In order for a nonprofit business to maintain that status, and specifically when applying for tax exemption, it must supply the IRS with certain information. Some of the areas that the IRS will require information on are:
1. Mission: A clearly articulated mission statement, adopted by the board of directors, should explain the charity's purpose and guide its work. It also needs to address why the charity exists, what it hopes to accomplish, and what activities it will undertake, where, and for whom.
2. Organizational Documents: A charity must have organizational documents that provide the framework for its governance and management. State law often prescribes the type of organizational document and its content. The organizational document is usually its articles of incorporation. State law may also require corporations to adopt bylaws. The IRS will review these documents to ensure that the applicant is organized exclusively for exempt purposes and that the applicant's proposed or actual activities are consistent with those documents.
3. Governing Body: Governing boards need to be composed of persons who are informed and active in overseeing a charity's operations and finances. If a governing board tolerates a climate of secrecy or neglect, charitable assets are more likely to be diverted to benefit the private interests of insiders at the expense of public and charitable interests. Successful governing boards include individuals who not only are knowledgeable and engaged, but selected with the organization's needs in mind (e.g. accounting, finance, compensation, and ethics).
Attention should also be paid to the size of the board ensuring that it is appropriate to effectively make sure that the organization obeys tax laws, safeguards its charitable assets, and furthers its charitable purposes. Very small or very large governing boards may not adequately serve the needs of the organization. Small boards run the risk of not representing a sufficiently broad public interest and 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 making decisions.
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 IRS 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 IRS also reviews whether an organization has independent members, stockholders, 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.
4. Governance and Management Policies: Although the Internal Revenue Code does not require charities to have governance and management policies, the IRS will review an organization's application for exemption and annual information returns to determine whether the organization has implemented policies relating to executive compensation, conflicts of interest, investments, fundraising, documenting governance decisions, document retention and destruction, and whistleblower claims.
A charity may not pay more than reasonable compensation for services rendered. Although the Internal Revenue Code does not require charities to follow a particular process in determining the amount of compensation to pay, the compensation of officers, directors, trustees, key employees, and others in a position to exercise substantial influence over the affairs of the charity should be determined by persons who are knowledgeable in compensation matters and who have no financial interest in the determination.
Compensation payments are presumed to be reasonable if the compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement. Also, the authorized body must have obtained and relied upon appropriate data for comparability prior to making its determination, and adequately documented the basis for its determination concurrently with making the determination.
Comparability data generally involves looking to compensation levels paid by similarly situated organizations for functionally comparable positions. The IRS will look to the independence of any compensation consultant used, and the quality of any study, survey, or other data used to establish executive compensation.
Conflicts of Interest
The directors of a charity owe it a duty of loyalty. The duty of loyalty requires a director to act in the interest of the charity rather than in the personal interest of the director or some other person or organization. In particular, the duty of loyalty requires a director to avoid conflicts of interest that are detrimental to the charity. Many charities have adopted a written conflict of interest policy to address potential problems involving their directors, trustees, officers, and other employees. The IRS encourages a charity's board of directors to adopt and regularly evaluate a written conflict of interest policy that requires directors and staff to act solely in the interests of the charity without regard for personal interests; includes written procedures for determining whether a relationship, financial interest, or business affiliation results in a conflict of interest; and prescribes a course of action in the event a conflict of interest is identified.
A nonprofit should require its directors, trustees, officers and others covered by the policy to disclose, in writing, on a periodic basis any known financial interest that the individual, or a member of the individual's family, has in any business entity that transacts business with the charity. The organization should regularly and consistently monitor and enforce compliance with the conflict of interest policy.
The governing body or certain other persons may be required either by state law or by the organizational documents to oversee or approve major investments made by the organization. Increasingly, charities are investing in joint ventures, for-profit entities, and complicated and sophisticated financial products or investments that require financial and investment expertise and, in some cases, the advice of outside investment advisors.
Charities that make such investments should adopt written policies and procedures requiring the charity to evaluate its participation in these investments and to take steps to safeguard the organization's assets and exempt status if they could be affected by the investment arrangement. The IRS reviews compensation arrangements with investment advisors to see that they comply with federal tax law.
Charitable fundraising is an important source of financial support for many charities. Charities need to adopt and monitor policies to ensure that fundraising solicitations meet federal and state law requirements and solicitation materials are accurate, truthful, and candid. Fundraising costs should be reasonable and information about fundraising costs and practices should be available to donors and the public.
Governing Body Minutes and Records
The governing body needs to take minutes of its meetings and document actions taken outside of meetings.
Document Retention and Destruction
Charities are expected to adopt a written policy establishing standards for document integrity, retention, and destruction. The document retention policy should include guidelines for handling electronic files, backup procedures, archiving of documents, and regular checkups of the reliability of the system.
Ethics and Whistleblower Policy
The public expects a charity to abide by ethical standards that promote the public good. The organization's governing body bears the ultimate responsibility for setting ethical standards and ensuring they are practices throughout the organization. A charity's board should adopt and regularly evaluate a code of ethics that describes behavior it wants to encourage and behavior it wants to discourage. A code of ethics will serve to communicate and further a strong culture of legal compliance and ethical integrity to all persons associated with the organization.
The board of directors should also adopt a policy for handling employee complaints and establish procedures for employees to report in confidence any suspected financial impropriety or misuse of the charity's resources. Such policies are sometimes referred to as whistleblower policies. The IRS will review an organization to determine whether insiders or others associated with the organization have materially diverted organizational assets.
5. Financial Statements and Form 990 Reporting: Directors need to ensure that financial resources are used to further charitable purposes and that the organization's funds are appropriately accounted for by regularly receiving and reviewing up-to-date financial statements and any auditor's letters or finance and audit committee reports.
Some organizations prepare financial statements without any involvement of outside accountants or auditors. Others use outside accountants to prepare compiled or reviewed financial statements, while others obtain audited financial statements. State law may impose audit requirements on certain charities.
Many organizations that receive federal funds are required to undergo one or more audits. However, even if an audit is not required, a charity with substantial assets or revenue should consider obtaining an audit of its financial statements by an independent auditor.
Form 990 is the informational return that the IRS requires a nonprofit to file annually. Although not required to do so by the Internal Revenue Code, some organizations provide copies of the IRS Form 990 to its governing body and other internal governance or management officials, either prior to or after it is filed with the Internal Revenue Service.
6. Transparency and Accountability: By making full and accurate information about its mission, activities, finances, and governance publicly available, a charity encourages transparency and accountability to the public. The Internal Revenue Code requires a charity to make its exemption application and Form 990 available for public inspection. The IRS encourages every charity to adopt and monitor procedures to ensure that its IRS forms, annual reports, and financial statements are complete and accurate, are posted on its public website, and are made available to the public upon request.
Clearly, the IRS sets very strong federal guidelines on nonprofits that define what is expected in order to receive and maintain tax-free status. These guidelines supplement each state's rules and regulations. Following these guidelines can be an onerous process. However, in many ways this is to your benefit, since the specificity of what needs to be done makes your organization stronger and more viable in the long run.
A portion of the information in this article is courtesy of the Internal Revenue Service