Introduction
Business lawyers bring a valuable breadth of knowledge and experience to nonprofit boards, but as any business lawyer knows, a director of a nonprofit corporation owes a fiduciary duty of care to the corporation. This duty generally requires the nonprofit director to act with the care an ordinarily prudent person would in a like position under similar circumstances. At a minimum, the duty of care requires a nonprofit director to keep apprised of and understand financial and executive reports, strategic initiatives, budgets and fundraising developments, and other operational matters that materially impact the organization.
One area implicating the duty of care that is often minimized or even neglected by many boards of directors of tax exempt charities (hereinafter Board(s)) is the review and approval of the organization’s annual information return filed with the Internal Revenue Service (IRS), the Form 990. Form 990 is easily accessible by the public and therefore invites scrutiny on a broad range of the organization’s internal operations, including financial performance, compensation of executives and other insiders, results of key programs, and interested transactions. It is thus imperative for the Board and senior staff to understand and help frame the information presented in Form 990 well in advance of the due date for its filing.
Form 990 in All Its Shapes and Sizes
The IRS requires most organizations exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code of 1986, as amended (the Code), and classified by the IRS as public charities (hereinafter organizations or exempt organizations) to file Form 990 by the 15th day of the fifth month after the end of the organization’s fiscal year. Organizations may obtain one, automatic six-month extension of the filing due date by timely filing Form 8868 with the IRS. The type of Form 990 that is filed depends on the annual “gross receipts” and total assets of the filing organization. “Gross receipts” are the total amounts the organization received from all sources (e.g., grants, donations, and earned income) during its annual accounting period, without subtracting any costs or expenses.
Small organizations with annual gross receipts that are normally $50,000 or less may file the Form 990-N “e-postcard” online. Form 990-N is the smallest form in the 990 series and includes only basic information about the organization, including its name, principal officer, website address (if any), business address, and employer-identification number.
Organizations with gross receipts of less than $200,000 and total assets of less than $500,000 may file a Form 990-EZ, which is more robust than Form 990-N, but less than half the size of Form 990 and includes a basic balance sheet and statement of revenue and expenses. It also reflects changes in net assets or fund balances from the previous fiscal year. In addition, Form 990-EZ requires the organization to provide a statement of program service accomplishments and related expenses, as well as the level of compensation paid to directors, officers, and key employees, among other information.
Form 990 is the most comprehensive of the information returns filed by public charities, and it is the focus of this article. Form 990 is 12 pages without schedules, and requires the organization to report a vast amount of data about the organization which is made publicly available. Most organizations with gross receipts equal to or more than $200,000 or total assets equal to or more than $500,000 must file Form 990.
As a preliminary note, this article will discuss only the Form 990 that is filed by exempt organizations classified by the IRS as “public charities.” Code Section 501(c)(3) organizations classified as “private foundations” file a different annual information return, Form 990-PF, which will not be discussed in this article. However, many of the observations contained in this article with respect to the review of Form 990 may apply to a foundation Board’s review of its Form 990-PF, or to a small public charity’s review of a Form 990-EZ.
Must the Board Review the Form 990?
Form 990 Part VI, Line 11a, asks whether the organization “provided a complete copy of this Form 990 to all members of its governing body before filing.” There is no requirement that the organization actually have the Board review the Form 990. Rather, this question represents an example of the IRS’s “regulation by disclosure” method of promoting what the IRS perceives as good governance practices for exempt organizations. It may therefore reflect poorly on an organization were this question answered in the negative.
Although seldom the case in many organizations, the Board should receive a copy of the draft Form 990 well in advance of the due date for its filing. Enough time should be given to the Board to decide whether to assign the review of the form to specific Board committees, directors, and/or senior staff. Although audit committees are often assigned the task of reviewing the Form 990, it may make sense for other committees, senior staff, or Board members with relevant expertise to review the form’s more qualitative and governance-focused parts.
Does the Organization Have a Process for Review of Form 990?
This is another question asked by the IRS on Form 990, Part VI, Line 11b. The IRS asks the organization to describe any such process on Schedule O. The Form 990 review process typically involves one or more Board committees, Board members, and/or senior staff that review and make recommendations to the full Board with respect to approval of Form 990 based on their respective expertise or Board-assigned tasks. However, there is no “one-size-fits-all” approach to a Form 990 review process, and policies and procedures differ widely from organization to organization. What is important is that the organization undertakes the effort to craft and follow policies and procedures that are effective based on the organization’s unique characteristics, including Board size, budget, internal competencies, and particular operations.
Special Areas of Review on Form 990
Although not intended as an exhaustive list, what follows is a general discussion of selected areas of Form 990 that commonly require special Board attention.
Reporting changes in purpose or mission. Form 990, Part I, Line 1 and Part III, Line 1 ask the organization to briefly describe the organization’s mission. Form 990, Part VI, Line 4 asks the organization to indicate whether it has made any “significant changes to its governing documents” since its last Form 990 filing. The organization must describe these changes on Schedule O. Thus, if an organization amended its bylaws or articles of incorporation to change its mission or purpose, the organization’s next Form 990 filing should reflect that change.
Many changes to an organization’s mission or purpose will not jeopardize its tax-exempt status. However, if there have been substantial changes to an organization’s purpose—changes that call into question whether it is still organized and operating in furtherance of tax-exempt purposes—those changes should be discussed with qualified legal counsel before they are implemented or adopted by the organization, and certainly before they are reported on Form 990. Occasionally, a request for a private letter ruling from the IRS may be necessary to support that any such changes are consistent with recognized tax-exempt purposes.
