Paper : Three

This is just to prove the point in my last post about being able to write well. It is also in honor of school starting again in less than a week. (AHHHH!)

Calla Wright
M.O.B.
Prof. John Clinton
17 December 2008

Ethical Financial Management:
The Nonprofit Sector and Government Regulation

Abuse of the privileges granted charitable organizations, while perpetrated by a small number of individuals and organizations, threatens the work of the entire sector and may diminish the generosity of donors.

- The Panel on the Nonprofit Sector (June 2005)

Introduction

The nonprofit sector is often held to higher ethical standards than the for-profit sector; without a clear mission, and a transparent operating system, nonprofit organizations would struggle to gain and to retain donor and volunteer support. Donors give because they believe their gifts are going to charitable causes through a reputable organization. If the ethics of an organization are called into question, donor support will likely cease; donors are unwilling to give if they are not sure that their gifts are going to charity, and if they must give through a reputably questionable organization. Without the proper funding, nonprofits have no means of operation. This is why, especially with their financial planning and implementation, it is vital that nonprofits remain ethical.

Ethics and Financial Management
Ethics

King (2004) described ethics as “a systematic reflection on morality. It uses specific methods and approaches to examine moral situations, and questions assumptions about existing components of moralities. It is meant to give answers to questions about how men and women should act in certain situations” (p. 131). In order to make these judgments on morality, society must have a universal idea of what values make up ethics. Beauchamp and Childress penned four basic principles of ethics: autonomy, beneficence, justice, and beneficence. Autonomy involves understanding that every human being and every organization is capable of making his/her/its own decisions. Justice requires one to be fair and nondiscriminatory. Beneficence is the promotion of human welfare. And non-malfeasance requires one to do no harm and to protect others from harm (as cited in Benner, 2005). These four dimensions should be used in the operation of nonprofit organizations. The dimensions should govern the organization’s mission, frame the organization’s code of ethics, drive the delivery or service, and facilitate the day-to-day operations.

Financial Management

Financial management is valuable to all organizations and to all people. Service-providing nonprofits need to be especially careful of their financial situation, and be certain to treat their organization as a business. Monks (1995) listed many tools and methods organizations can use to ensure sound financial management. These include the break even point analysis¬––this is the point where the contribution margin equals the fixed cost, forecasts–– using current data to plan for the future, benchmarking–– measuring current activities against best recorded level of performance, budgets––an instrument through which operations can be quantified, and reporting.

Ethical Financial Management

The Panel on the Nonprofit Sector (2007) organized the principles of ethical governance into four main categories: (1) Legal Compliance and Public Disclosure, (2) Effective Governance, (3) Strong Financial Oversight, and (4) Responsible Fundraising (p. 3). Within these categories are more specific suggestions for proper ethical management. Some of the ethical issues are related to finance, though the Panel included best practices of various kinds throughout the report.
The list of legal compliances and public disclosures includes “responsibilities and practices . . . that will assist charitable organizations in complying with their legal obligations and providing information to the public” (Panel on the Nonprofit Sector, 2007, p. 3). According to the Panel, these include implementing a code of ethics with which all staff and volunteers are familiar, adopting whistleblower policies, implementing procedures to handle conflicts of interest, establishing policies to preserve important business documents, and ensuring that all applicable laws are followed (pp. 8 -11). The suggestions relating to finance included making sure that adequate plans are in place to protect the organization’s assets, and making the organization’s financial records available to the public (pp. 11,12).
Effective governance refers to the governing responsibilities of the board of directors. It is a list of suggestions that, if followed, would assure the board could effectively fulfill its oversights and governance responsibilities. These include, but are not limited to, scheduling regular meetings for board members, establishing an effective board size, including diverse members on the board, keeping a substantial majority of the board independent of the organization, and evaluating the performance of the CEO. Financially speaking, the board should expect to serve without compensation. Additionally, a governing body is needed who can “review the organization’s annual budget, key financial transactions, compensation practices and policies, and fiscal and governance policies” (Panel on the Nonprofit Sector, 2007, pp. 13-19).
Having strong financial oversight means wise stewardship (Panel on the Nonprofit Sector, 2007, p. 3). This means a board must “keep complete, current, an accurate financial records” (Panel on the Nonprofit Sector, 2007, p. 3). Also, the board must ensure that the organization invests funds responsibly and legally, that the organization does not provide loans to trustees, directors or officers, that a significant percentage of the budget is being spent on programming, and that the organization does not reimburse expenses incurred by spouses, children, etc. when such a person is accompanying someone who is on business. (Panel on the Nonprofit Sector, 2007, pp. 20-23).
Responsible fund-raising includes gaining donor and community trust and support (Panel on the Nonprofit Sector, 2007, p. 3). To ensure the trust of donors, organizations must (1) be honest and accurate with solicitation materials, (2) honor the donor’s intent, (3) provide donors with acknowledgements of their contributions, (4) accept only those gifts which are ethically sound, (5) provide training for those soliciting funds, (6) refuse to compensate fundraisers by commission, and (7) respect the privacy of all donors. (Panel on the Nonprofit Sector, 2007, pp. 24-27).

