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Concerns about abuses in the nonprofit sector arising out of charitable organizations allegedly formed to benefit victims of tragedies such as 9/11 and tsunami relief have led to efforts to apply a version of SOX to nonprofits. Evidence of this scrutiny has arisen on both the administrative and legislative fronts. At the state level, California, Massachusetts, and New York are key states which have publicly pushed for heightened scrutiny, with Governor Arnold Schwarzenegger firing the first salvo by signing California S.B. 1262, entitled the California Nonprofit Integrity Act of 2004, effective January 1, 2005 (California Act). The California Act added corporate accountability provisions to existing California reporting requirements for charities. While the filing, registration, and reporting provisions of the new California statute do not apply to hospitals, 2 other provisions may still apply. For example, the California Act requires nonprofit corporations to have audit committees with detailed requirements on their composition. 3 More rigid requirements on fundraising, and a required annual compensation review, are also part of the California Act. 4 Editor’s note: Albert Y. Lin is an associate in the law firm of Brown McCarroll, LLP, in Austin, Texas. Mr. Lin may be reached by e-mail at alin@mailbmc.com or by telephone at 512/703-5726. By now most compliance officers are well aware of the 2002 Sarbanes-Oxley legislation (SOX), which imposed far greater accountability, financial reporting, independence, and governance principles on corporations than ever before. With the possible exception of document retention requirements and whistleblower protections, SOX technically applies only to publicly held companies. Nonprofit companies—in particular, nonprofit taxexempt health care entities—should be aware of proposed federal legislation that may soon increase accountability of their top-level management and executive boards and impose SOX-like burdens upon their compliance professionals. While transgressions of nonprofit organizations have not yet reached the level of notoriety as Enron and WorldCom, the potential for such abuse exists since nonprofits have such a major financial impact in the world economy (with one estimate of total worldwide nonprofit expenditures at $1.6 trillion in 2002). Moreover, the nonprofit health care sector makes up a significant portion of By Albert Y. Lin that figure. According to a 2003 report by the National Center for Charitable Statistics, 13.2 percent of all “501(c)(3)” organizations in the United States are in the health care industry. Of the nation’s nearly 5,000 hospitals, approximately 85% are nonprofits. 1 In Massachusetts, state Attorney General Tom Reilly introduced the “Act to Promote the Financial Integrity of Public Charities” in May 2005. 5 The Massachusetts proposal contains SOX-like provisions such as annual certification of financial statements submitted to the state attorney general, a required audit committee if audited financials are required under state law, a requirement for reasonable compensation and prohibited excessive compensation to insiders, whistleblowing provisions, and increased penalties of $5,000 for violations of the new law. Similarly, in New York, Attorney General Eliot Spitzer has actively called for statutory SOX extensions to nonprofits, such as state laws mandating required financial statement and internal control certifications by nonprofit CEOs. Current proposed New York legislation appears to take a less severe approach, although the state Web site on charities has increased transparency by permitting searches for nonprofits that have failed to comply with basic state filing requirements. Other states have proposed or passed laws with similar SOX concepts. 6 Maine passed “An Act to Strengthen the Charitable Solicitations Act” in 2004, which imposed notice and approval requirements when nonprofits engage in “conversion” transactions (transfers of assets from a public charity to non-public charities) imposed specific limitations on the number of board members who can be “financially interested,” and requires audited financial statements for every nonprofit. That same year, New Hampshire passed a new law that requires nonprofits with revenues of $500,000 or more to file the most recent audited financial report with the state attorney general. 7 Compliance officers should carefully review their state’s January 2006 24 Health Care Compliance Association • 888-580-8373 • www.hcca-info.org