It is also important to socialize an organization’s change in purpose or mission with the organization’s constituents and stakeholders before implementing the change. A key donor or community partner should not find out about the change indirectly from a Form 990 filing. Senior staff should determine how best to convey changes in mission or purpose to the organization’s stakeholders. They should also consider involving key Board members and outside communications professionals in the implementation process if resources allow. In some cases, the organization might need to consider the advisability of seeking an automatic extension of the Form 990 filing deadline to properly roll out a change that has already been adopted.
Review of financial information. Form 990 reports a bevy of financial information. Organizations are required to complete a detailed statement of revenue and expenses, a balance sheet, and detailed compensation statements for directors, officers, key employees, and contractors. Obviously not every Board or committee member will also be a certified public accountant, but fiduciary duties dictate that each Board or committee member assigned the task of reviewing the financial information in the Form 990 at least know enough about the organization’s general financial condition to spot any material misstatements or omissions.
For instance, does the Form 990 omit a large grant that was recently received or a large capital project undertaken? Has the organization paid compensation to a new executive that is not accurately reflected on the expense and compensation statements? Those assigned the task of reviewing Form 990’s financial information should also consider reviewing that information against the organization’s internal financial statements. They should also follow up with the preparer of Form 990, outside professionals, and any accounting staff, as needed, to answer any questions or help correct any inconsistencies. Nonprofit corporation statutes have long permitted directors to reasonably rely on officers and outside experts in exercising their fiduciary duties.
Review of compensation arrangements with personnel and insiders. It is crucial to the Board’s review of the Form 990 that each director understand and appreciate the substantial impact that Code Section 501(c)(3) status has on an exempt organization’s compensation arrangements with its service providers and insiders. In general, an exempt organization must not confer a “private benefit” on an individual or entity, and must not allow any of its revenue or assets to “inure” to the benefit of insiders, such as its executives, officers, directors, or their respective family members or affiliates. These are general restatements of the “private benefit” and “private inurement” prohibitions that apply to all Code Section 501(c)(3) organizations. The private benefit and private inurement prohibitions are generally implicated any time an unreasonable sum of the organization’s money or property is provided to such persons in exchange for services or property. Violating the prohibitions may jeopardize the organization’s federal income tax exemption.
When news media publish stories about “excessive” compensation paid to nonprofit executives, the origin of those stories is typically the Form 990, which requires detailed reporting on the name and title of a service provider, how much the service provider worked, and the service provider’s total compensation from the organization. Red flags should immediately go up for a director if, to take an extreme example, he or she reviews the Form 990 of a small organization and notices an employee who worked only 15 hours per week but was paid $100,000. This is because, to help avoid application of the private benefit or private inurement prohibitions, or their less punitive cousin, the “intermediate sanctions” rules, compensation paid to a service provider must be reasonable. Approving and documenting a compensation payment in accordance with the “rebuttable presumption” safe harbor of the intermediate sanctions rules, in addition to following any applicable conflict-of-interest policy or state interested transactions laws, will help support that the payment does not violate such rules or prohibitions. See 26 U.S.C. § 4958 and 26 C.F.R. § 53.4958-1, et seq.
If a director identifies a compensation issue on the Form 990, the Board should work collaboratively to better understand the issue and have a plan in place to address it once it is reported. It should also consider whether to further report the issue as an interested transaction or, if appropriate, an “excess benefit transaction” under the intermediate sanctions rules on Form 990, Schedule L. Depending on the circumstances, it may be prudent for the Board to consider consulting competent legal counsel to aid in reviewing the Form 990 disclosures, and public relations specialists to advise it on any related public statements or media inquiries.
Reporting on programs, fundraising events, and related expenses. Similar to compensation paid by exempt organizations, there has been renewed focus among donors, the media, and nonprofit regulators on high-expense programs or events sponsored by exempt organizations. No law specifically prohibits an exempt organization from spending freely on a program or fundraising event with the object of attracting even greater financial support or creating even greater mission impact. However, it is still not uncommon for funders and pundits in the nonprofit space to set expense expectations around an organization’s activities, advising that “overhead” not exceed a stated percentage in relation to the overall budget for an organization or for its particular programs or events.
Part III of Form 990 asks organizations to report revenue and expenses for its “program service accomplishments for each of its three largest program services, as measured by expenses.” It also requires the organization to include “gross income from fundraising events” in Part VIII, Line 8, less “direct expenses,” to calculate the total “net income or (loss) from fundraising events.” The applicable instructions to Form 990 make it clear that common fundraising events like “dinners/dances” and “auctions” are covered by this disclosure. Accordingly, any programs or events that show substantial losses on Form 990 have the potential to draw scrutiny from the media and stakeholders. For this reason, if the Form 990 review process uncovers any such losses, the organization may wish to consider contacting internal or external accounting professionals to confirm that expenses related to such activities are properly allocated and reported.
Conclusion
Serving on the Board of an exempt organization is both a privilege and a responsibility. To help fulfill their duties of care, nonprofit directors should diligently participate in the Form 990 review process. Exempt organizations are well advised to implement and follow a Form 990 review policy and related procedures. This will help ensure that the organization is doing all it can to accurately report information to the IRS and get ahead of any disclosures that may present particular challenges for the organization.
This article is intended for informational purposes only and should not be relied upon as legal advice, as being current or accurate, or as creating an attorney-client relationship between the author and any person or entity.
