Dangers of Unregulated Charities: Revising Nonprofit Corporate Governance

The address of the fake charity “American Cancer Society of Michigan” led to a rented mailbox on Staten Island in New York City—hundreds of miles away from Michigan. Beginning in 2014, this rented mailbox became the “home” to seventy-six fake charities, all approved by the Internal Revenue Service (IRS), under which the regulatory system for U.S. charities falls. Despite warnings from the real American Cancer Society about these sound-alike groups, the IRS approved them anyway. [1]

Ian Hosang, who created the seventy-six fake charities, is accused by New York prosecutors of operating a charity fraud that stole over $150,000 through soliciting donations for supposed cancer charities. [2] Many of these fake charities started with the words “American Cancer Society,” “American Cancer Foundation,” and “United Way,” despite Hosang’s lack of affiliation with the actual American Cancer Society and United Way. [3]

The charities, created through the IRS’s Streamlined Application (Form 1023-EZ), represent fundamental issues with the approval of charitable organizations by the IRS: the lack of legal framework regarding nonprofit incorporation and governance has led to greater abuse of charitable donations and tax-exempt status. With $499.33 billion in total U.S. charitable giving in 2022, greater legal measures must be taken to address nonprofit corporate governance, to allow for greater distinction between for-profit business and nonprofit corporation laws, and to promote greater financial accountability within nonprofit organizations. [4] More specifically, the laissez-faire legal framework for nonprofit organizations should be eliminated in favor of adopting clearer federal requirements for mandated auditing, charitable solicitation registration, and satisfying the structured governance measures outlined in the Model Nonprofit Corporation Act.

The Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code or Form 1023-EZ (the “Streamlined Application”), created as a response to approval delays and budget cuts, is designed specifically for “smaller charities”—organizations with less than $250,000 in assets who expect to have less than $50,000 of gross receipts in any of the subsequent three years. [5] The Streamlined Application fails to request and evaluate any financial data other than the requirements for 501(c)(3) status under Form 1023-EZ. Furthermore, the Streamlined Application fails to require copies of an applicant’s organizational documents. While there is an attestation, there is no actual proof required in designating the organization’s charitable purposes. [6]

With almost no disclosures, this system has led to increased difficulty in suspecting scammers—the denial rate has decreased from 1.8% to .04%. [7] In fact, the decreased level of vetting—through the use of Form 1023-EZ—has resulted in 46% of the approved applicants not actually being qualified, according to a 2019 study by the agency’s taxpayer advocate. [8] Although the Streamlined Application is designed to process applications in a more efficient manner, the screening process is inadequate, due to its limited ability to exercise meaningful oversight. [9]

Furthermore, although the regulatory system for U.S. charities depends on the IRS’s approval process, tax law does not include distinct measures to prevent the impersonation of better-known nonprofits. Furthermore, there are no systematic checks for a history of fraud by incorporators. [10] As a result of these limitations, Hosang’s fake charities were approved by the IRS.

Once a charity is incorporated, there are also limited laws regarding nonprofit governance and financial accountability; a lack of legal clarification exists regarding board duties, board structure, and checks on board actions. [11] Although some provisions are outlined in the Sarbanes-Oxley Act of 2002—which was passed to promote public trust in the corporate sector—most measures for accountability and governance only apply to public companies, not nonprofit organizations. [12]

Currently, the practices and requirements for corporate financial reporting and governance for public companies are defined under the federal Sarbanes-Oxley Act of 2002 (SOX Act). Following the accounting scandals at Enron, WorldCom, and Tyco, bipartisan efforts for greater financial accountability resulted in the passing of the SOX Act, which strengthens disclosure and auditing requirements for public corporations. The provisions for public companies within the SOX Act include corporate responsibility for financial reports (Section 302), requirements for disclosures in periodic reports (Section 401), and whistleblower protection (Section 806). The SOX Act also ensures auditors’ independence from their clients: the Act requires that each member of a company’s audit committee be an independent member of the board of directors—with independence defined as not being part of the management team and not receiving any compensation for other professional services. This audit committee is responsible for setting compensation, hiring, and overseeing the auditor’s activities. [13] Beyond the SOX Act, court cases regarding the duty of care demonstrate that a director owes a fiduciary duty to perform their position in good faith, in accordance with the manner they believe to be in accordance with the best interests of the corporation. [14]

