Charity Best Practices (or How Best to Avoid The Portland Marathon's Recent Troubles)

06.30.18

This article was previously published in the Nonprofit Association of Oregon's members-only newsletter.

Oregon's Attorney General recently concluded its investigation of The Portland Marathon by reaching a settlement with management and the board; as a result, we may never know the specific details of what transpired. The settlement resulted in sanctions and a significant payment ($865,000) against and by its former management. More recently the organization's board announced it was cancelling the 2018 race and planned to dissolve the 47-year old organization. Based on the settlement agreement, news articles, and my own experience in advising nonprofit organizations, this article aspires to provide some guidance for other charities that might apply in that case, but in any event comprise some basic best practices for charity or nonprofit stewardship.

The Nature of Charities

At the beginning of the 20th century, the United States became one of the few countries in the world to grant income tax exemption to organizations that serve a public interest. The further grant of a charitable income tax deduction to donors who contribute to such organizations has helped create a large private sector of charitable organizations in America (unmatched by any other country) that perform a variety of socially beneficial functions, in addition to those provided by government. But characterization as a charity in our country is a privilege, not a right; and it comes with a price: charities must adhere to a complicated set of special rules and are subject to increased oversight by the federal government and the states.

It's not possible in this article to list the entire gamut of rules applicable to charities, but two basic rules are worth mentioning: "private inurement" and "private benefit." Charities formed under Internal Revenue Code Section 501(c)(3) (and some other provisions) are strictly prohibited from engaging in any activity that constitutes private inurement or private benefit. For this purpose, "private inurement" means a transfer of value to a private shareholder or individual (generally, an insider, such as a founder, member, officer, director, manager, substantial contributor, or any other individual who can exert substantial control over the organization). In contrast to private inurement, "private benefit" focuses on individuals outside the organization who receive a more-than-insubstantial benefit that is not directly related to and an essential function of the charity's public-interest mission. A finding of either public inurement or private benefit constitutes grounds for revocation of charity and, sometimes, tax-exempt status.

Charity status is often not required for an organization to accomplish its mission. When considering formation of a new tax-exempt entity, if charity status is being considered, think about whether that status is critical to the mission. Will the organization seek income-tax-deductible donations as a significant part of its operations? Will the organization seek grants from private foundations? Many organizations, particularly those that receive most of their revenues from admissions, sales of merchandise, performance of services, or furnishing of facilities, might not need to be classified as charities at all. Many such organizations could be more simply structured and operated to be merely tax-exempt (exempt from income tax), without having to qualify for charity status or being subject to its more strict overlay of rules and oversight.

The Board of Directors

A corporate charity's board of directors is its main defense against mismanagement. A strong, talented, independent, engaged, informed, active board of directors, with a chair who sets (or at least approves) the agendas for its meetings (rather than allowing the CEO to do so) and that meets regularly, asks management the tough questions, actively requests, receives, and reviews financial reports (including the annual IRS form 990), reviews and sets management compensation based on comparative data for similar positions (more on this below), and sets and regularly reviews the organization's policies and goals, as well as its own performance, is the first line of defense for safeguarding any charitable corporation. Over the years, many studies, news articles, conversations, and my own and others' experiences have created that list.

Recently, for example, a 2017 "National Index of Nonprofit Board Practices" (available from Leading with Intent, https://leadingwithintent.org) highlighted the need for stronger leadership in the nonprofit sector. The study emphasizes the importance of the board's understanding its roles and responsibilities, and working as a collaborative team toward shared goals. Furthermore, the study documented that boards that regularly assess their board performance are shown to better discharge their responsibilities.

Applicable Law

The Portland Marathon is in Oregon, as am I. Oregon's Attorney General provides a pamphlet, Your Rights, Roles and Responsibilities as a Nonprofit Officer (https://www.doj.state.or.us/charitable-activities/laws-guides-for-charities/your-rights-roles-and-responsibilities-as-a-nonprofit-officer/). In turn, the end of the pamphlet has additional references that provide resources on best practices. (Also note a companion online resource, titled 20 Questions Directors Should Be Asking, at the same site.) These are likely useful resources, regardless of whether you are in Oregon, but should not be read as necessarily applicable to your state without confirming whether and to what extent your state's laws are similar to Oregon's.

