When the Revenue Agent Comes Calling: Organizational Control

Since the early 2000s, federal and state charity regulators around the nation – spooked by the high-profile corporate scandals of Enron and Worldcom – have turned their attention more closely to the governance practices of tax-exempt organizations. Although these spectacular corporate meltdowns involved for-profit conglomerates, the possibility that similar instances of corporate board negligence were also lurking in the nonprofit sector caused government officials in Washington, D.C. and around the nation to institute heightened audit and oversight programs.
While matters of governing are ordinarily in the jurisdictional purview of the states’ attorneys general, the IRS has also stepped up its interest in these matters. The agency –

believes that a well-governed charity is more likely to obey the tax laws, safeguard charitable assets, and serve charitable interests more than one with poor or lax governance…. [W]hile the tax law generally does not mandate particular management structures, operational policies, or administrative practices, it is important that each charity be thoughtful    . . . [about] governance practices….

As part of this heightened scrutiny, the IRS “encourages a charity’s board of directors to adopt” specific written policies on matters including executive compensation, fundraising, and organizational structure and control. While they are not express requirements, this inquiry has become part of the newer versions of the tax-exemption application (Form 1023) and the annual information return (Form 990). “And just to make sure charities are paying attention, the agents on a field audit are asking some pointed questions.”

     IRS Revenue Agent Audit Checklist

In 2009, the Internal Revenue Service issued Form 14114, a Governance Check Sheet, which is used by IRS field audit staff during examination of 501(c)(3) organizations. This two-page audit guide is divided into six separate sections, each focusing on a specific aspect of charity governance: namely, (1) Governing Body and Management; (2) Compensation; (3) Organizational Control; (4) Conflict of Interest; (5) Financial Oversight; and (6) Document Retention
In “When the Revenue Agent Comes Calling: Part 1,” we reviewed the specific matter of governing body and management policies and practices. In Part 2 of this series, we turned our attention to compensation protocols.

      Organizational Control Questions

Here, we turn our attention to the focus of the next section of Form 14114, IRS Governance Audit Checksheet, “Organizational Control.”
Once again, there are multi-part questions, including drop-down menus for the agent to record detailed answers to these queries:  

  • Do any of the organization’s voting board members have a family relationship and/or outside business relationship with any other voting or nonvoting board member, officer, director, trustee, or key employee?;
  • If there are any such relationships, how many are there – specifically – as to officers, directors, trustees, or key employees?;
  • What are the total numbers of these key players in terms of: (1) family relationships; (2) business relationships; (3) both types of relationships?; and
  • Does “effective control” of the organization rest with a single or select few individuals?

What is the reason for the Internal Revenue Service’s interest in this issue of relationships among key players in a 501(c)(3) organization?
Most significantly, there’s the overriding premise asserted by the IRS that a well-governed organization with an “active and engaged board” is more likely to properly follow the detailed rules and regulations that apply to section 501(c)(3) charities.
There is no optimal board size; it should be suitable in terms of that particular organization.

Small boards run the risk of not representing a sufficiently broad public interest and of lacking the required skills and other resources required to effectively govern the organization. On the other hand, very large boards may have a more difficult time getting down to business and making decisions.

A key consideration, though – according to the IRS – is that “irrespective of size, a governing board should include independent members and should not be dominated by employees or others who are not, by their very nature, independent individuals because of family or business relationships.”

The Internal Revenue Service reviews the board composition of charities to determine whether the board represents a broad public interest, and to identify the potential for insider transactions that could result in misuse of charitable assets. The Internal Revenue Service also reviews whether an organization has independent members, … or other persons with the authority to elect members of the board or approve or reject board decisions, and whether the organization has delegated control or key management authority to a management company or other persons.

   Conclusion

Form 14114, Governance Audit Checksheet is a useful tool not only for the revenue agent conducting an audit but also for the organization itself. “It is a ‘very specific roadmap for exempt organizations – well in advance of any potential audit – to compare their practices and policies with what the IRS wants to see and to make adjustments where necessary.’”
 

