7 IRS Policies All 501(c)(3) Nonprofits Should Have

What It Is

A conflicts of interest policy is a written procedure the board follows whenever a director, officer or key employee has a personal financial interest in a transaction or arrangement with the charity. Common examples include the charity leasing office space from a director, buying insurance through a board member's agency, hiring an officer's spouse, or paying a director's company to build its website.

A conflict of interest is not automatically wrong. Sometimes the insider offers the best price or the best service. The policy makes sure the conflict is disclosed, the interested person steps out of the decision, and the disinterested directors decide whether the deal is fair and in the charity's best interest.

When It Is Required

Federal tax law does not require one, but this is the policy the IRS cares about most. Form 990, Part VI, asks three questions about it:

• Line 12a: Did the organization have a written conflict of interest policy?
• Line 12b: Were officers, directors, trustees and key employees required to disclose annually interests that could give rise to conflicts?
• Line 12c: Did the organization regularly and consistently monitor and enforce compliance with the policy, and how?

The Form 1023 application asks the same question, and the IRS publishes a sample conflict of interest policy in Appendix A of the Form 1023 instructions. An applicant that answers "No" should expect follow-up questions from the IRS. We recommend that every Arizona nonprofit corporation adopt a conflicts of interest policy, even one that will never seek tax exemption.

Arizona law also governs director conflicts. The Arizona Nonprofit Corporation Act's director conflicting interest transaction provisions, beginning at A.R.S. §10-3860, define a conflicting interest, define the "related persons" whose interests are treated as the director's own, and describe the disclosure and approval procedure that protects a transaction from being set aside or from creating liability for the director.

What It Should Include

• A definition of an "interested person" and a "financial interest," including interests held through family members and businesses.
• A duty to disclose the conflict, and all material facts, to the board before the board acts.
• A requirement that the interested person leave the meeting during the discussion and vote.
• A procedure for the disinterested directors to investigate alternatives and decide whether the transaction is fair and reasonable to the charity.
• Minutes that record the disclosure, who was present, the alternatives considered and the vote.
• An annual written statement signed by each director, officer and key employee disclosing his or her interests and confirming that he or she has read and will follow the policy.
• Periodic reviews to confirm that compensation arrangements and transactions with insiders serve the charity's purposes and do not result in private benefit.

What Happens If the Policy Is Violated

The policy exists to prevent "excess benefit transactions" under Internal Revenue Code Section 4958, often called the intermediate sanctions rules. An excess benefit transaction occurs when a charity gives an insider (a "disqualified person," such as a director, officer, substantial contributor or their family members) more than the insider gives back in value. The penalties are severe and fall on individuals, not just the charity:

• The insider who received the excess benefit owes an excise tax equal to 25% of the excess benefit and must repay the excess benefit to the charity.
• If the insider does not correct the transaction in time, an additional tax of 200% of the excess benefit applies.
• Each director or officer who knowingly approved the transaction owes a 10% tax, up to $20,000 per transaction.

In serious or repeated cases the IRS can revoke the charity's tax exemption for private inurement, because a 501(c)(3) organization may not let any part of its net earnings benefit an insider. At the state level, a transaction approved without proper disclosure under Arizona's conflicting interest statutes can be challenged in court, and directors who breach their duty of loyalty can be personally liable. For private foundations, the self-dealing taxes of Section 4941 apply to almost any financial transaction between the foundation and an insider, even one that is fair to the foundation.

What It Is

A whistleblower policy tells employees, volunteers and directors how to report suspected illegal conduct, financial fraud, or violations of the charity's policies, and promises that the charity will not retaliate against anyone who makes a good-faith report. It gives the board a way to learn about problems internally before they become public scandals or government investigations.

When It Is Required

Form 990, Part VI, line 13, asks whether the organization has a written whistleblower policy. No federal law requires a nonprofit to adopt one, but the Sarbanes-Oxley Act of 2002 makes this policy strongly recommended.

Most of Sarbanes-Oxley applies only to publicly traded companies. Two of its criminal provisions, however, apply to every organization, including nonprofit corporations. One of them, codified at 18 U.S.C. §1513(e), makes it a federal crime to knowingly retaliate against a person, including by interfering with his or her job, for giving truthful information to a law enforcement officer about the commission or possible commission of a federal offense.