Government Regulations and Oversight
Purpose

In June 2005, The Panel on the Nonprofit Sector released a report in which they summed up the necessity of government regulations in the nonprofit sector and a put forth a list of recommendations for improved oversight. The Panel explained, “Regulation is necessary for those situations where the sector cannot reasonably be expected to deal with those who deliberately abuse the public trust and exploit nonprofit organizations for personal gain, and new regulation may be needed where current legal standards have proven inadequate” (p. 25). Among the many issues with which the Panel was concerned were
• Charitable entities being used to benefit the donor instead of being used for a charitable purpose
• “Abusive credit counseling organizations”
• Taxpayers overstating their contributions
• No consistent method for determining the compensation of executives (p. 13)
Government intervention is often needed in order correct the ethically questionable practices listed above. This is one of the ways the integrity of the nonprofit sector can be tested.
Though government oversight is needed, it also must remain balanced. It is the government’s responsibility to ensure regulations are followed and “deter abuse without discouraging legitimate charitable activities” (Panel on the Nonprofit Sector, 2005, p. 21). In other words, regulations must be understanding of the great diversity within the nonprofit sector; laws must be specific enough to allow all organizations to function to their fullest capacity while curtailing abuses that may occur. It is beneficial to have laws apply to specific kinds of organizations rather than to the sector as a whole.
The Panel on the Nonprofit Sector (2005) offered other pieces of advice involving oversight. As a means of utilizing thin resources to their fullest degree, Federal and State officials should communicate to ensure that duplication in oversight is not occurring. Additionally, since there is a large amount of size in the nonprofit sector, government must ensure that laws and requirements for smaller organizations are not financially overwhelming. Lawmakers “must refrain from adopting regulations where the costs of demonstrating compliance outweigh the benefits gained” (p. 22).

