”); or

o A corporation of which more than 35% of the total combined voting power, a partnership of which more than 35% of the total combined profits interest, or a trust of which more than 35% of the beneficial interests, respectively, is owned by persons listed above.

3. Prohibited Self-dealing

These six specific acts of self-dealing are prohibited transactions for private foundations:75

• Sale,76 exchange, or leasing of property regardless

of whether the foundation is the seller, lessor, purchaser, or lessee, unless the space or property is leased to the private foundation free of rent;

• Lending of money or extension of credit, unless funds are leant to the private foundation interest-free and if the proceeds of the loan are used for I.R.C. §501(c)(3) purposes;

• Furnishing of goods, services, or facilities, unless such goods, services, or facilities are provided to the disqualified person in the same manner they are regularly provided to the general public. An

74 The term “foundation manager” is defined in I.R.C. §4946(b)(1) and Treas. Reg. §53.4946-1(f)(1)(i) and refers to an officer, director, or trustee of a foundation or any individual having similar powers or responsibilities. A person is considered to be an officer of a foundation if he is so designated under the Articles of Incorporation, bylaws, or other constitutive documents of the foundation, or if he regularly exercises general authority to make administrative or policy decisions on behalf of the foundation.

75 I.R.C. §4941(d)(1); Treas. Reg. §53.4941(d)-(2), (3).

76 Including bargain sale, but not including gift.

example would be admission to a museum that is a private operating foundation or unless the goods, services, or facilities are provided to the private foundation if the furnishing is without charge and the goods, services, or facilities are used for I.R.C. §501(c)(3) purposes.

• Payment of compensation or payments or reimbursement of expenses, unless reasonable and necessary to accomplish an exempt purpose;77

• Transfer to or use by or for the benefit of a disqualified person of any of the income or assets of the private foundation; or

• Certain agreements to pay a government official, such as certain scholarship, travel, and pension payments.78

77 I.R.C. §4941(d)(3)(E) provides the term “self-dealing” does not include a private foundation’s payment of certain reasonable compensation to, or reimbursement of certain reasonable expenses for, a disqualified person. I.R.C. §4941(d)(3)(E) does not apply to “government officials;” thus, a payment of compensation to, or reimbursement of expenses by a private foundation to or for a government official constitutes self-dealing.

78 As stated in the foregoing Footnote, any payment of compensation to, or reimbursement of expenses by a private foundation to or for a government official constitutes self-dealing.

The applicable definition of “government official” includes “an individual who…holds an elective or appointive public office in the…judicial branch of the government of a State…held by an individual receiving gross compensation at an annual rate of $20,000 or more. I.R.C. §4946(c)(5). The applicable Regulations provide that the term “government official” includes “the holder of an elective or appointive public office in the …judicial branch of the government of a State…for which the gross compensation is at an annual rate of $15,000 or more…. Treas. Reg. §53.4946(g)(1)(iv). (The discrepancy between the dollar limitation of the Code and the Regulations is attributable to the Regulations’ not being updated to reflect the 1986 increase in the dollar limitation in the Code from $15,000 to $20,000.)

The diction of I.R.C. §4946(c)(5) is ambiguous. The term, “held by an individual receiving gross compensation at an annual rate…” does not indicate whether the compensation subject to the limitation is that coming from the public office, from the private foundation, or from any and all sources. The diction of the applicable Regulations is slightly clearer. The term “for which” as opposed to “for whom” clearly relates to an object referent (in this case, the office) not to a human referent (which, in this case, would be the individual). Thus, the grammar is clear on its face: the


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Although the acts listed above normally constitute self-dealing, where the disqualified person’s status arises only as a result of the transaction at issue, the transaction is not deemed to be self-dealing.79

dollar limitation applies to compensation received from the office, not accruing to the individual from other sources.

The grammatical analysis is supported by adjacent Regulations. Treas. Reg. §53.4946(g)(1)(iii) reads “an individual who holds a position…who receives gross compensation therefrom at an annual rate of $15,000 or more. It is not clear why Treas. Regs. §53.4946(g)(1)(iii) and (iv) are structured differently, but the former clearly indicates that the compensation in question is that which is received from the office, not from a private foundation. Consistency within the I.R.C. §4946 Regulations requires that Treas. Reg. §53.4946(g)(1)(iv) be read the same way: to require analysis of compensation from the office, not from any other source.

The grammatical conclusion is supported by Treasury Decisions on point. Rev. Rul. 77-473 provides “[t]he term ‘gross compensation’ as used in section 4946(c)(5) of the Internal Revenue Code refers to all receipts attributable to public office that are includable in gross income for Federal income tax purposes. 1977-2 C.B. 421.

