(a) Governance Philosophy in General

In some quarters, the philosophy underlying the concept of governance of nonprofit organizations is changing. The traditional role of the nonprofit board is oversight and policy determination; implementation of policy and management is the responsibility of the officers and key employees. An emerging view, sometimes referred to as best practices, imposes on the nonprofit board greater responsibilities and functions, intended to immerse the board far more in management.

(b) Inventory of Sets of Principles

The Senate Committee on Finance, in 2004, held a hearing on a range of subjects pertaining to tax-exempt organizations.²⁴ In connection with that hearing, the staff of the committee prepared a paper as a discussion draft, containing a variety of proposals.²⁵

The Treasury Anti-Terrorist Financing Guidelines provide that a charitable organization's governing instruments should (1) delineate the organization's basic goal(s) and purpose(s); (2) define the structure of the charity, including the composition of the board, how the board is selected and replaced, and the authority and responsibilities of the board; (3) set forth requirements concerning financial reporting, accountability, and practices for the solicitation and distribution of funds; and (4) state that the charity shall comply with all applicable federal, state, and local law.²⁶

The Committee for Purchase has proposed various criteria and tests that it believes are “widely considered as benchmarks of good nonprofit agency governance practices.”²⁷

The American National Red Cross Governance Modernization Act of 2007 was signed into law on May 11, 2007.²⁸ The essence of the legislation is unique to the National Red Cross entity, yet there are elements of the act with larger significance. For example, the legislation refers to the governing board as a “governance and strategic oversight board.”²⁹ It outlines the board's responsibilities (a checklist for boards in general): (1) review and approve the organization's mission statement; (2) approve and oversee the organization's strategic plan and maintain strategic oversight of operational matters; (3) select, evaluate, and determine the level of compensation of the organization's chief executive officer; (4) evaluate the performance and establish the compensation of the senior leadership team and provide for management succession; (5) oversee the financial reporting and audit process, internal controls, and legal compliance; (6) ensure that the chapters of the organization are geographically and regionally diverse; (7) hold management accountable for performance; (8) provide oversight of the financial stability of the organization; (9) ensure the inclusiveness and diversity of the organization; (10) provide oversight of the protection of the brand of the organization; and (11) assist with fundraising on behalf of the organization.

Independent Sector issued the 2015 edition of its principles for good governance for public and private charitable organizations.³⁰ The principles are predicated on the need for a “careful balance between the two essential forms of regulation—that is, between prudent legal mandates to ensure that organizations do not abuse the privilege of their exempt status, and, for all other aspects of sound operations, well-informed self-governance and mutual awareness among nonprofit organizations.” These principles, organized under four categories, are as follows (slightly edited for brevity):

(a) Matter of Agency Jurisdiction

Controversy abounds as to whether the IRS should be so heavily involved in the governance of public charities and other categories of tax-exempt organizations in terms of priorities, competence, and jurisdiction. As to the latter two elements, a Supreme Court justice wrote, in a concurring opinion, that the “business” of the IRS is to “administer laws designed to produce revenue for the Government, not to promote ‘public policy.’”⁴¹ Some would add: “and not to regulate nonprofit governance.”⁴²

This justice added: “This Court often has expressed concern that the scope of an agency's authorization be limited to those areas in which the agency fairly may be said to have expertise.”⁴³ The Court wrote that “an agency's general duty to enforce the public interest does not require it to assume responsibility for enforcing legislation that is not directed at the agency.”⁴⁴ It also wrote: “It is the business of the Civil Service Commission to adopt and enforce regulations which will best promote the efficiency of the federal civil service. That agency has no responsibility for foreign affairs, for treaty negotiations, for establishing immigration quotas or conditions of entry, or for naturalization policies.”⁴⁵ Also: “The use of the words ‘public interest’ in the Gas and Power Acts is not a directive to the [Federal Power] Commission to seek to eradicate discrimination, but, rather, is a charge to promote the orderly production of supplies of electric energy and natural gas at just and reasonable rates.”⁴⁶

