Charitable Miss-Givings

If you advise clients on charitable giving, you're responsible for making sure the recipients are legit.

Imagine your wealthiest and most philanthropically-minded clients, a highly respected businessman and his equally successful wife, are due in your office in five minutes to discuss which charitable organizations would satisfy their charitable-giving goals. Surely you checked with the Internal Revenue Service to verify that the charities you are about to suggest have secured a 501(c)(3) status so they may legally accept tax-deductible donations. No doubt you perused the organizations' Web sites to learn more about the charities' missions before you contacted the groups' executive directors to discuss the organizations' latest successes and miscues.

What? You didn't?

As a financial advisor, you should perform due diligence on charities before advising high-net-worth clients to donate money. And it's not just because of rampant charity fraud (although Hurricane Katrina relief did bring the unscrupulous out in droves to fraudulently solicit charitable donations in the name of humanitarian relief). Where you can really help your clients is in ascertaining if the money is being put to good use. “If a charity spends less than a third of its budget on the programs and services it exists to provide, then we automatically give that charity a score of zero for organizational efficiency,” says Charity Navigator, an independent research group. In general, you should avoid “inefficient” charities, ones that spend too much per dollar raised, “limiting the difference they can make with your dollars,” according to Charity Navigator. (At charitynavigator.org, the research group ranks firms on their fundraising efficiency and other standards.)

Due Dilly

That said, it's absolutely necessary. “Due diligence is a strategy to reduce the risk of failure,” says Herrington Bryce, professor of Business Administration at the College of William and Mary and the author of Financial and Strategic Management for Non-Profit Organizations (Prentice Hall, 1992), widely considered the bible of financing nonprofits.

With so much research material about charities available — some conflicting, some confusing — just how do you know when you've satisfied your due diligence duty? It's not enough to review the charity's financial reports or even merely contact the entity to ask questions. According to Lois Colley, founder and CEO of Due Diligence, an arm of her private detective agency with offices in Manhattan and Columbus, “That is an outdated method of verifying information due to the transient nature of our society and the ability of individuals to create a fake persona or financial report.” (See table.)

Daniel Borochoff, president of the Chicago-based American Institute of Philanthropy (AIP), which bills itself as a charity watchdog service, recommends digging deep into an organization: Read notes and minutes of the organization's board meetings, articles of incorporation, by-laws, financial audits and accompanying notes. Borochoff expects charities with an annual budget over $250,000 to undergo an external audit yearly to ensure funds are being spent according to the organization's mission statement, philanthropic goals and budget.

“Internal audits tend to be lacking in nonprofits versus other types of organizations,” says John Warren, general counsel of the Association of Certified Fraud Examiners in Austin, Texas. According to the organization's 2003-2004 survey of 508 fraud cases, 58 occurred at nonprofit agencies. Of those 58, internal audits only detected 11.5 percent of those frauds. Overall, internal audits uncovered illegal activity in nearly one-fourth of the 508 total cases of fraud. What this means, says Warren, is that even if a nonprofit organization conducts an internal audit, it's not likely to uncover fraudulent behavior.

But it's still important to choose charities that perform audits. David Meyer, a Columbus attorney whose law firm represents clients with claims against financial advisors and brokerage firms, says financial advisors don't want to meet someone like him in court. He cautions financial advisors to “document the due diligence they perform, which will go a long way in proving they satisfied their obligation. Documenting as much as possible and maintaining an open and continuing line of communication with supervisors and compliance personnel,” will help rebuke claims of negligence, he says.

Where and What to Look for

Nonprofits should use most of their resources for their charitable purpose and not for staffing, internal reviews and other expenses, says Borochoff. It's also important to realize that not all organizations soliciting for good causes are eligible to receive tax-deductible contributions. It's noteworthy that charities frequently lose their tax-exempt status for various reasons, like fraud, the failure to file the required annual report on both state and federal levels, a systematic violation of its mission or demonstrating an over-riding for-profit motive. It is the financial advisor's duty to uncover this information, especially since case history has shown that the IRS is likely to hold them and the client responsible and not honor the tax deduction, says Bryce.

The IRS' Web site (governmentguide.com) is an excellent place to check the tax-exempt status of an organization. Look for the online version of Publication 78, A Cumulative List of Organizations, which details the tax-exempt status of nonprofits. Unfortunately, the Web site is not updated frequently, so you may need to call the IRS at 877-829-5500 to request a copy of the letter granting the charity its tax-exempt status. It is also imperative to verify the charity is not listed among organizations whose tax-exempt status is suspended under section 501(c) of the Internal Revenue Code.

