Often the public is focused on avoiding outright charity frauds and scams. While this is important, it is critical for donors to understand that even a "legitimate" charity may not have good governance or financial practices or be using your donations the way you intend. This can be true even when a nonprofit is properly registered with the IRS and state agencies, is operating well within the law, has had its financial activities audited by a qualified accountant, and receives top scores and transparency seals from nonprofit trade associations.
Difference Between "Legitimate" and "Efficient"
If you donate to an outright scammer, $0 of what you give will be used for charitable purposes. If you donate to a "legitimate" but highly financially inefficient charity, 1% to 35% of what you donate may be used for a charity's programs, with the rest going to overhead like fundraising and management expenses. The difference between donating to an outright charity scam and donating to a legitimate but highly inefficient charity may only be the difference between 0% or 1% of what you donate being spent on something charitable. A charity is "legitimate" if it is operating in line with state laws and is properly registered with the Internal Revenue Service (IRS). Knowing if a charity is "legitimate" is a good first step, but it is not enough.
Visit charitywatch.org/resources-for-donors to learn how to confirm that a charity is registered and in good standing with state and federal agencies.
Free Speech Concerns Limit Regulation
Many donors wrongly assume that the government regulates how much a charity can legally spend on overhead versus programmatic activities. This is not the case. In fact, the government is not allowed to regulate it due to First Amendment concerns.
In the 1980s the Supreme Court of the United States (SCOTUS) shot down several attempts by state and local governments to legally require charities to spend a minimum percentage of their donations on programmatic activities and limit their overhead spending. For example, the North Carolina Charitable Solicitations Act of 1985 attempted to limit the percentage of donations a charity fundraiser could retain as payment for services, deeming "up to 20%" as "reasonable," and amounts exceeding this as generally "unreasonable," subject to certain conditions. This effort was deemed unconstitutional by the SCOTUS in 1988 on First Amendment grounds (Riley v. National Federation of the Blind of North Carolina) due to concerns that limiting a charity's ability to disseminate information, even when such information is intertwined with fundraising efforts, could have the effect of limiting free speech.
In Schaumburg v. Citizens for a Better Environment, the village of Schaumburg, Illinois was prohibited on First Amendment grounds from enforcing an ordinance that would bar charities from soliciting donations within city limits unless they used 75% or more of their receipts for charitable purposes. Such fundraising appeals are considered a form of communication involving the dissemination of ideas and advocacy of causes. While they are subject to reasonable regulation, according to the SCOTUS's 1980 ruling, such regulation may not impinge upon free speech. On these grounds, the "75%" rule was deemed unconstitutional.
In Secretary of State of Maryland v. Joseph H. Munson Co., a Maryland statute that limited the amount a charity could pay to fundraisers to no more than 25% of the amount raised was ultimately deemed unconstitutional in 1984 by the SCOTUS on free speech grounds. In short, limiting a charity's ability to contract with fundraisers due to putting a cap on the amount of money that can be paid for their services could have the unintended consequence of preventing the charity from distributing information that is considered protected speech.
Nonprofit Trade Association Ratings
A donor may search online for charity ratings before making their giving decisions thinking this will help them avoid donating to highly inefficient or irresponsible charities. Unfortunately, CharityWatch's research has found many instances of nonprofits that spend 35% or less of their annual expenses on programs receiving perfect scores on one such website: charitynavigator.org. Charity Navigator relies on automation to publish ratings on nearly 200,000 charities, pulling data from fields in charity tax filings and otherwise formulating ratings based on the face value of what charities report about themselves. Some organizations to which CharityWatch has assigned "F" ratings based on our in-depth analysis of their audited financial statements and tax filings have received perfect 4-Star ratings on this site.
In a June 5, 2023 article published in The Chronicle of Philanthropy entitled, "Charity Navigator Stars Can Boost Donations - but Nonprofits Might Game the System," an economist discussed her research into how a charity's donations increase as its star rating improves on charitynavigator.org. The author, Assistant Professor of Economics at the University of Missouri-Columbia stated that "if a charity's rating rises from two to three stars or from three to four stars, its donations rise by about 6 percent. Larger charities - that is, those with net assets of more than $5.6 million - benefit even more. Their donations grow 9 percent for an increase in rating from three to four stars and 12 percent for an increase from two to three stars."
The problem? "The existence of ratings appears to induce charities to change their behavior by just enough to earn themselves a higher rating," said Mayo. "By reviewing the 990 form that charities must file with the Internal Revenue Service every year that details their expenditures, I've found that some charities are a little sneaky. Sometimes they classify - incorrectly- some of their administrative expenses as program-related expenses in what could be a bid to cut down on their overhead costs because they know it can improve their ratings," Mayo continued.
