United States: States Ramp Up Regulation Of Nonprofits - With Help From The Feds

Last Updated: July 13 2011
Article by John E. Christopher and Sean P. Callan

"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.

www.dinslaw.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Sign Up
Gain free access to lawyers expertise from more than 250 countries.
 
Email Address
Company Name
Password
Confirm Password
Country
Position
Industry
Mondaq Newsalert
Select Topics
Select Regions
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions