Nonprofit Governance: Conflict of Interest Policy, Board Oversight, and the Form 990 Questions

Part VI of Form 990 asks 25 yes-or-no questions about the organization’s governance, management, and disclosure practices. The IRS does not impose specific governance requirements on tax-exempt organizations (state law governs nonprofit governance), but it uses the Form 990 answers to identify organizations at higher risk of private inurement, excess benefit transactions, and mismanagement. An organization that answers “no” to questions about conflict of interest policies, independent board members, and financial oversight is not automatically penalized, but it is more likely to face an IRS examination and more likely to lose that examination if governance failures contributed to the problem.

What does the conflict of interest policy need to include?

A conflict of interest policy addresses situations where a board member, officer, key employee, or their family member has a financial interest in a transaction with the organization. The IRS’s sample conflict of interest policy (Appendix A of the Form 1023 instructions) provides a template, and most nonprofits adopt it with minor modifications.

The essential elements:

Definition of conflict. A conflict exists when a person with decision-making authority (or their family member, or an entity in which they have a 35% or greater ownership interest) has a financial interest in a transaction being considered by the organization. The definition should be broad enough to capture indirect conflicts (a board member’s spouse runs the company that the nonprofit is considering hiring).

Disclosure requirement. Persons covered by the policy must disclose actual or potential conflicts before the board (or a committee) acts on the related transaction. The disclosure is typically annual (each covered person completes a disclosure form listing their affiliations and financial interests) and transactional (when a specific conflict arises, the interested person discloses it before discussion begins).

Recusal procedure. The interested person must leave the room during discussion and voting on the conflicted transaction. They may present information and answer questions before the discussion, but they do not participate in the deliberation or the vote. The minutes must record the disclosure, the recusal, and the vote.

Determination of reasonableness. The board (or committee), after the interested person has left, determines whether the transaction is in the organization’s best interest, whether the terms are fair and reasonable, and whether comparable alternatives exist. This mirrors the “rebuttable presumption of reasonableness” process under IRC 4958 for excess benefit transactions.

Documentation. The minutes of the meeting must record: the name of the person with the conflict, the nature of the conflict, the action taken (approval, rejection, modification), the basis for the decision (comparability data, alternative quotes, market research), and that the interested person recused.

Violations. The policy should specify consequences for failure to disclose a conflict (removal from the board, termination of employment, repayment of any benefit received).

Form 990, Line 12a asks whether the organization has a written conflict of interest policy. Line 12b asks whether officers, directors, and key employees are required to disclose interests that could give rise to conflicts. Line 12c asks how the organization monitors and enforces compliance (the answer goes in Schedule O).

Why do independent board members matter?

Form 990 (Part VI, Line 1b) asks how many board members are “independent.” An independent board member is one who: (1) was not compensated as an officer or employee of the organization or a related organization during the tax year, (2) did not receive more than $10,000 in total compensation or payments from the organization (other than as a board member), and (3) is not a family member of anyone who received compensation from the organization.

The IRS looks at board independence as a proxy for whether the organization has effective oversight of management. An organization where every board member is also a paid employee, or where all board members are family members of the executive director, has no independent check on management decisions. The risk of private inurement (using the organization’s resources for personal benefit) is higher.

There is no federal requirement for a specific percentage of independent board members. State law varies: some states require a majority of independent directors for certain types of nonprofits, and some require independent audit committees. The IRS’s implicit expectation (based on examination patterns and guidance) is that a majority of the board should be independent. An organization where less than half the board is independent will not be penalized solely for that reason, but the IRS will scrutinize compensation, related-party transactions, and financial reporting more closely.

The practical recommendation: aim for at least two-thirds independent board members. Board members who receive compensation for services (beyond a reasonable board stipend) should be a minority. Family relationships should be disclosed in the conflict of interest process.

What are the whistleblower and document retention policies?

Whistleblower policy (Line 13). A written policy that protects employees and volunteers who report suspected illegal or unethical activity from retaliation. The policy should: identify who can receive reports (a designated board member, an independent hotline, or outside counsel), describe the types of concerns covered (financial misconduct, legal violations, safety hazards, harassment), promise confidentiality to the extent possible, prohibit retaliation, and describe how reports are investigated and resolved.

The Sarbanes-Oxley Act of 2002 (SOX) made it a federal crime to retaliate against a whistleblower at a publicly traded company. Two provisions of SOX also apply to nonprofits: the prohibition on destroying documents to obstruct a federal investigation (18 USC 1519) and the prohibition on retaliation against whistleblowers who provide information to law enforcement (18 USC 1513(e)). A whistleblower policy is not legally required for nonprofits (beyond these SOX provisions), but the absence of one on Form 990 suggests the organization has not considered how it would handle reports of misconduct.

