Congress Should Reject the Idea of Adding New Restrictions on Charities

The current “pitchfork” climate in Washington is likely to have a spillover effect on the nonprofit world. As the White House and Congress grow more angry about lax regulations and excessive executive compensation at the nation’s businesses, the odds are that this attitude will soon lead to proposals to tamp down perceived abuses at charities and foundations. If new rules are adopted, they could lead to big changes in the way nonprofit groups handle conflict-ofinterest issues, recruit and keep qualified board members, and compensate experienced executives.

For example, an experienced state regulator’s proposal to extend tough foundation sanctions to charities found a welcome audience before the Senate Finance Committee. The Internal Revenue Service’s report in February on hospitals, including a section raising concerns about executive pay levels, prompted calls for legislation from Sen. Charles E. Grassley, of Iowa, the senior Republican on the finance committee. And the Obama Administration’s new proposal to regulate the financial industry is a significant step in advancing the idea of federal limits on executive compensation.

In ordinary times, it isn’t worth the effort to get exercised about nascent legislation, or how the regulation of one area of commerce may affect nonprofit organizations. But these are not ordinary times. As lawmakers and members of the public seek to assign blame for the general economic turmoil, they have made clear that they don’t believe much in the idea of businesses or other types of organizations pledging to regulate themselves. Already nonprofit groups have lost credibility because of scandals at both big and small organizations. More regulation, at every level, is perceived by many as necessary to fix the abuses that created the current mess. It is a fertile climate for legislative mischief and one that nonprofit organizations must monitor closely.

Particularly ominous was the testimony last month of the estimable William Josephson before the Senate Finance Committee. Mr. Josephson, former head of the New York State Charities Bureau, proposed tough new rules governing charities at a hearing called “Tax Issues Related to Ponzi Schemes.” Mr. Josephson testified about how donors, charities, and their regulators got caught off guard in the investment scam led by Bernard Madoff.

The main theme of his testimony was that Madoff-like charity scandals can be prevented by extending to charities the rules that are designed to prevent conflicts of interest in investment policies and other problems at foundations.

Those significant new penalties are needed, according to the proposal, to counter what Mr. Josephson describes as “remarkably weak” state laws and the “haphazard and ineffective state charity oversight.” His view is that such rules would have prevented situations where charities lost money by investing with Mr. Madoff or others like him.

This is pretty strong medicine for what might be a rather localized virus. The rules governing foundations are harsh, affect all aspects of a nonprofit group’s operations, and in many instances are either specific and overbroad or aggravatingly vague.

For example, foundations can be required to pay penalty taxes on investments they make that jeopardize the institution’s ability to carry out its charitable mission. What’s more, board members and foundation leaders who participated in the investment can also be taxed, if it turns out that they knew that the investment was risky and that there was no real justification for making it.

Foundations must also pay excise taxes on certain types of payments that are inconsistent with their charitable purposes.

Separate taxes are imposed on board members and managers who agree to the making of the payment knowing it to be a taxable expenditure. Foundations also face tough federal rules designed to make sure top officials don’t receive undue financial benefits from their association with a philanthropy. The rules apply penalty taxes on the person who received the financial benefits, as well as directors and officers who knowingly participate in or vote to approve a self-dealing transaction. Among the transactions that are subject to this regulation: board members whose businesses supply paid accounting, legal, or other professional services to a foundation.

Extending those rules to charities could have a huge, negative impact on their governance structure. However remote the risk, the perception that board and committee members could be subject to excise taxes for certain decisions could scare lots of otherwise qualified people away from voluntary board service. You can imagine the refrain — Why do I need this headache? — when the charity’s lawyer tries to explain the steps the IRS is allowed to take in considering whether to impose taxes on board members.

Applying the self-dealing rules would serve to upend the entire system that nonprofit groups use to guard against conflicts of interest. Many business and other arrangements between charities and board members that are now legal would be prohibited if the foundation restrictions on self-dealing applied. The whole concept by which the board is authorized to approve certain conflicts-of-interest transactions would be gone. Charities in small communities would be particularly hard hit because they don’t always have wide choices of board members and vendors. For instance, if their hometown has just one office-supply store, charities couldn’t both buy from that store and have its owner on their boards.

There should be no debate about the need for vigorous enforcement of charity laws at both the state and federal level.

This is especially the case during difficult economic times, when charities feel extraordinary pressure to deal with revenue shortfalls. Yet there is no clear evidence that the existing menu of charity laws cannot do the job. For example, diligent application of conflicts-of-interest procedures can serve to protect against many other troublesome situations.

More important is the need to give new regulatory and self-regulatory efforts time to work. The IRS has started a significant project to improve the governance of tax-exempt organizations, in part by adding new reporting rules to the Form 990 informational tax return charities must fill out and offering charities instruction on what the IRS expects from nonprofit boards.

What’s more, states have only recently started adopting an investment regulation that modernizes the laws to ensure that charities and foundations are acting responsibly when they manage the assets of their organizations.

The principles of effective governance promoted by the Panel on the Nonprofit Sector, a committee started by the nonprofit coalition Independent Sector, are also relatively new, and many charities are still in the process of adopting them. Further, we should hear from state attorneys general and state charity regulators before concluding that existing laws are indeed insufficient to do the job.

Let’s give this combination of governmental and self-regulatory efforts the opportunity to work before Congress considers a significant new level of public charity regulation. The potential harm that could arise from applying foundation rules to charities requires careful, deliberate debate that is insulated from the exaggeration and hyperbole that pervade political debates today.

Elizabeth M. Mills and Michael W. Peregrine are partners at McDermott Will & Emery, a Chicago law firm.