Internal Revenue Service White Paper
Well-Governed Charities & 501(c)(3) Exemptions
Revenue Service believes that a well-governed charity is more likely to obey the tax laws, safeguard charitable assets, and
serve charitable interests than one with poor or lax governance. A charity that has clearly articulated purposes that describe
its mission, a knowledgeable and committed governing body and management team, and sound management practices is more likely
to operate effectively and consistent with tax law requirements. And while the tax law generally does not mandate particular
management structures, operational policies, or administrative practices, it is important that each charity be thoughtful
about the governance practices that are most appropriate for that charity in assuring sound operations and compliance with
the tax law. As a measure of our interest in this area, we ask about an organization’s governance, both when it applies
for tax-exempt status and then annually as part of the information return that many charities are required to file with the
Internal Revenue Service.
Some of the
policies and practices we commend for your consideration are divided into the
topics below. Although the discussion that follows is generally directed to public charities, private foundations and other
exempt organizations should also consider these topics. Depending on an organization’s specific situation, some of the
recommended policies and practices will be more appropriate than others. References to Form 990, Return of Organization
Exempt From Income Tax, are to the 2008 Form 990.
Revenue Service encourages charities to establish and review regularly the organi-zation’s mission. A clearly articulated
mission, adopted by the board of directors, serves to explain and popularize the charity’s purpose and guide its work.
It also addresses why the charity exists, what it hopes to accomplish, and what activities it will undertake, where, and for
whom. Organizations required to file Form 990 may describe their mission in Part I, Line 1 and are required to describe their
mission in Part III, Line 1.
2. Organizational Documents
whether a charity is a trust, corporation, unincorporated association, or other type of organization, it 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 of a trust is usually the trust agreement or declaration of trust, and
of a corporation, its articles of incorporation. State law may also require corporations to adopt bylaws. The Internal Revenue
Service requires the submission of organizational documents and bylaws, if adopted, with an application for exemption under
section 501(c)(3), and 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. Organizations required to
file Form 990 will find that Part VI, Section A, Line 4 requires organizations to report significant changes to their organizational
documents since the prior Form 990 was filed.
3. Governing Body
Revenue Service encourages an active and engaged board believing that it is impor-tant to the success of a charity and to
its compliance with applicable tax law requirements. Governing boards should 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, we
are concerned that 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).
also be paid to the size of the board ensuring that it is the appropriate size 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 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. If an organization’s governing board is large, the organization may want to establish an executive
committee with delegated responsibilities or advisory committees.
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, stock holders, 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. Organizations that file Form 990 will find that Part VI, Section A, Lines 1, 2 ,3,
and 7 ask questions about the governing body.
If an organization
has local chapters, branches, or affiliates, the Internal Revenue Service encourages it to have procedures and policies in
place to ensure that the activities and operations of such subordinates are consistent with those of the parent organization. Organizations that file Form 990 will find that Part VI, Section A, Line
9 asks about such procedures and policies.
4. Governance and Management Policies
Internal Revenue Code does not require charities to have governance and management policies, the Internal Revenue Service
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. Executive compensation. 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. Organizations that file Form 990 will find that
Part VI, Section B, Line 15
asks whether the process used to determine the compensation of an organization’s
top management official and other officers and key employees included a review and approval by independent persons, comparability
data, and contemporaneous substantiation of the deliberation and decision. In addition, Form 990, Part VII and Form 990, Schedule
J, solicit compensation information for certain officers, directors, trustees, key employees and highest compensated employees.
The IRS encourages
a charity to rely on the rebuttable presumption test of section 4958 of the Internal Revenue Code and Treasury Regulation
section 53.4958-6 when determining compensation of its executives. Under this test, 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, the authorized body obtained and relied upon appropriate
data as to comparability prior to making its determination, and the authorized body adequately documented the basis for its
determination concurrently with making the determination.
data generally involves looking to compensation levels paid by similarly situated organizations for functionally comparable
positions. One method is to obtain compensation surveys or studies from outside compensation consultants for this purpose.
The Internal Revenue Service 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. Once that test is met, the Internal Revenue Service may rebut
the presumption that an amount of compensation is reasonable only if it develops sufficient contrary evidence to rebut the
probative value of the comparability data relied upon by the authorized governing body.
The IRS has
observed significant errors or omissions in the reporting of executive compensation on the IRS Form 990 and other information
returns (e.g., Form W-2 and employment tax returns). Organizations should take steps to ensure accurate and complete compensation
reporting on these forms, and to also ensure that appropriate income and employment taxes are withheld and deposited with
the Internal Revenue Service. Executive compensation continues to be a focus point in our examination program.
B. 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 conflicts of interest
involving their directors, trustees, officers, and other employees.
Revenue Service 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.
Revenue Service encourages organizations to 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. Instructions to Form 1023 contain a sample conflict of
interest policy. Organizations are urged to tailor the sample policy to their own particular situations and needs, with the
help of competent counsel if necessary. Organizations that file Form 990 will find that Part VI, Section B, Line 12 asks whether
an organization has a written conflict of interest policy, and whether it regularly and consistently monitors and enforces
compliance with the policy.