Corporate Governance Redesigned: A Sweet Briar College & San Diego Opera Update

 Last year, we highlighted two intriguing governance stories that captured the attention of the philanthropy community.
There were certain striking similarities in these cases on opposite sides of the U.S. continent.  Each involved a prestigious community institution in which board and executive insiders strong-armed a shutdown vote on the grounds of purportedly insurmountable financial difficulties. Each was eventually unsuccessful – the dissolution vote was overturned – and a newer stronger governance model has emerged.

   A Tale of Two Coups

The West Coast case was in 2014. The San Diego Opera had been dominated for many years by charismatic Ian Campbell, who was in charge of both the artistic and organizational sides of the institution.
There were financial struggles, partly due to the maestro’s penchant for lavish, grand-opera, productions. He and board insiders, convinced there was no alternative to calling it quits, announced an emergency special board meeting and rammed through a dissolution vote. Quickly, many independent board members had buyer’s remorse and launched a coup, bolstered by impressive community and media support as well as a successful crowdfunding campaign to get the 2014-2015 season back on track. Ian Campbell was out; bold, innovative leadership was in, along with a new organizational culture and open governance practices. See “San Diego Opera: A Dynamic Different Than Sweet Briar,” our 2015 post with more details and analysis of this situation.
The East Coast story was exactly one year later, in the spring of 2015. The aforesaid Sweet Briar College is a prestigious, 100-year-old, women’s college nestled in the idyllic foothills of Virginia’s Blue Ridge Mountains. Like other rural, single-gender, educational institutions, enrollment was declining and there were worries about continued viability.
Nevertheless, everyone but a handful of insiders – the acting president and the executive committee of the board – was blindsided at an emergency special meeting when a “sky-is-falling” financial report was presented. Pressured and cowed by the apparent superior knowledge of these insiders, the community board voted to close the school by end of term. Reaction was immediate; faculty, students, staff, alumnae, and community members in local Amherst were furious. This time, the board did not relent and reverse its decision; it went to war with these stakeholders, in emergency litigation that went up to the Virginia Supreme Court in record time. Within a few months, the old guard were out, a new board was in place, and old ways of running the College were gone. The fall 2015 academic term of this venerable, 100-year-old, institution went on as planned. See Sweet Briar College: Saved – At Least for Now,” our post in 2015 about this case.

    Lessons Learned and Shared

Last fall, The Nonprofit Quarterly’s editor, Ruth McCambridge, hosted a webinar featuring the two women who had played key roles in each institution’s reorganization: Sweet Briar College’s Teresa Tomlinson and San Diego Opera’s Carol Lazier. Also participating was Vernetta Walker, Vice President of Programs and Chief Governance Officer for BoardSource.
The lively panel discussion was “full of important insights for charity boards, large and small.”  See “Lessons in Charity Governance, Courtesy of Sweet Briar and San Diego Opera,” our report on that session.
The panelists focused particularly on the significant changes in organizational governance practices and culture that were ushered in at these two important community institutions once the old guard were replaced. Their success in the short- and long-term will depend not just on a change of personnel, but on institutional reforms to ensure that a secretive, insular, leadership cadre would not again emerge and dominate the organization.
There was a consensus on three key points of advice, each of which was discussed at some length:

  • Be Wary of Vanity Boards and Top-Down Management by Insiders
  • Reform Governance Documents and Policies
  • Recognize the Value of Stakeholders and Networks

     Sweet Briar’s New Bylaws

Recently, Sweet Briar took a giant step in connection with the second of these three goals; that is, revamping corporate governing documents. In April 2016, the new board adopted entirely new bylaws that include multiple safeguards against insider dominance and – particularly – an executive committee with too much authority and discretion.
Nonprofit Quarterly’s report of this development includes a copy of the two-page letter summary issued by the Sweet Briar board to all of the stakeholders that helped save the College; that is, faculty, students, staff, alumnae, and town residents and leaders.
The publication’s analysis reads, in part:  

Once it had wrested control away from a board that had no faith in the future of the college, the new board needed to demonstrate clearly that it was a different kind of governing body—one which recognized that the power of the stakeholders to revolt when necessary could also be the power to sustain. But shifting from revolution mode to sustenance mode required clear new governance practices from this board.

