Advisory Committee on Tax Exempt and Government Entities (ACT ...

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The Appropriate Role Of The Internal Revenue Service With Respect To Tax-Exempt Organization Good Governance Issuesmembership groups, and innumerable voluntary standards and publications fromleading organizations regarding nonprofit governance. Because large, sophisticatedand complex organizations are subject to regulation and/or are accredited and, in anyevent, have numerous governance resources available to them, it is less clear what theIRS adds to the governance discussion in their cases. Conversely, while smaller andmore rural organizations have less governance resources available to them, there is agreater need to tread lightly because of the burdens flowing from encouragingunnecessarily extensive governance reforms, the fact that the costs of adoptingpractices that may be advisable for larger nonprofits simply may not be worth thebenefits, and the reality that the costs of governance will consume charitable assets thatcould otherwise be devoted to the organizations’ programs. Finally, while disclosureand transparency, facilitated by the public availability of Forms 990 and 1023,undeniably play an influential role in encouraging appropriate nonprofit governance,they have limitations. This section briefly reviews these regulation and self-regulationmeasures involving nonprofit governance outside of the IRS.B. StatesWhether formed as nonprofit corporations or charitable trusts, charities are creatures ofstate law. The laws under which they are formed and the laws controlling their structureand finances are state laws, and their internal affairs remain subject to state laws evenwhen they operate entirely in other geographical jurisdictions. 47 While not all statesdistinguish the formation and operation of nonprofit and business corporations byseparate statutory schemes, 48 every state accords to the attorney general the authorityto correct abuses by charitable fiduciaries and to bring them to account in the courts. 49As a mechanism to protect charitable assets, and flowing from the formative authorityfound in state law, states nonprofit laws speak with increasing specificity to governancepractices. 5047Under long-standing, although sometimes criticized, conflict-of-laws principles for business corporations, the “internal affairsdoctrine” holds that the law of the state of incorporation applies to regulate the intra-corporate matters of a foreign corporationauthorized to transact business in the forum state. However, a few states are particularly concerned about the “pseudo-foreigncorporation”—the entity whose only tie to the state of incorporation is incorporation itself. California and New York, in particular,have adopted statutes applying much of their domestic corporate law to foreign corporations operating in-state that meet a thresholdtest. For a discussion of the internal affairs doctrine in the context of nonprofit corporations, see, e.g., American Center forEducation, Inc. v. Cavnar, 145 Cal. Rptr. 736, 742 (Cal. App. 1978); National Association for the Advancement of Colored People v.Golding, 679 A.2d 554, 559 (Md. 1996).48See, e.g., Delaware General Corporations Law § 101.49The authority of the state attorneys general typically is very broad. See, e.g., In re Milton Hershey Sch. Trust, 807 A.2d 324, 328(Pa. Commw. Ct. 2002); In re the Charles M. Bair Family Trust, 208 MT 144 (April 29, 2008). While standing to enforce fiduciaryduties has long been limited to the state attorney general and insiders with sufficient stake in the nonprofit’s governance, such asdirectors, officers, and members of the corporation, see, e.g., Carl J. Herzog Foundation, Inc. v. University of Bridgeport, 699 A.2d995, 998 (Conn. 1997), the doctrine of limited standing has occasionally been relaxed to permit others to enforce these obligations,particularly in response to perceived inaction by the state attorney general, see, e.g., Smithers v. St. Luke’s-Roosevelt HospitalCenter, 281 A.D. 2d 127 (App. Div. 1 st Dep. 2001). See generally, Evelyn Brody, From the Dead Hand to the Living Dead: TheConundrum of Charitable Donor Standing, 41 GA. L. REV. 1183 (2007).50California has the most detailed state laws requiring particular governance practices, specifying among other things thecomposition of the audit committee for those corporate-form charities required by state law to have audited financial statements(Cal. Gov. Code Section 12586(e)(2)); the procedure by which the governing body of a charity, regardless of form, must review thecompensation of certain corporate officers (Cal. Gov. Code Section 12586(g)); and the maximum percentage of a nonprofit publicbenefit corporation’s board that may consist of persons who are compensated by the charity or family members of those whom thecharity compensates (Cal. Corp. Code Section 5227).ADVISORY COMMITTEE ON TAX EXEMPT AND GOVERNMENT ENTITIES (ACT) June 11, 2008 18
