​The Madoff Scandal and Charities and Foundations: The Need for All 501(c)(3) Entities to Improve Their Governance and Conflicts of Interest Policies in Advance of Reports for 2008 on Form 990 to be Filed With the IRS – Installment 6

March 9, 2009Articles White Collar Compliance & Defense Blog

This is the sixth in a series of Installments on this blog that will discuss some of the threshold issues that face the manifold stakeholders who have been materially affected by the Bernard L. Madoff scandal, allegedly the longest, most widespread and financially devastating Ponzi scheme on record. All potential stakeholders should consult professional advisors promptly to have their positions evaluated.

We will continue the discussion of charitable entities and foundations that were affected by the Madoff scandal. However, we believe that the unfortunate experiences of many charitable organizations and foundations (collectively, “501(c)(3) Entities”) that were directly involved in enormous losses from the Madoff morass should be poignant object lessons for all charitable organizations and their fiduciaries, whether or not victims of Madoff. This Installment will continue the discussion of the aftermath of the Madoff scandal for 501(c)(3) Entities, with an emphasis on the review and analysis of governance and investment policies that charitable organizations should be conducting to repair and/or enhance their standing among their peers and competitors for contributions.

Installment 5 and prior Installments raised certain problems that exist for private foundations that are 501(c)(3) Entities which invested with Madoff. Such private foundations face the “triple jeopardy” of actual losses of investment value, the possibility of penalty excise taxes for imprudent investments and/or the potential for “clawback” by the trustee for the Madoff assets if the private foundation received substantial and disproportionate payments as compared to the average return for all other investors.

While 501(c)(3) Entities that are public charities and not private foundations do not have the potential for penalty excise taxes, they are subject to loss of investment value and clawback from Madoff investments. Therefore, all 501(c)(3) Entities have similar concerns.

This series of Installments will discuss a number of issues arising from the Madoff scandal in the context of an expanded and more comprehensive Form 990 that 501(c)(3) Entities must file annually with the IRS. The adverse publicity that many charities have suffered from having been involved with Madoff, combined with the substantial losses in market value that charitable endowment and trust funds have incurred over the last year, make it critical that all 501(c)(3) Entities review, analyze and reform their operating policies and procedures. Only by demonstrating their commitment to best practices in governance and operations can they succeed in the increasingly competitive environment for shrinking donor dollars in an adverse economic climate.

Required Filings by 501(c)(3) Entities with the IRS

501(c)(3) Entities that achieve certain minimum sizes as to revenues and/or assets are required to file annual tax returns with the IRS. The filing form for public charities is Form 990 and for private foundations is Form 990-PF. This Installment will focus on Form 990 for public charities because of the dramatic changes that have occurred in the requirements for a 2008 Form 990 filing to be made in 2009 (“2008 Filing”).

It is a coincidence that the uncovering of the Madoff scandal occurred in the year relating to the 2008 Filing and its comprehensive changes to Form 990. However, the Madoff scandal has raised the stakes for a charity to be sufficiently proactive in reviewing, analyzing and revising its compliance, transparency and accountability to enable it to file on a timely basis a complete and accurate 2008 Filing. The changes in the 2008 Filing, which will be hereafter described in greater detail, will require disclosures for a charity that relate directly to the Madoff investments and scandal as to governance and decision-making by their boards. The changes for 2008 Filings may only be the beginning of an evolution in Form 990 that will require even more comprehensive disclosures by charities in the future.

Form 990 as a Financial Reporting Document

For many years Form 990 was viewed as an annual financial report by a 501(c)(3) Entity to the IRS on the charity’s operations for the prior fiscal year. The financial statements track very closely the annual audited financial reports of the 501(c)(3) Entity. The annual financial statements of 501(c)(3) Entities in the 2008 Filing can be expected to be generally dismal because of significant losses in market values of charitable endowment and trust funds during 2008. Both the balance sheet and statement of revenues and expenses in the 2008 Filing will reflect such losses. The financial statements of 501(c)(3) Entities that invested with Madoff will be even more negative to the extent that the Madoff investments may prove to be almost worthless. Such 501(c)(3) Entities will have a need to explain clearly and carefully in the 2008 Filing the steps that they have taken and will take to avoid a repetition of serious mistakes of the past. The changes in the Form 990 for 2008 encourage that approach.

