The nonprofit sector has exploded in the last 10 years with a 20% growth rate and almost 1.5 million organizations across the country. This growth illustrates the need for programs to alleviate societal ills, particularly in light of the COVID-19 pandemic. Formation of I.R.C. § 501(c)(3) nonprofit entities, however, comes with a cost—tax and corporate legal compliance. With 75 percent of nonprofit organizations reporting annual revenue less than $100,000, tax and legal compliance may sound simple. Yet a renewed focus on nonprofit organizations as a source of tax evasion or fraud by the IRS means effective governance and organizational policies are critical. Attorneys that practice in nonprofit law should be aware of current landmines befalling the sector, including cybersecurity issues, excess benefit transactions, unrelated earned income, cryptocurrency donations, and ineffective governance.
The Tax Exempt and Government Entities Compliance Program by the IRS highlights 2022 priorities inclusive of expansion of algorithm usage to increase nonprofit entities selected for audit. Audit priority has focused on:
- unrelated business income—where expenses materially exceed gross income reported on Form 990;
- social clubs—nonmember income and investment within tax-exempt pleasure, social, and recreation clubs designated as I.R.C. § 501(c)(7) entities;
- non-exempt charitable trusts—I.R.C. § 4947(a)(1) designated entities that under-report income or over-report charitable contributions;
- previous for-profit entities converted to I.R.C. § 501(c)(3) designated nonprofits;
- private benefit and inurement—nonprofit organizations inclusive of private foundations that show indicators of private benefit to individuals; and
- private foundation loans to disqualified persons.
Private benefit was recently in the public eye through “Operation Varsity Blues.” This case highlighted the desire of wealthy parents to have their children admitted to elite universities through bribes and misuse of charitable foundation funds, which resulted in 57 defendants charged with crimes ranging from fraud to conspiracy. It also resulted in the U.S. Senate’s Committee on Finance requesting the “IRS to be vigorous in enforcing the applicable tax laws . . . as parents . . . may have misappropriated funds from private foundations over which they ha[d]control to make illicit payments.” This desire has propelled IRS audit priorities to target private foundation activities.
Nonprofit clients should annually assess who are “disqualified persons” and the parameters of self-dealing that trigger unallowable activities between the organization and those persons. I.R.C. § 4946(a)(1)(A)–(I) defines “disqualified persons” expansively, and includes substantial contributors to a private foundation and a foundation’s family members. Similarly, self-dealing, direct or in-direct activities between the foundation and “disqualified persons,” is defined in I.R.C. § 4941(d)(1). Prohibited activities between a private foundation and “disqualified person” can result in excise taxes imposed on the foundation. Hence, annually a private foundation and its legal counsel should identify all contributors to the foundation, examine all transactions between each contributor (individual, corporate, partnerships, and other potential disqualified persons) and the foundation, and review the activities of each person having authority to control foundation activities who is not technically an officer. This review will aid clients to avoid excess benefit transactions and possible claims of inurement.
Expenditures of private foundation funds for grant-making should additionally be expended in compliance with board-approved oversight procedures. Pursuant to I.R.C. § 4945(h), procedures should ensure grants are spent for their intended purpose; a thorough grantee reporting structure is implemented detailing all grant expenditures; and grantee reports facilitate accurate reporting to the IRS on all foundation expenditures. Also, annual orientation and training of foundation directors in the organizational concepts of duty of loyalty, obedience, and care is critical to effective governance.
Effective oversight keenly focuses on conflicts of interest, dual roles of foundation officers, routine identification of disqualified parties, and reasonable adherence to expenditure responsibilities. Even with proper oversight mechanisms, Congress continues to advance legislative changes to buttress fraud occurring within private foundation grant-making. Both foundations and legal counsel need to stay abreast of possible impending changes, particularly related to private foundation usage of donor-advised funds.
Similarly, I.R.C. § 501(c)(3) nonprofits need to monitor excess benefit transactions that occur between its board members and the organization. I.R.C. § 4958 prohibits and provides sanctions for excess benefit transactions and defines these transactions as “[one] in which an economic benefit is provided by a tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.” A nonprofit organization thus should not provide a “disqualified person” with any benefit that exceeds fair market value of what the organization received in return. As previously noted, “disqualified persons” include those with substantial influence over the organization, including members of the board of directors and employees who manage the organization.
