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The Appropriate Role Of The Internal Revenue Service With Respect To Tax-Exempt Organization Good Governance Issuesvibrant and flexible charitable sector in this country. Accordingly, we believe that theIRS should approach this area with caution.Our goal then is to attempt to provide a framework that will assist the IRS as it seeks tobalance the desirability of promoting good governance against the potential deleteriousconsequences to the sector.This report is comprised of the following additional sections:• Section V defines the scope of the nonprofit sector addressed in the report, looksat the meaning of “good governance,” and considers the extent to which there isempirical evidence that can be helpful in considering appropriate governance;• Section VI looks at regulation of the nonprofit sector outside the IRS—the states,accreditation systems, voluntary standards, and oversight by watchdog groups,the media, the public and others;• Section VII reviews the IRS’s evolving role in governance issues involving taxexemptentities at the IRS’s five points of contact with the tax-exempt sector: increating standards for exemption; on determination of exemption; on examinationor in other compliance initiatives; in 990 reporting; and in education andoutreach;• Section VIII explains the bases for our call for caution; and• Section IX sets forth specific recommendations and a framework we hope willassist the IRS as it continues to promote good governance.V. BACKGROUNDA. Scope of ReportAlthough concerns about governance cut across every part of the nonprofit sector, wefocus in this report on organizations recognized as exempt under section 501(c)(3) ofthe Internal Revenue Code. These organizations represent both the largest number oftax-exempt entities and those in which the public has the greatest stake; and most ofthe attention and discussion about governance has centered on this segment of thesector. 32We also focus on public charities rather than private foundations. Because privatefoundations tend not to rely on, and therefore not to be accountable to, governmentalunits or the general public for their source of funds or for their operations, Congresschose to restrict their conduct prophylactically through the imposition of excise taxes. 3332See, e.g., Panel Principles, supra note 13.33IRC sections 4941 (self-dealing), 4942 (failure to distribute income), 4943 (excess business holdings), 4944 (jeopardizinginvestments), and 4945 (taxable expenditures). For example, Section 4941 creates a per se prohibition on certain “self dealing”transactions between private foundations and insiders, by imposing excise taxes even if such transactions are “fair” and at arm’slength (or even more favorable to the private foundations). In passing the Tax Reform Act of 1969, which subjected privatefoundations to these harsher rules, the House Report explains: “[Y]our committee has concluded that even arm’s-length standardsADVISORY COMMITTEE ON TAX EXEMPT AND GOVERNMENT ENTITIES (ACT) June 11, 2008 12
The Appropriate Role Of The Internal Revenue Service With Respect To Tax-Exempt Organization Good Governance IssuesThus, certain significant decisions, such as those involving purchases and leasesbetween an organization and its insiders, that the law generally leaves to the discretionof the governing board of a public charity are not permitted in the case of privatefoundations. While we do not mean to suggest that governance is unimportant in thecontext of private foundations, we have chosen not to discuss them here because of thedifferent regulatory framework applicable to them.Finally, we often refer in this report to “boards” and “board members,” although ouranalysis and recommendations apply with equal force to other types of governingbodies, including those directing charitable trusts.B. What Does “Good Governance” Mean?Notwithstanding the substantial attention devoted to nonprofit governance in recentyears, analysis of the appropriate role for the IRS is hampered by the lack of a commonunderstanding of what characterizes “good governance.” The foundation for nonprofitgovernance is based on the relative behavioral standard found in the “duty of care,” inwhich board members are held to norms appropriate for similarly situated individuals,and in the standard of conduct contained in the “duty of loyalty,” pursuant to whichboard members are expected to act in the best interests of the charity. 34This conceptual underpinning, however, captures neither the mindset that characterizessuperior board governance nor the specific practices that so often serve as proxies forthat condition. We may agree that a vigilant and involved board that is continuallyeducated about its responsibilities, understands the organization and its obligations,receives in advance and reviews information necessary for decision-making, attendsand participates in meetings attentively, determines the strategic direction of theorganization, approves and oversees significant activities performed by management,adopts or causes management to adopt policies and procedures relating to areas ofsignificant vulnerability for the organization, and seeks appropriate counsel and otherexpertise when warranted is likely to result in an organization that is governed well. Butthis description does not begin to capture the lengthening catalog of procedures andpolices that are, at least according to conventional wisdom, today considered indicatorsof good governance. We predicate this report on the conviction that no list of specificgovernance practices, however comprehensive, can ever capture the attitude ofoften permit use of a private foundation to improperly benefit those who control the foundation. . . . In order to minimize the need toapply subjective arm’s-length standards, to avoid the temptation to misuse private foundations for noncharitable purposes, toprovide a more rational relationship between the sanctions and improper acts, and to make it more practical to properly enforce thelaw, your committee has determined to generally prohibit self-dealing transactions. . . .”34See, e.g., ALI Draft Nonprofit Principles § 300 (Fiduciary Duties), § 310 (Duty of Loyalty), § 315 (Duty of Care); New York Not-for-Profit Corporation Law § 715 (“Directors and officers shall discharge the duties of their respective positions in good faith andwith that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in likepositions.”); California Corporations Code § 5231(a) (“director shall perform the duties of a director, including duties as a member ofany committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the bestinterests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position woulduse under similar circumstances.”). Some states also separately recognize a “duty of obedience,” combining a general duty of legalcompliance with an obligation to adhere to the corporation’s charitable mission. See, e.g., Manhattan Eye Ear and Throat Hospitalv. Spitzer, 186 misc. 2d 126; 715 N.Y.S. 2d 575 (Sup. Ct. NY Co. 1999).ADVISORY COMMITTEE ON TAX EXEMPT AND GOVERNMENT ENTITIES (ACT) June 11, 2008 13
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