July 14, 2004

Comments on Senate Finance Committee Staff Discussion Draft Concerning Tax-Exempt Organizations
(Referring to The Senate Finance Committee white paper entitled Tax Exempt Governance Proposals: Staff Discussion Draft. The PDF of this report is at http://finance.senate.gov/hearings/testimony/2004test/062204stfdis.pdf.)

The Nonprofit Coordinating Committee of New York, Inc. (NPCC) is an umbrella organization devoted to representing the interests of and assisting all types of 501(c)(3) organizations in the New York metropolitan area. NPCC has over 1,300 such organizations as its members, ranging from tiny organizations with no full-time employees to nationally known institutions, such as museums.

NPCC has a very active Government Relations Committee, consisting of many prominent lawyers in the New York City area who advise nonprofits as the principal focus of their practices. The Committee includes three former heads of the Charities Bureau of the New York State Attorney General’s office, as well as the new head of the Charities Bureau (who is ceasing to function as a member of our Committee only by reason of his appointment).

A special focus of NPCC has always been smaller nonprofits that lack other sources of assistance in seeking to operate capably, and in a manner that is transparent and accountable. When commenting on proposed legislation and regulations, NPCC’s role has been to urge legislators to strike an appropriate balance between the benefits likely to be achieved and the cost in time and money of satisfying the new rules being proposed.

Everyone agrees that there are some “bad actors” in the nonprofit sector and that their bad practices should be stopped. There is also broad consensus that the successful functioning of nonprofits depends upon a high level of public trust. The tough problem now being grappled with by the Senate Finance Committee and its staff is how to achieve those objectives without producing significant adverse consequences for the nonprofit sector and thus, most importantly, for those it serves.

Our comments on the white paper are particularly focused on matters affecting smaller nonprofits and are as follows:

General Comment

We hope you will keep in mind as you review federal regulation of nonprofits the Hippocratic oath taken by doctors: “Do No Harm.” There are already many laws and regulations governing the operation of nonprofits, as well as a number of watchdog organizations monitoring them. We believe that the vast majority of abuse and misconduct is already covered by existing rules; therefore, what is needed most is enforcement of those rules at the federal and state levels. Also, each new rule that prevents misbehavior or catches a bad actor can impose additional costs on tens of thousands of organizations that are behaving properly and for whom the rule is irrelevant. Thus, the capacity of even well-intentioned new rules and regulations to do harm is substantial. Therefore, we ask that you consider with great care not only the bad conduct you believe will be stopped by new rules, but also the costs imposed by those new rules and their effect on delivery of services by an untold number of charities.

A. Exempt Status Reforms

1. Five-year review of tax-exempt status by the IRS

Much of the information called for here would be provided under other provisions or is called for by current federal and/or state reporting requirements, e.g., changes in the articles of incorporation. Requiring submission of conflict of interest policies is not objectionable. Requiring submission of policies regarding best practices raises the specter that you will receive lots of “canned” versions of such policies, but we doubt that such submission will be effective in stopping the bad actors. Unlike individualized policies, whose creation might be a valuable exercise for organizations with the resources to prepare them, “canned” policies are not likely to invigorate governance practices within organizations or provide relevant new information to the IRS.

The reference to a detailed narrative about an organization’s practices is distressingly vague and will leave people confused as to what they should submit. It is also not clear to us what producing such a detailed narrative will accomplish; but producing it will take time and divert management attention from operations directed to carrying out the mission. That is really the crucial trade-off.

In short, there is something to be said for an updating process every five years. But the demands of that process need to be very carefully considered to make sure that the benefits to be derived from carrying out the process will really be worth the implicit costs of the time involved in doing so. To mitigate concerns regarding the burden such enhanced filing requirements may place on small organizations, if they are to be imposed, we urge the Committee at least to impose a minimum threshold size before these requirements become operative.

2. Donor advised fund reforms

In light of our focus on small organizations, we have no comments on exempt-status reforms 2 through 5.

B. Insider and Disqualified Person Reforms

1. Apply private foundation self-dealing rules to public charities and modify intermediate sanction compensation rules

We strongly urge you not to apply the private foundation self-dealing rules to public charities. Applying to public charities the flat prohibitions of the private foundation self-dealing rules would be very costly in many circumstances. Here is a case in which we would expect the costs to vastly exceed the benefits. Many acts of self-dealing between a public charity and its disqualifying persons involve transactions that are very favorable to the public charity—such as a board member renting space to the public charity at a rent well below market. These transactions should be documented as to their fairness to the nonprofit and should be prohibited where they are not fair, as is generally the case under state law. In addition, the “intermediate sanctions” excise tax provisions under Section 4958 of the Internal Revenue Code already impose serious penalties on unfair and abusive transactions between public charities and their disqualified persons, while allowing beneficial transactions to go forward. A simple prohibition on transactions between public charities and disqualified persons is too blunt an instrument to wield in this context, and would deprive a great many nonprofits of opportunities to obtain needed goods and services on very favorable terms.