In PLR 9804040, the Service ruled that an appointed official was not a government official for I.R.C. §4941 purposes. In making its determination, the Service considered the fact that the individual’s appointment would last for only 130 days, such that his pro-rated salary from the position was within the dollar limitation of I.R.C. §4946(c)(3) (even though the annual salary exceeded the limitation). The individual received compensation in exchange for his service to the private foundation. However, the Service did not consider his private foundation salary in making its determination. The fact that the Service examined only compensation attributable to the public office, and not compensation attributable to the private foundation, indicates that the dollar limitation of I.R.C. §4946(c)(3) applies to compensation received from a public office. Again, consistency within I.R.C. §4946 requires I.R.C. §4946(c)(5) to be read the same way as the other subsections, including I.R.C. §2926(c)(3).

Based on the wording of the applicable Code section and Regulations, as well as on Treasury Decisions on point, it is clear that the dollar limitation of I.R.C. §4946(c)(5) applies only to compensation received from public office, not to compensation received from a private foundation or from any other source.

79 Treas. Reg. §53.4941(d)-1(a). It is not clear that the same rule applies in the public charity/excess benefit context.

4. Self-dealing Consequences The consequence for self-dealing is an excise tax.

The tax begins as a “first-tier” tax and then moves to a more punitive “second-tier” tax.80

A first-tier tax is imposed on a self-dealing transaction based upon the amount involved, which is the “greater of the amount of money and the fair market value of the property given or the amount of money and fair market value of other property received.”81

The disqualified person pays a 10% tax on the amount involved.82 The first-tier tax applies to the disqualified person regardless of whether, at the time, he had knowledge that the act constituted self-dealing, unless the disqualified person is a government official.83 The foundation manager pays a 5% tax on the amount involved (up to $20,000 collectively84), unless the manager was not aware that the act was self-dealing85 or the manager’s participation was not

80 A person liable for the excise tax under I.R.C. §4946 also may be liable for penalties. If the act (or failure to act) was not due to reasonable cause and either 1) the person has theretofore been liable for tax under chapter 42 or 2) the act (or failure to act) was both willful and flagrant, then such person is liable to a penalty equal to the amount of the tax. I.R.C. §6684.

81 I.R.C. §4941(e)(2); Treas. Reg. §53.4941(e)-1(b)(1). For purposes of determining the amount involved with regard to the fair market value of property, for purposes of the first-tier tax under I.R.C. §4941(a), it is the value of the property on the date the transaction occurred, and for purposes of the second-tier tax under I.R.C. §4941(b), it is the highest fair market value for the taxable period. I.R.C. §4941(e)(2); Treas. Reg. §53.4941(e)-1(b)(3). In the case of excessive compensation for personal services, the amount involved is only the excess compensation. §4941(e)(2).

82 The Pension Protection Act of 2006 (H.R. 4, Public Law 109-280) (“PPA”) raised the tax rate for disqualified persons from 5% to 10%.

83 Treas. Reg. §53.4941(a)-1(a)(1).

84 I.R.C. §4941(c)(2), as modified by PPA §1212. Prior to the enactment of the PPA, the initial foundation manager tax was imposed at the rate of 2 ½ %, up to $10,000 collectively.

85 A person will be considered to have participated “knowingly” in an act of self-dealing only if 1) he has actual knowledge [not “reason to know”] of sufficient facts so that, based solely upon these facts, the transaction would be an act of self-dealing; 2) he is aware that such an act under these circumstances may violate the provisions of federal law governing self-dealing; and 3) he negligently


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willful.86 Reliance upon a reasoned legal opinion normally will protect a foundation manager from being deemed to have “knowingly” participated in an act of self-dealing.87 Silence or inaction can constitute participation where the foundation manager is under a duty to speak or act.88

A disqualified person who is a foundation manager can be subject to both taxes. The first-tier tax cannot be abated by the Service, even for reasonable cause.89

If the first-tier tax is imposed, then the transaction must be corrected so that the private foundation is placed in a financial position no worse than it would be in if the disqualified person were dealing under high fiduciary standards.90 If the transaction is not corrected in a timely manner,91 the disqualified person may be subject to the second-tier tax of 200%, and the foundation manager to tax of 50% (up to $20,000 collectively92) of the amount involved.93 The second-tier tax is imposed on the foundation manager only if it is imposed on the disqualified person and if the foundation manager refuses to agree to part of all of the correction of the self-dealing act.94

fails to make reasonable attempts to ascertain whether the transaction is an act of self-dealing or he is in fact aware that it is such an act. Treas. Reg. §53.4941(a)-1(b)(3).

