New York Nonprofit Revitalization Act: Its Effect on CPAs, Boards, and Nonprofit Management

On December 18,2013, Governor Andrew M. Cuomo signed into law the New York Nonprofit Revitalization Act of 2013, the first major revision to the state's Not-for-Profit Corporation Law (NPCL) in more than 40 years. The act aims to improve the efficiency of administrative procedures in organizing nonprofits and to strengthen nonprofit governance and fiscal oversight. All of New York's nonprofits, as well as several out-of-state organizations that solicit contributions in New York, are subject to the new law's provisions, and many will have to take action to comply with them.

In addition to the NPCL, the act also amends the Estates Powers & Trusts Law and article 7-A of the Executive Law. The act also enhances the oversight powers of the New York Attorney General's (AG) Office and its Charities Bureau, the state's regulator of nonprofit organizations.

The ensuing sections highlight specific components of the act that are relevant to CPAs, attorneys, nonprofit boards, CFOs, and nonprofit senior management. As of this writing, New York's legislature is in session and might revise the law based upon the nonprofit sector's early compliance experience and commentaries; however, the act's fundamental principles and major provisions are likely to remain intact. (During the drafting of the law, this author had the privilege of testifying before the State Senate and noted that several components of the day's discussions were incorporated into the final act, indicating that the state is open to pertinent suggestions.)

Background

The effective date for most of the act's provisions is July 1,2014. Some provisions, such as the new revenue thresholds for required independent audits, have later (or phased-in) dates. Note that in April 2014, the AG issued a memo, "Guidance on Provisions of the Nonprofit Revitalization Act of 2013" (Guidance Document 20141, Charities Bureau) clarifying certain effective dates, which are discussed in further detail below. Furthermore, the act offers audit committees a grace period for certain responsibilities if an organization's revenues are between $1 million and $10 million for the fiscal year ended prior to January 1,2014. The effective date for these organizations will be January 1, 2015.

Applicability. The new law applies to any nonprofit that is authorized to conduct activities in New York State, regardless of its state of incorporation or main office locationfor example, organizations incorporated in Delaware that do business in New York and organizations that do business as "friends of' New York but are located outside the state or outside the country are also under the purview of the new law.

Accountants working with multistate or international organizations should be aware of the act's far-reaching applicability and should advise those nonprofits accordingly. In addition, there are multiple areas of the act that contain thresholds that could create varying applications of the law; the higher the revenue, the more items become applicable. (Most common are audit thresholds, as seen in Exhibit 1, and whistleblower policies, as discussed below.)

Provisions Affecting CPA Engagements

In an effort to relieve the regulatory burdens on small nonprofits, the act created new thresholds that increase the annual revenue amounts for requiring an independent audit or review. The threshold requirement for a review will increase to $250,000. The new annual revenue thresholds for audits will be phased in over seven years, beginning at $500,000 in 2014 and reaching $1 million in 2021, as shown in Exhibit 1. Nonprofit boards might still want an audit or review at a lower revenue threshold as a best governance practice or to meet other third-party requirements.

Under the act, the AG may request that an organization submit to an audit, even if it is not required to have one based upon the revenue thresholds noted in Exhibit 1. Normally, this would be the direct result of a government investigation. The NYSSCPA has been effective in advocating for extended due dates for these audits, from 60 days after the request by the AG's office to 120 days, because an entity that is required to undergo an audit might not have immediate funds to pay for it; in addition, the entity will have to find an auditor and facilitate its stages, such as audit bidding, scheduling, planning, and fieldwork-steps that can take month.

Key Governance Provisions

After the enactment of the Sarbanes-Oxley Act of 2002 (SOX), components of its public company corporate governance provisions became suggested voluntary best practices for nonprofits. The 1RS found that nonprofit compliance with such practices correlated with improved tax law compliance. Subsequently, the 1RS added related governance questions to Form 990, Return of Organization Exempt from Income Tax. The act has now converted some of these formerly recommended best practices into New York State law.

Accordingly, the act creates specific requirements for whistleblower and conflict of interest policies as outlined below. The act provides a degree of flexibility and it does not require nonprofits to amend existing policies if they are substantially similar. In coordination with finalizing their policies, it is advisable for organizations to review the wording of Schedule O, Form 990, in order to avoid inconsistencies with the act.

Conflict of interest policy. The act requires all organizations, regardless of their annual revenue, to have a conflict of interest policy administered by the board secretary. It is unclear whether the secretary can delegate this task to others and then oversee the process in a manner similar to board committees. This will need further clarification by the state. The NYSSCPA has advocated for allowing this process to be performed by any appropriate individual designated by management.