espective nonprofit law compliance responsibilities, as state approaches vary greatly. Developing federal activity impacting nonprofits Enforcement activity and legislation at the federal level is moving along at a fairly rapid pace as well. In 2004, the IRS announced it would be targeting more than 2,000 tax-exempt organizations for examination, with special attention directed towards executive compensation within such tax-exempt entities. 8 That same year, U.S. Senators Charles Grassley (R-IA) and Max Baucus (D-MT) of the Senate Finance Committee requested the Independent Sector, a coalition of 500 charities, to consider and recommend actions to improve governance, ethical conduct, and accountability in the nonprofit sector. This study, entitled “Strengthening Transparency, Governance, and Accountability of Charitable Organizations,” was issued in June 2005 (the Sector Report). 9 Senator Grassley is expected to introduce legislation that will incorporate proposals suggested by the Sector Report (introduction plans in September 2005 were delayed, no doubt due to the Hurricane Katrina crisis that required emergency legislation). Proposed principles of the Sector Report The following key principles within the Sector Report may eventually be components of the new laws. Governing members of tax-exempt health care organizations should be aware of these new requirements, which may increase their accounting and oversight responsibilities. Note that the following discussion highlights only proposals recommended by the Sector Report; adherence to these proposals before they become law may be viewed, as with SOX in general, as a “best practices” strategy that, if followed, could pay off in the long run even if the practices do become required by federal law. Increased monitoring effectiveness and signature requirements. Tax-exempt organizations with more than $25,000 in annual gross receipts must file IRS Form 990 (Annual Information Return), which discloses all pertinent financial information, typically in more detail than for-profit federal tax returns. 10 The Sector Report reveals that too many Form 990s are inaccurate or incomplete, and sometimes reveal little useful information. The inability to interpret such reports leads to ineffectiveness in enforcement. The disclosures required on the face of Form 990 are arguably too vague and open to interpretation. For example, the current Form 990 requires that revenue be broken into “program service revenue,” “management and general,” and “fundraising” components. Possible revisions would make it clearer what is expected to be within classifications. For example, the key program achievements of the tax-exempt entity could be disclosed on the first page (rather than buried in a supporting schedule behind the second page). Form 1023 (Application for Recognition of Tax-Exempt Status) for 501(c)(3) organizations was recently updated to reflect many principles later set forth in the Sector Report; as such Form 990 revisions are likely. Form 1023, for example, asks if the entity has a conflict of interest policy, but nonetheless mentions that such a policy is not required. This type of hesitant questioning may be changed; it should be clearer, for example, that conflicts of interest policies are generally required for tax-exempt health care organizations due to various administrative rulings, if not by explicit statute. The Sector Report also recommends mandatory electronic filing of Form 990s. And currently, while any authorized officer may sign the Form 990; proposed legislation is likely to require the chief executive officer or chief financial officer to sign it, in a nod to SOX’s requirement that for-profit top officers certify the financial statements Current IRS rules only provide for late filing penalties; the proposed legislation would lend far more urgency to Form 990 filings if the IRS heeds the Sector Report’s recommendation of automatic suspension of an organization’s tax-exempt status after two consecutive failures to file Form 990. Form 990 is a critical monitoring device for ensuring compliance with tax-exempt laws and regulations, and the Sector Report urges that tax-exempt organizations pay close attention to its preparation and filing. It is suggested that health care entities avoid a “less is better” approach in Form 990, and instead move toward detailed and coherent disclosure in Form 990. Filed Form 990s for virtually all charitable organizations are now easily available online, thus the ease of public scrutiny should be considered as an additional motivation for accurate and timely filings. Increased audit activity for tax-exempt organizations. The Sector Report also suggests mandatory internal review of the taxexempt purposes of charitable organizations, with additional IRS audits serving as the motivating force. Currently, there is no effective way to determine whether or not an organization has substantially changed its mission or governance structure, apart from a general plea in the determination letter and a check-the-box question in Form 990 asking if governing documents have changed. The Sector Report therefore recommends that Congress allocate additional resources for audits and reviews of the annual Form 990s. It is hoped that increasing the effectiveness of Continued on page 28 Health Care Compliance Association • 888-580-8373 • www.hcca-info.org January 2006 25
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