"Dear Charity Leader, A review of our records and information from the Internal Revenue Service cause us to believe that your organization should be registered with our office. ... However, we have no record of any filing."
This is the opening paragraph of a form letter being circulated by the Ohio Attorney General's Office to certain Ohio charities. The letter is remarkable not because it directs a charity to comply with state registration requirements, but rather because the original inquiry was prompted, in part, by information received from the Internal Revenue Service. The letter reflects growing cooperation between federal and state regulators in a heightened regulatory environment, a cooperative trend that will no doubt continue and deepen.
As set forth below, states are delving ever more deeply into regulating charities, and doing so in an ever more aggressive fashion. The states are using old tools in this effort, most prominently the charitable fund-raising registration statutes that exist in 38 states and the District of Columbia. The notable difference is that states are using information provided directly by the federal government, as well as information reported on the new Form 990, Return of Organization Exempt From Income Tax, to aid in their enforcement efforts, creating a much tighter regulatory environment.
Moreover, states are also looking at new tools, such as a bill (S.B. 40) under consideration in Oregon. The Oregon bill, if passed, would require charities to devote a minimum amount of their expenditures each year to the furtherance of charitable purposes. Donors to charities that do not reach the prescribed threshold will not be entitled to an Oregon income tax deduction for their contributions. This article briefly examines the regulatory environment in which charities have operated, and the changes to that environment we currently see.
State Regulatory Framework
State governments have concurrent jurisdiction with the federal government with respect to the oversight of, and regulatory control over, charities. After all, nearly every U.S. charity is a creation of state law, formed under a specific state's trust, unincorporated association, or nonprofit corporation law. In other words, most charities would not legally exist but for state law.
Moreover, the states' attorneys general have nearly exclusive authority over enforcement of rules and regulations regarding charitable solicitation, fraud, and breach of fiduciary duty. Generally speaking, there is no private right of action allowing individuals to police the operation of charities. As a charity is generally formed to benefit the public, it follows that the attorneys general should enforce rules designed to safeguard the public and its donations to charity, ensure that charitable assets are preserved, and protect against diverting charitable assets for personal enrichment.
So, while state regulation is not a new phenomenon, state regulatory and enforcement actions have historically been reactive. That is, state action against charities was generally in reaction to consumer complaints about a particular charity. Upon receipt of complaints, state enforcement agents would investigate a charity's compliance with registration and reporting requirements and fund-raising disclosures, and identify any fraud or excess benefit arising from a charity's operation. Rarely did a state investigation begin in the absence of a complaint.
Federal Regulatory Framework
In addition to state government regulation, the federal government also regulates charities, primarily through the Internal Revenue Code. Organizations furthering charitable purposes often qualify for exemption from federal income taxation under I.R.C. Section 501(c)(3). Exemption under I.R.C. Section 501(c)(3) is a tremendous benefit in that not only is the organization exempt from income tax, but donations to the organization are generally also tax-deductible to the donor.
To qualify for exemption under I.R.C. Section 501(c)(3), organizations must specify in their governing documents that they are "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes ...." Moreover, the organization's governing documents must also provide that:
- no part of the organization's net earnings may inure to the private benefit of any private shareholder or individual,
- no substantial part of its activities may consist of certain activities aimed at influencing legislation, and
- the organization may not participate or intervene in any political campaign on behalf of any candidate for public office.
In short, the federal government, through IRS, is concerned with the organization's activities, and specifically with whether those activities fit within the parameters of I.R.C. Section 501(c)(3).
Interestingly, IRS has very limited authority to compel a charity to conform to the purposes set forth in its organizing documents. Its authority is typically limited to the imposition of excise taxes and the revocation of the organization's tax exempt charity status. However, by conditioning a charity's exemption under I.R.C. Section 501(c)(3) on its inclusion of the above limitations in its organizational documents, IRS anticipates state involvement in policing the operations of the charity.
For example, where a nonprofit corporation engages in activities not authorized under its formation documents, an agent of the state may initiate a quo warranto proceeding. In Ohio, at least one court has issued a writ of quo warranto revoking the charter of a nonprofit corporation for failing to conform to the purposes stated in its articles of incorporation. 1 Again, however, this reliance on state action demonstrates the federal government's inability to effectively compel compliance with a charity's organizational documents.