2. Expand definition of disqualified person

Assuming the foundation self-dealing rules are not applied to public charities, we cannot object to the proposed expansion of the “disqualified person” definition for purposes of applying Section 4958.

3. Increase taxes for self-dealing, jeopardizing investments, and taxable expenditures

As noted, we do not believe these rules should be applied to public charities.

4. Compensation of private foundation trustees

No comments.

5. Compensation of disqualified persons

No comments.

C. Grants and Expense Reforms

No comments.

D. Federal-State Coordination of Actions and Proceedings

1. Establish standards for acquisition/conversion of a non-profit

No comments. 2. Provide States the authority to pursue federal actions

We approve this proposal.

E. Improve Quality and Scope of Forms 990 and Financial Statements

1. Require signature by Chief Executive Officer

We believe that requiring Form 990 to be signed by the Chief Executive Officer is appropriate. The Chief Executive Officer should be comfortable signing the return and taking appropriate responsibility for its accuracy. We believe, however, that the signature-related language currently used in Form 990 is adequate for that purpose. The white paper’s suggestion that the Chief Executive Officer must have put in place processes and procedures to “ensure” that the organization’s returns comply with the Internal Revenue Code will raise major concerns for conscientious Chief Executive Officers. Unlike in the financial and other for-profit industries, a nonprofit CEO will often lack a staff with the expertise to “ensure” him or her that sufficient processes are in place to avoid all errors. Especially if a signing Chief Executive Officer may be subjected to personal penalties, as later proposals suggest, we may begin to face even greater reluctance on the part of qualified individuals to serve organizations in vital leadership positions.

2. Penalties for failure to file complete and accurate 990

Nonprofits often do not have staff with the level of financial sophistication enjoyed by those working for business corporations (who are usually paid much more). Mistakes are made in filing Forms 990, as they are in filing corporate and individual tax returns. The existing penalties are already significant and provide a strong incentive not to make a mistake. Tripling them is punitive and counterproductive. Donors contribute money to a homeless shelter so that it can feed and house the homeless. If the Internal Revenue Service takes significant portions of that money because a staff person made a mistake on a Form 990, those resources are not available to feed and house the homeless, and the donor’s intent in making the contribution is substantially defeated. Even worse, the homeless shelter may be put out of business. Also, electronic filing should eliminate almost all of the filing errors by “bouncing” the erroneous returns.

It is crucial to keep in mind that a great many nonprofits provide services that society believes should be provided and that are not provided by government. Creating an oppressive environment for those nonprofits, usually staffed by people earning much less than what would be paid for comparable work in the private sector, is not the answer.

3. Penalty for failure to file timely 990

Treating extensions of more than 4 months as a failure to file is a reasonable proposal so long as there is an exception when “reasonable cause” can be demonstrated. For example, records may have been lost in a fire or an accountant may have died (many nonprofits are audited by a sole practitioner accountant).

4. Electronic filing

Electronic filing is a fine idea so long as it works, is user-friendly, and the costs of use do not increase the administrative and accounting costs from those incurred with paper filing. Getting that system in place is the tricky part, particularly creating incentives in terms of simplicity, cost, etc., for outside preparers to use it. If this task can be achieved, we fully support the establishment and use of an electronic filing system, to enhance the data on the sector available for state and federal enforcement, as well as for study and analysis.

5. Standards for filing

We fully support clear standards and conformity with financial statement accounting. The statement in the white paper that “there are no standards for filing a Form 990” seems to be hyperbole, given the many pages of instructions for the current Form, but the standards could be clearer. Perhaps the bigger issue is that the meaning of certain information required to be given on Form 990 is unclear to non-experts. Clarifying the nature of the information called for would be helpful—e.g., distinguishing between the two kinds of “temporarily restricted funds.”

We would also like to suggest that the option be specifically given for an organization to offer an explanation of its financial data if it wishes to do so. For example, consider an organization that has spent in one fiscal year a considerable sum to ready a fundraising campaign expected to produce a splendid return in the next fiscal year. This organization will appear from its Form 990 data for the first fiscal year to have had very large fundraising expenses relative to receipts. Yet, over time, these fundraising expenses may be shown to be fully justified. Many readers of Forms 990 do not appreciate the importance of looking at Forms 990 for several years to get a better sense of the organization’s finances, and the option of including an explanatory statement would help organizations to clarify that confusion.