Examples

The government already has a degree of control over the nonprofit sector, as they do over any sector. Nonprofit organizations must comply with all applicable laws, be they regulations directly related to the nonprofit sector or broader regulations related to all organizations. There are a number of requirements that pertain only to nonprofits. These include, but by no means are limited to, how an organization (1) files with the IRS, (2) compensates its executives, (3) pays for travel expenses, (4) differentiates between tax exempt and taxable entities, and (5) uses donor advised funds.
Nonprofit organizations are required to file Forms 990, 990 -EZ or 990-PF. The 990 includes information about the organization’s operations, programs, finances and governance. If an organization fails to file or files their form with missing information, the IRS may penalize the organization monetarily. These annual information returns are made available to the public on such websites as guidestar.org (Panel on the. Nonprofit Sector, 2005, pp. 28-31).
Nonprofit organizations are allowed to pay their executives only what is “reasonable.” However, as the Panel on the Nonprofit Sector (2005) explained, “reasonable compensation is defined as the amount that would ordinarily be paid for like services by like enterprises . . . under like circumstances” (p. 68). Public charities are encouraged, under current regulations, to have the board set or approve the executive’s salary. This gives nonprofits a lot of flexibility under the law, though they must remain cautious of any public damage that could come to their reputation. For-profit entities may be able to pay their executives lush salaries. This may be seen as unethical in any sector. However, in the nonprofit world it is also dangerous; donors expect their gifts to go to a charitable cause, not to pay an immoderate salary, and may stop giving. (Panel on the Nonprofit Sector, 2005, pp. 66-72).
Travel expenses in the nonprofit sector may be reimbursed as long as there is documentation that such expenses where incurred in connection with work, and as long as these expenses are not “lavish or extravagant.” Any expense that is not documented is treated as taxable income for the recipient of the expense. This then must be reported to the IRS. (Panel on the Nonprofit Sector, 2005, pp. 73, 74)
Organizations with the tax codes 501(c)(3), 501(c)(4), and 501(c)(6) do not pay taxes on income as long as the income is related to their charitable missions. The key words here are “related to their charitable missions.” Nonprofits do need to pay what is called an unrelated income tax. If there is a commercial trade unrelated to an organization’s charitable purpose that is regularly carried on (i.e. maintaining a gift store at a museum), the profits from this are classified as unrelated business income. If a ‘substantial’ amount of income comes from unrelated business ventures, a charities tax-exempt status is called into question. There are two exceptions to this rule. If the commercial trade is staffed entirely by volunteers, the organization may be exempt from the unrelated business income tax. Additionally, at the federal level, any income an organization receives from renting out unutilized space is exempt from the unrelated business income tax. However, these tax laws about rental space vary from state to state. (Simon, Dale & Chisolm, 2006).
Some funds which organizations acquire come in the form of “donor-advised funds.” This means that the donor gives a gift with directions on how it should be used. According to Brody, “a charity is legally bound to honor donor restrictions, no matter how confident are the parties that a better use could be made of the funds.” (p. 253). However, the nonprofit can always petition the court to modify the restriction (Brody, 2006, pp. 253,54).

Supporting Organizations

During the remainder of this paper, I will examine a specific incident of government oversight in detail. I will be focusing on Type III supporting organizations and (1) what they are, (2) why they became a popular alternative to private foundations, (3) some of the abuses which took place prior to law reform, and (4) the 2006 Pension Protection Act’s relation of Type III supporting organizations.

What Are Supporting Organizations?

A Supporting Organization (SO) is a public charity similar to a private foundation–– It makes grants to, or performs the operations of, other public charities. Supporting Organizations are divided into three different types based on the relationships they have with the charity/ies they support.
Type I SOs have the closest relationship to their supported charities. They are “operated, supervised or controlled by” the supported charity “in a parent/subsidiary relationship.” Often the two have overlapping boards or the SO has board members who are appointed by the supported charity.
Type II SOs are “supervised or controlled in connection with” their supported charities in “brother-sister relationship[s].” The same person or entity controls both the SO and the supported charity.
Type III SOs are “operated in connection with” their supported charities. Since these SOs have a greater degree of independence from their supported charities than Type Is and Type IIs have, Type IIIs are subject to greater controversy and potential abuse. (Council For Advancement and Support of Education (CASE), 2007, p. 2).

Popularity

In the 1990s, the number of supporting organizations doubled from 13,000 in 1989 to 26,000 in 1998, while private foundations only rose about 50%, from 42,000 to 64,000 (Bostwick, 2003). The reason for these disproportionate growth rates, as Bostwick wrote in his 2003 article in Trusts & Estates, was the overwhelming advantages of organizing as a Type III SO as opposed to a private foundation. He told readers of “a technique that allows private foundations to be converted relatively quickly into SOs—the Supporting Organization Accelerated Roll-over—or SOAR.”
Bostwick (2003) continued to list, for his wealthy readers, the superiority of Type III SOs: “Probably the most striking advantage of the SO are the freedom from the various and extensive regulations and private foundation excise taxes and increased deductibility thresholds for charitable contributions.” He also stated that “Although SOs are scrutinized by the Internal Revenue Service, they are, by virtue of their independent status, free to use flexibility and judgment of their independent board to invest in, and consider relationships, that private foundations are prohibited from considering.” Additionally, though independent bodies must govern SOs, Bostwick pointed out that “populating a board with a donor’s brothers and sisters may satisfy the ‘independent’ requirement.”
This article exemplifies the attitudes of many Type III SO founders. Founders are not necessarily looking for a means to perform charitable tasks. Rather, some are looking for loopholes in the tax code, or ways to convert their private foundations into organizations with fewer restrictions. Thus, it comes as no surprise that Type III SOs do not have the utmost ethical reputation.