What It Should Include

• A statement encouraging good-faith reports of suspected wrongdoing.
• Who receives reports, with an alternative person (often the board chair or an audit committee member) for reports about the executive director.
• A way to report confidentially, and anonymously if the organization can manage it.
• A clear prohibition on retaliation, with discipline for anyone who retaliates.
• A procedure for investigating reports, documenting the outcome, and reporting results to the board.
• A statement that knowingly false reports are not protected.
• A requirement that the policy be distributed to employees and volunteers.

What Happens If the Policy Is Violated

A person who retaliates against a whistleblower in violation of 18 U.S.C. §1513(e) can be fined, imprisoned for up to 10 years, or both. The policy itself does not create that crime, but a charity without a policy is more likely to have a manager who fires or punishes a whistleblower without understanding the law.

Retaliation also creates civil exposure. A fired employee may bring a wrongful termination claim, and Arizona law protects employees who report violations of Arizona law or refuse to commit them. Beyond the legal risk, the damage to donor trust when a charity punishes someone for reporting fraud can be permanent.

What It Is

A document retention and destruction policy states how long the charity keeps each type of record, who is responsible for the records, how records are destroyed when the retention period ends, and, most importantly, when all destruction must stop. It applies to paper records and electronic records, including email, text messages, cloud files and backups.

When It Is Required

Form 990, Part VI, line 14, asks whether the organization has a written document retention and destruction policy. Like the whistleblower policy, it is strongly recommended because of Sarbanes-Oxley. The second Sarbanes-Oxley criminal provision that applies to nonprofits, 18 U.S.C. §1519, makes it a federal crime to knowingly alter, destroy, conceal or falsify any record or document with the intent to impede or obstruct a federal investigation, or in relation to or in contemplation of one.

Arizona and federal tax law also impose retention requirements. Under A.R.S. §10-11601, an Arizona nonprofit corporation must keep the minutes of all board and member meetings, and records of all actions taken without a meeting, as permanent records, and it must maintain appropriate accounting records. The IRS expects a charity to keep records that support the items reported on its returns, and Section 6104 requires the charity to make its exemption application and its three most recent annual returns available to anyone who asks.

What It Should Include

• A retention schedule by type of record. Typical periods include permanent retention of the Articles of Incorporation, Bylaws, board minutes, the IRS determination letter, Form 1023 and Forms 990; at least seven years for most financial and tax records; and at least four years for payroll tax records.
• Rules for donor records and gift agreements, especially restricted gifts and endowments, which should be kept permanently.
• A person responsible for administering the policy.
• A litigation hold provision: when the charity learns of a lawsuit, government investigation or audit, or reasonably expects one, all destruction of related records stops immediately.
• Secure destruction methods for records containing personal or financial information.
• Rules for electronic records, email and personal devices used for charity business.

What Happens If the Policy Is Violated

Destroying, altering or hiding records to obstruct a federal investigation is punishable by a fine, up to 20 years in prison, or both. The litigation hold provision is what keeps an innocent volunteer from shredding the wrong box of files after an IRS audit letter arrives.

Poor recordkeeping causes other harm as well. In an IRS examination, a charity that cannot produce records may be unable to prove that its funds were spent for exempt purposes. In civil litigation, a court can sanction a party that destroys relevant evidence, including instructing the jury to assume the missing documents would have hurt that party. Failing to keep the permanent records Arizona law requires can also leave the directors unable to prove that the board properly approved important actions.

What It Is

A gift acceptance policy describes which gifts the charity will accept, which gifts need special review before acceptance, and which gifts it will refuse. Cash gifts are easy. Gifts of real estate, closely held business interests, vehicles, artwork, cryptocurrency, life insurance, partial interests in property and gifts with unusual strings attached can create costs, liabilities and tax reporting obligations that exceed the gift's value.

When It Is Required

Form 990, Schedule M, line 31, asks whether the organization has a gift acceptance policy that requires the review of any non-standard contributions. A charity must file Schedule M when it reports more than $25,000 of noncash contributions for the year, or when it receives certain types of property such as art, historical treasures or qualified conservation contributions. No law requires the policy, but any charity that expects to receive anything other than cash should have one.

What It Should Include

• Who has authority to accept gifts, and which gifts require board or committee approval.
• Rules for real estate, such as an environmental review before acceptance, a title review, and an analysis of carrying costs like property taxes, insurance and maintenance.
• Rules for closely held stock, S corporation stock, partnership and LLC interests, which can generate unrelated business income or saddle the charity with debts or capital calls.
• Rules for restricted gifts, naming rights and endowments, including when the charity may decline restrictions that conflict with its mission.
• A statement that the charity does not provide tax or legal advice to donors and that donors should obtain their own appraisals.
• Procedures for donor acknowledgments, quid pro quo disclosures, vehicle donations and the IRS forms that noncash gifts require.
• Authority to refuse gifts from sources that could damage the charity's reputation or create a conflict of interest.