86 Treas. Reg. §53.4941(a)-1(b)(1).

87 Treas. Reg. §53.4941(a)-1(b)(6).

88 Treas. Reg. §53.4941(a)-1(b)(2).

89 Internal Revenue Code Section 4941(b).

90 I.R.C. §4941(e)(3); Treas. Reg. §53.4941(e)-1(c)(1). The Regulations contain specific instructions for how various types of prohibited transactions must be corrected.

91 Specifically, if the transaction is corrected during the period beginning with the date of the transaction and ending with the earlier of a) the date of mailing of a notice of deficiency under I.R.C. §6212 with respect to the excise tax, or b) the date on which the excise tax imposed on the disqualified person is assessed, the second-tier tax is abated. I.R.C. §4941(e)(1); Treas. Reg. §53.4941(e)-1(a)(1).

92 I.R.C. §4941(c)(2), as modified by PPA §1212. Prior to the enactment of the PPA, the limitation on second-tier manager taxes was $10,000.

93 I.R.C. §4941(b); Treas. Reg. §53.4941(b)-1.

94 I.R.C. §4941(b)(2).

Where more than one disqualified person or foundation manager are subject to excise tax under I.R.C. §4941, they are jointly and severally liable for the tax owed.95

The excise tax imposed on the disqualified person by I.R.C. §4941(a)(1) is imposed even if the disqualified person had no knowledge that the act constituted self-dealing.96 The only exceptions to this rule apply where the act of self-dealing involved the purchase or sale of securities through a stock broker where neither party nor the broker knows the identity of the other party involved97 and where the “disqualified person” is a disqualified person by reason of being a government official. In the case of a government official, the excise tax is imposed only if the government official knew98 that the act was an act of self-dealing.99

The excise tax imposed on the foundation manager by I.R.C. §4941(a)(2) is imposed only if the foundation manager knew that the act was an act of self-dealing and participated willfully and unreasonably.100 101

Because self-dealing transactions result in such punitive taxes, and because the difference between a prohibited transaction and a permitted transaction is so slight, wisdom dictates that all transactions be submitted to the private foundation’s tax advisor,

95 I.R.C. §4941(c)(1); Treas. Reg. §53.4941(c)-1(a)(1).

96 Treas. Reg. §53.4941(a)-1(a)(1).

97 Treas. Reg. §53.4941(a)-1(a)(1).

98 The term “knowledge” is defined in Treas. Reg. §53.4941(a)-1(b)(3).

99 Treas. Reg. §53.4941(a)-1(a)(2).

100 Treas. Reg. §53.4941(a)-1(b)(1).

101 Technically, I.R.C. §4941(a)(2) and Treas. Reg. §53.4941(a)-1(b)(1) also require that, in order for an excise tax to be imposed on the foundation manager, an excise tax must also be imposed on the disqualified person under I.R.C. §4941(a)(1). Thus, it is possible for a foundation manager to knowingly engage in an act of self-dealing but avoid excise tax (for example, where the government official exception of Treas. Reg. §53.4941(a)-1(a)(2) applies). At the same time, although imposition of tax under I.R.C. §4941(a)(1) is a prerequisite for imposition of tax under I.R.C. §4941(a)(2), the tax under I.R.C. §4941(a)(1) need not be determined or enforced. The Commissioner may issue a notice of deficiency to a foundation manager without first issuing one to the disqualified person. Waise v. Comr., 86 T.C. 962 (1986).


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whether such advisor be an accountant or an attorney, for a compliance check prior to the transaction.

IV. THE SARBANNES-OXLEY ACT

Issues of corporate governance have featured prominently in recent headlines. A significant element of the government’s response to the current crisis in corporate governance is the enactment of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). Sarbanes-Oxley is directed at publicly-held companies who have registered with the U.S. Securities and Exchange Commission under the Securities Act of 1934 and seeks to, among other things, promote corporate responsibility, enhance accountability, and improve the quality and accuracy of financial reporting.102

In examining Sarbanes-Oxley, one should remember that it was adopted during a particular period in time. A few decades ago, the country was concerned with encouraging entrepreneurial spirit and initiative, not with regulation and ensuring transparency and accountability. As recently as the 1980s, almost every state enacted volunteer protection statutes giving immunity from liability to volunteers, including officers and directors, for a wide variety of actions. While these statutes were not uniform, the common theme among them was to raise the “liability threshold.” Soon after, the Federal government enacted its own volunteer protection legislation, the Volunteer Protection Act of 1997.103 The Volunteer Protection Act of 1997 provides that if a volunteer is acting within the scope of his or her responsibilities and meets certain criteria, he has a complete defense against third party actions (but not actions by the organization). When the Act applies, a volunteer is liable only where there is willful or criminal misconduct, gross negligence, reckless misconduct, or conscious flagrant indifference to the rights or safety of the person harmed. With Sarbanes-Oxley and proposed similar legislation directed specifically at nonprofits, the accountability pendulum has swung to the other side. Without insinuating that Sarbanes-Oxley is not appropriate for public companies, it is important to recognize that Sarbanes-Oxley is but one end of the spectrum of reasonable legislation and that nonprofit organizations have no reason to implement its provisions across the board.

