The International Journal
of Not-for-Profit Law

Volume 6, Issue 3, June 2004

By John H. Graham IV*

On May 1, 2002, New York State Attorney General Eliot Spitzer delivered an address to an assembly of the state’s top legal minds entitled “The Crisis of Accountability.” He took note of a pervading corporate crisis in America, an environment in which established institutions had failed to abide by proper standards and had engaged in an “ever-increasing opaqueness” toward the public that destroyed their trust and credibility when inappropriate conduct was finally exposed.

Spitzer’s speech was timely, given the investigations and media interest then in Enron, Arthur Andersen, and several other large corporations. But the speech was notable for another reason as well, in that it provided the first indication that Spitzer’s office wanted to extend new federal corporate accountability laws (also known as the Sarbanes-Oxley Act) to charities and other nonprofits—a sector that has traditionally been self-regulating or, at the very least, has operated in a culture quite distinct from that of corporate America. Specifically addressing nonprofit governance, Spitzer said: “We need to insist that our charitable and not-for-profit organizations are led by directors who understand the nature of their responsibility—which is to achieve their charitable mandate, and to lead their organizations—and not merely to act as rubber stamps for entrenched staff members.”

Most important in Spitzer’s address was the assertion that the institutional reputations of nonprofits were very much at stake in relation to their decisions about transparency and governance. The messages were and are clear: the passage of the Sarbanes-Oxley Act represents a huge wake-up call for businesses, publicly traded or otherwise; and nonprofits cannot afford complacency in the area of governance, regardless of whether the legislature in New York or any other state elects to extend governance standards to nonprofits.

The thousands of associations and nonprofits in existence today are operating in a new environment. Not only are we accountable to members, donors, and volunteers—our key stakeholders—but there’s an increasing level of attention on nonprofits coming from Congress, from regulators, from attorneys general at the state level like Spitzer, and from the general public, who need to be reassured that the organizations they support as members and donors are being managed in the most efficient, forthright manner possible.

In my career as an association executive, I have been involved in two major organizational transitions that illustrate the importance of responsible governance and accurate and open communication. The first was in my role as president and CEO of the American Diabetes Association (ADA) in Alexandria, Virginia, in the 1990s. When I took over as chief staff executive, the ADA was a conglomeration of 53 independent, separately incorporated affiliate organizations. My vision and the vision of the association’s volunteer leadership was to transition the organization into one nationwide organization. This required changing ADA’s business plan, budgeting process, and culture to improve its efficiency and respond to new opportunities and challenges. It would have been impossible to get the “buy-in” we needed from members and volunteers to go forward with these organizational changes without transparency on our part and assurances that we were acting responsibly and in the best interests of the organization.

Similarly, since joining the American Society of Association Executives (ASAE) in August 2003, I have been part of discussions with the Greater Washington Society of Association Executives (GWSAE) that have resulted in a proposal to consolidate four existing entities (ASAE, the ASAE Foundation, GWSAE, and the Center for Association Leadership) into two organizations: ASAE and the Center for Association Leadership. The parties believe the consolidation can greatly benefit the association community by combining the market strength, history, ideas, and innovation of the organizations involved; by eliminating unnecessary competition in the Washington, D.C., marketplace; and by allowing ASAE to focus on its programming and services at the national level, all while maintaining the culture, educational opportunities, and dynamic network for association professionals in the Washington region. All of the parties are sensitive to the concerns and questions that such a proposal raises within the membership of the organizations and in the association community at large. Through a series of town halls and regular communications to members and business partners, we have attempted to be as forthright and communicative as possible so as to give our stakeholders every opportunity to tell us what they think about the concept, to let them know where we are in the process, and to demonstrate that we absolutely are engaging in due diligence and hold the best interests of these organizations and their members foremost in our minds.

Regardless of whether organizational changes are afoot, however, we’re seeing increased attention to nonprofit governance on several fronts in the business arena post-Sarbanes-Oxley. Since the summer of 2003, when the Washington Post published a series of articles questioning the land sales and other activities of the Nature Conservancy, Senate Finance Committee Chairman Charles Grassley and ranking Democrat Max Baucus have been investigating the activities and governance structures of several charities and foundations. There is also growing support for legislation increasing Internal Revenue Service (IRS) scrutiny of charitable donations and in-kind gifts. A General Accounting Office report released in late 2003 indicated that charities receive only pennies on every dollar from the donation of used cars and that the tax breaks for such donations cost the government millions of dollars per year.

We also anticipate that the IRS will soon make public its first three market segment studies, conducted in 2002. Between 100 and 150 501(c)(6) trade associations, 501(c)(5) labor unions, and 501(c)(7) social clubs were randomly chosen by the IRS to provide detailed information about their compliance and their use of IRS resources. The IRS clarified last year that the market segment studies were not undertaken in response to any perceived noncompliance on the part of the exempt community and should not be considered formal audits, but were necessary to capture a snapshot of the activities and compliance levels of the organizations.

At the state level, meanwhile, New York Attorney General Spitzer has been active in investigating conflicts of interest on Wall Street, and he remains a proponent of legislation to extend provisions guarding against financial fraud and abuse to nonprofits. Although it was not acted on last year, we expect this bill will see some attention in the New York State Senate in 2004. Massachusetts Attorney General Thomas F. Reilly has also drafted legislation modeled on Sarbanes-Oxley that would give his office more corrective authority in instances where financial abuses are discovered at foundations and public charities. California Attorney General Bill Lockyer has proposed similar legislation strengthening the state’s oversight of nonprofits and commercial fundraisers.