The act requires that the following components be included within the policy:

* A definition of the circumstances that constitute a conflict of interest

* Procedures for disclosing a conflict of interest to the audit committee or, if no audit committee exists, to the board

* A requirement that the conflicted individual not be present at or participate in board or committee deliberations or voting on the matter

* A prohibition of any attempt by the conflicted individual to improperly influence the deliberations or voting on the matter

* A requirement that the existence and resolution of the conflict be documented in the organization's records, including minutes of any meeting where the conflict is discussed or voted on

* Procedures for disclosing, addressing and documenting related party transactions.

The policy must also require that directors, prior to their initial election and annually thereafter, submit to the secretary a signed written statement identifying, to the best of the director's knowledge, 1) any entity that the director is an officer, director, trustee, member, owner, or employee of and that the organization has a relationship with, and 2) any transaction that the organization is a participant in and the director might have a conflicting interest in. The secretary must provide copies of all such statements to the chair of the audit committee or, if there is none, to the chair of the board.

Whistleblower policy. Under the act, notfor-profit corporations and wholly charitable trusts with 20 or more employees and annual revenues in excess of $1 million (in the prior fiscal year) are required to have whistleblower policies.

The whistleblower policy must provide that directors, officers, employees, or volunteers who, in good faith, report any action or suspected action taken by or within the organization that is illegal, fraudulent, or in violation of any organizational policy will not suffer intimidation, harassment, discrimination, other form of retaliation, or (in the case of employees) adverse employment consequences.

Employers and attorneys should assess whether the "good faith" component has been met in light of the fact that complaints can damage the nonprofit as a whole. The act requires the following components be included in the policy:

* Procedures for reporting violations or suspected violations of laws or organizational policies, including procedures for preserving the confidentiality of reported information

* A requirement that an employee, officer, or director be designated to administer the policy and report to the audit committee, another committee of independent directors, or the board

* A requirement that a copy of the policy be distributed to all directors, officers, employees, and volunteers who provide substantial services to the organization.

Employee handbooks and finance manuals identifying the entity's policies, processes, and procedures can become subject to legal disputes; therefore, they should be vetted for legal compliance, as well as compliance with organizational policies and operational practices.

The Act's Impact on Boards

Corporate bylaws. Because of the act's breadth and the consequences for violating its provisions, all New York nonprofit corporations and other entities subject to its provisions are advised to review their bylaws for legal compliance. The following areas should be included within this evaluation:

* Electronic communications {Exhibit 2 features a comprehensive list of items affected by electronic means of communication.)

* Voting requirements (i.e., Must ballots be in writing? Is a two-thirds majority necessary? Is there a quorum requirement?)

* Board committees (i.e., Are committee members required to be members of the board and independent?)

* Increased audit oversight requirements (including an articulation of the audit committee's responsibilities in accommodating the act)

* Related-party transactions (can be addressed in various areas but should be consistent with the act)

* Audit requirements (i.e., organizations should comply with the revised reporting requirements)

* Board chair serving as the executive director (The law states that no employee of the corporation can be chair of the board. Instances where the bylaws require the board chair to be the executive director will clearly have to be revisited.)

* Compensation for Board members (Although compensation is permitted, board members' subsequent ability to become employees of the nonprofit will be limited because the act requires three years of independence.)

* Fiscal matters (i.e., Which responsibilities would satisfy the act's requirement of "overseeing accounting and financial reporting processes"?).

The board committee. Audit committees must be composed of independent board members. The law makes a distinction between a committee of the "organization," which is similar to a nominating committee, whose members do not have to be board members, and a committee of the "board," which must be composed of board members. Board members have specific fiduciary responsibilities that non-board members do not have.

The audit committee must now be composed solely of independent board members; however, many nonprofits lack enough board members with the necessary technical expertise to competently serve on their audit committees. Until now, the typical remedy has been for an oiganization to look beyond its board for CPAs or financial experts to serve on the committee, often chaired by a board member. The act no longer permits this, but boards can look to outside experts and rely on their advice for decisions on areas outside of their own expertise. In addition, organizations that require participation in a committee as a prerequisite to becoming a board member will also have to revisit and perhaps modify their policy.