Prudent directors of nonprofit organizations (whether charitable or otherwise and whether or not exempt) would be wise to examine the “best practices”

102 Sarbanes-Oxley Act of 2002, 73 Corporation (Aspen Law & Business) ¶ 16.1 (Aug. 15, 2002).

103 42 U.S.C.A. §14503 (2003 Pamphlet).

codified in Sarbanes-Oxley.104 To the extent that Sarbanes-Oxley was designed to promote corporate responsibility and accountability, it can be read as guidelines for any organization.105

At the same time that nonprofit directors familiarize themselves with the provisions of Sarbanes-Oxley, they should bear in mind that the act was designed to address specific issues in large, publicly-held companies. Thus, Sarbanes-Oxley is not necessarily a cure-all for the ails of the nonprofit sector.

Regardless of how strictly nonprofit leaders choose to apply the other provisions of Sarbanes-Oxley to their own organizations, the language of two provisions of Sarbanes-Oxley, dealing with destruction of documents and retaliation against whistle-blowers, respectively, is broad enough to encompass directors of nonprofit organizations. It is imperative that nonprofit advisors are aware of these provisions and the penalties for their violation.

104 Even the term “best practices” is a bit of a misnomer in the Sarbanes-Oxley context. The Sarbanes-Oxley regime is in its early stages, and it is not yet clear that the requirements it imposes will have their intended result. Even if the provisions of Sarbanes-Oxley prove to be an effective antidote to problems in the for-profit sector, it is not clear that the provisions will have the same salubrious effect (such that they can be called “best practices”) in the nonprofit sphere.

105 At the same time, Sarbanes-Oxley was designed in part to ensure the reliability of the financial information that drives capital markets. The problems that arise in nonprofit organizations rarely involve accounting fraud, restatement of financial statements or the like. Nonprofit organizations do not have shareholders poised to sell their investments or prepared to invest in a company based on public information. In the nonprofit sector, financial performance is only one (and typically a minor one) of the many factors that potential donors consider when deciding whether to support a charitable organization and its mission. See Daniel L. Kurtz, The Sarbanes-Oxley Act of 2002: Lessons for Nonprofits?, 23-MAY Corp. Couns. Rev. 43 (2004). Thus, given their unique organizational goals, it is not clear that nonprofits should follow the requirements Sarbanes-Oxley lays out for publicly-traded, for-profit organizations. Sarbanes-Oxley applies not to all publicly-held companies, but only to the small segment of publicly-held companies (roughly 14,000) that report to the Securities Exchange Commission and that have availed themselves of the public financing that enables them to shoulder the significant costs of complying with Sarbanes-Oxley. This fact should give pause to directors of small nonprofit organizations who are considering trying to implement all of the Sarbanes-Oxley provisions in their organizations.


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This section will provide a brief overview of certain requirements of Sarbanes-Oxley. The whistle-blower and document-destruction provisions, which actually do encompass nonprofit organizations will be discussed in some detail. Throughout this section, the reader will be encouraged to put Sarbanes-Oxley, and the effect it will have on nonprofits, in context. Finally, this section will discuss current legislation more germane to the nonprofit sector.

A. Audit Committee Requirements

Sarbanes-Oxley requires the audit committee of a company’s board of directors appoint, determine the compensation of, and oversee the auditor’s work.106 The audit committee must be independent; its members may not be affiliated with the company or its subsidiaries, and they may not receive fees from the company beyond their compensation for serving on the board of directors and the audit committee. 107 Sarbanes-Oxley encourages companies to have financial experts on the audit committee by requiring companies to disclose whether their committees comprise at least one financial expert and, if not, the reasons why.108

The audit committee provisions of Sarbanes-Oxley are guidelines for how nonprofit organizations can enhance the effectiveness of their audit committees and ensure their financial integrity. Though directed at for-profit entities, these provisions are also suited to the nonprofit world; some large nonprofits should be able to implement the Sarbanes-Oxley provisions with ease.109 A possible exception is private foundations. Private foundations typically have small boards that include directors who receive compensation for services other than their service to the board. This conflict is not terribly troubling, however, because the self-dealing rules imposed on private foundations by I.R.C. §4941 reduce the need for audit committee independence.110

106 Sarbanes-Oxley Act §301.

107 Id.

108 Sarbanes-Oxley Act, §407(A).

109 Those organizations that are able to conduct outside audits should have an audit committee separate from the finance committee and, where possible, should model that committee to fit the requirements of Sarbanes-Oxley (the committee has at least one financial expert; the committee should be independent, etc.).