The Appropriate Role Of The Internal Revenue Service With Respect To Tax-Exempt Organization Good Governance IssuesThe conceptual advantages of state supervision of nonprofit governance are manifest.The duties of care and loyalty imposed upon nonprofit board members and otherfiduciaries that are the foundation of good governance are evolving matters of state law.These duties are rarely expressed as “bright lines” that forbid certain actions andmandate others, but rather are relative standards that invite comparison to others insimilar positions in comparable subsectors and geographical areas. What passes foradequate board conduct in one part of the country may be an anathema to the public inanother, given the diversity of nonprofit activity and the variety of governance practicesaround the country. Local regulation respects those differences and allows innovationeven as it accords discretion to the overseers in the offices of the attorneys general todefine the boundaries of acceptable conduct through individual enforcement action.Where action is appropriate, states generally are closer to the activity and more able tobe responsive. State regulation and supervision also promotes experimentation amongstates, allowing for individual states to experiment and for other states to then see whatworks. More importantly, the equitable powers invested in state courts and the power ofthe state attorneys general, unknown in the federal tax code but historic and longstandingin the states, generally permit solutions to malfeasance and nonfeasance,such as the removal of miscreant board members, that are tailored to the violations oflaw and minimize depletion of the very assets that the enforcement actions aredesigned to protect. 51The incursion of the IRS into matters of nonprofit governance beyond enforcement ofthe tax laws represents a departure from that long-standing division of authority,notwithstanding its gradual erosion over the past 40 years. The IRS has only limitedformal enforcement tools—revocation of exemption, and in certain cases the ability toassess excise taxes. Moreover, any effort to impose a uniform set of federal standardsrisks obstructing the evolution that is so critical to the sector. At the same time,however, we recognize the persistently limited resources devoted to charities’ regulationby the states has encouraged an expanded role for the IRS in promoting strongernonprofit governance. Although charitable fundraising is subject to regulation in 39states, few but the most active states devote significant staffing to charities’ oversight,including oversight of nonprofit governance, a pattern that has remained unchanged inmore than thirty years. 52 At the same time, the enforcement staffs in even the mostactive states are increasingly disproportionate to the number of charities operating andsoliciting in their jurisdictions as the nonprofit sector has grown dramatically in recentdecades. 53 We also recognize the geographically expansive nature of nonprofit activity,without regard to state borders, that makes federal involvement more attractive. The51For example, New York Not-for-Profit Corporation Law § 706(d) provides “an action procuring a judgment removing a director maybe brought by the attorney general or by ten per cent of the members, whether or not entitled to vote.” See also, Adelphi Universityv. Board of Regents of the State of New York, 229 A.D. 2d 36 (App. Div. 3 rd Dept. 1997)(board of regents of state educationdepartment properly delegated authority under education law to private parties to bring proceeding to remove trustees for permittingexcessive compensation to CEO and unlawful self-dealing by trustees).52David Biemesderfer & Andras Kosaras, The Value of Relationships Between State Charity Regulators and Philanthropy (2006),at. 4.53New York, for example, has the largest charities enforcement staff in the country, with more than 20 attorneys. However, the NewYork Attorney General’s website states that New York has almost 50,000 charitable organizations registered to operate and/or solicitfunds within its borders. http://bartlett.oag.state.ny.us/Char_Forms/search_charities.jsp.ADVISORY COMMITTEE ON TAX EXEMPT AND GOVERNMENT ENTITIES (ACT) June 11, 2008 19
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