Oregon has adopted its own version of the American Bar Association's "Model Nonprofit Corporations Act," as have more than 30 other states. While many provisions are similar across the various states, many have been customized to each state; so you will want to consult with the Attorney General in your state for specific rules and resources applicable to your organization. The states' Attorneys General enforce the law and represent the public interest with respect to charitable corporations operating or soliciting donations within state borders.

Under Oregon law, each member of the board of directors has the responsibility to discharge his or her duties in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner that the director reasonably believes to be in the best interests of the corporation. Oregon law requires the board of directors of a charitable corporation to have at least three members; we generally recommend a larger board, although not so large as to become unwieldly. We also recommend "staggered" terms for board members—for example, a three-year staggered term, so that one-third of the board seats are up for election each year. This allows for some institutional history (one-third of the board at any given moment has at least two years' prior experience) and "refreshes" the board regularly, so that there is always a new perspective. Some organizations specify board term limits, such as two terms, to further ensure new members on a regular basis. A healthy board is independent of the organization and its management, is diverse and inclusive, constantly has new members participating, and never gives management, even the CEO, a voting seat. In all corporations (whether for profit or nonprofit), senior management reports to and takes direction from the board, not the other way around.

Conflicts of Interest

One of the important functions of a strong board of directors is to promulgate and enforce a conflict-of-interest policy. Board members and senior management should regularly review the policy and either report potential conflicts to the board or certify that they have none. In Oregon, there are general prohibitions, with narrow exceptions, on a member of the board or senior management's borrowing money from a charitable corporation, or the corporation's guaranteeing a loan to such an individual. This may differ by state (Washington, for example, has an absolute prohibition, with no exceptions); but since any transaction with key management or a board member is obviously a conflict-of-interest transaction, any such proposal should be carefully vetted by the board of directors and legal counsel, and should require the approval of an independent board, before proceeding.

Performance Reviews and Setting Compensation

A strong board regularly reviews the performance of the chief executive officer (whether called CEO, president, or executive director), sets measurable goals for the coming year, evaluates achievement of previously established goals, and sets compensation (at least annually), based on performance and data obtained for similar positions in other organizations.

Internal Revenue Code Section 4958, also known as the "excess benefit doctrine," imposes excise taxes on both the recipient and the governing body that approves any transaction in which an organization described in Internal Revenue Code Sections 501(c)(3), (4), or (29) directly or indirectly bestows on a "disqualified person" an economic benefit that exceeds the value of what it receives in return. The section clearly applies to compensation paid to key management personnel. Treasury Regulations promulgated under that section provide a methodology for establishing a "rebuttable presumption" that the compensation paid to key management is reasonable. Boards should view the methodology outlined in the regulation as a "best practices" process for setting the corporation's CEO's compensation and documenting the process.

To establish the rebuttable presumption, the regulation suggests that (1) compensation should be approved by an authorized body of the organization (generally, the board of directors), comprising individuals who do not have a conflict of interest concerning the transaction; (2) compensation should be based on "appropriate data" obtained before the decision is made; and, (3) the authorized body should concurrently "adequately document" the basis for its determination. The regulation provides a lot more detail than can be described in this article, but the following are a few basics: "appropriate data" generally includes compensation data of what is paid by at least three comparable organizations in the same or similar communities for similar services; "adequate documentation" requires documenting (a) the basis for the decision, and the decision itself, before the later of the next meeting of the same authorized body or 60 days; (b) the terms and amount of the compensation, and the date approved; (c) who was present for the discussion and how individual members of the authorized body voted; (d) the comparability data reviewed and how it was obtained; and (e) any actions taken by a member of the authorized body having a conflict of interest. Aside from being a good outline for best practices in this area, if an organization meets the rebuttable-presumption standard, it shifts the burden of proof under the statute to the Internal Revenue Service (which would have to prove that the compensation is not reasonable), instead of the organization (which, without the rebuttable presumption, would have to prove that the compensation is reasonable).

In Closing

Many more "best practices" exist than are mentioned in this article. (Please pursue some of the resources mentioned.) Whether you are a charity's member, CEO, director, or trustee (as some directors are called), when you provide good stewardship you not only bring honor to your organization's mission, its beneficiaries, and its donors, but also contribute to the greater charity and nonprofit community by discharging your individual responsibilities in a manner that best ensures that your organization will not become a case study for prohibited abuses or mismanagement of the funds that each charity struggles so hard to raise.

Please enable JavaScript, then refresh this page. JavaScript is required on this site.