110 See Daniel L. Kurtz, Nonprofit Governance (2003).

Smaller nonprofits, for which an outside audit would be an unreasonable financial burden, should, at the very least, have their financial statements compiled by a professional accountant and should consider having an outside review of their financial statements. Another option for smaller nonprofits—particularly where board members do not possess financial literacy expertise and skill—is to have the board appoint an audit committee outside of the board. By doing so, organizations can avail themselves of the auditing skill of individuals who do not sit on the board, and can further ensure their audit committees’ independence by appointing individuals who do not have family, employment, or business relationships.

While nonprofit boards should not hasten to satisfy all of the audit committee requirements of Sarbanes-Oxley in their organizations, they should recognize that Sarbanes-Oxley signals the importance of proper and appropriate financial housekeeping.

B. Auditor Provisions

Sarbanes-Oxley prohibits auditors from providing certain non-auditing services along with an audit; it requires the audit committee to pre-approve audit and permissible non-audit services (such as tax services, bookkeeping, appraisal and actuarial services, management or human resources services, legal services, etc.), and requires that all audit committee approvals of non-audit services be disclosed.111 Sarbanes-Oxley requires that the lead audit partner and the lead review partner overseeing a company’s audit be rotated off their engagements after five years112 and prohibits an auditor from providing audit services to a company if the auditor employed the company’s CEO, CFO, Chief Accounting Officer, or controller and such individual participated in any way in the audit of the company within one year before the initiation of the audit.113

The audit committee provisions increase communication between the audit committee and the auditor, place responsibility for all aspects of the audit with the audit committee, and enable the auditor to act without conflict of interest.114

Nonprofit organizations should consider self-imposing certain of these requirements to ensure their auditors are independent and to maintain the integrity




114 Daniel L. Kurtz, Nonprofit Governance (2003).


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of their audits and the accuracy of their financial statements. Changing auditors every five years is a reasonable practice for all organizations, and by preventing auditing firms from providing non-auditing services, nonprofit organizations can avoid conflicts of interest. It is good practice for nonprofits to disclose to the audit committee critical accounting policies and discussions with management. Such disclosure allows the audit committee to make more informed judgments and produces greater transparency.

At the same time, as with the other provisions of Sarbanes-Oxley that do not actually apply to nonprofit organizations, nonprofit directors should take a measured approach to the audit provisions. The audit committee should consider pre-approving certain non-audit services to be performed by the auditor, particularly preparation of the From 990 or 990-PF. While nonprofit organizations should take care in using their auditing firms to provide non-auditing services, there is no reason why a nonprofit organization should not avail itself of the economies of appropriately using the same firm for multiple services.

C. Document Destruction

While the Sarbanes-Oxley provisions on auditors and audit committees can be read as suggested practices for nonprofit organizations and their directors, nonprofit directors are subject to the provisions on document destruction. Sarbanes-Oxley makes it a crime, punishable by fine or imprisonment for up to twenty years, to corruptly alter, destroy, mutilate, or conceal a record, document, or other object, or to attempt to do so, with intent to impair the object’s integrity or availability for use in an official proceeding or to otherwise obstruct, influence, or impede any official proceeding, or to attempt to do so.115 (An audit by the Service presumably would be an official proceeding.)

A nonprofit organization should have written, document retention and periodic destruction policies. Such a policy would address the fact that while the organization needs to maintain appropriate records about its operations, it also needs to dispose of unnecessary and outdated documents on a regular basis. The policy should include rules for handling electronic files and voicemail, which have the same status as paper documents in litigation. The policy should provide that when an official investigation or proceeding is undertaken, all document purging should be suspended.


D. Whistle-blower Provisions According to Sarbanes-Oxley, anyone who

knowingly, with the intent to retaliate, takes any action harmful to any person, including interfering with the person’s lawful employment or livelihood, in response to such person’s providing to a law enforcement officer any truthful information relating to the commission or possible commission of any Federal offense, is subject to fine or imprisonment for up to ten years. Even if the employee’s claim is unfounded, so long as he had a reasonable basis to believe that fraud existed, he is protected under the whistle-blower provisions.

Nonprofit organizations must develop procedures to handle employee complaints. Ideally these procedures will provide confidentiality and anonymity to encourage employees to report inappropriate activity.