Identification of an excess benefit transaction involves an examination of the nature of the transaction. The critical inquiry focuses on the fair market value cost by a disinterested service provider to a disinterested organization. If the transaction at issue is higher than the disinterested fair market value cost, it likely constitutes an excess benefit. A “disqualified person” can remedy an excess benefit transaction by paying the organization the cost of the excess benefit over the fair market value of the transaction, plus any accrued interest. The IRS however can also levy taxes, including a 25% excise tax on the excess benefit and a 200% excise tax on the excess benefit if the violation is not corrected within the taxable period. These excise taxes can be imposed on the “disqualified person.” An additional 10% excise tax on the excess benefit may be imposed on the individuals who ratified the excess benefit transaction, i.e., members of the board of directors. Legal counsel should thus aid nonprofit organizations in an annual identification of “disqualified persons” and excess benefit transactions to remedy any issues within the taxable year. Disclosure of excess benefit transactions should also be included on the organization’s Form 990 annual tax return on Schedule L.
Unfortunately, nonprofits have become the second-highest target of nation-state security attacks with attackers attempting to infiltrate nonprofit databases every 39 seconds. Attackers have recognized the sector lags in secure networks and organizational protocols, which results in substantive threats leveraged against organizations and resultant breaches of donor and client data. Effective legal counsel should advise organizations to create robust cybersecurity policies inclusive of an initial vulnerability assessment. Identification of policies and training needed for all staff, board, and volunteers to further enhance the organization’s information technology protocols must be included in this initial assessment.
Currently, minimal regulation dictates data protection and enforcement. In the absence of a congressional statute, states have become the primary vehicle through which consumer protection and data privacy legislation is promulgated. Nonprofits should thus be aware of their state’s respective legislation in this area and if they are exempt. For example, Colorado recently enacted the Colorado Consumer Protection Act that requires companies to take responsibility for the protection of consumer data, and in the wake of a breach what steps are required to inform and assist those affected by the breach. This statute does not exempt nonprofits from these requirements as a covered business, unlike many other corporate focused statutes. Oklahoma is similarly considering consumer protection legislation that may impact nonprofit organizations. Hence, legal counsel should advise nonprofit clients of the growing organizational risk of cybersecurity attacks as the organizational duty of care demands its awareness.
Crypto-donations continue to rise as a new source of charitable giving. The Giving Block, a company that provides back-end support to charities receiving crypto-donations, reported donations valued at an exchange of $70 million in 2021, up from $4.2 million in 2020. With the rise in this new digital currency, nonprofit organizations must develop robust gift acceptance policies inclusive of crypto-donations. These policies need to identify how organizational acceptance will occur, what exchange platform will be used, or if the organization plans to retain the donation in its initial form of cryptocurrency. Due to the currency’s volatility, most organizational policies should detail immediate exchange.
Recent examples however highlight that some donors may insist the organization retains the donation or a portion in cryptocurrency. A crypto-donation to the University of Pennsylvania stipulated that it retain a portion of the original gift in bitcoin. Legal counsel aided the organization in effectuating a donor agreement that allowed for this retention; yet contained a clause requiring the donor to ensure the total gift amount of $5 million was provided to the university regardless of the value of bitcoin. Organizations that lack policies addressing crypto-donations should work with legal counsel in 2022 to develop effective practices for these gifts. Attorneys need to include policy language about acknowledgement and recognition of crypto-donations and any additional steps required if the organization learns the donation came from hackers or stolen cryptocurrency. As tax guidance continues to change, effective advice for nonprofits on the acceptance and recognition of crypto-donations is imperative.
Nonprofits face a host of issues inclusive of the landmines previously discussed. In light of growing programmatic need, nonprofits require legal counsel that can effectively guide and discern policies that will ultimately position organizational fundraising success. Enhanced corporate and tax compliance require a robust legally compliant nonprofit sector. This sector of “do-gooders” deserves competent legal counsel akin to its for-profit corporate colleagues.
About the Authors
Jeri D. Holmes is the founder of Nonprofit Solutions, which she created in 2004 to serve as legal counsel to nonprofit entities. She also also teaches the law and nonprofit organizations class for the Master of Arts in Nonprofit Leadership program at Oklahoma City University.
Jennie A. Hill is a legal intern at Nonprofit Solutions and has many years of experience as an executive at nonprofit organizations.