One option for nonprofit organizations is to find and appoint a sufficient number of independent board members with the professional competence to also perform audit committee duties under the act. (As a practical matter, some organizations may have to waive "expected charitable contribution" requirements in order to attract such board members, especially if the amounts are substantial.) A second option is to supplement the audit committee with one or more experts who can serve as advisors; however, audit committee members remain responsible for the decision making required by the act and cannot delegate that to such advisors.

Additional areas of focus are on how board members are appointed; the act requires them to be appointed or elected by other board members because they will have the power to act on behalf of the board.

Electronic Communications

As discussed earlier in Exhibit 2, the act includes provisions to legally accommodate the use of electronic communications. Some confusion has already surfaced in cases where a board wants to go paperless, but a minority of members does not use e-mail or does not have access to the Internet. Therefore, before addressing this issue, a board should understand the capabilities of its members and accommodate them accordingly.

The usage of electronic communication should be reasonable. For example, the law does not allow for participation in a board meeting where a member does not have the ability to actively participate, vote, or object, but can only listen in on the meeting's discussions.

Related-Party Transactions and Conflicts of Interest

Related-party transactions can frequently benefit a nonprofit, such as when a board member or the executive director is the landlord and allows for free or discounted rent, when a board member provides an interest-free loan, or when professionals provide discounted or no-cost services. But during the drafting of the law, this topic and the related situations garnered considerable attention. (Exhibit 3 provides some definitions related to this topic.) Taking into account the potential benefits, the law does not prohibit related-party transactions; rather, it places the burden of proof on the organization to demonstrate that the transactions are reasonable and not abusive, given the circumstances.

To meet the act's requirements, related-party transactions must be fair, reasonable, and in the best interests of the organization. These decisions should be made carefully, because the act gives the AG's office the power to rescind a transaction it deems inappropriate; to seek restitution, including penalties up to double the transaction amount; and, if it is deemed necessary, to remove board members.

In addition, there are requirements to ensure that a transaction is transparent, such as having the interested individual (e.g., director, key employee, etc.) disclose the transaction, the consideration of altema- tive possibilities, and the documentation of the basis for the decision to enter into the related-party transaction. Furthermore, such a transaction requires "majority of the board" approval (based on members present at the meeting) and requires that the individual with the conflict be recused from the meeting during related deliberations. It is absolutely vital to document every action taken concerning a related-party transaction, including in the minutes of board meetings. This evidence is necessary to confirm that the act's requirements have been met and avoid AG sanctions.

Board of directors: duties relating to timely filings. The act affects board members by expressly charging the board with the responsibility of filing the appropriate documentation to the state, such as the Form CHAR 500, Annual Filing for Charitable Organizations. Accordingly, the act states that willful failure to submit required filings constitutes a breach of a director's duty to the corporation and allows the AG to dissolve the corporation. Board members often question their personal exposure for board service; a common answer given is that board members can be personally liable for noncompliance with payroll taxes. Under the act, failure to file the appropriate documents constitutes a breach of the director's duty. It is important for the board to have a control process in place to ensure that all regulatory filings are properly prepared, reviewed, and sent timely to regulators.

Board composition. The act states that "no employee shall be chair of the Board or hold any other title with similar responsibilities." The board composition must include an independent board member as chair, which precludes the executive director from being board chair; however, the executive director may still be a board member, as long as he recuses himself from deliberations on areas where conflicts of interest exist, such as his own compensation. As discussed above, the bylaws should be reviewed to ensure that its requirements are in concert with the law. The effective date for this provision was extended to January 1,2015, for small nonprofits (defined as having annual revenues less than $10 million in their last fiscal year ended prior to January 1, 2014).

Smaller nonprofits will likely face challenges in finding new board members, and prospective members might hesitate due to the act's increased responsibilities. Many smaller nonprofits have expressed concern about their ability to be in compliance. These concerns have drifted up to state legislators and the AG's office. Remedies are under discussion but might take time to finalize; however, the AG is well aware of the issue and is seeking to create awareness and outreach to assist in the widespread implementation of the law. The implications of the financial burdens, such as potential professional consultations, are a concern. Costs of compliance with the act will be a vital line item on an organizational budget. Therefore, those involved with the budget process should incorporate the cost of compliance with the act.

Board oversight of the annual independent audit The act imposes and clarifies board oversight responsibilities. Either the full board or an audit committee is responsible for overseeing the annual audit. As noted, the act requires the audit committee to be composed of independent board members; however, it does not directly identify how many members must be on the audit committee. Separately, the act states that the board may designate standing committees to work on its behalf; those committees must consist of three or more directors. Therefore, it stands to reason that the audit committee must have three independent directors.

