Putting Charity to the Test

As the Internal Revenue Service signals that it plans to take a more-aggressive approach

to making sure the nation’s nonprofit organizations are not hoarding or wasting money, numerous charity officials and legal experts are worried about how the agency will devise a fair system to assess how organizations use their resources.

Steven T. Miller, commissioner of the IRS’s tax-exempt and government-entities division, announced in a speech last month that the agency will spend more effort monitoring the “efficiency and effectiveness” of charitable organizations. He said the IRS would try to “create and enforce a standard to ensure that organizations spend in line with their resources.”

“No one wants the service dictating how a charity should do its job,” he said. “But every charity should make responsible and appropriate use of its resources to achieve its charitable purposes. That is what the tax-exempt subsidy is for.”

Congress’s Concerns

Questions about how nonprofit groups spend their money have been raised frequently on Capitol Hill lately, Mr. Miller noted. The Senate Finance Committee, he pointed out, has been exploring whether to require universities and other nonprofit organizations to distribute a minimum percentage of their endowments each year. And the House has been holding hearings on veterans groups that lawmakers say spent too much money on fund raising and other items.

But Senny Boone, executive director of the DMA Nonprofit Federation, an association in Washington with 400 members, said she thinks the revenue service may be overreaching.

“You want an independent charitable community performing well and using donor money wisely,” said Ms. Boone. “You don’t want a federal regulator’s possible subjective view of how charitable assets ought to be spent. That’s the danger.”

In his speech, Mr. Miller said the IRS would use a controversial measure the agency had briefly embraced years ago but then set aside — a so-called commensurate test — to determine whether charities were using their money in an acceptable way.

He said the agency would first focus on colleges and, over the next 18 months, devise a way to apply the test to other types of charitable organizations.

The revenue service first described the test in a two-paragraph ruling in 1964 and apparently has applied it directly to a charity only one time, in a high-profile case in 1990. That year, the IRS revoked an organization’s tax exemption in part, it said, because the group did not perform charitable activities commensurate in scope with its financial resources.

Although the IRS soon backed away from the test, its use alarmed many charity officials, who saw it as a reflection of a new interpretation of tax law that could affect the status of nonprofit groups that the government thought spent too much money on fund-raising and administrative costs.

Mr. Miller’s remarks — delivered at a conference on tax-exempt organizations held by the Georgetown University Law Center — triggered an immediate response.

“This could go anywhere,” said Bruce R. Hopkins, a Kansas City, Mo., lawyer who has written many books on nonprofit law.

“It’s an interesting development, to say the least, because there is so little law on the commensurate test,”he said. “The IRS has almost a clean slate to work with. We all know what the test is, but applying it is a whole other thing.”

Mr. Hopkins added: “The concept is to force more charitable activity out of public charities.”

‘Hasn’t Given Up’

Mr. Miller received some positive reviews for his proposal. Chief among them was from the person who apparently was instrumental in encouraging current IRS officials to re-embrace the commensurate test: Charles Grassley, the Iowa senator who is the senior Republican on the Senate Finance Committee.

A year ago, Mr. Grassley and Sen. Max Baucus, the Montana Democrat who chairs the finance committee, wrote to the Treasury Department that “the commensurate test is an important part of assessing whether an entity is acting as a charity.”

In a letter to the department, which oversees the IRS, the senators urged the tax agency to issue guidelines to “put more teeth” into the test and to explain how it would use the test in audits.

After Mr. Miller’s speech, Senator Grassley said, in a statement to The Chronicle, “I’m glad to hear that the IRS hasn’t given up on monitoring the efficiency and effectiveness of charitable organizations. But the commensurate test requires legal analysis. It’s not a black-and-white measurement, so it will require substantive effort from the IRS, not just a verbal commitment.”

Mr. Grassley added: “There is a very real need to bring sunlight to the fund-raising and administrative expenses of charities so that donors and the public can better judge how well an organization is doing what it’s supposed to be doing.”

A former top adviser to Senator Grassley was more blunt.

“Congress and the public are frustrated in so many ways that many so-called charities with such significant assets are doing little or nothing that would be considered charitable,” said Dean A. Zerbe, who recently stepped down from his finance-committee job.

“My hope is that the IRS does something sooner rather than later so we can see the benefits of actually getting charities back on the rails,” he said.

Mr. Zerbe said that application of the test by the IRS would clearly force many charitable organizations to do more.

“Establishing a real and substantive commensurate test,” he said, “could potentially do more good for our nation’s poor and working families than any act of Congress.”

Challenging a Charity

The IRS’s previous use of the commensurate test — nearly 20 years ago — also shocked nonprofit leaders.

The IRS said the measure was a key reason it revoked the tax-exempt status of a small Indianapolis health charity, the United Cancer Council, which had a fund-raising contract with Watson and Hughey, a company in Virginia.

The revenue service said the cancer council had excessive fund-raising expenses and had paid more than 93 percent of its total gross income in 1986 and 1987 to its fund-raising company.

After the case was made public in 1991, many nonprofit groups worried that if the IRS won, organizations would have to prove they spend enough money on their programs or lose their tax exemption.

The United Cancer Council denied all allegations and sued the IRS in U.S. Tax Court. The charity challenged the revenue service’s interpretation of its own 1964 ruling (Revenue Ruling 64-182) — which involved a charity that derived most of its income from rents — saying it was “vague and overbroad.”

In 1990 the IRS had included a question about the test in a list given to its agents who were reviewing the solicitation practices of charities.

