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Understanding How and Why Nonprofits Face More Government Scrutiny

U.S. nonprofit organizations are entering an era of the most intense federal and state regulation in history. After cracking down on corporate America by enacting the Sarbanes-Oxley Act (SOX) in 2002, lawmakers and enforcement officials are now setting their sights on the country's 1.8 million nonprofits. Many provisions in the Pension Protection Act of 2006 are a direct response to high-profile scandals in the nonprofit sector.

The following are examples of developments currently converging into a perfect legal storm for the nation's nonprofits:

  • Federal legislation: On August 17, 2006, President George W. Bush signed into law the Pension Protection Act of 2006 (PPA), which includes a package of charitable giving incentives and safeguard measures as well as a series of reforms designed to deter individuals from using public charities for private benefit.
  • Sweeping state reforms: States are passing tough new laws, such as California's Nonprofit Integrity Act of 2004, which is rapidly becoming a template for other state initiatives. The act requires charities with at least $2 million in revenue to conduct annual audits, to follow certain procedures in compensating executives, to establish a board-level audit committee, and to work with the attorney general's office before fundraising. At this writing, similar bills cracking down on nonprofits have also been proposed in at least a dozen other states, including New York, Arizona, and Maine. West Virginia even funds programs to educate board members who oversee the state's nonprofit organizations.
    Many states already have stringent laws on the books, and nonprofits anticipate them being enforced with new vigor. Fortunately, most state laws contain common elements for accountability and governance, and it's possible for nonprofits, which often operate and solicit donations in many states, to adopt policies and governance structures that will fulfill all emerging state requirements.
  • IRS initiatives: The Internal Revenue Service (IRS), which grants tax exemptions to nonprofits, is dedicating more auditors to its tax-exempt unit. Various legislative initiatives have been proposed to increase the resources available to the IRS to monitor nonprofits and would require the IRS to pass more stringent regulations for nonprofits.

Under these emerging state and federal regulatory schemes, nonprofits not only face new regulatory requirements, but they also face much higher risks of litigation. Regardless of whether a lawsuit or an investigation is meritorious, the associated publicity can place nonprofits in peril, as donors awaiting the outcome withdraw critical financial support.

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