This article is from the summer 2016 edition of the Nonprofit Quarterly magazine, “The New Nonprofit Regulatory Environment: What You Should Know.”
In an extraordinary development, all fifty states, the District of Columbia, and the Federal Trade Commission filed a federal lawsuit in May 2015 against four charities and their operators, alleging that they had defrauded more than $187 million from donors.1 While the dollar amount was staggering, the most unusual aspect of the lawsuit was the incredible level of cooperation among state nonprofit regulators. This cooperation was evident not only in the bringing of the lawsuit but also in its successful settlement less than a year later, with the defendant charities and their principal officers surrendering substantial assets, agreeing to dissolution of the charities, and acquiescing to being banned from fundraising and management of charities and charitable assets in the future.2
This development highlights the growing sophistication and cooperation of state nonprofit regulators. And it is not an isolated incident. Building on seeds planted over the past several decades, state regulators are both individually and collectively increasing their oversight of nonprofits.
This trend is fortunate for those who care about oversight of nonprofits, because it comes at a time when the Internal Revenue Service’s efforts in this area are atrophying. Even before the recent controversy related to the handling of exemption applications filed by politically active nonprofits, the IRS faced a tight budget and a growing list of responsibilities, including significant rulemaking and administrative duties related to the Affordable Care Act, or Obamacare. These pressures, in turn, led to a growing backlog of applications for recognition of exemption, a decline in the already low audit rate for tax-exempt nonprofits, and limited new guidance for nonprofits seeking to comply with the complex federal tax rules applicable to them.3
The mess involving exemption applications filed with the IRS by Tea Party and other conservative-leaning groups worsened this situation in several ways, however. It accelerated the development of streamlined application procedures—including, but not limited to, the new Form 1023-EZ—that significantly reduce the level of IRS review for new organizations. It also gave Congress another reason to underfund the IRS, forced a wholesale change in the leadership of the IRS Exempt Organizations Division, and almost certainly made employees throughout that division wary of pursuing all but the most egregious violations of federal tax law. IRS examinations of annual information returns (primarily the Form 990 series) are now at an anemic level of less than four-tenths of a percent annually. This is at a time when the number of tax-exempt nonprofit organizations has grown to over one and a half million—not including churches and other houses of worship that are not required to seek such recognition from the IRS.
So, what have state nonprofit regulators been doing during this time of decline in IRS oversight? Individually, many of them have been working hard to review and improve their laws and procedures governing nonprofits, as well as increase efforts to reach the regulated community and those who advise that community.
Individual State Initiatives
In the wake of the Enron disgrace and other scandals that rocked the for-profit sector, California enacted the Nonprofit Integrity Act of 2004 to improve the governance procedures and enhance the filing requirements for charities, other nonprofits that hold funds for charitable purposes, and commercial fundraisers.4 Significant new requirements included in the act are a shortened period for registering with the attorney general (thirty days after the initial receipt of property); mandatory audited financial statements and detailed audit-committee requirements for charitable corporations with gross annual revenues of $2 million or more; mandatory board or board committee review of senior officer compensation; and numerous additional filing requirements for commercial fundraisers.
In 2013, New York enacted the Nonprofit Revitalization Act based on recommendations from Attorney General Eric T. Schneiderman’s Leadership Committee for Nonprofit Revitalization, made up of representatives from the New York nonprofit community.5 The act sought to relieve burdens on that community by reducing the number of categories for nonprofit corporations under New York law, simplifying certain formation procedures, and increasing revenue thresholds for certain auditing requirements. It also imposed enhanced corporate governance standards—including those relating to conflicts of interest, related party transactions, whistle-blowing, and financial audits—and gave the attorney general increased enforcement authority. More specifically, the act requires a written conflict of interest policy (with certain provisions for boards of all nonprofit corporations), mandates certain procedures for related party transactions, and requires a whistle-blower policy for nonprofit corporations with twenty or more employees and over $1 million in annual revenue. New York also recently announced a project to systematically review its registration and financial filing procedures for charities and fundraising professionals.6
These efforts are in addition to the increasing availability of state nonprofit filings through Internet-accessible databases, prominent announcements of investigations into alleged wrongdoing by nonprofits, and required annual reports detailing the high fundraising costs of certain nonprofits. On the latter point, examples include California’s commercial fundraisers reports, Massachusetts’s Report on Professional Solicitations for Charity, and New York’s Pennies for Charities report. In addition, state regulators have been working to enhance the other information available on their websites, providing an increasing number of plain-language guides on topics ranging from formation to fiduciary duties to dissolution. State regulators have also become regular presenters at many conferences focused on nonprofit legal issues, including meetings of the Exempt Organizations Committee of the American Bar Association, Section of Taxation; the Georgetown Law Representing and Managing Tax-Exempt Organizations conference; and the Loyola Law School Western Conference on Tax Exempt Organizations.
At least one state has taken a more innovative approach to combating what it perceives as unduly high fundraising expenses: An Oregon statute now disqualifies charities from eligibility to receive contributions that are tax deductible for purposes of Oregon’s income tax and corporate excise tax if program expenses fall below 30 percent of total annual functional expenses for the most recent three-year period. In December 2015, the Oregon Department of Justice announced the first three nonprofits to fall afoul of this rule; it remains to be seen whether any of them try to challenge their disqualification in court.7
States and localities have also become increasingly active in challenging the often very valuable property tax exemptions enjoyed by many nonprofits. These disputes have involved Princeton University; the Shrine of Our Lady of LaSalette, in Attleboro, Massachusetts; dozens of hospitals; and property owned by numerous other types of nonprofits.8 With no relief in sight for many state and local government budgets, these challenges show no signs of ebbing.
At the same time, state nonprofit regulators appea