What Happens If the Policy Is Violated

Violating a gift acceptance policy usually results in practical and financial harm rather than criminal penalties, but the harm can be significant:

• Environmental liability. A charity that accepts contaminated land can become liable for cleanup costs as the owner, even though it did nothing to cause the contamination.
• Tax reporting penalties. If a charity sells or disposes of donated property within three years after receiving a gift for which it signed the donor's Form 8283, it generally must file Form 8282 with the IRS. Failing to file triggers information return penalties.
• Donor deduction problems. Under Internal Revenue Code Section 170, donors cannot deduct a single gift of $250 or more without a contemporaneous written acknowledgment from the charity. Under Section 6115, a charity that receives a payment of more than $75 that is partly a gift and partly payment for goods or services must give the donor a written disclosure, or pay a penalty of $10 per contribution, up to $5,000 per fundraising event or mailing.
• Unwanted obligations. Accepting a gift with restrictions the charity cannot honor can lead to a dispute with the donor or the donor's family, and in some cases a lawsuit to return the gift.

What It Is

A travel and expense reimbursement policy states which business expenses the charity pays or reimburses for directors, officers, employees and volunteers, what documentation is required, who approves reimbursements, and which expenses are never allowed. It typically covers airfare class, lodging, meals, mileage, conference fees, spouse or companion travel, and the use of charity credit cards.

When It Is Required

Form 990, Schedule J, asks about these expenses when a charity reports total compensation of more than $150,000 for any listed officer, director, key employee or highly compensated employee. Line 1a asks whether the charity provided any of a list of benefits, including first-class or charter travel, travel for companions, tax gross-up payments, discretionary spending accounts, housing, use of a personal residence, health or social club dues, and personal services. Line 1b asks whether the charity followed a written policy for those payments. Line 2 asks whether the charity required substantiation before reimbursing expenses of all directors, trustees and officers, including the chief executive.

Even a small charity that never files Schedule J needs this policy, because federal payroll tax rules decide whether a reimbursement is tax free or taxable wages.

What It Should Include

• A requirement that every reimbursed expense have a business purpose connected to the charity's work.
• Substantiation rules: receipts, dates, places and the business purpose, submitted within a set period (the IRS safe harbor is within 60 days after the expense).
• A requirement to return any advance or excess reimbursement within a set period (the IRS safe harbor is within 120 days).
• Limits on travel class, lodging and meals, and a prohibition on first-class or charter travel unless the board approves it in advance.
• Rules for spouse and companion travel, which is generally taxable to the officer unless the spouse or companion has a genuine business purpose for the trip.
• Approval of the executive director's expenses by someone other than the executive director, usually the board treasurer or chair.
• Rules for charity credit cards, and a ban on personal charges.

What Happens If the Policy Is Violated

A policy that meets the IRS "accountable plan" rules under Internal Revenue Code Section 62(c) lets the charity reimburse business expenses tax free. If reimbursements do not meet those rules, the payments are taxable wages subject to income tax withholding and payroll taxes, and the charity can owe back payroll taxes, interest and penalties.

The bigger risk is the excess benefit rules. Under the Section 4958 regulations, when a charity pays an insider's personal expenses and does not clearly treat the payment as compensation at the time (for example, by reporting it on the insider's Form W-2 or Form 1099), the payment can be an automatic excess benefit transaction. That means the 25%, 200% and 10% excise taxes described above can apply even if the insider's total compensation would have been reasonable. A paid vacation disguised as a "conference trip" or a spouse's airfare charged to the charity are classic examples. Unchecked expense practices are also where embezzlement most often starts.

What It Is

A compensation policy sets out the process the board uses to decide how much to pay the executive director, other officers and key employees, and whether to pay directors at all. Compensation includes salary, bonuses, retirement contributions, deferred compensation, health insurance, fringe benefits and expense allowances. The goal is to pay enough to attract qualified leaders while never paying more than reasonable compensation.

When It Is Required

Form 990, Part VI, line 15, asks whether the process for determining the compensation of (a) the chief executive and (b) other officers and key employees included three things: review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision. The charity must describe its process in Schedule O. Form 1023 asks similar questions about how the organization will set compensation. Any charity that pays its officers or key employees should have this policy.

