IRS to Nonprofits: "Do You Have a Policy on That?"
 
May 22, 2008
 
Telly J. Meier- Washington
Kathleen Nilles - Washington

The Internal Revenue Service (IRS) recently released two documents that effectively encourage nonprofit organizations to adopt appropriate written policies related to corporate governance. In light of these new releases, nonprofit organization boards and their counsel should carefully consider whether the organization’s current corporate policies are sufficient or whether they may need to be supplemented and/or revised.

This article discusses the recent IRS documents and the policies they reference. It also examines what the IRS may be looking for when it recommends adoption of a particular type of policy.

IRS Documents Encourage Corporate Governance Policies

The first IRS document is a draft paper entitled “Good Governance Practices for 501(c)(3) Organizations” (the Draft Article). It recommends the adoption of the following policies by all charitable organizations:

• a mission statement
• a code of ethics and whistleblower policy
• a conflict of interest policy (for both directors and staff)
• a financial information disclosure policy
• a charitable fundraising policy
• a financial audit policy (including possible establishment of an audit committee)
• compensation and expense reimbursement policies
• a document retention policy

The IRS Draft Article was obtained by a member of the press on February 2, 2007. According to an article published on that date in Tax Notes Today, “IRS Prepares Draft of Good Governance Practices for 501(c)(3) Organizations,” the proposed good governance practices are designed to ensure that nonprofit directors understand their roles and responsibilities as persons charged with guiding and overseeing a charity’s operations and finances.

The second IRS document is the completely re-designed draft Form 990 (Draft Form 990) released by the IRS on June 14, 2007. The IRS has requested comments on this radically different and expanded form by September 14,2007. (The short deadline was necessary to facilitate IRS plans to implement the new form for the 2008 filing year.) Draft Form 990 focuses much more heavily on corporate governance than the existing Form 990. It specifically asks each tax-exempt organization filing the Form 990 whether they have the following written policies in place:

• a conflict of interest policy
• a whistleblower policy
• a document retention and destruction policy
• policies to ensure consistency in the operation of chapters, affiliates and branches
• policies regarding affiliates and joint ventures
• a policy regarding reimbursement of business, travel and entertainment expenses
• compensation policies (for both directors and key staff)
• a financial information/audit policy (including tax filings)
• a financial information disclosure policy

If the proposed changes contained in the Draft Form 990 are adopted, all tax-exempt organizations filing the annual Form 990 (not just charitable or so-called “501(c)(3)” organizations) will be required to state annually whether they have such policies in force in the taxable year to which the filing relates. In addition, certain specialized Form 990 schedules applicable to nonprofit hospitals ask about charity care and billing and collection policies; schools are asked about racial discrimination policies; and conservation organizations are asked about conservation easement policies.

The following is a brief overview of each of the different policies the IRS would like tax-exempt organizations to adopt.

Conflict of Interest Policy

Nonprofit organizations are increasingly subject to intense public scrutiny, especially when an officer, director or other related party is perceived to benefit inappropriately. Thus, a conflict of interest policy should emphasize the nonprofit director’s duty of loyalty, which requires every director to act in the best interest of the nonprofit organization, rather than in the personal interest of the director or some other person or organization. The Draft Article specifies that a good conflict of interest policy should:

1. require directors and staff to act solely in the interests of the nonprofit without regard for personal interests
2. include written procedures for determining whether a relationship, financial interest or business affiliation results in a conflict of interest
3. prescribe a certain course of action in the event a conflict is identified

In addition to avoiding the appearance of impropriety or fiduciary breach, a well-drafted conflict of interest policy helps nonprofit organizations to safeguard their tax-exempt status, which can be jeopardized if they operate in a manner inconsistent with their charitable purposes.

Whistleblower Policy

Since the Enron, Adelphia, and WorldCom scandals, nonprofit organizations have been encouraged to adopt a whistleblower policy. Whistleblower policies establish a procedure for individuals to report complaints or unethical conduct occurring at an organization without fear of retaliation. A well-drafted policy allows the organization to investigate and remedy any potential issues before situation has unintended consequences. When adopting a policy, nonprofits should consider the following questions:

• How broad should the policy be?
• Who is protected by the policy?
• How should complaints be reported?
• Who should resolve the complaints?
• What protection is the whistleblower afforded?

Document Retention and Destruction Policy

Nonprofit organizations should adopt a written policy establishing standards for document integrity, retention and destruction. The document-retention policy should also include guidelines for handling electronic files, and should cover backup procedures, archiving of documents, and regular system reliability check-ups. IRS Publication 4221, Compliance Guide for 501(c)(3) Tax-Exempt Organizations (Publication), provides further document retention detail. The Publication states that supporting documents, such as contributions, purchases, sales, payroll, grant applications and awards, sales slips, paid bills, invoices, receipts, deposit slips and canceled checks should be kept, because they support organization transactions and accounting entries. The Publication further explains how long records, such as permanent records, employment tax records and non-tax records should be retained.