E. Indirect Application of Sarbanes-Oxley

While only Sarbanes-Oxley’s document destruction and whistle-blower provisions directly apply to nonprofits, it would be misguided to assume that the other provisions will not have an indirect effect on nonprofit organizations. Following are some predictions of the effect Sarbanes-Oxley could have in the nonprofit sector.

Sarbanes-Oxley naturally will affect judicial conceptions of fiduciary standards and thus will “raise the bar” for all organizations, including nonprofits. Also, nonprofit board members who also serve as executives at large for-profit organizations may come to accept Sarbanes-Oxley-compliant governance as the standard. Those who do will expect (and perhaps require) the nonprofit organizations they serve to comply with part or all of the Sarbanes-Oxley provisions.

Finally, in many ways, nonprofit organizations that solicit donations (particularly Sec. 501(c)(3) organizations) contract for accountability. They solicit grant funding, private funding, and government funding, all of which require accountability and transparency. To the extent that Congress has, in Sarbanes-Oxley, codified what “accountability and transparency” look like, organizations could feel outside pressure to meet the Sarbanes-Oxley standard.

V. EXEMPT-ORGANIZATION-SPECIFIC

LEGISLATION While Sarbanes-Oxley was designed to address grievances arising from large, publicly-traded companies and thus has limited application to nonprofit


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organizations, legislation specific to exempt organizations is on the horizon.116

In June 2004, the Senate Finance Committee issued a white paper and conducted hearings discussing proposed reforms and best practices for exempt organizations. The purpose was similar to that of Sarbanes-Oxley: to achieve greater accountability and transparency in light of recent abuses and unethical conduct in the nonprofit sector. The suggested reforms included:

• Requiring exempt organizations to submit

documents to the Service every 5 years so that the Service can determine whether the organization continues to qualify for tax exemption;

• Changes to the “insider” and “disqualified person” rules;

• Improving the quality and scope of Form 990, including by requiring certification by the CEO117 as to the completeness and accuracy of the material contained therein, imposing penalties from incomplete, inaccurate, or untimely filed Forms 990; requiring Form 990 to be filed electronically;

• Requiring an audit and auditor rotation policy based on level of gross receipts;

On September 22, 2004, Senate Finance Committee Chairman Charles Grassley (R-IA) and ranking member Max Baucus (D-MT) encouraged Independent Sector President Diana Aviv to convene an independent national panel to make recommendations to strengthen the governance, ethical practice, transparency, and accountability within the nonprofit sector. On October 12, 2004, in response to this

116 This legislation will apply only to exempt organizations, not to all nonprofits. Thus, for example, a Texas nonprofit corporation that is not exempt from taxation under I.R.C. §501 would not be subject to these proposed federal requirements.

117 Sarbanes-Oxley requires CEOs and CFOs to certify the appropriateness of financial statements. The CEO requirement makes sense in the for-profit sector. A positive bottom-line ultimately is the CEO’s responsibility, and CEOs are hired in part for their business acumen and financial ability. In the nonprofit sector, however, CEOs often are hired for other, non-financial qualities including fundraising, expertise in the organization’s field, or fundraising. It will be interesting to see if the CEO-certification requirement, which makes quite a bit of sense in the for-profit sector, will be imported to the nonprofit sector, where it might be a less-than-ideal fit. (Currently, the Form 990 can be signed by a president or other corporate officer.).

suggestion, the national Panel on the Nonprofit Sector, comprising 175 industry professionals, was named.118

The Panel issued its final report to the Senate Finance Committee and IRS Commissioner Mark Everson on June 22, 2005. Among its recommendations for “strengthening transparency, governance, and accountability of charitable organizations” were:

• That Congress increase the resources allocated to

the Service for overall tax enforcement and oversight of charitable organizations, and institute a federally-funded program to help states establish or increase oversight and education programs for charitable organizations;

• Improvements to information returns filed by charitable organizations so they provide more accurate, complete, and timely information for federal and state regulators. According to the Panel, electronic filing would increase accuracy and compliance in completing the returns.119 The Panel also recommended that Congress impose a penalty on preparers who willfully omit or misrepresent information on the returns and that it direct the Service to require the organization’s highest ranking officer to sign and certify the Form 990, as well as institute a new, brief annual reporting requirement for organizations with less than $25,000 in annual revenues.

