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The IRS's New Regulation of Nonprofit Governance
The Annual Form 990 Is Now Much More than a Tax Return
By Lisa A. Runquist and Michael E. Malamut
Form 990 is the Internal Revenue Service (IRS) filing required annually of most nonprofits. It has been significantly amended for filings beginning in 2009. The new emphasis on governance issues that have at most a tenuous connection to the tax rules means that completing the form can no longer be considered simply an accounting function. Business lawyers should be involved not only in completing the form, but, more importantly, in assisting the nonprofit in drafting appropriate policies, the existence of which must now be disclosed on the form.

Unlike almost all other tax returns, Form 990 is a public disclosure document. All Form 990s are available for public inspection, with limited exceptions for donor identification information. These forms are regularly examined by potential contributors and others.

The IRS has added a new section entitled "Governance, Management, and Disclosure" and placed additional governance-related questions throughout the form. The instructions for the revised form provide additional guidance on the nature of the governance policies that the IRS would like to see.

[The Form 990--with the new amendments--was due for the first set of covered organizations by May 15, 2009. Because of rolling fiscal year reporting and a three-year phase-in period, a large number of covered organizations have yet to file their first revised Form 990. Moreover, using Form 8868, organizations are entitled to request an automatic three-month extension, and an additional (but not automatic) three months--a total extension of six months beyond their initial filing date.]

In light of the Enron debacle and parallel scandals in the nonprofit world, Congress and the IRS have put nonprofits, and specifically nonprofit governance, under the microscope. Sarbanes-Oxley (SOX) instituted federal corporate governance oversight of public companies. Governance of nonprofits has continued to be largely a matter of state law. However, the IRS's recent foray into "regulation through disclosure" may erode state control over nonprofit governance.

The new form has only recently begun to be brought to the attention of those who specialize in governance issues. Comments on the draft form and instructions came almost exclusively from the tax side of the bar. The resulting IRS foray into corporate governance is simplistic; neither the form nor the instructions recognize the many problems that may result from the revised form. And because of this disconnect, the form is likely to catch many exempt organizations and their advisors unaware.

The Form 990 information return is not only required to be filed annually with the IRS, but also with a significant number of states. Filers include not only public charities that are exempt under section 501(c)(3) of the Internal Revenue Code, but also most other noncharitable exempt organizations such as chambers of commerce, social clubs, labor unions, and fraternal benefit societies. Smaller organizations may be eligible to file the simpler Form 990-EZ instead of Form 990. However, some attorneys general have indicated that organizations using Form 990-EZ may have to file supplemental information with the state. Moreover, some organizations must use Form 990 regardless of their size. The smallest organizations—those with gross receipts of $25,000 or less that used to be exempt from any IRS filing—must now file online a Form 990-N, Electronic Notice (also referred to as an "e-Postcard"). Private foundations (that is, 501(c)(3) organizations other than public charities) must continue to use Form 990-PF, which has not yet been updated. Churches continue to be exempt from such filings.

Who Needs to Be Involved?
In the past, most nonprofits have left the preparation of Form 990 to the accountant, with whatever assistance was necessary from staff. This is no longer sufficient.

The revised form asks whether each member of the board received the Form 990 before it was filed. To answer "yes," each member must have received the final version, and not merely a draft, before filing. Further, the organization must describe the actual review process. Cursory submission to board members immediately before filing will allow the organization to answer "yes," but the organization may need to disclose that the board had little time for its review. Boards should consider adopting a Form 990 review policy that provides adequate time for review by at least a subcommittee of the board. This may mean that the board (or the relevant subcommittee) will have to schedule an extra meeting for this purpose, and that a draft of the Form 990 will have to be prepared in anticipation of this meeting.

The organization may answer "no" to the question whether the entire board has received the final Form 990 prior to filing, and explain why the review process was nevertheless sufficient. However, it is likely that many members of the public, such as potential donors and ratings agencies, will only look at the yes/no answers on the form itself, rather than examining the explanation of the process, to determine whether the process is satisfactory.