By the time the United Cancer Council case went to trial in 1992, the revenue service had backed away from its emphasis on the commensurate test. The agency argued that the test was one factor that the judge should consider in his deliberations. The IRS said the test did not involve specific mathematical formulas or percentages but varied from case to case depending on the “facts and circumstances” of each.

After years of fighting, the United Cancer Council and the IRS eventually reached an out-of-court settlement.

But the case that seemed relegated to the history books is now back under the microscope.

Noland MacKenzie Canter III, a Washington lawyer who represented the United Cancer Council, said that the commensurate test wound up having no bearing as an issue in the tax court or on appeal. “It has a nice name to it, but when you break it down, it just doesn’t work,” he said.

He added:”It’s an invitation to the IRS to engage in arbitrary decision making. This thing is like Moby Dick: a great concept out in the ocean somewhere, but what do you do with it?”

For example, Mr. Canter said, a charity may have a justifiable reason for having a large endowment.

“Suppose its board anticipates a need in the future to undertake new programming or buy a building, or maybe they worry about the vicissitudes of the market or declining direct-marketing revenue,” he said. “They need to retain capital to have a nest egg for operational funding. To have an IRS agent challenge that doesn’t make sense. There is good reason this concept has lain dormant.”

Other nonprofit experts said they do not believe the IRS needs to use the commensurate test in order to properly regulate charities.

“The IRS already has significant tools to use” if a charity does not operate properly, said Errol Copilevitz, a lawyer in Kansas City, Mo.

He said that if a nonprofit group, for example, had as its mission “to cure a dreaded disease and they have $10-million in the bank and they only spend $500 to ask someone to write an article about the disease,” the IRS already could step in and take action.

“The IRS doesn’t need a commensurate test,” said Mr. Copilevitz. “They have the authority to revoke tax-exempt status when a charity is not being run for charitable purposes.”

Other IRS observers were optimistic that the tax agency would be able to devise a workable standard.

Diana Aviv, president of Independent Sector, a coalition in Washington of roughly 600 charities and foundations, said she has found Mr. Miller to be consistent over the years in searching for reasonable ways to make nonprofit organizations more efficient and effective.

“He is a sophisticated professional who recognizes that no one size fits all, but that this is no reason to give up,” she said. “He never said the commensurate test would apply universally in all situations. He said he’s going to take a look at a test that might work for different groups. Possibly, he’ll come up with a formula that we can support. It doesn’t have to be all or nothing.”

Some tax experts who are watching Mr. Miller say they believe he was more cautious in his pronouncement than many think.

Paul Streckfus, a former IRS lawyer who is editor of the EO Tax Journal, said Mr. Miller is probably following the lead of Congress and is trying to take the temperature of the situation.

“Commensurate and efficiency tests will be very controversial, so he throws them out there,” said Mr. Streckfus, “and if the [nonprofit] sector really objects, maybe nothing comes of it. But if six months go by and there’s not a strong reaction, maybe next year he announces another step. He’ll try some initiative and see what kind of blowback or feedback there is and see what the folks on Capitol Hill will say.”

Mr. Streckfus added that the most likely next development will be an IRS study on the matter.

“If one were cynical,” he said, “one could say that this will be just information-gathering so the next time the IRS is called to the Hill [for a hearing], they’ll have data. In the past, they’ve been embarrassed because they didn’t have the information [Congress] wanted.”

‘Fundamental’ Issue

In his speech, Mr. Miller said that monitoring efficiency and effectiveness “is an issue of fundamental importance, and one that increasingly is attracting attention,” including from the House of Representatives.

The House Oversight and Government Reform Committee this winter held hearings on veterans organizations at which lawmakers showed increased interest in finding ways to require charities to tell donors what percentage of their revenue they spend on programs related to their missions.

The hearings “were essentially about fund-raising efficiency and compensation,” Mr. Miller said. “It is an issue we cannot ignore if we are to faithfully administer” tax laws.

“The public and the Congress may and often do have an expectation that the service can act when we see organizations spending 98 cents of every dollar on fund raising or compensation, he said, and two cents on services,” said Mr. Miller. He said such situations, if serious enough, are the type the IRS can punish under current law.

“But for the most part,” he said, “what we can do about efficiency and effectiveness is what we have been doing lately: pushing transparency so people can see for themselves just how efficient and effective an organization is, or is not” through the public informational tax returns, called Forms 990, that charities file.

“As the public seeks a good return on its contribution dollar, we push for enhanced and meaningful transparency in the hope that market forces and the good sense of the public will bring about change,” said Mr. Miller.

Disclosure Form

The IRS’s Form 990 is getting a significant makeover for the 2008 tax year, Mr. Miller noted. “One of our guiding principles was to create uniformity and transparency in reporting,” he said.

Mr. Miller said he was disappointed that the IRS eventually had to give up its effort, in a draft version of the Form 990, to ask charities to provide “efficiency indicators” on the front, summary page of the document that he said could have helped the public make “apples to apples” comparisons.

The IRS originally was going to ask charities for their fund-raising expenses as a percentage of total contributions; their compensation of top officials as a percentage of total contributions; their total expenses as a percentage of net assets; and the percentage of gross receipts that charities received after professional fund raisers were paid. It dropped such questions, Mr. Miller said, “in the face of strong criticism.”

Charities “convinced us that we had not yet found a universal indicator of efficiency or effectiveness,” he said. “I have to tell you that I was and remain disappointed by the service’s and the [nonprofit] sector’s current inability to devise one or more shorthand indicators. But I have not given up.”