Abuses

Type III SOs are regularly accused of financial mismanagement. Prior to the Pension Protection Act of 2006, it was easy for Type III SOs to make almost no charitable contributions, as the organizations were not subject to minimum payout requirements. Additionally, Type III SOs were not subject to excess business holding rules, and were often under suspicion for engaging in transactions that effectively return donated money back to the donor, known as “round-tripping,” and for making large loans, usually interest-free, to the donor or family members of the donor (Dade Community Foundation, 2005, p. 3; Bostwick, 2003; Strom, 2005; Leibell & Daniels, 2005).
Furthermore, donors often retain control over their gifts, which they donate as donor-advised funds. Langley (1998) wrote about the abuses of Carl Icahn, Gerry Spence and David Cammack. Her article appeared in the Wall Street Journal in 1998, over eight years before congress would take measures to reform the behaviors of Type III SOs.
Billionaire Carl Icahn put $100-million worth of stock into an SO he created in 1997 called the Foundation for Greater Opportunity. He thus received the tax advantage of a public charity and avoided a capital gains tax while retaining control of the stock. As of April 2005, the SO had spent $2.9-million total; this is half the amount the Foundation for Greater Opportunity would have been required to pay in a single year as a private foundation (Langley, 1998; Strom, 2005).
The defense lawyer Gerry Spence donated his 220-acre ranch to his Trial Lawyers College, the main charity supported by his SO. Yet, Spence continues to essentially own the ranch, stating, “I don’t understand what I’ve done . . . We conveyed the ranch to a charitable whatever-it-is.” He followed the advice of his financial advisers, but does not see how this donation impacts his relationship with the ranch (Langley, 1998).
David Cammack, a real-estate investor and antique car enthusiast, is also among those who benefited from the Type III SO. He maintains the rights to decide when, where and how the cars, which he has donated to a museum, are displayed. With demands that the cars only be displayed after a “Cammack family wing” is built, the cars were still sitting in Cammack’s own garage after the donation was made and tax deduction received (Langley, 1998).
All of this has not gone unnoticed, and in the summer of 2004 the leadership of the U.S. Senate Finance Committee conducted a hearing and a roundtable discussion on oversight and reform. The Committee followed with additional hearings in April and June of 2005. (Panel on Nonprofit Sector, 2005, p. 13) Part of what was heard during these additional hearings was related to the Dixie and Anne Leavitt Foundation. Mike Leavitt, Health and Human Service Secretary, is part owner of this Type III SO. Since this was a high-profile case, it helped with the push for reform (Weisman, 2006; Berkes, 2006). Below is a list of some of the ethically questionable financial decisions the Dixie and Anne Leavitt Foundation have made.
• In the years 2002, 2003 and 2004 the SO donated less than 1 percent of its assets to charitable causes (Weisman, 2006).
• The foundation assets have been used for loans to the family and other family companies, such as a $332,000 loan to Leavitt Land and Investment Inc. (Weisman, 2006).
• The Dixie and Anne Leavitt Foundation put over half a million dollars in a housing scholarship program at Southern Utah University. A tax deduction was received and then all the money was effectively returned. Students were placed in housing units owned by Cedar Development Company, another Leavitt family business. The Leavitt’s thus received the rent they had donated to the University back from the University (Berkes, 2006). (This is an example of what is called “round-tripping.”)

The Pension Protection Act of 2006

On August 17, 2006 The Pension Protection Act of 2006 (PPA) was signed into law, and Type III SOs lost some of their appeal; the PPA took many measure to close their extensive loopholes. CASE (2007), and Flynn and Fleming (2008) explained what the PPA meant for Type III SOs. Foremost, the PPA divided Type III SOs into two distinct categories, those “functionally integrated” (Type III FI-SO) and those “non-functionally integrated” (Type III NFI-SO). The basic difference is implied in the new names; to receive “functionally integrated” status, an SO must pass a test showing it is an "integral part" of the supported charity. The PPA has stricter requirements and limitations for Type III NFI-SO than for their functionally integrated counterparts, though some new rules apply to all Type III SOs regardless of their integration status. All of the restrictions serve to ensure that Type III SO status is no longer desirable over Private Foundation status; the perks have been removed for those NFI-SOs.
Type III NFI-SOs are now prohibited from receiving donations from persons controlling supported charities, subject to minimum annual payout requirements of 5 percent, and subject to an excess business holding rule similar to that of private foundations (CASE, 2007; Flynn & Fleming, 2008; Leibell & Daniels, 2007).
All Type III SOs, regardless of their integrations status, are now required to provide notifications to supported charities in order to enable the supported charities to monitor the responsiveness of their SOs, prohibited from supporting foreign organizations as this is how much of the round-tripping was occurring, and required to include a list of supported charities in their Form 990 so the public can see to where or whom the SO’s charity is going (CASE, 2007; Flynn & Fleming, 2008; Leibell & Daniels, 2007).

