Nonprofit Regulators Need Promised Funds to Oversee Sector

The fastest-growing part of the U.S. economy is not business, at least not the commercial kind. It’s the nonprofit sector. In the past decade, the number of nonprofit groups has grown by 25 percent to 1.6 million. They now account for 5.4 percent of gross domestic product and 10 percent of jobs.

As the sector has boomed, however, government resources devoted to overseeing it have either declined or stayed the same. That has left considerable room for questionable practices. In recent reports, Bloomberg Markets has explored nonprofits’ use of dishonest solicitations by professional fundraisers whose efforts primarily benefit themselves, the issue of high executive compensation, and the matter of whether groups even deserve to be tax exempt.

The American Bureau of Shipping, for instance, functions like other companies that certify ships as seaworthy but enjoys a tax exemption because it’s registered as a nonprofit trade association. With $605.3 million in profits since 2004, it paid its chief executive officer $21.5 million over seven years.

Nonprofits fall under the jurisdiction of both the Internal Revenue Service and state authorities, notably the attorneys general. One barrier to effective oversight is that AGs lack access to IRS information about ongoing investigations. An amendment to the federal tax law lifting that proscription would improve coordination.

More important, both federal and state regulators need greater resources. Never a colossus, the IRS’s Exempt Organizations Division at its height had 950 staff members. It’s down to 860 today and still shrinking. By having more members of this staff focus on the task, the division has, since 2003, doubled the number of audits to determine whether nonprofits continue to qualify for tax exemption, to 11,699 in fiscal 2011. Still, that represents an audit rate of 0.7 percent, compared with 1.5 percent for corporate returns.

State officials typically police such matters as donation solicitations and the fiduciary responsibilities of corporate officers. All 50 states have enacted statutes governing the creation and operation of nonprofit corporations. Yet there has been no significant increase in the number of state officials assigned to enforce the rules. What’s more, attorneys general might not make nonprofits regulation a priority.

In this time of shrinking state budgets and ballooning federal debt, where can more money for oversight be found? And how can attorneys general be motivated to act?

It happens that a source for funds was long ago promised for just this purpose. As part of the Tax Reform Act of 1969, Congress imposed an excise tax on private foundations’ investment income to pay for nonprofit oversight by the IRS. To the dismay of many in the sector, the money has never been designated for that purpose. Funding for the IRS Exempt Organizations Division is just a fraction of the amount the tax brings in.

The tax proceeds should be earmarked for oversight as originally planned. The IRS should receive enough funding to audit nonprofit filings at least as often as it does individual returns, at the rate of 1 percent a year. The remainder of the excise tax revenue should be allocated to state attorneys general, according to the size of each state’s nonprofit sector, to encourage them to make regulating nonprofits a higher priority. To receive funds, AGs should be required to dedicate staff to the job. A dozen states have such special nonprofit units, though many are poorly financed.

Since proceeds from the excise tax can stretch only so far, state enforcers need their own funding streams, as well – the money could come from annual nonprofit registration fees.

While nonprofits would not like the extra expense, it could make possible the kind of reform that is needed to maintain public confidence in all of them.