• That the Service suspend the tax-exempt status of any charitable organization that fails to correct incomplete or inaccurate returns for two consecutive years;

• That organizations have financial statements prepared and audited in accordance with Generally Accepted Accounting Principles and auditing standards to improve the quality of financial information available to boards, government officials, and the public. The Panel

118 More information about the Panel is available at www.nonprofitpanel.org.

119 In 2005, the Service announced that exempt organizations with assets of $100 million or more that file at least 250 returns during the year would be required to e-file for tax year 2005. The Service extended the same requirement to all exempt organizations that file at least 250 returns during a calendar year beginning with the 2006 tax year. According to National Taxpayer Advocate Nina Olson, requiring organizations to file electronically does not address the real problem: organizations that do not file at all. Ms. Olson questioned the value of the e-filing requirement, stating that its only effect would be to “[create] an additional penalty on people.” Doc 2005-12576, 2005 TNT 110-4.


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also recommended that Congress require charitable organizations with at least $1 million in annual revenues to conduct an audit and attach audited financial statements to their Forms 990, and those with annual revenues between $250,000 and $1 million to have their financial statements reviewed by an independent public accountant.120

• That organizations voluntarily provide detailed information about their operations, including methods used to evaluate the outcomes of programs, to the public through their annual reports, websites, and other means;121

• That the penalties on a board member who approves an excess benefit transaction be imposed not only if the director knew that the transaction as improper, but also if he “should have known” (i.e., if he failed to exercise reasonable care);

• That the excise tax penalties on disqualified persons in the foundation context who are found to receive excess compensation be increased to 25% of the excess amount;

• That the penalties on board members and other managers who approve excess compensation, be increased from 2½% to 10% of the excess amount, and that the penalty on board members and other managers who approve other self-dealing transaction be increased from 2 ½% to 5%;122

120 The thresholds in the final report are lower than those in the Panel’s interim report of March 1, 2005. In its interim report, the Panel suggested an audit requirement for charitable organizations with at least $2 million in annual revenues and a review requirement for organizations with finances between $500,000 and $2 million.

121 In the market for donations, many above-board organizations already address this requirement—evidence that the public scrutiny to which Sec. 501(c)(3) organizations are subject serves a function similar to that of the proposed legislation.

122 The Pension Protection Act of 2006 (H.R. 4, Public Law 109-280) (“PPA”), signed into law on August 17, 2006, echoes these recommendations in part. PPA §1212 amends I.R.C §4941(a) to raise the initial taxes imposed on disqualified persons and foundation managers involved in any type of excess benefit transaction. Under the new law, the tax on disqualified persons is imposed at a rate of 10% (up from 5%), and the tax on foundation managers is imposed at a rate of 5% (up from 2 ½ %). PPA §1212 also raises the excise tax limitation for managers involved in self-dealing transactions from $10,000 to $20,000. The PPA does not change the rate of tax imposed in excess benefit transactions in the public charity context.

• That the cap on first-tier penalties imposed on board members and other managers of charitable organizations who approve excess benefit transaction, including excess compensation, should be raised from $10,000 to $20,000;123

• That loans to board members be prohibited entirely in the public charity context.

In April, 2006, the Panel issued a Supplementary Report containing nine additional recommendations, including guidelines for international grantmaking, compensation of trustees, and the prudent investor standard.

VI. CURRENT RECOMMENDATIONS

While the nonprofit sector awaits the outcome of additional pending legislative initiatives specific to it, exempt organizations, particularly small to mid-sized organizations should not attempt to implement all provisions of Sarbanes-Oxley. While they are required to address Sarbanes-Oxley’s document destruction and whistle-blower requirements, they need not impose on themselves the remedies prescribed for large public companies. Rather, Sec. 501(c)(3) organizations should focus on their areas of noncompliance and vulnerability and concentrate on common-sense remedies. They should adopt conflict of interest policies consistent with state law and the sample policy provided in the Form 1023; ensure that they file timely and accurate Forms 990 and 990-PF (if required); they should have appropriate sized boards of roughly 10 to 15 directors;124 they should avoid letting

123 This change was signed into law as part of the Pension Protection Act of 2006, which raises the excise tax limitation for exempt organization managers from $10,000 to $20,000. Although the limitation has been raised, the rates of tax in the excess benefit transaction context remain at 25% for disqualified persons and 10% for organization managers.

124 Nonprofits have legitimate reasons to expand the size of their boards: accommodating donors and volunteers whose service merits the recognition a board seat provides as well as prominent citizens and celebrities who, by lending their names, enhance the visibility and marketability of organizations. However, governing bodies comprising dozens of people cannot effectively deliberate and make decisions. Too-large boards often become passive and uninvolved, allowing the “real” decisions to be made by a small handful of officers or board leaders. A too-large board often provides too much latitude for aggressive insiders. Daniel L. Kurtz, The Sarbanes-Oxley Act of 2002 (2004). The American Bar Association suggests that organizations consider other structures, including advisory boards and fundraising committees, that allow organizations to involve and acknowledge important individuals while minimizing


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their CEO or other “insider” director be the sole point of contact for outside directors;125 they should not stray from the activities for which their tax exemptions were granted,126 and they should take care in handling donations, particularly directed donations and donations made on-line with credit cards.

