Significant, Indeed: What to Make of Nonprofit Fraud and Significant Diversions of Assets (Part 1)

A recent investigation published by the Washington Post has resulted in a maelstrom of scrutiny and whistle-blowing in the nonprofit sector. In its highly publicized report, the Post identified more than 1,000 larger nonprofits that recently disclosed having experienced substantial diversions of assets.

The root of the issue runs deeper than mere diversions, however. Acts of fraud and embezzlement were rampant, according to the report, and accounted for a significant portion of the hundreds of millions of dollars in diversions that were revealed. The Post also noted apparent violations in Federal reporting rules, with organizations omitting large amounts of lost assets, along with other crucial details.

In response to these distressing findings, Federal and state officials have launched their own investigations to determine whether or not groups have been properly reporting losses to authorities and sufficiently safeguarding their charitable funds. We’ve already discussed on this blog how organizations can be proactive and effectively carry out an internal investigation following the discovery of fraud, but what does a company need to know in order to identify and properly report such cases of misconduct? Here, we break down the most important definitions and caveats that all nonprofit organizations should understand. In this post, we tackle exactly what constitutes a diversion of assets.

What is a diversion of assets?

First and foremost, a diversion of assets encompasses theft, embezzlement or any unauthorized use of the organization’s assets, and can involve any person, regardless of whether or not they are an officer, director, key employee or independent contractor. By definition, it can also include investment advisors and grantees diverting grant funds. Diversions of assets do not include transactions at fair market value. For example, if an exempt organization sets up a taxable subsidiary and then takes back the stock—or enters into a partnership agreement in which the exempt organization gets a quid pro quo interest—there is no diversion of assets to be reported.

The IRS instructions to the Form 990 note that, “A diversion of assets can in some cases be inurement of the organization’s net earnings. In the case of section 501(c)(3), 501(c)(4) and 501(c)(29) organizations, it can also be an excess benefit transaction, taxable under section 4958 and reportable on Schedule L (Form 990 or 990-EZ).” Essentially, this means that if it is found that a Disqualified Person—i.e., someone who can substantially influence the organization—diverts assets on their own behalf, in addition to any other adverse actions that could result, then that person could be subject to a 25 percent tax on the excess amount (see more on this in our blog post on excess benefits), as well as a 200 percent tax if the transaction is not corrected and returned with interest.

Stay tuned for part two of this series, where we discuss the role of transparency and appropriate procedures in reporting diversions of assets.