Three sections of the SOX Act apply to nonprofit organizations and public corporations: record-keeping provisions, penalties for the obstruction of official proceedings, and whistleblower protections. Section 802 establishes criminal penalties for knowingly destroying or falsifying documents, to obstruct or influence an investigation or bankruptcy matters. [15] Section 1102 defines a penalty of not more than 10 years for “corruptly” altering or concealing a document, attempting to do so, or otherwise obstructing any official proceedings. [16] Section 1107 amends Federal criminal law, establishing criminal penalties for retaliation against whistleblowers, relating to federal offenses. [17]

While requirements for corporate financial reporting and governance in public companies are defined in the SOX Act, the seventy-six legally approved fake charities—created for illegal activities—exemplify the lack of specific regulations and provisions for nonprofit corporate governance and financial reporting. While the IRS grants tax-exempt status to nonprofits, there is a lack of sufficient government oversight to ensure that nonprofits—especially small charities—spend these funds according to their missions. [18] The monitoring mechanisms for smaller charities—organizations with under $50,000 in gross receipts—are inadequate. Smaller charities are only required to submit the e-Postcard (Form 990-N). [19] Compared to the annual reporting requirement for large and mid-sized charities—Form 990 and Form 990-EZ, respectively—smaller charities are not required to report detailed financial information and make the form available to the general public. For example, Form 990 requires disclosure of gross income, expenses, disbursements, a balance sheet, total contribution received, and salaries paid. [20]

Furthermore, even though the law for the governance of nonprofit organizations largely mirrors that of for-profit organizations, the regulation of nonprofits primarily occurs at the state level, rather than the federal level. [21] This leads to inconsistent regulations and a lack of oversight across states, as the IRS requires no mandated governance structure. [22]

The IRS only encourages nonprofit organizations to adopt and maintain structured governance practices, including the establishment of an “active and engaged board”—governing boards that include individuals who are knowledgeable, active, and selected with the organization’s needs in mind. [23] Furthermore, even though the IRS reviews an organization’s annual information returns to determine if the organization meets IRS policies regarding executive compensation, conflicts of interest, investments, fundraising, documentation, and whistleblower claims, the IRS only encourages organizations to adopt such policies, rather than requiring them. [24]

Beyond the policies suggested by the IRS, states have varied regulations for registration and nonprofit governance, including the partial or full adoption of the Model Nonprofit Corporation Act (MNCA), which outlines the basic operations and provides a framework for accountability. The MNCA was drafted by the American Bar Association. Thirty-seven states have adopted a version of the MNCA, while seven of these states have adopted the law entirely, including Arkansas, Indiana, Mississippi, Montana, South Carolina, Tennessee, and Washington. The states that have not adopted the MNCA follow for-profit business law in regard to nonprofit organizations. [25]

The MNCA clarifies and identifies the governance structure of the organization and the use of bylaws and governing principles. Under the act, the members of a nonprofit’s governing body owe a fiduciary duty to the organization: members of the governing body must act in good faith and in what they “reasonably believe” to be in the organization’s best interests. Once a nonprofit organization is formed, a board of directors with fixed terms must be elected. As a result, the IRS requirement for an “active and engaged” board is satisfied. To promote transparency, the MNCA requires the maintenance of certain records for a specified period of time, and grants members of the organization the right to inspect records in accordance with maintenance. [26] However, the MNCA does not require governing boards to adopt bylaws—the organization’s internal operating rules. [27] This is consistent with current federal tax law, even though some states currently require bylaws. [28]

Several states have also adopted requirements for charitable solicitation registration, which decrease the potential for unlawful charitable solicitation practices by nonprofit organizations. These statutes generally require organizations to register with the state before soliciting donations. Currently, 45 jurisdictions have some form of regulation regarding charitable solicitation, which protects donors from illegitimate and fraudulent organizations. [29]