The U.S. Supreme Court stated that one of the tasks of courts is to determine “whether [a governmental] agency has stayed within the bounds of its statutory authority.”⁴⁷ Courts have not been reticent recently in finding that the IRS has strayed outside the bounds of its jurisdiction. For example, it has been held that the IRS does not have the authority to regulate tax-return preparers,⁴⁸ that the IRS lacks the authority to regulate the preparation and filing of ordinary refund claims,⁴⁹ and that the IRS lacks the authority to charge fees for issuance of preparer tax identification numbers.⁵⁰

In what appears to be the most direct court case on point, an appellate court held that the Federal Energy Regulatory Commission did not have the statutory authority to make or enforce its order endeavoring to dictate the composition of the board of a public benefit corporation over which it had some regulatory authority.⁵¹ The FERC took the position that the nonprofit organization violated its rules concerning independent system operators; its order dictated replacement of the board. The court of appeals ruled that the FERC “has no authority to replace the selection method or membership of the governing board of an ISO.”⁵² The court, having found the FERC's position “breathtaking,” wrote that the agency “commit[ed]…an absurdity.”⁵³ The court added that the FERC was “overreaching,” its attempt to order the nonprofit entity to change its board was an “extreme measure,” and the agency was “stretching” in asserting its authority over this aspect of nonprofit governance.⁵⁴

Courts, in assessing the validity of agency regulations and comparable pronouncements, follow a two-step process. The first step is to determine whether Congress has directly spoken to the precise question at issue; if it has, that is the end of the analysis.⁵⁵ In this context, Congress has hardly spoken to the matter at all, in that no statute defines the IRS's jurisdiction.⁵⁶ A court is then to move to a second step, which is to determine whether the agency's regulation or other interpretation is based on a permissible construction of the statute; an agency's interpretation is permissible unless it is arbitrary or capricious in substance or manifestly contrary to the statute.⁵⁷

To return to the analogy of the IRS's role in enforcing aspects of public policy, a dissenting justice wrote that, where the “philanthropic organization is concerned, there appears to be little to circumscribe the almost unfettered power of the Commissioner. This may be very well so long as one subscribes to the particular brand of social policy the Commissioner happens to be advocating at the time…but application of our tax laws should not operate in so fickle a fashion. Surely, social policy in the first instance is a matter for legislative concern.”⁵⁸

(b) IRS Officials' Speeches

The policy of the IRS concerning tax-exempt (particularly public) charities and matters of governance has evolved over recent years. Perhaps the best evidence of the contours of this evolution is the content of three speeches delivered by the then TE/GE Commissioner during 2007 and 2008.

When the TE/GE Commissioner first began talking about the IRS's role in nonprofit governance, in an April 2007 speech, he conceded that for the IRS to propound and enforce good governance principles, the agency would have to go “beyond its traditional spheres of activity.”⁵⁹ The Commissioner on that occasion revealed that he was pondering the question of “whether it would benefit the public and the tax-exempt sector [for the IRS] to require organizations to adopt and follow recognized principles of good governance.” He asserted that there is a “vacuum” that needs to be filled in the realm of education on “basic standards and practices of good governance and accountability.”

The TE/GE Commissioner, that day, made the best case that can be asserted for the intertwining of the matter of governance and nonprofit, tax-exempt organizations' compliance with the federal tax law. He said that a “well-governed organization is more likely to be compliant, while poor governance can easily lead an exempt organization into trouble.” He spoke, for example, of an “engaged, informed, and independent board of directors accountable to the community…[that the exempt organization] serves.”

By the time the TE/GE Commissioner returned to this subject in a November 2007 speech, his attitude and tone had dramatically changed.⁶⁰ No more pondering, musing, and speculating. Rather, the Commissioner stated that “[w]hile a few continue to argue that governance is outside our jurisdiction, most now support an active IRS that is engaged in this area.” He expressed his view that the IRS “contributes to a compliant, healthy charitable sector by expecting the tax-exempt community to adhere to commonly accepted standards of good governance.” He continued: “We are comfortable that we are well within our authority to act in these areas.” And: “To more clearly put our weight behind good governance may represent a small step beyond our traditional sphere of influence, but we believe the subject is well within our core responsibilities.”