The new bylaws adopt a “‘strong Working Committee model of Board governance. The Executive Committee, unlike the practices of the prior Board, cannot act for the Board. Rather, the Executive Committee is empowered only to recommend items for consideration to the Working Committees.’”
The role of the “Working Committees” is “developing and vetting ideas and proposals that are then presented to the entire Board for discussion and approval.”
An innovative feature of the new governing scheme is that the Working Committees “include, as voting members, appropriate stakeholders such as faculty, students, alumnae, and other members of the Sweet Briar community.”  And the Sweet Briar College Board of Directors views its new bylaws as a “living document” that can and should be re-evaluated frequently and changed as needed.

   Conclusion

Nonprofit Quarterly shared this document because —

[t]he changes laid out … speak to the dangers of an executive committee with too much power and to the benefits of enlisting the intelligent support of [an institution’s] natural networks.

When the Revenue Agent Comes Calling: Nonprofit Executive Compensation

In “When the Revenue Agent Comes Calling,” we explained that the Enron and Worldcom scandals in the early 2000’s had a profound effect on charity regulators at all levels of government. They have doubled-down on the scrutiny of 501(c)(3) organizations (and public charities, specifically) on issues of governance, organizational control, and conflict of interest as well as on compensation and financial oversight.

IRS revenue agents use Form 14114, “Governance Check Sheet,” in audits of public charities. It’s a 2-page form with distinct sections on (a) governing body and management; (b) compensation; (c) organizational control; (d) conflict of interest; (e) financial oversight; and (f) document retention. Most of the questions are also on the Form 990. “It is a ‘very specific roadmap for exempt organizations to compare their practices and policies with what the IRS wants to see and to make adjustments where necessary.’”

   Compensation Evaluation

We’ve already described the questions on “governing body and management.”  Next up is the section on “compensation.”

The Internal Revenue Service takes a keen interest both in the amount of executive compensation as well as the process by which a public charity’s board of directors determines the compensation level.

From the perspective of the IRS, the payment of “reasonable” compensation is a matter of responsible governance in the public interest. It is also important for purposes of avoiding violation of the inurement/private benefit restrictions of Section 501(c)(3) of the Internal Revenue Code. “Excessive compensation paid to nonprofit executives is the most common violation” of these restrictions.  
What are the rules? In a nutshell, “[t]he IRS –

permits tax-exempt organizations to pay executives ‘fair and reasonable’ compensation. There is no universal standard defining fair and reasonable, however; what’s fair and reasonable at one nonprofit may be a gross under- or overpayment at another.

There is “no standard formula, … nor are there any tables or schedules….” so this determination is complicated.
The Internal Revenue Service offers a recommended 3-step process:

  • Designate an independent body.
  • Conduct a “comparability review.”
  • Document who was involved and the process that was used to conduct the review, “as well as the disposition of the full board’s decision to approve the compensation.”

In any event, on the Form 990, Schedule O, nonprofits must describe the process they use to determine and approve executive compensation.

For California nonprofits, California Government Code section 12586(g) prescribes similar, though not identical, requirements for executive compensation decisions.  Any such determination must be reviewed and approved “to ensure that the payment is ‘just and reasonable.’” It must occur when the executive is first hired, when the term is renewed or extended, and if and when the compensation amount or terms are modified.

