Falling Through the Cracks

IRS pursues few corrupt charities despite tough federal law

A federal law that was supposed to crack down on charity officials who reaped undue financial benefits from

their nonprofit work has accomplished little in the six years that it has been on the books, according to a Chronicle review of charities’ informational tax returns, as well as interviews with state attorneys general and numerous experts on nonprofit law. The law was largely intended to make sure that charity leaders didn’t receive exorbitant pay and perquisites and that trustees and top officials didn’t approve any sweetheart financial arrangements for friends or family members.

So far, the Internal Revenue Service appears to have pursued only four nonprofit organizations under the law, though it is possible the agency, which is prohibited by law from announcing whom it is pursuing, has undertaken additional actions. The IRS promises that enforcement is being stepped up: Steven T. Miller, the agency’s director of exempt organizations, says tax auditors identified close to 30 instances of possible violations of the law in the past year, and some involve “significant sums,” he says.

Although Congress predicted that if the law was working as intended it would produce about $60-million a year in fines from charity officials found guilty of misdeeds, the IRS does not seem to have collected anything close to that. The service won’t say how much was collected, but it appears to be no more than $10-million.

Among the reasons the law isn’t working as well as expected: The Internal Revenue Service says it doesn’t have sufficient manpower or sophisticated enough computer-tracking systems to enforce the law fully. What’s more, charity tax experts and others say the law puts too much onus on charities to report their own misdeeds. Such issues are likely to come up next year when the Senate is expected to review the progress made under the law, as part of an overall review of federal regulation of charities.

Not everyone agrees the law has been a bust. Some tax experts, including those who helped draft the law, say it has made many organizations, especially big ones, more careful about how they set compensation of top officials and what kinds of financial arrangements they make with trustees and others. And some nonprofit officials say Congress overestimated how much wrongdoing was occurring in the charity world, so that’s why the law isn’t producing nearly as much in fines as had been predicted.

Even so, concern about enforcement of the law has been growing, in part because of increased public attention to financial accountability at both charities and for-profit companies prompted by the collapse of Enron and controversies involving charities like the American Red Cross and United Way of the National Capital Area, in Washington.

The law that President Bill Clinton signed in 1996 was drafted in large part to deal with charity financial scandals that erupted in the 1980s and early 1990s, including one that forced the resignation of the president of United Way of America after newspapers reported that he was using the charity’s money to pay for items such as first-class air travel, a chauffeur and limousine, and jobs for friends and relatives, and cases where televangelists were found to be using their tax-exempt organizations to channel money to themselves.

Under the law, the IRS for the first time was allowed to levy fines, known as excise taxes, on charity trustees, chief executives, and others who received undue financial benefits. Also punishable: officials who authorized irregular financial deals. The officials are required to return to the charity any money they received wrongly and to pay fines to the government.

The statute’s penalties are often referred to as “intermediate sanctions,” because until the law was passed, the only way the IRS could punish abuses by a charity’s executives was to revoke its tax exemption. Taking such a big step was something the IRS rarely wanted to do, since that meant punishing an entire organization and the people who benefited from its services. The 1996 law also gave the IRS more authority to get involved in issues such as executive pay at charities, and for the first time spelled out how a charity was supposed to figure out whether it was compensating employees too generously.

Blowing the Whistle

Perhaps the most unusual part of the law is that it counts heavily on charities to blow the whistle on wrongdoing by their own top officers, trustees, and others. Charities are supposed to report to the IRS each year whether they were involved in any financial transactions that violated federal standards, explain the nature of any illegal transaction, and state whether they paid any penalties or received any repayments as a result of those transactions.

Lawmakers asked that the reports be made part of the informational tax return, or Form 990, that charities fill out each year. Not only did they want charities to flag problems for the IRS, they also wanted to let potential donors and others know that a charity had gotten in trouble and what kind of action had been taken to make up the lapse.

Many charities say they are concerned that the reporting requirements put them in the awkward position of accusing their top executives and trustees of wrongdoing, and opening the door to potential lawsuits over damage to a person’s reputation if the IRS decides that the financial transactions listed on the 990 don’t violate the law.

Not surprisingly, very few charities have reported their own violations. A Chronicle review of the informational returns filed by charities from 1996 to 2001 found that a total of 194 groups reported that they had broken the law. That figure represents less than one-tenth of 1 percent of the 800,000 groups that hold charity status.

What’s more, many of the groups that reported violations did so by mistake: Numerous charities contacted by The Chronicle said that they had misunderstood the question they were being asked or that they had made a clerical error on their tax forms.

Of the charities that said they had made payments that violated the law, very few were among the major national charities in the United States. Fewer than half of the groups had more than $100,000 in assets, and only 16 of the groups had assets that exceeded $10-million. In some cases, the groups’ total revenue was too tiny to raise a question about overly high pay to employees.

The Home for Contemporary Theatre and Art Limited, in New York, which had no assets, though it reported revenue of $970,484 in fiscal 2000, says it erroneously reported excess-benefit transactions on returns for fiscal years 1997, 1998, and 2000. Sandra Gilmore, the group’s general business officer, says the mistake may have recurred because the group often copies a previous year’s return. “Basically we struggle to keep our staff paid fairly,” she says. “Our highest salary here is $31,000. There’s no way anybody could get their hands on a lot of money.”

The largest charity reporting so-called excess benefit transactions on its Form 990 was Kamehameha Schools in Honolulu, which reported $3.3-billion in assets in fiscal 2000. The Hawaii organization was the subject of major legal battles involving the state and the IRS in the 1990s, in part because it paid each of its trustees more than $1-million annually. Details of what the trustees paid in fines to the IRS haven’t been disclosed. Terms of the settlement were sealed by a Hawaii probate judge.