When April 2008 rolled around, the TE/GE Commissioner had once again significantly evolved in his thinking on these points. In two speeches he made his view quite clear: (1) the IRS has a “robust role” to play in the realm of charitable governance; (2) the IRS does not even entertain the thought that involvement in governance matters is beyond the sphere of the agency's jurisdiction; and (3) he cannot be convinced that, “outside of very, very small organizations and perhaps family foundations, the gold standard should be to have an active, independent and engaged board of directors overseeing the organization.”⁶¹ Thus, the “question is no longer whether the IRS has a role to play in this area, but rather, what that role will be.” The governance section of the new annual information return, he said, will primarily dictate that role.

In the aftermath of these speeches, the then-director of the Exempt Organizations Division stated that the IRS is stepping back from recommending best practices as to governance and is focusing on education as to good governance.⁶² On that occasion, she conceded that “not all IRS agents have gotten the message.” Apparently this cadre of agents is not inconsequential in terms of size. The facts of a 2008 court opinion reflect the policy of some agents to demand changes in board composition, adoption of a conflict-of-interest policy, and adoption of other policies and procedures as a condition of recognition of tax exemption.⁶³

The then-Commissioner of the IRS made his first public comments about nonprofit governance in November 2008.⁶⁴ After expressing his admiration for the nonprofit sector, and its “diversity, its creativity, and its risk taking,” he stated that the IRS “shouldn't supplant the business judgment of organizational leaders, and certainly shouldn't determine how a nonprofit fulfills its individual mission.” He said that he “clearly see[s] our role as working with you and others to promote good governance, beginning with the proposition that an active, engaged, and independent board of directors helps assure that an organization is carrying out a tax-exempt purpose and acts as its best defense against abuse.” The Commissioner concluded his remarks by saying: “We want to arm you with information and guidance you need to help you comply.”

The next TE/GE Commissioner took office in early 2009. In her first public address on nonprofit governance in June of that year, she said that the IRS “has a clear, unambiguous role to play in governance [of tax-exempt organizations]. Some have argued that we do not need to be involved, because we can count on the states to do their job and the sector to stay on the path of self-regulation. While both state regulation and sector self-regulation are important, and I welcome and respect them, they do not get the IRS off the hook. Congress gave us a job to do, and we cannot delegate to others our obligation to enforce the conditions of federal tax exemption. The federal tax law must be applied consistently across the country, and we will use both our education and outreach programs and a meaningful enforcement presence to accomplish this.”⁶⁵

These IRS speeches on nonprofit governance are inconsistent and are sending mixed messages to the nonprofit community. There is the message of militancy, stating that the IRS will robustly impose and enforce rules as to the governance of tax-exempt organizations, particularly public charities, while simultaneously conceding that these rules are not conditions of exemption. There is the message of the IRS as adviser, not an imposer of nonprofit governance requirements, focusing on educational efforts and other forms of guidance to assist organizations in complying with the federal tax laws.

(c) IRS Ruling Policy

The IRS is actively issuing private letter rulings in the area of nonprofit governance, founded principally on an expansive interpretation of the private benefit doctrine.⁶⁶ One set of these rulings holds that an organization cannot qualify as an exempt charitable entity if it has a small board (even if the board size is permissible under state law). For example, the IRS ruled that an organization could not be exempt as a charitable entity, in part because it had only two board members.⁶⁷ The IRS privately ruled that an organization could not qualify as an exempt charitable entity, in part because two individuals exercised “absolute control” over the organization.⁶⁸ Indeed, the agency ruled that an organization cannot constitute an exempt charitable entity in part because its three directors had “unfettered control” over the organization and its assets.⁶⁹ Not surprisingly, then, the IRS is ruling that one-person boards are evidence of private benefit.⁷⁰