At least 60 percent of an organization's budget should go directly to its programs, says Borochoff. A nonprofit should also not spend more than $35 to raise $100 in donations, he cautions.

Borochoff's organization publishes a Charity Rating Guide and Watchdog Report, available by contacting the AIP (charitywatch.org). The largest charity evaluator in the U.S. is Charity Navigator. which, according to its Web site, attracts more visitors than all other charity groups combined.

The Better Business Bureau highlights charities that voluntarily meet that organization's standards of accountability on its Web site, found at give.org.

According to Sandra Miniutti of Charity Navigator, the site's rating system gleans information from a charity's IRS Form 990 to assess the nonprofit's overall stability. The AIP analyzes what a charity does with its contributions in determining that organization's overall rating.

Two well-known charities whose names and causes have been much publicized over the past year are the American Red Cross and the national office of Habitat for Humanity. But experts rank them differently. Whereas Borochoff's group and Charity Navigator both gave the Red Cross high overall ratings, they widely disagreed on the effectiveness of Habitat for Humanity. While Habitat earned a B from AIP, it earned only one star, the lowest rating, from Charity Navigator.

If you think such advice isn't part of your duty to your clients, you'd be wrong. “Unless you know your [client's] financial boundaries, the financial advisor can't effectively control planning in the totality of their wealth,” says Rory Diefendorf, a fourth-generation financial planner in Long Island, N.Y. As a financial planner, he says, “I need to help my clients define their boundaries so they can accomplish their overall financial goals.”

10 Charities Worth Watching

Many of the most effective charities are household names. But, according to Charity Navigator, an independent research firm in Mahwah, N.J., some well-known charities are less effective than you'd think. Here is a list of some lesser known, but “truly exceptional” charities, as ranked by Charity Navigator. Each received the firm's highest rating. Oh, and they are frugal, operating on less than $2 million a year.

Charity Mission Location Phone
Asha for Education socio-economic change in India via secular education New York 877-811-6943
United States-Japan Bridging Foundation to meet needs of American students studying in Japan Washington, D.C. 202-653-9800
Disabled American Veterans Charitable Service Trust to build better lives for disabled veterans and their families Cold Spring, Ky. 859-442-2055
Oregon Heat helping low-income Oregonians meet their energy needs Tualatin, Ore. 503-612-3790
CURE Childhood Cancer to fund clinical research to fight pediatric cancer Atlanta 800-443-2873
PAWS Atlanta a no-kill pet adoption center Decatur, Ga. 770-593-1155
The Wild Foundation to protect “highly threatened” wilderness areas and wildlife in Sub-Saharan Africa Ojai, Calif. 877-447-9453
PAWS Chicago to alleviate Chicago's pet overpopulation problem via free spay/neuter clinics and pet adoption Chicago 773-843-4887
Dreams Come True provides momentary reprieve for children suffering from life-threatening disease Jacksonville, Fla. 904-296-3030
The Elephant Sanctuary to provide a haven for old, sick or needy elephants Hohenwald, Tenn. 931-796-6500
Source: charitynavigator.org

The Due Diligence Dance

Lois Colley, founder and CEO of Due Diligence, an arm of her private detective agency, says advisors should:

  • Verify the name of the organization by doing records researches. In some states, charities must file with the Secretary of State's office. Check your state government's Web site for specific details;

  • Identify the principals of the organization and members of the board of directors. Establish each person's length of service. If necessary, conduct identity research as well as criminal and civil background checks;

  • Personally visit the charity's headquarters. If your client is particularly hands-on, they might want to participate in this aspect of due diligence; and

  • Review the charity's IRS 990 form, which must be filed annually if the organization has assets over $25,000. It contains pertinent information, like how donations were raised and the percentages expended on the organization's programs, overhead and fundraising efforts. It also details the charity's accomplishments over the past year. The IRS uses this form to determine if the nonprofit can obtain or retain its tax-exempt status.

American Institute of Philanthropy (AIP) publishes a Charity Rating Guide and Watchdog Report, available by contacting the AIP (charitywatch.org). The largest charity evaluator in the U.S. is Charity Navigator, which, according to its Web site (www.charitynavigator.org), attracts more visitors than all other charity groups combined.

The Better Business Bureau highlights charities that voluntarily meet that organization's standards of accountability on its Web site, found at give.org.

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