6. Independent audits or reviews

These proposals are likely to add significantly to audit costs. If you are going to require that audited financial statements be submitted, where they exist, and that the Form 990 needs to take its information from those statements, that should be adequate. Please note that when a paid outside preparer prepares the Form 990, that preparer currently signs the return. As to the $250,000 threshold for requiring audited financial statements, different states have taken different views on that requirement and many would urge that the $250,000 figure is too low. As that is the threshold in New York, those of us working with nonprofits here are accustomed to this threshold.

Requiring a new auditor at least every five years is truly problematic. Would that mean a new individual or a new firm if a firm has been used? While switching auditors has desirable aspects, it ordinarily involves increased audit expenses, as the new auditor needs to familiarize herself/himself with the operations of the organization. An organization lucky enough to receive free audit work would be hard pressed to find a free successor and so would likely incur the greatest audit expense increase. Also, in certain geographic areas, there are a limited number of people or firms competent to prepare an audit of a nonprofit, which involves, as you know, the application of special rules. As this proposal involves a classic weighing of burdens versus benefits, it should not be adopted without careful consideration of whether the value of switching, in terms of misconduct or abuse caught or prevented in some organizations, will really be worth the additional cost to be imposed on almost all organizations.

7. Enhanced disclosure of related organizations and insider transactions

In our experience, this is the area in which most of the bad acts occur. We support such enhanced disclosure.

8. Disclosure of performance goals, activities, and expenses in Form 990 and in financial statements

As Derek Bok made clear in his testimony, some requirements in this proposal have the dual disadvantages of increasing administrative costs while not producing meaningful standards for judging an organization. Specifically, we are concerned that producing the additional performance goals and measurements contemplated by this proposal will take time and resources away from pursuing a charitable organization’s mission. This might be a cost worth bearing if it would significantly improve the IRS’s ability to evaluate compliance with exemption requirements. Unfortunately, we fear that mandating the articulation of performance goals will not significantly improve analysis and enforcement capacity of the IRS. Finding and applying effective metrics for nonprofit performance is notoriously difficult. How can a university show whether it is “teaching philosophy better” than it did before? In addition, if their continued tax-exemption depends upon meeting performance goals, most organizations will concentrate on setting goals and standards that they feel they can meet, rather than engaging in a rigorous program of self-evaluation. Thus, the effort involved in doing so and in compiling data to report such successes is unlikely to produce useful information.

Perhaps the most important point about performance goals is that exemption cannot depend on the IRS’s determination of whether an organization is doing a “good job.” Quality is often in the eyes of the beholder. The legal criteria for exemption are, and should remain, distinct from whether an organization is perceived as doing a “good job” or not.

However, NPCC fully supports efforts to enhance the quality of information provided to the IRS on Forms 990 and to improve the ability of the IRS to analyze and manage this information. Nevertheless, we urge the Committee to consider whether each additional disclosure burden it proposes will yield benefits sufficient to justify the extent to which it will divert time and money from pursuit of an organization’s charitable mission.

9. Disclose investments of public charities

This proposal appears to be a reasonable one in terms of promoting transparency. However, the Committee should consider the details of such disclosure carefully, taking into account the potential for harassment by those who disagree with the charity’s mission or mode of operation.

F. Public Availability of Documents

We support the first 4 of these proposals.

Proposal 5, requiring publicly-traded corporations to disclose all gifts over $10,000 (in the aggregate) for which a charitable deduction is claimed, calls for very careful evaluation of whether this disclosure will do more harm than good. Corporations often make gifts to organizations with which their senior executives are affiliated, usually in a board capacity. Many of these gifts are to major local charities seeking board service by people with the talents and wherewithal to make individual donations. If this proposal becomes law, a corporation will think hard about the flak it might take by reason of having its senior executives serve on boards of charities to which it makes substantial donations. The corporation may then either stop making the donations, or it may ask its senior executives to go off the board so as to preclude attacks on the grounds that the corporation is being used to support the individual interests of such directors. Neither result is constructive. To the extent that corporations are giving money to further the interests of their executives, as distinguished from the appropriate interests of the corporation, this sunshine may have a positive effect. Our concern and expectation is that the net effect is much more likely to be negative, as worthy organizations lose valuable contributions, qualified directors, or both.

G. Encourage Strong Governance and Best Practices for Exempt Organizations

1. Board Duties

Good board governance is, of course, an essential element of a properly run 501(c)(3) organization. The “musts” contained in the white paper are all appropriate from a conceptual standpoint. They are, however, very detailed, and, if codified, will create major operational problems that will divert resources of time and money and discourage board participation by the very people most likely to provide good governance. Here, again, the impact on small organizations would be particularly powerful. We believe that the proper tool here is education, not regulation.