The IRS began moving away from a focus on board size as such to an insistence that an organization, to be a tax-exempt charitable entity, must be under control by a “community” or the “public.” The IRS issued a private letter ruling holding that an organization could not be an exempt, charitable entity, in part because it was “not operated by a community-based board of directors.”⁷¹ Likewise, the IRS ruled that an organization that refused to transform its board into an “independent” one could not qualify as a charitable entity.⁷² The IRS has gone so far as to rule that an organization did not constitute an exempt synagogue, in part because there was no “public oversight” of the entity's board.⁷³

Likewise, the IRS held that an organization with a board of five individuals was ineligible for exemption as a charitable entity in part because it is governed by a “small group of individuals” who have “exclusive control over the management of [the entity's] funds and operations.”⁷⁴ Indeed, a health care organization was denied recognition of exemption as a charitable organization because its six-member board of directors did “not have a majority of directors representing the community,”⁷⁵ and another health care entity was similarly denied exemption inasmuch as no one on its 28-member board of directors “will represent the broad interest of the community.”⁷⁶

When a small board is presented to the IRS as part of the application-for-recognition-of-exemption process, the agency may attempt to persuade the entity to expand its board as a condition of receipt of the recognition. In some instances, the applicant refuses to change the board composition.⁷⁷ An organization may comply with this type of request, only to have the IRS deny recognition of exemption on other grounds.⁷⁸

Another set of rulings has it that private benefit arises where an organization's board is composed of related individuals.⁷⁹ For example, the IRS ruled that an organization was not entitled to exemption as a charitable entity, in part because the entity is “governed by a board of directors that is controlled by members of the same family.”⁸⁰ The IRS privately ruled that the existence of a board of a nonprofit organization, with a majority of related individuals, was per se evidence of violation of the private benefit doctrine.⁸¹ The agency observed, in a private letter ruling, that an organization was controlled by members of a family, with the governing board consisting of the president's “family members or professional friends.”⁸² The IRS ruled that an organization was not entitled to exemption as a charitable entity, in part because it refused to expand its three-person board of directors, two of the members of which are related, to “place control in the hands of unrelated individuals.”⁸³ An organization was denied recognition of exemption as a charitable entity in part because it had a “closely related” governing board.⁸⁴ An organization was denied recognition of exemption in part because it would not expand its two-person (related) board; the organization's board did not do so on the ground that “no one shares our vision.”⁸⁵ An organization was denied recognition of exemption as a charitable entity in part because its governing board consisted of members of the same family.⁸⁶ Similarly, an entity was denied recognition of exemption in part because its governing board was composed of five related individuals.⁸⁷ The IRS ruled that a five-individual board consisting only of family members was a violation of the private benefit doctrine because the organization is governed “by a small group of individuals who have exclusive control over the management of [its] funds and operations.”⁸⁸ Structures where a three-individual board includes two individuals married to each other are deemed by the IRS to entail private benefit, precluding exemption.⁸⁹

A third set of private letter rulings concerns situations where the IRS denied recognition of exemption in part because an entity did not adopt a particular policy. For example, the IRS has found private benefit in part where an entity did not have a conflict-of-interest policy.⁹⁰ An organization failed to gain exemption in part because it lacked an executive compensation policy.⁹¹ The IRS, in connection with a private letter ruling, while not revoking exemption on this basis, went out of its way to highlight the fact that an organization did not have a conflict-of-interest policy or a document-retention-and-destruction policy, noting also that it lacked any internal control reports, annual reports, or audited financial statements (none of which are required by law).⁹²

These applications of the private benefit doctrine are flatly erroneous. There is absolutely no authority for the positions being taken by the IRS about board composition, independent boards, conflict-of-interest policies, and other policies. Indeed, in what obviously is an aberration, the IRS stated in a private letter ruling that the fact that an organization had a board of three related individuals is a factor that “alone is not enough to deny exemption.”⁹³ Aside from the issue of whether the IRS should be involved with nonprofit governance at all, it is certainly inappropriate to use the private benefit doctrine as a bolster for insertion of the agency into this realm. Moreover, these applications of the doctrine are based on speculation. The private benefit doctrine is to be applied where there has been unwarranted private benefit, not where there is some amorphous potential for private benefit. Indeed, in some of its rulings in the governance context, the agency has so stated. For example, in an instance where a small governing body controlled by an organization's founders was considered by the IRS, the agency did not find private benefit but instead observed that the facts created the need for the organization to be open and candid.⁹⁴ Likewise, the IRS, noting that an organization's board consists of three related individuals, wrote that this fact is “creating the potential for private control of” the entity.⁹⁵