In effect, the changes in Form 990 have converted the Form 990 to much more of a disclosure document for 501(c)(3) Entities akin to the Form 10-K Annual Report filed by public business corporations on an annual basis with the federal Securities and Exchange Commission.

Universal Transparency and Filing Dates for Forms 990

Form 990 is required to be filed with the IRS by the 15th day of the month following the end of a charity’s fiscal year, e.g., May 15, 2009 for the 2008 Filing by a charity with a fiscal year ended on December 31, 2008 (“Calendar Year Filer”). It must be understood that, unlike federal tax returns filed by business corporations, the Form 990 filed by 501(c)(3) Entities can be accessed anonymously by anyone in the world at any time. It becomes a matter of public record after it is filed with the IRS. Web sites, perhaps the most well known of which is www.guidestar.org, publish Forms 990 on line, ordinarily within two months after they are filed. Potential donors, competitors, governmental agencies, beneficiaries and many others easily and routinely access the Forms 990 to analyze operations and other aspects of a 501(c)(3) Entity.

A Calendar Year Filer can have up to two extensions for filing its 2008 Filing that would allow it to delay filing until November 15, 2009. It can be anticipated that many 501(c)(3) Entities will extend their filing dates as long as they can. First of all, those 501(c)(3) Entities that invested with Madoff will most likely require extra time to determine the extent to which the value of the Madoff investment has deteriorated. Such valuation may be closely tied to the prospects for recovery of monies and progress with related civil and criminal cases.

A second reason is that the new requirements for disclosure in 2008 Filings will make it necessary for a 501(c)(3) Entity to generate new material and respond to new questions, perhaps only after the implementation of new policies by its governing board, so that the responses reflect best practices in the Form 990.

Another reason for the likely delays in filing of the 2008 Filings will be that many 501(c)(3) Entities will endeavor to see what types of responses to the new 2008 Filing questions other 501(c)(3) Entities will make. In a number of cases the larger, more seasoned 501(c)(3) Entities may be among the early filers of 2008 Filings. For example, a hospital that is a 501(c)(3) Entity may have obligations under trust indentures for outstanding bond issues that require provision to the trustee of the Form 990 by a specified time based upon the original due date of the Form 990. The early filers of 2008 Filings will, therefore, in some cases be setting some unofficial benchmarks for responses to new questions in the 2008 Filings.

Penalties for Violations of Provisions Covering Form 990 Filings

There are potential serious adverse consequences for a 501(c)(3) Entity that fails to file on a timely basis a complete and correct Form 990. The Internal Revenue Code provides for civil monetary penalties of $20 per day for failure to file a complete and correct Form 990 by its original due date (or permitted extension date for filing). The maximum penalty for any one Form 990 is the lesser of $10,000 or 5% of the gross revenues of such 501(c)(3) Entity. However, for a 501(c)(3) Entity that has gross receipts exceeding $1,000,000 for any year, the penalty for failure to file a complete and correct Form 990 by its required due date is $100 per day up to a maximum of $50,000 for any one Form 990.

Additionally, a private IRS ruling released on February 27, 2009 revoked the tax exempt status of a 501(c)(3) Entity that did not observe the conditions for its continued exempt status by failing to file a Form 990 for each of the preceding two fiscal years. Accordingly, the 501(c)(3) Entity was no longer exempt from federal income taxation and contributions by donors were no longer tax deductible.

The civil monetary penalties and revocation of tax-exempt status cover the new disclosure requirements for Form 990.

The next Installment will continue the discussion of the aftermath of the Madoff scandal for 501(c)(3) Entities with an emphasis on its relationship to the 2008 Filings and the related compliance, transparency and accountability obligations of the 501(c)(3) Entities.

[To be continued in Installment 7]