January 2008

With increased enforcement by the IRS and state charity regulators, renewed Congressional interest in investigating just what it means to be a charity, and continuing media stories highlighting some nonprofit abuses, the Panel on the Nonprofit Sector (convened by Independent Sector) published Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations in October to help guide charities in these sometimes difficult times. What's in this report that you need to know?

The Panel list of principles and practices attempts to strike a balance—listing what nonprofits must do (legally required) and adding recommendations on what they should do. Although some find the Panel's format of "recommendations" too weak to establish the system of self-regulation needed to bolster public confidence (see comments by Peter V. Berns in the November 1, 2007, Chronicle of Philanthropy, for example), others find this report a positive beginning step.

The Panel's 33 principles include 6 required by law and another 27 that charities should consider adopting if they make sense based on their legal status, operational structure, and purpose. The focus on accountability and transparency is not going away, and this compilation by the Panel shows how charities can improve their governance themselves, without the addition of more federal and state laws.

First, a review of the Panel principles described as legal requirements:

Principle #1—Comply with all applicable laws and regulations—federal, state, local, and international. Check out IRS's Stay Exempt Web Site for guidance from the IRS about what is required.

Principle #3—Have policies and procedures for conflicts of interest. Charity regulators require that board members and staff disclose any interest in a transaction or action that could be viewed as affecting their objectivity or independence. First, any potential conflicts should be disclosed. Then there should be policies to deal with them transparently. If a board member has a material conflict of interest, the law requires that he/she not discuss or vote on the issue. An Internet search will provide sample conflict-of-interest policies to use as a model.

Principle #21—Keep complete, current, and accurate financial records, preferably audited or reviewed by a qualified independent financial expert. State laws vary on the sizes and types of organizations that are required to have audits or reviews by an outside accountant, so check on your state's requirements. Creating an audit committee of board members (including some with financial expertise) helps reduce a possible conflict of interest between the paid staff and the outside auditors.

Principle #25—Establish clear written policies for paying or reimbursing business or travel expenses. The IRS does not want to see "lavish, extravagant, or excessive expenditures." A review of IRS Publication 463, "Travel, Entertainment, Gift, and Car Expenses," can help you write your reimbursement policies.

Principle #26—Do not pay for expenses or reimburse travel for spouses, dependents, or others who accompany someone conducting business for the charity. This restriction doesn't apply for small costs (such as a meal) or if the person is also working on charity business.

Principle #27—Be accurate and truthful in your solicitation materials. What you need to address is covered in A Donor Bill of Rights, developed by the Association of Fundraising Professionals.

Whereas all nonprofits must adhere to the six principles above, there are a number of additional practices that will help ensure that charity regulators won't be focusing on you. The IRS is looking at compensation and benefit levels for nonprofit executives these days and actually assessed nonprofits over $21 million in fines in 2007. Adopting some of the other recommendations in the panel's list can help you deal with regulator and media questions.

Here's a review of the principles that relate to compensation and benefits—often sensitive issues with board members, federal and state regulators, the media, and the public.

Principle #8—Have a governing body responsible for reviewing and approving the organization's mission and strategic direction, annual budget and key financial transactions, compensation practices and policies, and fiscal and governance policies. Not being responsible about compensation can cost money—in fact, the IRS's Executive Compensation Initiative Project report concluded that there was need for "a continued enforcement presence in this area."

Principle #12—Have a substantial majority of independent board members. Board members should not be compensated as employees or independent contractors. They should not have compensation determined by individuals compensated by the organization, not receive material financial benefits, and not be related or residing with those who are not independent.

Independent judgment is required of board members, and the organization's interest must be placed above personal interests. Thus, most individuals on the board should be free of financial conflicts of interest.

Principle #13—The Board should hire, oversee, and annually evaluate the performance of the CEO and conduct an evaluation prior to any change in compensation. This is the board's responsibility, and the IRS guidance is clear:

1. Set compensation in advance using appropriate comparability data.
2. Make sure no one involved in setting the salary has a conflict of interest.
3. Document decisions on compensation.

The IRS regulations call for "reasonable" compensation—the amount that would be paid for "like services" by "like enterprises" (could be taxable or tax-exempt), under "like circumstances." Small organizations should have at least three comparables, and the IRS implies that larger organizations should have more than three.

Principle #20—The Board should serve without compensation. If compensated, use appropriate comparability data to determine the amount to be paid. Because compensating board members is unusual, detailed documentation is necessary if a charity does more than reimburse expenses. If board members are setting their own compensation, they clearly have a conflict of interest, so use an independent data source.

The panel principles outlined above provide a blueprint for good compensation practices that keep an organization in legal compliance and also strengthen transparency and ethical standards.

Just document the compensation decisions, ensure that those with conflicts of interest are not included in the decision making, and collect information on comparable salaries (for like services, in like enterprises, in like circumstances) from independent data sources. Implementing what's required and what's recommended on compensation will let you focus on your mission, not defending the credibility of the organization.

Linda M. Lampkin, ERI Economic Research Institute
© 2008, ERI Economic Research Institute

Linda M. Lampkin is director of research of ERI Economic Research Institute, a company that provides Form 990 compensation data for use by nonprofits, and former director of the National Center for Charitable Statistics at the Urban Institute. She can be reached at Linda.lampkin@erieri.com or (877) 799-3428.