In 2005, the Independent Sector, an umbrella organization of nonprofit organizations published a checklist127 that serves as guideline to help exempt organizations ensure that they are acting responsibly. In particular, the group recommends that organizations: develop a culture of accountability and transparency; adopt a statement of values and code of ethics; adopt a conflict of interest policy; ensure that the board of directors understands and can fulfill its financial responsibilities; conduct independent financial reviews, particularly audits; ensure the accuracy of the Form 990 and make it public; be transparent; set up a policy

risk. ABA Coordinating Committee on Nonprofit Governance, Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley 21 (2005).

125 Although a board full of outside directors, at first blush, would seem to promote board accountability and independence, the situation often results in all “inside” company information provided to the board being filtered through one inside director. Thus, the sole inside director can “game” the system by controlling the flow of information to the very board members who are charged with monitoring his performance. See Daniel L. Kurtz, The Sarbanes-Oxley Act of 2002. The problem can be solved formally, by adding provisions to the Bylaws to require employees to serve on committees, for example, or informally, by encouraging board members to regularly visit the organization’s facilities and meet with the staff. The American Bar Association also advocates using staff or other resources to ease directors’ burden to be independent overseers by, for example, developing “at-a-glance”summaries of key organizational operations. ABA Coordinating Committee on Nonprofit Governance, Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley 28.

126 Interestingly, in its final report of June 22, 2005 the Panel on the Nonprofit Sector recommended that Congress not implement a periodic review system the verify that a charitable organization continues to meet the qualifications for tax-exemption. Instead, the Panel recommended that the Service focus its resources on review and investigation of the current returns filed by charitable organizations. The Panel’s only concession to the problem of “mission creep” was to encourage boards of directors to undertake a full review of their organizational and governing documents and policies at least once every five years.

127 Available at www.independantsector.org.

on reporting suspected misconduct or malfeasance; and remain current with the law.

It seems likely that a nonprofit/exempt organization version of Sarbanes-Oxley is in the cards. The more stringent excise tax provisions imposed by the Pension Protection Act of 2006 certainly increase the penalties for failures to comply with existing rules, and the drum beat seems to suggest that the rules themselves will be toughened. For about as long as such reforms have been contemplated, those knowledgeable about the sector have expected the charitable reforms to be combined with charitable giving incentives. The PPA seems to have met these expectations. In addition to raising the rates of excise taxes and the limitations thereon (as well mandating tougher rules on charitable donations and making other charitable reforms), the Act includes charitable giving incentives. In particular, it permits taxpayers aged 70 ½ + to roll up to $100,000 annually from their IRAs to charitable donees (excluding I.R.C. §509(a)(3) supporting organizations) tax- and penalty-free through December 31, 2007.128 One hopes that continued reforms also will be accompanied by giving incentives.

Until all of the nonprofit/exempt organization measures are finalized, organizations may find themselves facing a collective action dilemma: if they conduct themselves accountably and transparently while such conduct is voluntary, the legislative prescription could be measured. However, upstanding organizations that do so incur expenses while contributing to the good of moderate requirements that benefit even dishonest organizations. Frustrating as the situation is, a more positive outlook would be to consider that Congress, by mandating practices for certain for-profit organizations, has unofficially prescribed “best” practices. In the market for donations, savvy Sec. 501(c)(3) organizations will, to the extent possible, adopt—and publicize that they have adopted—these standards.

At the same time, organizations should recognize that making themselves Sarbanes-Oxley compliant is expensive and could lead to an unbalances overhead/activity ratio that will harm their attempts to solicit donations.

128 In all, the Act’s reforms outnumber the incentives 17 to 7. Notably, neither the Act nor the Estate Tax and Extension of Tax Relief Act of 2006 (H.R. 5970) permit nonitemizers to claim charitable deductions, a provision that would encourage giving from people with limited or middle incomes, not just those comfortable and sophisticated enough to be able to take advantage of the IRA rollover provision.


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VII. CONCLUSION Those who represent Sec. 501(c)(3) organizations

should be alert to the potential for private benefit, private inurement, and prohibited transactions so that they can help their clients avoid onerous excise taxes and fatal exemption revocation. In the post-Sarbanes-Oxley era, the same representatives should comply with the document destruction and whistle-blower provisions that apply even to nonprofits and should recognize the indirect effects Sarbanes-Oxley will have on conceptions of appropriate nonprofit governance. Also, representatives should keep abreast of pending legislation that will be for certain nonprofits what Sarbanes-Oxley was for certain for-profit companies.

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