(d) IRS Training Materials

The IRS released the materials that it has been using for the training of its agents in the field of nonprofit governance, for their edification in reviewing applications for recognition of exemption and annual information returns, and during examinations. For the most part, these materials do not contain anything new in relation to what the IRS has been saying over the past several years about its position on governance issues pertaining to public charities. They reflect the inherent tension as to what the federal tax law requires, the IRS's lack of jurisdiction and competence in this area, and its positions on various governance matters.

Here (again) is the ultimate rationale the IRS uses to justify its involvement in nonprofit governance, particularly with respect to public charities: The agency “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.”

These materials are replete with contradictory statements. For example, the IRS states that 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.” Then, it writes that the tax law “generally does not mandate particular management structures, operational policies, or administrative practices.”

The federal tax law “does not require charities to have governance and management policies.” Then: The IRS “will review an organization's application for [recognition of] 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.” In other words, despite the fact that the law does not require these policies, the IRS is going to look for (and probably demand) them anyway.

There are many shoulds in these materials, even though there is no justification in law for any of them. For example, the IRS states that 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.” (Elsewhere the materials state that this is a suggestion and the IRS will not enforce the requirement.) The “nominating process” for members of the governing body “should reach out for candidates, actively recruiting individuals whose commitment, skills, life experience, background, perspective, and other characteristics will serve the public charity and its needs.” “Attention should also be paid to the size of the board ensuring that it is the appropriate size.” Governing boards “should be composed of persons who are informed and active in overseeing a charity's operations and finances.” And: “Term limits for board members are an effective way to ensure board vitality.”

(e) IRS Governance Check Sheet

The IRS, on December 10, 2009, made public the Governance Check Sheet that its examination agents are using to gather data about the governance practices of public charities,⁹⁶ accompanied by a set of instructions.

Here are some of the areas that are to be explored, in connection with governing bodies and management: (1) whether the organization has a written mission statement that articulates its current exempt purposes; (2) whether the organization's bylaws set forth information about its governing body, such as its composition, duties, qualifications, and voting rights; (3) the extent to which copies of the organization's articles and bylaws have been distributed; and (4) the frequency of meetings of voting board members with a quorum present.

As to compensation, (1) whether compensation arrangements for all trustees, directors, officers, and key employees are approved in advance by an authorized body of the organization composed of individuals with no conflict of interest with respect to the arrangement; (2) whether this body relies on comparability data in making compensation determinations; and (3) whether the basis for compensation determinations is contemporaneously documented.

As to organizational control, (1) whether none of the organization's voting board members have a family relationship and/or outside business relationship with any other voting or nonvoting trustee, director, officer, or key employee; and (2) whether effective control of the organization does not rest with a single or select few individuals.

As to conflicts of interest, (1) whether the organization has a written conflict-of-interest policy and, if so, whether it addresses recusals and requires annual written disclosures of conflicts; and (2) if any actual or potential conflicts of interest were disclosed, whether the organization's policy was adhered to.

As to financial oversight, (1) whether there are systems or procedures in place intended to ensure that assets are properly used, consistent with the organization's mission; (2) the frequency with which the organization provides its board members with written reports on its financial activities; (3) whether, prior to filing, the organization's annual information return was reviewed by the entire board and/or a committee; (4) whether an independent accountant's report was prepared and, if so, whether it was considered by the board and/or a committee; and whether an independent accountant prepared a management letter and, if so, whether this letter was reviewed by the board and/or a committee and whether the organization adopted any of the recommendations in the letter.

As to document retention, (1) whether the organization has a written policy for document retention and destruction; (2) if so, whether the organization adheres to this policy; and (3) whether the board contemporaneously documents its meetings and retains this documentation.⁹⁷