Some of our best friends are accountants, but preparing Form 990 requires the skills of other professionals in addition to accountants.Accountants are not public relations experts. The Form 990 is a public document and should be reviewed with public relations in mind. Because of its wide availability, the form may be the organization's number one public relations document. Accurate financial data, of course, are essential but are not sufficient. The accountant should not be expected to draft descriptions of the activities of the organization, the answers to the questions on governance, and other similar narrative statements.

Accountants also cannot be expected to function as lawyers. Many of the questions, particularly those dealing with corporate governance, have legal implications that go way beyond matters of accounting and finance. The organization would do well to work with its legal counsel to determine the implications of each answer. To complete this form accurately, the accountant, the attorney, and the exempt organization must work together.

The IRS and Corporate Governance
There is nothing in the Internal Revenue Code that gives the IRS any oversight over corporate governance. However, the IRS is convinced that good corporate governance is necessary to ensure that the organization lives up to its responsibilities as a tax-exempt organization. The IRS also has made it clear that it is not going to change its direction in this area.

The IRS is therefore engaging in regulation by public disclosure. There is no empirical evidence, however, that an organization that follows what the IRS considers to be good governance is any more likely to be well run or more faithful to its mission than an organization that has adopted alternative practices. Many organizations are likely to make changes to their operations or to adopt new policies in light of the implied mandate from Form 990, without having thought through the implications of such changes. This revised Form 990 might ultimately be the lawyers' full employment act.

"Correct" Answers to the Questions
While the governance practices that must now be disclosed in the form do not have mandated correct answers, donors, ratings agencies, and local tax and nonprofit governance regulators can be expected to review governance responses on the Form 990. The IRS also may use responses to evaluate which returns warrant more careful review or possible audits. Disgruntled members and miscellaneous gadflies can be expected to review organizations' publicly available Form 990 filings. For these reasons, exempt organizations filing the new Form 990 are likely to feel significant pressure either to adopt policies that will allow them to put down what is implied to be the right answer to the governance questions or to craft their accompanying explanations carefully to provide a reasonable description of why that answer is not applicable in their case.

However, nonprofits should be very careful about adopting policies simply for the sake of being able to answer "yes." The organization should be encouraged to adopt policies only after having carefully considered its particular situation. It is much better to say "no" than to adopt a policy that is not going to be followed or that might cause significant problems for a longstanding and successful organizational structure.

Independent Directors
The Form 990 inquires about the total number of directors and the number of independent directors who meet the definition in the instructions. Comparison of the numbers readily discloses the percentage of independent directors. A director is considered to be independent if all three of the following circumstances applied at all times during the organization's tax year:

  1. The director was not compensated as an officer or other employee of the organization or of a related organization (there is a limited religious exception).

  2. The director received total compensation as an independent contractor from the organization or other related entity of less than $10,000 for the year (may receive reasonable compensation as a director, and may receive reimbursement of expenses).

  3. Neither the director nor any family member was involved in a transaction, either with the organization or with a related organization, that was required to be reported on Schedule L, Transactions with Interested Persons.

The focus of the definition is on compensation received by the director or a relative from the organization or a related entity. This definition excludes ordinary members of membership associations and substantial donors who do not have other transactions with the organization.

In response to SOX, the question of when a director is independent has been endlessly debated. It is likely to come as a surprise to many experienced corporate attorneys that independence is so easily determined for purposes of completing Form 990. The IRS's simplistic approach to determining director independence is likely to give a feeling of comfort when it may not be deserved; alternatively, it may paint an organization as somehow being less deserving if a high percentage of directors fail to qualify as independent, when it is actually very well run.