Exhibit 4 provides details about specific board audit oversight responsibilities. The board is given express responsibility for overseeing the accounting and financial reporting process. This is an area that requires planning and deliberation to determine which key performance indicators and other metrics should be provided to the board, and at what level of detail, in order to assess compliance with the law's provisions. If the board does not have the necessary expertise, it might be advisable to seek professional assistance, both in developing the metrics and training board members.

The effective date for this provision was extended to January 1,2015, for small nonprofits.

Independent director. Only independent directors can serve on the audit committee. Under the act, an independent director is an individual that meets the following:

* Has not been an employee in the last three years

* Has not received more than $10,000 in compensation in the last three years

* Has not been an employee of or had substantial interest in an entity that has made payments to or received payments from the corporation or an affiliate for property or services in an amount that, in any of the recent three fiscal years, exceeds tiie lesser of $25,000 or 2% of consolidated gross revenue (not including donations)

* Has no relatives who do not meet these criteria.

Exhibit 4 indicates that the board or the audit committee is required to annually retain or renew the retention of an independent auditor to conduct the audit. The term "independent auditor" is defined by tiie law as "any certified public accountant performing the audit of the financial statements of a corporation." Whether this refers to the audit partner or the audit firm was not specified by the act and is pending further clarification.

It will be interesting to see how these responsibilities play out in practice. As the ground shifts beneath nonprofits and their board members, aftershocks are likely to be felt around the for-profit world. One example is directors' and officers' insurance rates, which might increase due to the increased legal responsibilities of board members. Banks and insurance companies alike might require verification that various components of this law are being adhered to prior to engaging or providing a rate.

The biggest impact is likely to be felt at smaller nonprofits that might lack resources. Many organizations will need to seek out volunteers and paid professionals with the necessary financial expertise to help them comply with the act. Otherwise, the burden of maintaining a board that can comply with the law may become unendurable.

Impact on CPAs: Technical Insights

Audit opinion. CPAs should be aware of the unique language the law uses and tiie standards it requires for auditors to form an opinion. The law states:

The annual financial report shall be accompanied by an annual financial statement which includes an independent certified public accountant's audit report containing an opinion that the financial statements are presented fairly in all material respects and in conformity with generally accepted accounting principles, including compliance with all pronouncements of the financial accounting standards board and the American Institute of Certified Public Accountants that establish accounting principles relevant to notfor-profit organizations.

The state is currently reviewing the alignment between the wording of the law and the practices of the accounting profession to ensure they are not misleading or in conflict. This wording is similar to the New York Executive Law Section 172-b; however, it might have been preferable for the requirements to be in accordance with the "applicable financial reporting framework."

One issue that might require clarification is the role, if any, of audits prepared under IFRS. The act's financial reporting mies apply to all nonprofits registered to solicit contributions in New York, including foreign entities. Several questions pertaining to IFRS GAAP standards convergence and related issues are likely to arise in this area, as the law does not seem to include all of the frameworks of financial reporting.

For decades, organizations meeting the AG's financial reporting thresholds have had to prepare GAAP financial statements. Accordingly, instructions for the CHAR 500 refer solely to financial statements prepared in accordance with GAAP, precluding any other method of accounting. Here, the act's reference to AICPA pronouncements, and their commentary on cash basis and other bases of accounting, might be helpful. The author believes that the current wording stands a realistic chance of being revisited and revised. For example, the state might be persuaded to reconsider the use of cash or other bases of accounting. For the present, however, wherever financial statements are required under the act, they should be prepared in accordance with GAAP.

Auditors' responsibilities. Auditors have traditionally had the responsibility to report deficiencies and communicate with those in charge of governance. Some practitioners fear that this law might be misinterpreted as an additional requirement for auditors to follow. It is therefore important to distinguish between the act, which is incumbent upon the nonprofit itself, and the auditor's responsibilities under the accounting and auditing guidelines.

Form 990 Issues

Independence. The detail provided on Schedules L and R regarding interested persons and related organizations should be aligned with the law. Accordingly, nonprofits will have to take a fresh look at their Form 990. Under the act, if an individual has received compensation within the past three years, it would preclude the recipient from being an independent director; according to Form 990, on the other hand, only if compensation was received during the most recent tax year would such an individual not be considered independent.