However, despite the partial or full adoption of the MNCA and charitable solicitation registration requirements by states, the lack of consistent regulations for financial reporting and management between state and federal laws leads to a lack of accountability and responsibility among organizations. Due to the great diversity in nonprofit organizations, a “one-size-fits-all” approach to nonprofit corporate governance is unrealistic. [30] As such, federal regulations for nonprofit organizations, beyond the current IRS system, must prioritize flexibility. Applying provisions from the SOX Act to nonprofit organizations is a potential solution for promoting greater financial accountability within nonprofit organizations. Furthermore, adopting proposed nonprofit legislation at the federal level—including requiring Charitable Solicitation registration and the proposed Model Nonprofit Corporation Act—will balance corporate governance practices and accountability with diversity in nonprofit organizations.

Provisions under the SOX Act for public companies, including mandating audit committees, can be applied to nonprofit organizations. State legislation mandating audits and audit committees includes the Nonprofit Integrity Act of 2004 in California, which requires an audit for charities with gross receipts of $2 million or more and mandates the creation of audit committees. [31] Similar legislation can also be found in Massachusetts and New Hampshire. For example, Massachusetts requires nonprofit organizations with gross support and revenue of more than $200,000 in a fiscal year to submit financial statements audited or reviewed by an independent certified public accountant (CPA). [32] Federal mandates for the submission of audited financial statements will strengthen the monitoring mechanisms for nonprofit organizations, considering the weakened monitoring mechanisms employed by the IRS. [33]

Additionally, the federal adoption of the proposed MNCA and requirements for charitable solicitation registration will provide flexibility and governance guidelines for nonprofit organizations. With the adoption of the act by thirty-seven states, federal adoption of the MNCA will clarify nonprofit requirements, in accordance with the IRS recommendations for nonprofit corporate governance. [34] MNCA provisions for the board of directors and maintenance of records are also consistent with the governance, transparency, and record-keeping requirements in the SOX Act. [35] Furthermore, federal charitable solicitation registration requirements will prevent unethical fundraising and prevent solicitors from taking advantage of public support for charitable institutions.

Nonetheless, increasing federal nonprofit regulation is a slow and steady process, requiring the joint alignment of several states. As the number of nonprofit organizations continues to grow, so does the potential for fake charities—such as those created by Ian Hosang. With increasing charitable giving over the years, the regulation of nonprofit corporate governance must be addressed with increased attention. Otherwise, failures by the current regulatory system may become increasingly harder to identify and address.

Edited by Marie Miller

[1] Julie Tate and Troy Closson, “76 Fake Charities Shared a Mailbox. The I.R.S. Approved Them All,” New York Times, July 3, 2022, https://www.nytimes.com/2022/07/03/us/politics/irs-fake-charities.html.

[2] Kings County District Attorney, “Man Indicted for Stealing over $150000 by Soliciting Donations for Fake Cancer Charities,” The Brooklyn District Attorney's Office, May 9, 2022, http://www.brooklynda.org/2022/05/09/man-indicted-for-stealing-over-150000-by-soliciting-don ations-for-fake-cancer-charities/.

[3] Kings County District Attorney, “Man Indicted for Stealing.”

[4] “Giving USA: Total U.S. charitable giving declined in 2022 to $499.33 billion following two years of record generosity,” IU Lilly Family School of Philanthropy, June 20, 2023, https://philanthropy.iupui.edu/news-events/news-item/giving-usa:-total-u.s.-charitable-giving-dec lined-in-2022-to-%24499.33-billion-following-two-years-of-record-generosity.html?id=422.

[5] "Instructions for Form 1023-EZ," IRS, March 1, 2023, https://www.irs.gov/pub/irs-pdf/i1023ez.pdf.

[6] IRS, "Instructions for Form 1023-EZ”. [7] Tate and Closson, “76 Fake Charities.”

[8] Taxpayer Advocate Service, “2019 Annual Report to Congress,” IRS, 2019, https://www.taxpayeradvocate.irs.gov/wp-content/uploads/2020/11/ARC19_Volume1_TRRS_04 _StudyExtent.pdf.