A related question asks the organization to identify any officer, director, or key employee who has a family relationship or a business relationship with another officer, director, or key employee. The instructions make it clear that this question does not refer to relationships in the ordinary course of business, nor to attorney/client or certain other professional relationships. The problem with this question is twofold:

  1. It is not limited to business relationships that might in some way affect the nonprofit. If two directors choose to engage in a private business relationship that has absolutely no impact on the nonprofit, the requirement that the relationship be disclosed on a publicly available form may violate the directors' right to privacy without, in any way, improving nonprofit governance. If anything, it might simply encourage either or both directors to resign, thus decreasing the pool of individuals willing to serve; and

  2. If the business matter involved a public company and could have an impact on the stock price if it were disclosed, a premature disclosure of the matter could violate securities laws. Although the instructions state that the explanation can simply name the parties and state "business relationship," even this may be more than is appropriate depending on the circumstances.

The Need to Adopt or Amend Policies
Form 990 asks whether the organization has adopted a number of policies and procedures. Although, as noted already, these policies are not mandated by the Internal Revenue Code, the implication appears to be that a well-run nonprofit would have them. Some of the most significant include

Conflict of Interest Policy. Conflict of interest policies have long been a good governance standard. IRS Form 1023, Application for Recognition of Exemption Under § 501(c)(3), has, for several years, strongly suggested that applicants adopt a conflict of interest policy. State law also requires that directors act in a manner that is in the best interests of the organization. The form considers conflicts to consist solely of financial conflicts and does not address conflicts of loyalty that may arise for directors who serve on several boards. The form also expects the policy to apply to key employees as well as officers and directors and requires disclosure of how the policy is implemented.

Whistle-blower Policy. The form goes on to ask if the organization has a written whistle-blower policy. SOX imposes penalties—including severe criminal penalties—against all organizations (including nonprofits) that retaliate against whistle-blowers. Although it is a good idea to have a written policy on whistle-blowers, there is nothing in the law that requires exempt organizations to have one. An effective whistle-blower policy specifies the process to be used for reporting confidentially on any potential wrongdoing so that the organization can investigate and, if necessary, correct any problems, while eliminating, as much as possible, the chance of retaliation against the whistle-blower.

Record Retention and Destruction Policy. SOX also extends its record retention and destruction requirements to all entities, including nonprofits: Form 990 asks whether the organization has a written document retention and destruction policy. As with the whistle-blower issue, the law does not require a written policy, but it is certainly a good idea for the organization to have one. A written policy should cover not only document retention and destruction, but also standards for document integrity, such as guidelines for handling electronic files, backup procedures, archiving of documents, and regular checks to determine the reliability of the system.

Worse than not having a written policy is having such a policy and not following it, so be careful about implementation. In case of a dispute, unfavorable inferences can readily come to mind when an organization destroys records in violation of its own policy.

Compensation Policy. Executive compensation has been a significant issue for exempt organizations, especially since the introduction of the intermediate sanctions law for excess benefits transactions, adopted by Congress in response to a number of high-profile nonprofit scandals involving excess compensation issues. (26 U.S.C. § 4958.) (See www.runquist.com/article_intermedsancts.htm for more information.) Compliance with the procedures that the questions seem to encourage will allow the organization to come within the safe harbor provided by the regulations on intermediate sanctions. In addition, the Form 990 requires the organization to describe the process used in setting compensation in narrative. State law also may impose requirements concerning executive compensation.

Joint Venture Policy. If the organization engages in joint ventures or similar arrangements, such as partnerships, whether with nonprofit or for-profit partners, it must state whether it has in place a written joint venture policy. The instructions define such a policy as one that safeguards the organization's tax-exempt status during its participation in the endeavor. Again, there is no legal requirement for the organization to adopt such a policy, or that it be in writing.

Form 990 Disclosure Policy. Another question inquires about how the organization disseminates its Form 990. This is not an inappropriate question since, as noted previously, Congress has required the Form 990 to be made available for public inspection. This same question also asks how the organization makes its Form 1023 or 1024 (the exemption application forms for 501(c)(3) and other 501(c) organizations, respectively) available. Form 990s are readily available for inspection (gratis) online. See www.guidestar.org. However, there is no similar method by which Forms 1023 and 1024 are made available.