Recent comments by House Ways and Means Chairman Bill Thomas also bear watching. Recently, Thomas told those attending the Federation of American Hospitals’ annual meeting that a broader examination of what organizations do to deserve exempt status under the federal tax code might be in order. He specifically singled out 501(c)(3)s, (c)(4)s, and (c)(6)s in saying that taxpayers need to know what these organizations provide in exchange for tax-preferred status. No hearings have been planned on this issue yet, but these comments certainly get ASAE’s attention.

When you read comments like this, it’s apparent that ASAE and others need to do a better job of communicating the value of associations and of other charitable, scientific, and educational organizations with exempt status to key audiences. Congress first gave associations favored tax treatment largely in recognition of the public benefit derived from their activities—the theory being that the government is compensated for any loss of tax revenue by its relief from the financial burden of undertaking standards-setting, skills training, community service, research, and other essential functions performed by nonprofits. In other words, associations and other nonprofits earn their exempt status by meeting needs of the general public that the government would otherwise be forced to meet.

It will be interesting to see how broad a look Congress will take at exempt organizations, but the fact that Congressman Thomas singled out (c)(3)s, (c)(4)s, and (c)(6)s is notable. As we all know, there are already strict statutory requirements for exempt organizations, and the IRS routinely denies exemption when the standards are not met. Currently, the tax law provides that associations are exempt from federal taxation on income earned in the performance of their exempt purposes. For many years, however, they have been subject to federal corporate income tax on revenues from activities unrelated to their exempt purposes. The unrelated business income tax rules were designed to prevent tax-exempt organizations from gaining an unfair advantage over competing, for-profit enterprises in business activities unrelated to those for which tax-exempt status was granted.

As recently as 2000, budgetary proposals have been made to tax 501(c)(6) trade associations’ “passive” income—income from sources such as rents, royalties, interest, dividends, capital gains, etc., that these organizations use to further their purpose by maintaining modest reserve funds to ride out economic swings, saving for necessary capital expenditures, and the like. ASAE testified against this investment income tax in 1999 and 2000 before the same Ways and Means Committee currently chaired by Congressman Thomas, and fortunately, the proposal never really found a sympathetic ear in Congress.

What the investment income tax proposal did show us is how the structure and operation of tax-exempt organizations can be misunderstood, particularly in the search for new revenue sources. Proponents of the tax claimed that association members were receiving a double tax advantage by deducting dues or similar payments to trade associations, and at the same time avoiding paying taxes on investment income by having the association invest their dues surplus tax-free. In other words, the implication was that members voluntarily paid higher dues than necessary as an investment strategy, and these associations paid dividends or returns in some form to their members. We all know how flawed that argument is. Nonprofits by their very definition are barred from distributing any part of their net earnings to individuals, and their earnings must be dedicated to furthering their exempt purpose. There are no shareholders in a nonprofit, and there are no dividends. There is no tax benefit to those who pay dues to associations.

It would be alarmist at this point to suggest that Congressman Thomas’s comments are aimed at retooling the requirements for exempt status. But what we will say is that we welcome any opportunity to provide examples of what tax-exempt organizations do in exchange for their tax treatment. If the overarching question is whether society stands to gain or lose by the elimination of tax exemption for associations, the answer is unequivocally that we would all lose. An enormous number of programs and services now offered by associations would be in danger if such a change in the law were considered.

If association programs were discontinued, it would fall to the government to step in and perform many of the functions performed by private nonprofits—functions that are increasing for America’s tax-exempt community. At a time when legislators and the Administration grapple with record federal budget deficits, it seems ill-advised to place any of these vital programs and services in jeopardy.

Nonprofits of every stripe need to be sensitive to the mounting concerns about governance and transparency. In January 2004, ASAE and the New York Society of Association Executives hosted a first-ever National Consensus Conference on Nonprofit Governance in New York City. The National Consensus Conference was developed as a forum for leaders in the nonprofit community to address the increasing attention being given to their organizations’ governance standards, and to discuss ways to voluntarily enhance their own fiduciary practices and accountability to members, donors, grantors, and other stakeholders.

Although most nonprofits operate responsibly, the sector has not been untouched by well-publicized instances of fiscal mismanagement and ethical abuse. There was a general consensus at this conference that the adoption of governance standards or “best practices” that ensure transparency of decision-making, accurate financial reporting, and use of accepted auditing procedures would reduce instances of scandal and crisis in the nonprofit community and protect the public trust that is essential to member-, donor-, and grantor-based organizations.

ASAE will soon publish a white paper that summarizes some of the wonderful dialogue that took place at that meeting and, one hopes, provides direction for organizations already weighing adoption of new governance approaches. Independent Sector recently adopted a Statement of Values and Code of Ethics for Nonprofit and Philanthropic Organizations, which is also intended as guidance for nonprofits and foundations nationwide. Independent Sector President and CEO Diana Aviv was kind enough to participate in our National Consensus Conference as a panelist, and I applaud her and Independent Sector for urging all nonprofits and foundations to adopt a code of ethics to guide their governance and operations.

If we are to safeguard our tax status, our credibility, and by extension our programs and services that help so many people, we must take every step we can toward effective stewardship, and we must continue to tout the value and the role of this nonprofit community to different audiences. Our survival truly does depend on it.

Notes

* John H. Graham IV is President and CEO of the American Society of Association Executives (ASAE) in Washington, D.C. Copyright 2004 by John H. Graham IV.