C. Investments. 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.
Revenue Service encourages charities that make such investments to 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 Internal Revenue Service reviews compensation arrangements
with investment advisors to see that they comply with federal tax law. Organizations that file Form 990 will find that Part
VI, Section B, Line 16 asks whether an organization has adopted procedures and policies regarding participation in a joint
venture or similar arrangement with a taxable entity. In addition, Form 990, Schedule D, asks detailed information about certain
D. Fundraising. Charitable fundraising is an important source of financial support for many charities.
The Internal Revenue Service encourages charities to adopt and monitor policies to ensure that fundraising solicitations meet
federal and state law requirements and solicitation materials are accurate, truthful, and candid. Charities are encouraged
to keep their fundraising costs reasonable and to provide information about fundraising costs and practices to donors and
the public. Organizations that file Form 990 will find that Schedules G and M solicit information about fundraising activities,
revenues and expenses.
E. Governing body minutes and records. The Internal Revenue Service encourages the governing bodies
and authorized subcommittees to take steps to ensure that minutes of their meetings, and actions taken by written action or
outside of meetings, are contemporaneously documented. Organizations that file Form 990 will find that Part VI, Line 8 asks
whether an organization contemporaneously documents meetings or written actions undertaken during the year by its governing
body and each committee with authority to act on behalf of the governing body.
F. Document retention and destruction. The Internal Revenue Service encourages charities to adopt
a written policy establishing standards for document integrity, retention, and destruction. The document retention policy
should include guidelines for handling electronic files. The policy should cover backup procedures, archiving of documents,
and regular checkups of the reliability of the system. For more information, see IRS Publication 4221, Compliance Guide
for 501(c)(3) Tax-Exempt Organizations, available on the IRS website. Charities are required by the Internal Revenue Code
to keep books and records that are relevant to its tax exemption and its filings with the Internal Revenue Service. Organizations
that file Form 990 will find that Part VI, Section B, Line 14, asks about whether an organization has a written document retention
and destruction policy.
G. 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 permeate the organization and inform its practices. The Internal Revenue Service encourages a charity’s
board or trustees to consider adopting and regularly evaluating 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 organi-zation.
Revenue Service encourages the board of directors to adopt an effective policy for handling employee complaints and to 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 Internal Revenue Service will review an organization
to determine whether insiders or others associated with the organization have materially diverted organizational assets. Organizations
that file Form 990 will find that Part VI, Section B, Lines 5 and 13 ask whether the organization became aware during the
year of a material diversion of its assets, and whether an organization has a written whistleblower policy.
5. Financial Statements and Form 990 Reporting
stewards of a charity’s financial and other resources. The Internal Revenue Service encourages the board, either directly
or through a board-authorized committee, 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.
A. Financial Statements. 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 Many organizations that receive federal funds are required to undergo one or
more audits as set forth in the Single Audit Act and OMB Circular A-133. 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.
The board may establish an independent
audit committee to select and oversee an independent auditor. An audit committee generally is responsible for selecting the
independent auditor and reviewing its performance, with a focus on whether the auditor has the competence and independence
necessary to conduct the audit engagement, the overall quality of the audit, and, in particular, the independence and competence
of the key personnel on the audit engagement teams. The Internal Revenue Service encourages all charities to take steps to
ensure the continuing independence of any auditor that conducts an audit of the organization. Organizations that file Form
990, will find that Part XI, Line 2, asks whether the organization’s financial statements were complied or reviewed
by an independent accountant, audited by an independent accountant, and subject to oversight by a committee within the organization.
And, Part XI, Line 3 asks whether, as a result of a federal award, the organization was required to undergo an audit as set
forth in the Single Audit Act and OMB Circular A-133.
B. Form 990. Although not required to do so by the Internal Revenue Code, some organi-zations 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. Practices differ widely as to who sees the form, when they see it, and
the extent of their input, review, or approval. Some, especially smaller organizations, may provide a copy of the Form 990
to the full board for review or approval before it is filed. Others provide a copy of the form to a portion of the governing
body, or to a committee or top management officials, before it is filed. Still others provide a copy to the board, a committee
or top management officials, but not until after it is filed. Organizations that file Form 990 will find that Part VI, Section
A, Line 10 asks whether the organization provides a copy of Form 990 to its governing body, and requires the organization
to explain any process of review by its directors or management.
6. Transparency and Accountability
By making full
and accurate information about its mission, activities, finance, and governance publicly available, a charity encourages transparency
and accountability to its constituents. The Internal Revenue Code requires a charity to make its Form 1023 exemption application,
Form 990, and Form 990-T, available for public inspection. The Internal Revenue Service encourages every charity to adopt
and monitor procedures to ensure that its Form 1023, Form 990, Form 990-T, annual reports, and financial statements, are complete
and accurate, are posted on its public website, and are made available to the public upon request. Organizations that file
Form 990 will find that Part VI, Section C, Lines 18 and 19, ask whether and how an organization makes its Form 1023, Form
990 and Form 990-T, governing documents, conflict of interest policy, and financial statements available to the public.
Date originally posted: February 4, 2008