    Form 14114: Compensation Questions

Part 3 of the IRS Governance Audit Checksheet is “Compensation,” questions 13-15 with subparts. There are answer options in pull-down menus.  The revenue agent is directed to ask:

  • Whether there are “compensation arrangements for all officers, directors, trustees, and key employees approved in advance by an authorized body of the organization composed of individuals with no conflict of interest with respect to the compensation arrangement
  • If the authorized body “relies on comparability data in making compensation determinations”
  • If comparability data is considered, whether it was based on one or more of:
    • Exempt organizations
    • Non-profit entities not exempt from tax
    • Governmental entities
    • For-profit entities
    • Other
  • An explanation if the “other” box is checked, what is the explanation
  • If the basis for all compensation determinations is contemporaneously documented

   Conclusion

For more information on this important but complex issue, these are excellent resources:

Guidestar: What You Need to Know About Nonprofit Executive Compensation

National Council of Nonprofits: Executive Compensation   

Nonprofit Law Blog: Executive Compensation – The Legal Issues

Nonprofit Law Blog: Nonprofit Compensation: Tips on Using Comparability Data

IRS:  Form 990, and instructions to Form 990

IRS:  FAQs about setting executive compensation

 

Foundations of Public Universities: Too Secretive?

They have been called “‘slush funds’ and ‘shadow corporations’ that too often operate in secrecy, ….”  
“Public officials are raising questions about the spending practices of the nonprofit fundraising arms of public universities,” according to the Council of Nonprofits. They control huge amounts of money with little accountability.
Recently, in at least two states – North Carolina and Connecticut – this issue has been in the news.
But expert observers including academics and journalists reveal that this is a problem nationwide. One of the biggest obstacles is that these foundations are considered by many to be quasi-public, but they are not necessarily subject to states’ open records laws. This hazy status creates opportunity for questionable financial transactions to flourish without scrutiny.

   University of North Carolina System

The UNC system has some 17 foundations connected with 11 campuses around the state. Their (apparent) role is to “raise money for their associated universities.” As of figures for a few years ago, jointly these foundations have almost $1.66 billion in assets.”
There have been questions raised in the past, but there are renewed calls for a closer look at “the investment practices of the foundations and how they interact with university finance and property transactions.”
There is concern, as well, for the “lack of transparency.” Curiously, “the UNC system does not compile a comprehensive list of all campus foundations and their activities” so prying out information is difficult.
In particular, some unusual property transactions have raised eyebrows. “In North Carolina, these foundations buy property and then lease space back to their universities.” The standard situation is that the university leases space to an affiliated entity, not from it.
According to Marty Kotis, a concerned governing board member, these foundations are buying university property and then “are. ..leasing space to the university, and some of the centers and institutes, … which is just a little incestuous.”  Mr. Kotis, who happens to be a real estate developer, adds: “You wonder in that scenario why does the foundation do that, and what happens with the money that flows into the foundation, or out of it, and what’s the oversight on that.”
Are the foundations, he wonders, “…a tool that’s being used to avoid having to go through the red tape of the General Administration, the Board of Governors, the state oversight in a lot of cases…?” There are “a lot of different colors of money in university operations” and foundations intermingle that money. “[O]nce they flow through the foundation, any money coming out of the foundation can be used for anything….”

    University of Connecticut System

The UConn Foundation is the “private, nonprofit fundraising arm” for the University of Connecticut. “ About half of the foundation’s annual operating budget comes from UConn, and it receives “some $8 million a year of taxpayer funds.”  The foundation raised about $80 million last year.
University officials note that, as state higher education funding has decreased, there is increased “reliance on the foundation and philanthropy to fund programs at the university.”
Debate over access to records from the UConn Foundation has been a long-running issue at the legislature.”  Some important information – though hardly all – is available from IRS filings.
The UConn Foundation “is the only type of university organization in New England that is not subject to freedom of information laws.”
The matter of disclosure and transparency is back at the state capitol once again. Under legislation now pending, the UConn Foundation would have to “disclose information about its spending broken down into broad categories.” It would also be required to dedicate 15% of new revenue for student financial aid.
This bill is different than earlier, unsuccessful attempts; it does not require applying freedom of information laws to the foundation.
While the foundation has been resisting disclosure, arguing that it would “cause a decline of individual donors.” The CEO believes “those public battles have hurt the foundation and led to fewer individual donors, although total donations have risen.”
Nevertheless, the foundation “is supporting the bill amid growing calls by critics to scrap the bill for even stricter legislation.”
This pleases transparency advocates like James H. Smith, president of the Connecticut Council on Freedom of Information. “Sometimes you get [disclosure] in one fell swoop and sometimes … it literally takes years to get where you want to be. This is one of those cases.”  