[9] Eric Franklin Amarante, “Unregulated Charity,” Washington Law Review 94, no. 1 (2019): 1503-1576. https://digitalcommons.law.uw.edu/cgi/viewcontent.cgi?article=5085&context=wlr.

[10] Tate and Closson, “76 Fake Charities.”

[11] Evelyn Brody, “The Board of Nonprofit Organizations: Puzzling Through the Gaps Between Law and Practice,” Fordham Law Review 76, no. 2 (2007): 521-566. https://ir.lawnet.fordham.edu/flr/vol76/iss2/2.

[12] U.S. Congress, House, Sarbanes-Oxley Act of 2002, HR 3763. 107th Cong., 2nd sess, introduced in House February 14, 2022, https://www.congress.gov/bill/107th-congress/house-bill/3763.

[13] BoardSource and Independent Sector, "The Sarbanes-Oxley Act and Implications for Nonprofit Organizations," Columbia School of Professional Studies, January 2006, https://sps.columbia.edu/sites/default/files/2020-11/SarbanesOxley.BoardSource.pdf.

[14] "Duty of Care," Cornell Law School, January 2022, https://www.law.cornell.edu/wex/duty_of_care.

[15] U.S. Congress, “Sarbanes-Oxley Act of 2002.” [16] U.S. Congress, “Sarbanes-Oxley Act of 2002.” [17] U.S. Congress, “Sarbanes-Oxley Act of 2002.” [18] Eric Franklin Amarante, “Unregulated Charity.”

[19] "Annual Electronic Filing Requirement for Small Exempt Organizations — Form 990-N (e-Postcard)," IRS, June 5, 2023, https://www.irs.gov/charities-non-profits/annual-electronic-filing-requirement-for-small-exempt- organizations-form-990-n-e-postcard.

[20] "Instructions for Schedule A (Form 990) (2022),” IRS, December 1, 2022, https://www.irs.gov/instructions/i990sa#idm140528601893488.

[21] Lawrence J. Trautman and Janet Ford, “Nonprofit Governance: The Basics.” [22] Lawrence J. Trautman and Janet Ford, “Nonprofit Governance: The Basics.”

[23] "Governance and Related Topics - 501(c)(3) Organizations," IRS, February 4, 2008, https://www.irs.gov/pub/irs-tege/governance_practices.pdf.

[24] IRS, “Governance and Related Topics."

[25] Nonprofit Organizations Committee, Model Nonprofit Corporation Act: Official Text with Official Comments and Statutory Cross-references (N.p.: American Bar Association, Business Law Section, 2022).

[26] Nonprofit Organizations Committee, Model Nonprofit Corporation Act. [27] Nonprofit Organizations Committee, Model Nonprofit Corporation Act.

[28] "Exempt Organization - Bylaws," IRS, January 9, 2023, https://www.irs.gov/charities-non-profits/other-non-profits/exempt-organization-bylaws.

[29] "Charitable Solicitation - State Requirements," IRS, March 1, 2023, https://www.irs.gov/charities-non-profits/charitable-organizations/charitable-solicitation-state-re quirements

[30] Lawrence J. Trautman and Janet Ford, “Nonprofit Governance: The Basics,” Akron Law Review 52, no. 4 (2019): 971-1042. https://ideaexchange.uakron.edu/cgi/viewcontent.cgi?article=2482&context=akronlawreview.

[31] California Registry of Charitable Trusts, "Nonprofit Integrity Act of 2004 - Summary of Key Provisions," State of California Department Of Justice, January 1, 2005, https://oag.ca.gov/sites/all/files/agweb/pdfs/charities/publications/nonprofit_integrity_act_nov04. pdf.

[32] Office of the Attorney General, "Audits and Reviews for Charitable Organizations," Commonwealth of Massachusetts, https://oag.ca.gov/sites/all/files/agweb/pdfs/charities/publications/nonprofit_integrity_act_nov04. pdf.

[33] Eric Franklin Amarante, “Unregulated Charity.” [34] IRS, “Governance and Related Topics."
[35] U.S. Congress, “Sarbanes-Oxley Act of 2002.”