Also, these proposals represent a federalization of nonprofit law now handled, to a large degree, by the states, thereby imposing a new and complex additional set of compliance rules, with attendant costs in time and funds diverted for all affected organizations. Such federalization should be considered with the utmost care, with particular attention paid to costs imposed versus benefits.

2. Board Composition

We believe that a prohibition on boards of more than 15 directors will prove wildly counterproductive to the laudable goals you clearly wish to achieve. While 15 may be a reasonable maximum from a conceptual standpoint in promoting the deliberation and personal responsibility needed for good governance, this maximum fails to take into account the realities of membership on a vast number of nonprofit boards. Often, such boards need a significant number of people with different expertises to fulfill needed functions---program review, budgeting, technology oversight, as well as people who give or raise significant amounts of money, or provide free special expertise (e.g., as to real estate matters). These people ordinarily want very much to be “on the board." Organizations concerned about their survival, as so many charities are, will not be eager to pare their boards to 15, and are likely to suffer by doing so. Many large boards use executive and other committees to focus responsibility, and this could be encouraged.

3. Board/Officer Removal

The imposition of penalties on nonprofits for failure to conduct background checks of the type described will impose additional costs and distractions that seem very unlikely to be productive. Also, many non-criminals asked to serve on boards may well be offended to be asked if they are criminals.

As to IRS authority for removal, this authority, if it is to be asserted, must be circumscribed with appropriate procedural safeguards that do not permit the IRS to take such action without appropriate review by an independent authority. Also, such authority would be a major step towards federalization of nonprofit law, raising the concerns noted above.

4. Government encouragement of best practices

Having government encourage best practices is, of course, an excellent idea. The Charities Bureau of the New York State Attorney General’s office has a very active program devoted to this goal. We question, however, whether promoting accreditation is really constructive. Many existing accreditation programs are extraordinarily time-consuming and are likely to be undertaken by the organizations least in need of improved governance, most particularly organizations able to spend substantial amounts of money on the accreditation process. We again urge you to consider the impact of this kind of reform on the ability of organizations – and particularly small ones – to achieve their missions as well as to recruit and retain staff. If you put pressure on accreditation by outside organizations, as well as requiring extensive new filings with governmental agencies, the time and money required to comply with new accreditation and disclosure standards will be time and money taken away from pursuit of charitable organizations’ missions.

The effects on staff are likewise distressing. Executive directors of nonprofits like to feel that they are serving a mission. It is that feeling that encourages them to accept substantially lower pay and benefits than they would receive, in most cases, from the private sector. If you convert the jobs of those people into ones of carrying out and overseeing endless filings of reports and materials, the nonprofit sector will simply not attract the people with the passion and dedication needed for the organizations to serve their missions.

Finally, conditioning government grants and contracts on accreditation will bestow substantial power on accrediting agencies. This type of approach would require serious thinking about the standards accrediting agencies should use, as “people do what people measure”, whether it makes sense to do so or not. This privatization approach also would create require substantial investment in oversight of accrediting agencies, to ensure the accuracy and consistency of their accreditation processes.

5. Accreditation

Consistent with our prior comments, we strongly support the use of government funding to promote education as to best practices. As noted, full-scale accreditation with an intense accreditation program strikes us as a diversion. We believe that very few organizations have actually gone through the full-scale accreditation programs you note, presumably because of the extensive burdens of doing so. Also, accreditation programs raise serious concerns as to the nature of the standards established and the process for establishing them, particularly as those standards may be applied to non-comparable charities.

6. Establish prudent investor rules

This is another example of federalization of nonprofit law contemplated by the white paper. In our opinion, state standards in this area are adequate. However, if a federal standard were enacted, we urge you to adopt a standard sufficiently general that it would not create confusion and fear for nonprofits trying to comply with it. Also, as you know, some of the most successful investment programs carried out by prominent institutions use “alternative investments.” Limiting investment discretion is likely to have significant adverse consequences.

H. Funding of Exempt Organizations and for State Enforcement and Education

As noted, we favor such funding. In particular, we support permitting the IRS to share information with state charity regulators and we urge that this be included as part of any reform package you may propose. We know that the New York State Attorney General’s Charities Bureau considers this information sharing to be of great importance. (A provision permitting such sharing is contained in S.476 (as passed by the Senate), in S.882, and in H.R. 1528 (as passed by the House and Senate).)

However, imposing or increasing fees on charities simply defeats the intentions of the donors of those charities, who donate money to help serve the mission, by diverting that money to the government. “Fees” are indirectly a form of taxation; taxation of charities (except for taxation of unrelated business income) goes against longstanding government policy.

I. Tax Court Equity Authorities, Private Relator and Valuation

We are not prepared to comment on these proposals at this time.

Thank you for your consideration of these comments.

Jonathan A. Small
Executive Director
Nonprofit Coordinating Committee of New York, Inc.