    Conclusion

Experts like David Cuillier, director of the University of Arizona School of Journalism, note that it “…sometimes takes a high-profile gaffe to get the legislature to move, and pass a law saying [these types of ] foundations are subject to the public records laws.” He adds:

I think there are a ton of flags that need to be raised when it comes to university foundations. I think it’s one of the most underreported scams in America…What a great way to hide money for a university.

 

Consent Agenda: A Tool for Better Meetings

“If you had to identify, in one word, the reason why the human race has not achieved, and never will achieve, its full potential, that word would be ‘meetings.'”   – Dave Barry

Nonprofits are great at making the world a better place. Conducting productive board meetings? Not so much.
Of course, this is nothing inherent or unique in the philanthropy sector. Even successful businesses suffer from mediocre-meeting-malady.
The challenge across both sectors is to plan a tightly focused agenda, bolstered by comprehensive information packets sent to all board members well ahead of time.

  Consent Agenda

There is an under-used technique to streamline the meeting process that’s simple, straightforward, and entirely consistent with the directors’ duties to exercise due care and diligence in governing the charities they have volunteered to serve.
A “consent agenda” is –

a meeting practice which packages routine committee reports, Board meeting minutes, and other non-controversial items not requiring discussion or independent action as one agenda item.

This method speeds up the meeting considerably because the Board can approve the entire bundle of matters in one motion and without discussion.
The purpose is to efficiently dispose of as many items as possible so that the bulk of the meeting is reserved for issues that require explanation, discussion, strategic thought, or a decision or action.
The consent agenda is handled early in the meeting. It’s given an up-or-down vote after allowing any Board member to ask that one or more items be moved to the regular agenda.
Of course, this must be done strictly according to a procedure approved in advance by the Board that includes sending all relevant information and documents to Board members well ahead of time.

  Consent Agenda Items

Appropriate matters that can and should safely be relegated to the consent agenda bundle are those that: (1) are routine and non-controversial; and (2) don’t require discussion or individual deliberation.
Even within the consent agenda, reports and other documents can be grouped together.
Examples of matters that might be appropriate for a consent agenda:

  • Approval of Board and committee meeting minutes  
  • Committee and staff reports  
  • Updates or background reports provided for information only
  • Routine contracts that fall within policies and guidelines.
  • Confirmation of documents or items that need no discussion but are required by the bylaws
  • Correspondence requiring no action  
  • Approval of routine expenditures

On the other hand, matters like approving an annual budget or an update to the organization’s strategic plan would not be suitable for the consent agenda. ƒ If in doubt, leave it out.
The full agenda, including the consent items should be disseminated prior to the board meeting along with copies of reports and back up materials so that board members can do their due diligence prior to voting.

  Procedure Set in Advance

The consent agenda should not be used haphazardly or in an ad hoc manner. The Board should craft a comprehensive procedure and policy well ahead of the first use of the consent agenda.
This policy should include general guidelines about what categories of items may be included in the consent agenda and what issues are not appropriate for this short-cut method. From time to time, these guidelines should be reviewed and amended, if necessary.
A consent agenda cannot and should not be used unless all of the relevant information, reports, and backup documents are sent to each Board member (along with the full agenda) in enough time to be reviewed.
At the meeting, itself, typically the person presiding (Chair or President) asks the Directors if there are any requests to remove any item from the consent agenda (and place it on the regular, full agenda for that meeting.)  Even a single director can pull an item out of the “consent agenda” group of items, if that director asserts that discussion (and individual consideration) is needed.
The Board then moves to the vote. Generally, the consent agenda is voted on in a  single vote, but it may be divided into several, separate items. The meeting continues with consideration of all remaining (full) agenda items.

       Conclusion

Depending on the unique situation of each organization, appropriate use of the consent agenda can save a little bit of time or a half hour or so for more in-depth attention on other non-routine items.
Consent agendas, of course, should never be used to ramrod through anything other than items that are unusual, controversial, or require discussion and group deliberation.