While transparency, accountability, and oversight do not appear to be tax issues per se, recent legislative focus and IRS enforcement in this area have heightened the need for tighter controls within the nonprofit sector. The IRS increased the number of audits in 2006 by 40% in the exempt area and will continue to expend resources with a specific focus on management practices and internal controls.
Both the Tax Increase Prevention and Reconciliation Act of 2005 and the Pension Protection Act of 2006 (PPA ’06) have had a significant impact in the nonprofit sector. Additional disclosures on investment activities, such as foreign activities and participation in alternative investments, provide greater insight into the investment activities of nonprofits. In addition, many of the provisions of PPA ’06, such as the public disclosure requirement of an organization’s unrelated business income tax return (Form 990-T, Exempt Organization Business Income Tax Return) and the more stringent rules governing donor-advised funds and supporting organizations, have created additional complexities in the nonprofit sector.
Much of the overall tone heard in the nonprofit sector resonates from the Sarbanes-Oxley Act of 2004. While many state attorneys general introduced legislation in this area, the U.S. Senate Finance Committee has taken the lead with federal legislation aimed at the nonprofit sector. The Finance Committee also has encouraged the IRS to increase enforcement and Treasury to provide additional guidance.
In May 2007, in a letter to the Treasury Secretary, Senators Charles Grassley (R-IA) and Max Baucus (D-MT) proposed continued efforts to provide even greater transparency in nonprofit reporting (www.finance.senate.gov/press/Bpress/2007press/prb052907.pdf). Legislators are concerned that the current Form 990, Return of Organization Exempt from Income Tax, is not adequate to encompass vital information regarding parts of the nonprofit sector. The IRS and government officials are placing emphasis on large, complex institutions such as hospitals and universities, stating that the current Form 990 may require more detailed questions to provide transparency and accountability.
Both the 2005 and 2006 Forms 990 had significant revisions, but the completely redesigned Form 990, released on June 14, 2007, for public comment, listed transparency as the first of its three guiding principles. The second is the promotion of compliance, and the third is to minimize organizations’ burden of preparing the form. The new Form 990 is available on the IRS website (www.irs.gov), and the public comment period is open until September 14, 2007.
The revisions to the form are noteworthy, not only because of the potential for triggering IRS scrutiny, but also because of the form’s public nature. It is a 10-page core form that must be filled out by all organizations with a Form 990 filing requirement. Fifteen schedules supplement the core form; they are not applicable for all organizations but are required based on an organization’s entity type or its participation in certain activities.
While the form changes are not expected to be effective until tax year 2008, it is not too early for practitioners to familiarize themselves with the new form and and to educate their clients about the changes that are taking place in the nonprofit sector. Highlighted below are some key areas that have been identified as needing greater reporting and significant updating.
In determining the reasonableness of compensation or other transactions with disqualified persons (i.e., those individuals with significant influence over the affairs of an organization), the federal regulations provide that comparison data should be maintained by the organization. Examples include (1) compensation paid for comparable positions, (2) the availability of similar services in the geographic area, and (3) independent compensation surveys.
Users of Form 990 contend that there are instances when executives for charities receive compensation from various sources. In such cases, these payments may be creatively disguised on the tax form based on the number of places the same information is reported on the current forms. Because many executives of charitable organizations receive compensation in the form of housing, travel, deferred compensation, etc., legislators have recommended that the forms be redesigned to clearly distinguish the various financial arrangements treated as compensation to individuals.
Tax advisers working with charitable organizations should educate board members and organization officials on the need for comparison data. Emphasis should be placed on the importance of oversight and on officials’ responsibilities when reviewing and approving reasonable compensation packages and excess benefit transactions for executives.
Related Organizations/Joint Ventures
Because many nonprofit organizations are related to both for-profit and nonprofit organizations through common ownership and are also engaged in joint ventures, legislators believe that the public should be able to see the relationships among organizations. Concerns exist in particular with the potential for charitable assets being used for private benefit.
Much of the focus of legislators and the IRS is being placed on hospitals and universities. As the health-care industry continues to evolve at record speed, physicians and hospitals have begun to consider an increased number of options for forming joint ventures to provide various ancillary services, such as equipment-leasing ventures, diagnostic services, etc. Rev. Rul. 98-15 was released to help resolve tax questions about joint ventures between nonprofit tax-exempt organizations and taxable for-profit corporations. It allows exempt hospitals the flexibility to partner with other organizations or corporations. However, it does require that charitable purposes supersede profit motives. It is important that exempt organizations entering into such partnerships ensure that the partnership furthers charitable purposes and does not result in greater than incidental private benefit to the taxable partner or other private parties.
Redesigned Form 990’s goal will be to highlight the relationships between for-profit and nonprofit organizations to accurately reflect the organizations’ operations so the IRS can effectively assess the risk of noncompliance.
Charity Care/Community Benefits
Nonprofits, and hospitals in particular, have been under increased scrutiny as the government, legislators, and the public have become concerned about holding the organizations accountable to their communities for their tax-exempt benefits. The definition of “community benefit” that policy makers use as a basis for answering this question could influence their decisions about whether the nonprofit organizations are meeting their obligations to retain tax exemption.
The following are some attributes that a task force from the Healthcare Financial Management Association selected as relevant to explaining why a nonprofit organization warrants tax-exempt status. (Although relevant to tax-exempt status, any one of these attributes alone is probably not sufficient to warrant tax exemption.)
Mission : The organization should clearly articulate its charitable purpose and regularly demonstrate that its mission is fulfilled.
Use of financial surpluses: All financial surpluses are used exclusively to further the organization’s charitable purpose, and no individual receives any portion of the surplus, except as fair compensation.
Accountability: The organization is accountable to the public through a board that is committed to the needs of the community or service area.
Charity service: There is no denial of essential services (such as emergency services) to residents of the service area based on the inability of a person to pay for those services.
Reduced government burden: The organization provides services that are needed and that would otherwise have to be provided by the government.
As the bar has been raised, recent events suggest that the movement toward providing transparency, accountability, and oversight for nonprofit organizations will be implemented in revisions to Form 990. The new reporting requirements will aim to provide the public with a realistic picture of charitable organizations and to demonstrate how they are carrying out their missions. Nonprofit organizations should be advised to make a strong effort to play an active role in this policy debate to preserve their exempt status and build trust among their supporters.
Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.
Unless otherwise noted, contributors are independent members of Crowe Chizek.
If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.