Conclusion

Ethical financial management is a complicated subject. In order to maintain an ethically sound and financially stable nonprofit, board responsibilities, responsible fund-raising techniques, complete financial oversight policies, and legal obligations must all be considered. This is something that can only be achieved with ongoing commitment not only from board members, paid staff, and volunteers of a given organization, but with support from the entire nonprofit sector. It takes but one scandal to threaten the credibility of the whole nonprofit community. A strong commitment to ethical financial management should be priority for any organization.

References

Benner, P. (2005). Honoring the Good Behind Rights and Justice in Healthcare When More Than Justice is Needed. American Journal of Critical Care. 2005;14 (pp 152-56). Retrieved December 2, 2008 from .
Berkes, H. (2006, July 28). All Things Considered. NPR. Retrieved November 8, 2008 from http:///www.npr.org/templates/story/story.php?storyId=5590281
Bostwick, J. (2003, January). Choose supporting organizations. Trusts & Estates, 142(1), 25-31. Retrieved December 2, 2008, from ABI/INFORM Global Database. (Document ID: 286016051).
Brody, E. (2006). The Legal Framework for Nonprofit Organizations. In W. W. Powell & R. Steinberg (Ed.), The Nonprofit Sector: A Research Handbook (2nd ed.). (pp. 243-266). New Haven, CT: Yale University Press.
Council For Advancement and Support of Education. (2007, April 2). Supporting Organizations. (pp. 1-7). Washington D.C.: Author.
Dade Community Foundation. (2005, December). Type III Supporting Organizations. Professional Notes: Legislative Reform Chapter II. (p. 3).
Flynn, D. M., Fleming, N. A. (2008, June). Private Foundation or Public Charity? Type III Supporting Organizations After the PPA. Journal of Taxation. (pp. 365-372).
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Langley, M. (1998, May 29). Gimme Shelter: The SO Trend: How to Succeed in Charity Without Really Givng –– A ‘Supporting Organization’ Lets Wealthy Donate Assets, Still Keep Control –– Carl Icahn’s School Project. Wall Street Journal (Eastern Edition), p. A1. Retrieved November 18, 2008, from ABI/INFORM Global Database. (Document ID: 29774077).
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Leibell, D. T. & Daneils, D. L. (2007, September). TYPE III SO NOOSE TO TIGHTEN. Trusts & Estates, 146(9), 16,18. Retrieved November 8, 2008, from Research Library database. (Document ID: 1328759261).
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Monks, J.G. (1995) Schaum's Outline of Theory and Problems of Operations Management. New York: McGraw-Hill Professional.
Simon, J, Dale, H. & Chisolm, L. (2006). The Federal Tax Treatment of Charitable Organizations. In W. W. Powell & R. Steinberg (Ed.), The Nonprofit Sector: A Research Handbook (2nd ed.). (pp. 267-306). New Haven, CT: Yale University Press.
Strom, S. (2005, April 25). Big Tax Break Often Bypasses Idea of Charity. New York Times, p. A1. Retrieved December 2, 2008 from lexisnexis.
Weisman, J. (2006, July 21). HHS Secretary’s Fund Gave Little to Charity. Washington Post. Retrieved November 18, 2008 from http://www.washingtonpost.com/wp-dyn/content/article/2006/07/20/AR2006072001906_pf.html.

As always, I am too lazy to fix all the references and paragraphs, etc. DEAL WITH IT. (or comment that you want me to e-mail you the paper as a word document or something super strange.)