Governance Disclosure Policy. The organization also must disclose how it makes its governing documents, conflict of interest policy, and financial statements available to the public. Unlike the Forms 990 and 1023, there is no federal law requiring such disclosure (limited disclosure may be required by some states); therefore, the organization needs to determine if, and to what extent, such disclosure is appropriate.

Chapter Relations Policies. Form 990 asks whether multilevel associations have policies and procedures to ensure mission consistency throughout the organization, including chapters, affiliates, and branches. This question appears to encourage associations to adopt stronger central oversight, which may or may not be consistent with the structure of the particular organization. The requirements being suggested also could result in the associations finding themselves subject to franchise law.

Governing Document Changes. A narrative description is required for all significant changes in the "organizational documents," typically articles of incorporation or association, bylaws, and, for a trust, the trust instrument or declaration of trust. The requirement for a narrative description might, in some instances, discourage amendments to bylaws, and might further encourage migration of provisions from bylaws, which are reportable, to policies, which are not.

Audit Committee. The form asks whether the filing organization has an audit committee to review its outside audit. Not any committee denominated the "audit committee" will do. The instructions include a detailed definition of an "audit committee" that warrants a "yes" answer to the question. Many states have additional requirements concerning audits and audit committees. For example, any exempt organization subject to the California Nonprofit Integrity Act that has income of $2 million or more must have an audit—which must be disclosed publicly--and must have an audit committee in accordance with the terms set forth in that act.

Other notable policies suggested by the form include a gift acceptance policy (if it receives noncash contributions) and fund-raising policies to assure compliance with solicitation laws, accuracy of materials, reasonableness of fund-raising costs, and public disclosure of fund-raising practices.

Some of the policies suggested by the new Form 990 are closely related to tax compliance, such as compensation policies (related to tax sanctions for overcompensation) and gift acceptance policies, or to legal mandates, like whistle-blower and document retention policies derived from Sarbanes-Oxley. Others, however, are apparently thought by the IRS to be general good governance strictures, based on little or no empirical evidence and no generally accepted best practices.

The IRS has thus become the leading force behind the reform of nonprofit governance. Many smaller organizations that prepare their own returns or who work with accountants or lawyers unfamiliar with the new form will only become aware of the new governance suggestions while they are attempting to fill in the return. Many such organizations have gone about their missions quietly and effectively for years without governance review or policy drafting. They may now feel compelled to create more formalized systems, but need to make sure that these systems work for them, and should not be forced into a policy that simply does not fit their structure.

Because Form 990 responses relate to the end of the preceding tax year and not the date of filing, even if the organization puts in place a new policy, the organization may have to respond "No, but . . ." in the first year of phase-in, with an explanation that the relevant policy was either adopted after the end of the tax year, but before filing, or remains under study and is expected to be finalized in the future. Practitioners who work with nonprofits of all sizes should be thinking about how to guide their clients through a serious governance review.

[The burdensome amendments to Form 990 are another reason to carefully consider the suggestions in the article found in this issue by Gene Takagi and Emily Chan, "Alternatives to Forming a Charitable Nonprofit."]

Information on the IRS Website

The 2008 Form 990 and instructions are available on the IRS website at www.irs.gov/charities/article/0,,id=185561,00.html.

Links to background papers and commentary on the draft form and instructions are available at www.irs.gov/charities/article/0,,id=181089,00.html and www.irs.gov/charities/charitable/article/0,,id=185892,00.html.

The June 11, 2008, report of the Advisory Committee on Tax Exempt and Government Entities that discusses the appropriate role of the IRS in governance issues is available at www.irs.gov/pub/irs-tege/tege_act_rpt7.pdf.

Runquist is principal of Runquist & Associates in Northridge, CA. She is an editor and author of the recently released Guide to Representing Religious Organizations, published by the ABA Business Law Section. Her e-mail is lisa@runquist.com. Malamut is principal of Malamut & Associates in Dedham, MA. His e-mail is michael@michaelmalamut.com.

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