The Changing Federal Regulatory Environment
As discussed above, the federal government has traditionally had very little authority to compel a charity to conform to its charitable purposes. Prior to 1969, the enforcement mechanism for the Internal Revenue Service was limited to the revocation (or threat of revocation) of the offending organization's tax exempt charity status. In the Tax Reform Act of 1969 (Pub. L. No. 91-172), Congress enacted a number of penalty taxes that may be imposed upon private foundations that engage in activities deemed to evidence a potential for abuse.
Beginning in the early 1990s, a series of scandals beset a number of high profile public charities, most notably criminal wrongdoing by the leadership of the United Way. These scandals, in some cases reflecting real abuses and in others perceived abuses, led to legislative and administrative efforts to subject public charities to further regulation at the federal level. These efforts culminated in several changes in the federal regulatory scheme, beginning with the implementation of "intermediate sanctions" under I.R.C. Section 4958.
Prior to the 1996 passage of I.R.C. Section 4958, the only remedy available to IRS for punishing the improper diversion, or even conversion, of charitable assets was revocation of exemption. Revocation was widely viewed as a poor tool for enforcing the fiduciary duties of directors and officers, so the excise tax available under I.R.C. Section 4958 was a worthwhile alternative remedy. Through the enactment of I.R.C. Section 4958, the federal government stepped into what had been the domain of the states, namely enforcing and punishing breaches of fiduciary duty.
But enactment of I.R.C. Section 4958 did not end the regulatory overhaul. In the wake of the passage of Sarbanes-Oxley Act (Pub. L. No. 107-204) in 2002, Sen. Charles Grassley (R-Iowa) stated as follows:
Nonprofit organizations must earn the privilege to keep their tax-exempt status .... Just as Congress has acted in the public interest to protect shareholders and workers from corporate mismanagement, so too must Congress demand transparency, accountability and good governance from the non-profit sector." 2
So, since 1996 further significant changes in the federal regulatory scheme include:
- the Pension Protection Act of 2006 (Pub. L. No. 109-280), and
- the promulgation and implementation of the overhauled Form 990.
Thematically consistent in these efforts is the idea that the federal government, while still interested in the activities of exempt organizations, is equally interested in corporate governance and operational matters, matters typically reserved to the states. Moreover, both of these efforts clarify that greater federal-state cooperation is a goal.
Federal-State Cooperation
In 2008, the Exempt Organizations unit of IRS published its first-ever annual report. A section of the 2008 annual report was dedicated to spotlighting the "Federal and State Project." This section highlighted that, indeed, information sharing between the federal and state regulators was occurring, and that the information sharing was a two-way street.
In 2008, as reported in the EO annual report, IRS made 196 disclosures to state regulators under Section 6104(c) of the Pension Protection Act of 2006, while state regulators referred 83 organizations to IRS for various reasons. Again, just like the letter from the Ohio attorney general, this is evidence that IRS and the states are working together to create a more robust regulatory and enforcement environment.
The increase in federal-state cooperation is not just imagined, but confirmed by both federal and state officials. According to both Lois Lerner, IRS director, Exempt Organizations, and Mark Pacella, chief deputy attorney of the Pennsylvania Attorney General's Office, information sharing between IRS and state AGs is ramping up. Over the past four years, Lerner said in April, state charity oversight officials referred 600 organizations to IRS, and 90 percent of those referrals led to examinations. 3
Further on this point, the U.S. Treasury Department March 15 published proposed amended regulations to further facilitate information sharing between IRS and the states. The revised regulations allow:
- IRS disclosure of proposed revocations and denials before the appeals process is complete,
- IRS disclosure of returns or return information to states if it determines that the information may be evidence of noncompliance with state laws, and
- IRS disclosure of information to states about all applicants for I.R.C. Section 501(c)(3) status.
In essence, IRS may use required returns to act as federal attorney general, wielding tremendous enforcement powers through the referral process.