Compensation. Form 990 (part VI, question 15, p. 6) asks, "Did the process for determining compensation of the following persons (CEO, executive director, top management official, key employees) include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?" In order to check 'yes,' the compensation had to be reviewed by a governing body that does not have a conflict of interest. An organization that does not have the process of compensation being reviewed and approved by independent persons might consequently turn out to be in violation of the new law because the law requires independent persons on the board, and the board is responsible for approving the executive director's salary. It will be incumbent upon nonprofits with related parties on the board to recuse such parties from the approval process of affected transactions.

On Form 990, the 1RS defines an independent board member as one who did not receive compensation of $10,000 during the tax year. As noted above, the meaning of "independence" under the act is much more restrictive than the IRS's definition. Accordingly, New York organizations filing a Form 990 must ensure that this question is answered correctly. In addition, the descriptions provided on Schedule O should be aligned with the IRS's definitions and not be in conflict with the New York State law.

In the author's experience, small organizations often have three board members; the executive is the chair of the board and the other two board members consist of family members. An independent board member is now needed to satisfy the act's independence requirements. Based upon feedback from affected parties, the author believes this will be one of the more difficult areas for nonprofits to comply with in a timely fashion.

Governance. As noted above, the 1RS has found that sound nonprofit governance correlates with good tax law compliance. As a result, many governance questions have been added to Form 990. Answers that reflect poor governance can lead to a greater chance of being audited; however, it is generally left to the states to define the scope of governance policies that nonprofits under their jurisdiction are required to implement. These include the policies for conflicts of interest and whistleblowers now required by New York.

Committees. The 1RS does not require committees to be composed of board members, whereas the act requires the audit committee to consist solely of board members.

Observations on Revenue

The act has multiple revenue thresholds to determine various components of its application. But an issue arises when trying to develop a uniform method in defining revenue. The most common places to find total revenue are the audited financial statements and Form 990 (box G on p. 1 and line 12 on p. 1, derived from line 12 of part VIII). Not all nonprofits have an audited financial statement or a Form 990 to determine their revenue. But because the audit thresholds are going up under the act, it stands to reason that those affected would already have these documents to use as an indicator.

line 12 on page 1 of Form 990 represents a "net revenue" figure, after eliminating rental expenses from rental income; tiie costs of direct benefits to donors from fund-raising events revenue; and the costs of goods sold when selling inventory; and, if assets were sold and generated revenue, after eliminating the costs of the assets that were sold.

As some have observed, because box G on page 1 grosses up the revenue, it may be significantly higher than line 12. This can inadvertently put many organizations that would otherwise not require either an audit or review over the thresholds. Regarding in-kind contribution revenue, property is generally included, but donated services are often not. Per tiie 1RS, even though donated services and facilities may be reported as items of revenue in certain circumstances by GAAP, many states and the 1RS do not permit the inclusion of those amounts in parts VIII and IX of Form 990. Certain in-kind contributions, such as a law firm donating major pro bono services, may be included as revenue in GAAP financials.

Seasonal revenues occur when an organization conducts a biannual event, when there are infrequent increases to investment income, or multiyear pledges are recorded in the first year as restricted revenue. These events also put an organization over the threshold inconsistently. Because these raise an issue, many have advocated using an average of several years, similar to what is calculated on Schedule A of Form 990.

Given the goal to lessen the burden on nonprofits in New York, many experts have advocated treating line 12 of Form 990 as the defining revenue number. This would seem to be the most reasonable option, considering the general public's understanding of an oiganization's revenue.

What's Next?

The Nonprofit Revitalization Act is bringing about historic changes for New York and other affected nonprofits. Given the extensive efforts to draft the law and the high qualifications of those involved, it would not be surprising to see other states follow suit. It is the author's hope that the law will bring back credibility and trust to the nonprofit community. CPAs should remain abreast of the law's implementation and any new developments in its interpretation in order to best advise nonprofits.

To meet the act's requirements, related-party transactions must be fair, reasonable, and in the best interests of the organization.

EXHIBIT 2

Practical Applications of Permitted Electronic Communications

* Submission of annual reports to the Attorney General's office

* Submission to the Attorney General of other or additional documentation beyond the typical annual submissions

* Invitations to board or committee meetings

* Board votes

* Participation in board meetings (via videoconference), providing there is the ability to propose, vote, and object

Smaller nonprofits will likely face challenges in finding new board members, and prospective members might hesitate due to the act's increased responsibilities.

It is important to distinguish between the act, which is incumbent upon the nonprofit itself, and the auditor's responsibilities under the accounting and auditing guidelines.

Ethan Kahn, CPA, is a director at the accounting and advisory office of Ethan Kahn CPA LLC. He can be reached at [email protected]. This article should not be construed as legal advice.