Document retention and destruction policy (Line 14). A written policy that specifies how long the organization retains its records and when they are destroyed. The policy should cover: financial records (general ledger, bank statements, invoices, receipts), tax records (Form 990, Form 990-T, state returns, determination letter), employment records (W-4s, I-9s, payroll registers, personnel files), board records (minutes, resolutions, bylaws), donor records (contribution receipts, pledge agreements, grant agreements), and contracts and leases.

Common retention periods: tax returns and supporting records (7 years after filing), employment records (7 years after termination), board minutes (permanent), corporate records (permanent, including articles of incorporation, bylaws, and amendments), donor records (7 years after the last contribution), and contracts (7 years after expiration). The policy must include a litigation hold provision: when litigation is pending or reasonably anticipated, the organization suspends destruction of all records that may be relevant to the dispute.

How does the IRS use the governance answers in examinations?

The IRS’s Exempt Organizations division uses the Form 990 governance responses as a screening tool for examination selection. The 2008 Governance and Related Topics report identified several patterns that correlate with compliance problems:

Organizations that answer “no” to the conflict of interest policy question are more likely to have excess benefit transactions (unreasonable compensation or insider transactions) that were not properly evaluated by an independent board.

Organizations with few or no independent board members are more likely to have private inurement issues, because management decisions are not subject to independent oversight.

Organizations that do not review the Form 990 before filing (Line 11a asks whether the governing body reviewed the return) are more likely to have errors, inconsistencies, or unreported transactions.

Organizations that do not make the Form 990 available to the public before filing (Line 18 asks whether the organization makes the return available) may be less transparent about their operations.

The IRS does not audit an organization solely because it answers “no” to a governance question. But in combination with other risk factors (high executive compensation, related-party transactions, declining program expense ratios, large endowments with low program spending), governance weaknesses increase the likelihood of selection.

What compensation oversight does the IRS expect?

Part VI, Lines 15a and 15b ask about the process for determining compensation of the CEO/executive director and other officers or key employees. The IRS expects the answers (detailed in Schedule O) to describe a process that mirrors the rebuttable presumption of reasonableness under IRC 4958:

Who approves compensation? The board or a compensation committee composed of individuals who do not have a conflict of interest (not the executive director, not family members of the executive director, not individuals who report to the executive director).

What data is used? Comparability data from compensation surveys, Form 990 data from similar organizations, or documented written offers from similar organizations. The IRS wants to see that the organization looked at what comparable organizations pay for comparable positions, not that the board simply agreed to whatever the executive director requested.

How is it documented? The minutes of the meeting where compensation was approved should record: the members present, the comparability data reviewed, the terms of the compensation (salary, bonus, benefits, deferred compensation), and the reasoning for the decision. This documentation is the organization’s primary defense against an IRC 4958 excess benefit transaction claim.

The practical minimum: once per year, the board (or compensation committee) reviews the CEO’s total compensation against 3-5 comparable organizations, documents the comparison in the minutes, and votes to approve or adjust. For other officers, the same process applies at a level appropriate to the position (a $45,000 office manager position does not need the same rigor as a $300,000 executive director position, but both should be reviewed against comparable data).

What should I do next?

If your nonprofit does not have a written conflict of interest policy, adopt one before the next Form 990 filing. The IRS’s sample policy in the Form 1023 instructions is a serviceable starting point. If you have a policy but do not enforce the annual disclosure and recusal procedures, the policy exists on paper but not in practice, and the IRS will evaluate the practice, not the paper. If you are answering “no” to any of the three policy questions (conflict of interest, whistleblower, document retention), those are the easiest governance gaps to close.

• Nonprofit donor acknowledgment letters, the IRC 170(f)(8) substantiation rules, quid pro quo disclosures, and non-cash donation procedures
• Nonprofit Form 990 filing guide, the full annual return including the governance questions, public support test, and compensation disclosure
• Nonprofit UBIT, unrelated business income tax and the Form 990-T filing that accompanies the 990
• Church bookkeeping and fund accounting, the parallel governance and record-keeping requirements for churches (which are exempt from 990 filing but face the same fiduciary duties)
• Nonprofit executive compensation, reasonable pay, excess benefit transactions under IRC 4958, and Form 990 compensation disclosure
• IRS accuracy-related penalty, reasonable cause defense for governance-related filing errors
• IOLTA trust accounting, the parallel fiduciary governance requirement for law firms handling client funds

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.