Policy on Affiliated Organizations (Including Joint Ventures)

A nonprofit organization may team with another organization, exempt or non-exempt, to carry out its mission. These partnerships, while valuable, carry significant risk for nonprofits. A joint venture may lead a nonprofit organization to stray from its charitable purpose, which can cost the organization its tax exemption. As a result, a policy should be adopted that safeguards the organization’s tax-exempt status when partnering with other entities. The policy should make it clear that joint ventures must permit the tax-exempt partner to act exclusively in furtherance of its exempt purpose and only incidentally for the benefit of the for-profit partners,¹ allow the nonprofit organization to retain “effective control” of the venture,² and provide the nonprofit organization with enough authority over operations to further its charitable purposes.³

Compensation Policy

Nonprofit organizations should adopt a compensation policy designed to ensure that no more than reasonable compensation is paid for services rendered. Nonprofits generally do not compensate board members for service, but they frequently reimburse for board-related expenses. At the same time, nonprofits almost always compensate officers and staff. A well-drafted compensation policy will ensure that the compensation is “reasonable.” In determining what is reasonable, the board – or the committee setting compensation, as the case may be – should review what persons performing similar tasks for similar organizations are receiving as compensation. Section 501(c) (3) and 501(c)(4) organizations may wish to include procedures for satisfying the rebuttable presumption of reasonableness under Section 4958 of the Code.

Expense Reimbursement Policy

Nonprofit organizations are permitted to pay for or reimburse ordinary and necessary expenses incurred while carrying out the organization’s activities, including the costs of travel. However, expense reimbursement policies should be consistent with recent IRS guidance on the required elements of an “accountable plan” expense reimbursement. The required elements of an accountable plan are as follows:

1. there is a business connection or reason for the expense
2. the officer or employee adequately accounts for such business expenses within a reasonable time
3. the officer or employee returns any amount of excess reimbursement within a reasonable time

The IRS is now taking the position in audits of nonprofit organizations that expenses reimbursed outside of an “ac countable plan” must be reported as taxable income to the individual receiving such reimbursements, which means additional taxes must be withheld.

Nonprofit organizations may wish to reconsider whether they will continue to reimburse airline fares which exceed coach airfare. The new Form 990 contains a new Schedule J (Supplemental Compensation Information) in which it asks whether the organization paid or reimbursed for “first-class travel, club dues or use of personal residence.” This is a question that must be answered “yes” or “no,” with no opportunity for explanation.

Conservation Easement Policy

Nonprofit organizations should have a policy in place set ting forth their responsibility to protect any conservation easements in their possession. Specifically, the policy should contain a provision requiring the active monitoring of the easement and a procedure for investigating and enforcing any violations.

Racial Nondiscrimination Policy (Schools)

Schools are responsible for providing all students with educational opportunities. Nonprofit private schools should have a policy that ensures students of any race, color or ethnic origin the same rights, privileges, programs and activities generally accorded or made available to other students at the school. The policy should state that the school does not discriminate against any applicant or pupil because of sex or the other factors noted above in admissions, educational programs and activities. According to Part V, Schedule A of 2006 Form 990, the policy should be:

• included in the charter, bylaws, or other governing instrument, or in a resolution of the governing body
• included in brochures and catalogues
• publicly known throughout the community through news paper publication or broadcast media

Charity Care Policy (Hospitals)

Nonprofit hospitals are charged with the responsibility of providing medical care in a manner that benefits the community as a whole, including individuals who cannot afford to pay for such care. A policy should set forth the hospital’s guidelines when providing charity care. Many nonprofit hospitals provide free care, discounted rates and extended payment plans. A charity care policy should be adopted by the hospital’s board and publicized in a manner that effectively communicates its content to the community.

Debt Collection Policy (Hospitals)

The IRS also appears to believe that nonprofit hospitals should adopt a debt collection policy. It is difficult to prescribe what such a policy should contain since there are no official IRS standards governing billing and collection by 501(c)(3) hospitals. Such a policy could contain a provision requiring all debt collectors to abide by the Fair Debt Collections Practices Act. It also could set forth provisions accommodating individuals who are unable to pay medical debt, particularly those who are both low-income and uninsured or underinsured. Aggressive collection practices, such as seizing the primary residence of such persons, should be discouraged or banned.

For more information, email Kathleen M. Nilles or Telly J. Meier at kathleen.nilles@hklaw.com or telly.meier@hklaw.com, respectively, or call toll free, 1.888.688.8500.

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1 Revenue Ruling 98-15, 1998-1 C.B. 718.

2 Redlands Surgical Services, 113 T.C. 47, 92-93 (1999), aff’d 242 F.3d 904 (9th Cir. 2001).

3 St. David’s Health Care System v. United States, 349 F.3d 232, 236-237 (9th Cir. 2003).

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