Regulating Charitable Efficiency
The 2008 annual report also contained a work plan for fiscal year 2009. The 2009 work plan included several initiatives, including a charitable spending initiative. This initiative was described as follows:
EO will begin a long-range study to learn more about sources and uses of funds in the charitable sector and their impact on the accomplishment of charitable purposes .... The first stage of this initiative will focus on organizations with unusual fundraising levels and organizations that report unrelated trade or business activity and relatively low levels of program service expenditures. 4
IRS's focus on the efficient use of non-taxed dollars is neatly summarized by EO Director Lerner, who stated in the context of the issuance of the 2008 annual report that "[t]ax exemption is a huge benefit. The question is 'what are we getting back?' " 5
Director Lerner's question continues to reverberate on Capitol Hill. Just recently, a Senate aide confirmed that the Senate Finance Committee will likely hold hearings on tax exempt organizations and charitable issues in the near future. It is not clear when the hearings on EOs might occur or what the focus of such hearings would be. However, the aide provided a hint that it is likely that the analysis will center on "whether we're getting the right bang for the buck" from exempt organizations. 6
In short, the inquiry is shifting from whether the organization's activities qualify it for exemption under I.R.C. Section 501(c)(3). Now IRS also wants to know how much of each dollar raised is used to directly fund charitable works, and whether the spending is justified by the value of that charitable work. While efficiency concerns may have existed in the background for at least some period of time, it now appears we may be seeing a first attempt at a systematic, holistic approach to the regulation of charities.
State Evaluation of Efficiency—Oregon
At least one state appears poised to follow the federal lead in looking at charitable efficiency. The Oregon state Senate recently passed S.B. 40. This bill would require that charities demonstrate that they expend at least 30 percent of the charity's expenses on program services, calculated on a three year trailing average. If a charity fails this efficiency test, donations to that charity would not be deductible for purposes of state income tax.
This approach is aggressive, as well as controversial. In a series of three cases, the U.S. Supreme Court has previously held that state and local governments could not prohibit charitable solicitations based on such an efficiency test: Schaumberg, Ill. v. Citizens for a Better Environment, 444 U.S. 620 (1980), striking down an ordinance requiring a charitable solicitation permit but conditioning the permit on a demonstration that at least 75 percent of the proceeds of such solicitation would be used for charitable purposes; Maryland Secretary of State v. J.S. Munson Co., 467 U.S. 947 (1984), striking down a similar state statute that allowed a charity to seek a waiver from the 25 percent limit on fundraising costs and administrative overhead; and Riley v. National Federation of the Blind, 487 U.S. 781 (1988), striking down a tiered model of paying professional fund-raisers based upon efficiency.
Each of these cases was based upon the notion that solicitation was protected speech, and each of these schemes impinged on the right to free speech. It is doubtful that similar concerns would impact the determination of whether a charitable contribution is deductible under a particular state's law. However, these cases demonstrate a judicial discomfort with governmental evaluation of a charity's effectiveness.
In any event, the Oregon measure appears to be headed to defeat. Currently, following great public controversy, the bill is held up in the Oregon House and likely to die there. Nevertheless, the Oregon Senate bill is indicative of the approach regulators may take in the future.
Conclusion
Public charities, created to benefit the public, have always been subject to state and federal regulation. However, with the redesigned Form 990, more and more information about charities is available to the states, the federal government, and the public. While greater disclosure of information is probably a good thing, disclosure also effectively guarantees more enforcement—it is simply easier to bring cases or make referrals to the appropriate office. This conclusion is further supported by the explicit, expressed intention of IRS and states to share information and make referrals back and forth.
Not only is more enforcement likely, but both IRS and the states are seeking new ways to use the information they have. As set forth above, both the federal and state governments appear poised to test the efficiency of charities—"are we getting the right bang for the buck?" Charities should proactively ensure they are in compliance with all applicable state and federal laws, as well as evaluate their fund-raising efficiency. It is far better to take stock of a situation that may need a change now, rather than after any deficiency is identified by a regulator.
Footnotes
1 State ex rel. Corrigan v. West Shore Center, 31 Ohio St. 2d 192 (1972).
2 The Hill, July 12, 2006.
3 82 DTR G-4, 4/28/11.
4 2008 annual report, p. 20.
5 228 DTR G-1, 11/26/08, at G-2.
6 "Senate Finance Committee Hearings on EOs Likely, Aide Says," van der Berg, Tax Analysts, April 29, 2011.
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