Another charity that the IRS has taken to court using the 1996 law, the Sta-Home Health Agencies, didn’t report on its returns that it was involved in any wrongdoing. Sta-Home, the IRS said, had sold its assets to for-profit entities for less than their fair value. (For more details on the cases that the IRS has pursued under the 1996 law, see article on Page 32.)

Of the returns examined by The Chronicle, more than half that reported a violation contained no explanation of the problems at the charities. Many charities did not return repeated calls asking about the missing statements, while others said they didn’t attach a statement because they said they had made a mistake in stating on the tax form that they had any excess-benefit transactions.

Charities that did attach statements often revealed themselves to be extremely conscientious, sometimes to a fault. The Juvenile Diabetes Research Foundation International, in New York, reported its former chief executive’s housing allowance of $49,000 (a little less than one-sixth of his $335,000 salary) as an excess-benefit transaction on its fiscal 1998 return.

“They were being overly cautious,” says Edward J. Sebald, the foundation’s national finance director, who did not work at the organization at the time. “You can have a housing allowance as long as salary is not out of whack.” (The IRS has confirmed that interpretation, while not commenting on the specific instance.)

Other groups reported small transactions or salary levels that don’t appear to reflect the concerns that Congress had in mind when it passed the law. Faith Baptist Bible College, in Ankeny, Iowa, said an official had acquired a soldering gun, a stepladder, and other items from the college for $83 less than their fair market value. The official reimbursed the shortfall and paid a $20.75 penalty. The Greater Kanawha Valley Foundation, in Charleston, W.Va. reported that an official had used the fund’s credit card for personal purchases in 1997. The amounts were repaid, and the group also required the official to pay $391 in interest.

Beyond letting the public know which groups had gotten involved in excess-benefit situations, the reporting requirement is supposed to make it easier for the Internal Revenue Service to identify cases of possible abuse that it should examine. But the IRS says it isn’t able to take advantage of the extra information it is gaining from the tax forms. The main reason: The IRS says its computer system is unable to identify charities that reported excess benefits on their returns in any systematic way. The computers also don’t have the capacity to determine which charities are paying above-average salaries to their top officials.

As a result, the IRS says it can only spot potential violations when someone calls or writes with a concern or if the agency is already conducting an audit of an institution. The division that oversees tax-exempt groups continues to be hampered by too few employees: Outgoing Commissioner Charles O. Rossotti estimated the agency would need to add more than 1,100 employees to adequately monitor all tax-exempt groups. The service’s exempt-organizations division currently has 820 employees, a number that is expected to drop by about 60 by the end of next year.

The division hopes to get money to hire additional workers in 2004, but in the meantime it is taking other steps to overcome the problems it faces in enforcing the law.

Mr. Miller, the IRS’s director of exempt organizations, says the agency only began systematic enforcement last year, after it issued rules explaining what charities must do to comply. The division has established a committee of its most-senior employees to make sure the law is applied consistently and to make sure it learns from each case, he says. Next year, the IRS computers will be retooled so that agents can use them to follow up with groups that reported excess benefits and to look for charities with assets or revenue that are low relative to salary.

“I want people to know we’re going to be knocking on some doors,” Mr. Miller says. “By this time next year, we should have a better feel for whether the statute or the regulations have had any impact on the marketplace at all.”

Lack of High-Profile Cases

But others say the IRS should have been ready to do much more more quickly. Several state attorneys general and other tax experts said they would have expected several high-profile cases to be ready as soon as the regulations were issued.

Ross Laybourn, a lawyer in Oregon’s attorney general’s office, says such cases would send “a stronger message.” He adds: “Nothing gets people’s attention like an announcement that sanctions have been imposed.”

Meanwhile, some say they are concerned that too many charity officials seem to receive salaries that are out of line.

For instance, Mark A. Pacella, deputy attorney general of Pennsylvania, says the $1-million annual salary paid to Sherif S. Abdelhak, former CEO of the Allegheny Health, Education, and Research Foundation, which declared bankruptcy in 1998, could be considered excessive compensation. Mr. Abdelhak was sentenced earlier this year to up to 23 months in prison for raiding the foundation’s endowments to provide operating expenses for Allegheny health systems.

The IRS never went after Mr. Abdelhak’s pay, even though a Pennylvania judge said in a ruling that his salary, benefits, and pension rights “may have been significant, even obscene.”

Although the IRS will not state whether it pursued the matter, the foundation has not reported recovering any money under the law in its filings for 1997 through 2000, as would be required had it been reimbursed through the provisions in the 1996 law.

Until the IRS can show it’s on top of such cases, many observers remain dissatisfied. They say the law may be helping some charities improve their financial controls, but it’s not catching the scofflaws.

“There’s certainly value in helping people do things on the straight and narrow,” says Barnaby Zall, a lawyer in Bethesda, Md. “They were going to go after the William Aramonys of the world,” Mr. Zall says, referring to the former United Way president who was forced to resign in 1992. “But they’re not getting the Aramonys. They’re not getting the really big guys.”

But others are more sanguine about what the law has done, and has the potential to do.

Catherine Livingston, who recently rejoined the Treasury Department after several years in private practice working for nonprofit clients, says she believes that consciousness about inappropriate financial deals is much higher than it was before the law was passed.

“It has shaped the behavior of boards of directors,” she says. Before approving a top executive’s salary, boards now check similar charities to make sure the amount isn’t too high by comparison. “These days, if you’re going to renew the contract for CEO, you go and get some hard data” on compensation, she says. “The board isn’t sitting around the table anymore, saying, ‘That sounds about right.’”