Governance of Charitable Organizations: The IRS Releases Draft "Good Governance Practices"

The governance practices of charitable organizations have come under increasing scrutiny by state and federal regulators. In response, a variety of industry groups have issued laundry lists of “best practices” recommendations. The latest entrant on the “good governance” scene is none other than the Internal Revenue Service (IRS).

The IRS has released a discussion draft of governance practices for charities that are qualified under Section 501(c)(3) of the Internal Revenue Code. Entitled “Good Governance Practices for 501(c)(3) Organizations” (available at http://www.irs.gov/pub/irs-tege/governance_practices.pdf), the draft proposes specific measures that the IRS says charities should consider adopting to ensure good governance.

The draft is informal and, because most governance practices of nonprofits fall under the jurisdiction of state authorities, the IRS does not have authority to enforce compliance with most of the identified practices. The IRS suggests, however, that following the practices “may promote compliance with tax law,” and that an organization that adopts some or all of the practices is “more likely to be successful in pursuing its exempt purposes and earning public support.”

The draft outlines the basic fiduciary duties of a board member under state law, i.e., the duty of care and the duty of loyalty. Under the duty of care, a director must act in good faith, with the care that an ordinarily prudent person would exercise under the circumstances, in a manner the director reasonably believes to be in the charity’s best interest. Directors should be familiar with the charity’s activities, fully informed about its financial status and have full and accurate information to make informed decisions.

Directors also owe the charity a duty of loyalty. This means that the director must act in the best interests of the charity rather than in the personal interest of the director or some other person or organization. This duty requires a director to avoid conflicts of interest that are detrimental to the charity. Charities should have written procedures for addressing conflict (e.g., a conflict of interest policy), and directors and staff should disclose annually in writing any known business interest that they or their family members have in any business entity that transacts business with the charity.

The draft does not suggest a particular board size, but does seem to endorse a happy medium. It notes that organizations with very small or very large boards may be “problematic,” in that small boards may not adequately represent the public interest and large boards may be “less attentive to oversight duties.” The IRS notes that a charity’s board should include both individuals who are committed to and passionate about an organization, and those who have specific expertise in areas critical to an organization’s operations, including accounting, finance, compensation and ethics.

In addition, the IRS recommends that charities adopt the following practices:

• Code of ethics and whistleblower policy. The draft suggests that boards should establish a written code of ethics that includes established procedures for employees to report potential impropriety or misuse of an organization’s assets.
• Transparency. The IRS advocates transparency in operations and dissemination of information. The draft states that a charity should ensure that the organization’s Form 990 is made available to members of the public upon request. This is in fact more than just good practice; exempt organizations are legally required to make their Form 990s available on request. The IRS goes further, recommending that organizations post their Form 990s on their websites.
• Fundraising. The draft recommends that boards adopt policies to ensure that ongoing fundraising operations meet federal and state law requirements. Boards should ensure that fundraising costs are reasonable, and they should closely monitor the activities of professional fundraisers.
• Financial audits. While the draft does not suggest a dollar threshold at which an independent financial audit should be required, it does state that organizations with “substantial assets or annual revenue” should annually engage the services of an independent auditor. It further recommends that the auditor be changed approximately every five years to ensure that the organization’s finances receive a “fresh look.” Boards should regularly receive and review up-to-date financial statements, auditor’s letters and finance and audit committee reports.
• Compensation of board members. The recommendations on board compensation are likely to be the most controversial elements of the discussion draft. The IRS suggests that charities generally should not compensate board members for their service, and should do so only if such compensation is approved by an independent committee of members who are not compensated by the organization and who have no financial interest in determining the compensation. This recommendation does not accord with actual practice. While the majority of charities do not compensate their board members, it is not uncommon for directors to receive modest stipends for attending board and committee meetings. Anecdotal experience suggests that the practice of using an independent committee to establish board compensation is rare.
• Document retention policy. Boards should adopt a written data and document retention policy, according to the draft, including procedures for archiving documents, data back-up procedures, and routine maintenance of any such systems put in place.
• Mission statement. The IRS suggests that a clearly articulated mission statement will help to explain and popularize the charity’s purpose and serve as a guide to the organization’s work.
  While the IRS does not have the power to enforce the majority of these recommendations, it does have the authority to review applications for Section 501(c)(3) status, and it seems likely that the agency will be looking for compliance with its suggested practices in reviewing the qualification of new organizations for tax exemption.

The recommendations are not a fool-proof recipe for good governance, and some of these practices will be inappropriate for some organizations. For the most part, however, the recommendations do represent good practices, and charities should consider whether adopting some of these practices could enhance their operations.