What It Should Include

The most valuable compensation policies track the three steps of the "rebuttable presumption of reasonableness" in Treasury Regulation Section 53.4958-6:

• Independent approval. The compensation is approved in advance by the board, or a board committee, made up entirely of members with no conflict of interest regarding the arrangement. The person whose pay is being set does not vote and is not present for the deliberation.
• Comparability data. The board relies on appropriate data about what similar organizations pay for similar positions, such as compensation surveys, salaries at comparable charities, or written offers from similar organizations. A charity with annual gross receipts of less than $1 million can satisfy this step with data from three comparable organizations in the same or similar communities.
• Concurrent documentation. The board's minutes record the terms approved, the date, the members present and how they voted, the comparability data relied on, and any actions by conflicted members. The minutes must be prepared before the later of the board's next meeting or 60 days after the final action, and approved within a reasonable time.

The policy should also require an annual review of compensation, address bonuses and incentive pay (which should never be based on a percentage of donations raised without careful review), and state whether directors serve without pay.

What Happens If the Policy Is Violated

Paying an insider more than reasonable compensation is an excess benefit transaction under Section 4958. The overpaid insider owes the 25% excise tax and must repay the excess; failing to correct triggers the 200% tax; and directors who knowingly approve the arrangement owe the 10% manager tax. Excessive compensation is also the most common form of private inurement, which can cost the charity its exemption.

Following the three-step process does not just look good on Form 990. If the board follows it, the compensation is presumed reasonable, and the burden shifts to the IRS to prove otherwise with its own evidence. Skipping a step means losing that protection. Because Form 990 publicly discloses the pay of officers, directors and key employees, a compensation decision made without a documented process can also become a public relations problem.

What It Is

A joint venture policy governs the charity's participation in a partnership, LLC or other arrangement with a for-profit business or other taxable party. Examples include a hospital forming an LLC with physicians to run a surgery center, a charity co-owning a building with an investor, a nonprofit housing developer partnering with a for-profit developer, or a charity owning an interest in a business that sells products related to its mission. The policy requires the board to evaluate whether the venture furthers the charity's exempt purposes and to build in safeguards that protect the charity's tax exemption.

When It Is Required

Form 990, Part VI, line 16a, asks whether the organization invested in, contributed assets to, or participated in a joint venture or similar arrangement with a taxable entity during the year. If the answer is yes, line 16b asks whether the organization followed a written policy or procedure requiring it to evaluate its participation in joint ventures under federal tax law and to take steps to safeguard its exempt status. A charity that never participates in a joint venture answers "No" to line 16a and line 16b does not apply. Still, adopting the policy at formation means the board has a procedure ready before an attractive deal arrives.

What It Should Include

• A requirement that the board review every proposed joint venture with a taxable party before the charity commits, with legal and tax advice.
• A determination, documented in the minutes, that the venture furthers the charity's exempt purposes and that any benefit to the private parties is incidental.
• Terms giving the charity enough control to make sure the venture pursues charitable purposes, especially when the charity contributes a significant part of its assets.
• Provisions requiring that the venture's charitable purposes take priority over maximizing profits for the owners.
• Arm's-length terms, so that the charity's return is proportional to its investment and the private participants do not receive more than their fair share.
• A review of unrelated business income tax consequences and conflicts of interest, especially if any director or officer invests in the venture.

What Happens If the Policy Is Violated

The IRS has explained its approach in two published rulings. In Revenue Ruling 98-15, it described a "whole hospital" joint venture in which a nonprofit contributed all of its operating assets to an LLC with a for-profit partner. The nonprofit that kept control and required the venture to put community benefit first kept its exemption; the nonprofit that gave up control did not. In Revenue Ruling 2004-51, the IRS approved an "ancillary" venture in which a university kept control over the educational content of a program it ran with a for-profit company.

Courts have applied the same principle. In Redlands Surgical Services v. Commissioner (1999), the Tax Court upheld the denial of exemption to an organization whose only activity was a surgery center venture controlled by for-profit partners, and in St. David's Health Care System v. United States (2003), the Fifth Circuit held that a nonprofit hospital system's exemption depended on whether it kept effective control of its partnership with a for-profit hospital company.

The consequences of a poorly structured joint venture include:

• Loss of 501(c)(3) status if the charity's primary activities are carried on through a venture the charity does not control.
• Unrelated business income tax on the charity's share of venture income that is not substantially related to its exempt purposes, under Internal Revenue Code Section 512.
• Excess benefit transaction penalties if insiders invest in the venture on terms more favorable than the charity's.
• Private benefit concerns if the for-profit partners receive more than an incidental benefit from the charity's assets.