The government doesn't regulate the methodology charity rating websites use to compute their charity ratings or prohibit charities from republishing such ratings on their websites or in their marketing and fundraising materials. A donor should never rely on a charity rating they see online or elsewhere without first understanding the methodology the rater used to compute the rating and confirming that the rating process is rigorous and independent enough to account for the inaccuracies and inconsistencies ubiquitously found in charity tax filings and other reporting.
Read "F-Rated Charities Receive Top Ratings & Seals From Nonprofit Trade Associations" to view the chart of "F" Rated charities that receive 3-Star & 4-Star ratings on charitynavigator.org.
Ineffective Government Agencies
The IRS is first and foremost a revenue collection agency. There is not a lot of tax revenue to be recovered from charities since they don't pay tax on most forms of revenue. Scrutinizing charity tax filings for accuracy, consistency, comparability, or completeness is not a routine practice of the IRS, and charities are rarely subjected to an IRS audit.
In the for-profit world, the Securities and Exchange Commission (SEC) works to protect investors from market manipulation and fraud. While charities have stakeholders like donors, staff, board members, program participants, and grant recipients, they don't have investors who will sue if given false information such as inaccurate or incomplete tax filings. The nonprofit sector has no SEC equivalent that oversees nonprofit organizations. Charities that manipulate their tax filings to make themselves appear more efficient to donors, such as by overvaluing the donated goods and services they receive, or labeling fundraising activities as program expenses, rarely face consequences for doing so.
Some state regulation of charities' fundraising activities does exist. For example, charities that solicit donations nationally in the United States generally must register annually in 41 jurisdictions across the country to comply with state laws. Registrations are typically overseen by the Departments of the Attorney General or Secretary of State. Regulations vary from state to state but typically require charities to submit financial information, such as a copy of their most recent tax Form 990, and governance information such as the names of officers and directors and their respective positions. The majority of these jurisdictions also require charities over a certain size to submit a copy of their independent audited financial statements.
While charities may be required to submit a lot of information to states every year as a condition of being allowed to solicit donations within their borders, little of it is scrutinized in ways that can help donors understand if their donations to a particular charity will be used efficiently and effectively. State charity offices are notoriously underfunded and understaffed, and often lack the resources necessary to provide adequate oversight.
In addition, these regulators are charged with enforcing laws, not issuing opinions about whether they think a particular charity is worth supporting based on the worthiness of its cause or the reasonableness of its overhead expenses. Unless a charity is violating a statute or committing a criminal offense, state regulators are extremely limited in their ability to warn donors about unethical charities that aren't doing anything strictly illegal. A charity can spend 99% of its budget on overhead and 1% on its programs without violating any laws.
A "Clean" Audit Does Not Guarantee That a Charity is Operating Efficiently
Charities will often deflect criticism about their high overhead costs by pointing out that they have had an audit of their finances conducted by third-party Certified Public Accountants (CPAs) and that the results were "clean." This is a straw man argument. Audits don't measure or claim to measure how efficiently a charity will use your donations. Rather, an auditor's function is to follow Generally Accepted Auditing Standards (GAAS) to inspect a charity's assets, examine its accounting records, test its internal controls, and conduct analytical procedures to determine whether an organization is complying with Generally Accepted Accounting Principles (GAAP). There is no GAAP rule that prevents a charity from spending 99% of your donation on overhead.
Legal Manipulation of Financial Reporting - Donated Goods
CharityWatch has been a longtime critic of some of the valuation and financial reporting practices charities use when they receive and distribute noncash donations, also known as gifts in-kind. (GIK). Accounting rules provide only very general guidance on how charities are required to value GIK, which can result in different charities assigning widely different values to the same types of donations.
In other cases, a charity may place a multi-million-dollar valuation on GIK that is ultimately useless, such as pharmaceuticals that will expire before they can be distributed. In its financial statements a charity may report such obsolete GIK inventory as a program expense. Meaning, donated inventory that has been thrown away rather than distributed can have the effect of making a charity appear to be spending more on programs than if it hadn't received the GIK inventory at all.
Even when a charity receives and distributes useful noncash donations, the inclusion of such GIK in a charity's financial statements can still skew how efficiently it is operating. The dollar value a charity assigns to its GIK transactions gets mixed together with its cash contributions and expenses in its financial reporting, including in its IRS tax Form 990. This mixing of cash and non-cash transactions often makes a charity appear to be larger and more efficient in its program spending than it would otherwise appear if its cash transactions were reported and analyzed separately. Such mixed reporting can have the effect of obfuscating excessive fundraising costs by making those expenses appear low relative to the cash and potentially overvalued non-cash donations the charity reported raising as a result of such spending.
There have been numerous cases of charities significantly inflating the value of the GIK donations they receive relative to the fair market value of those items. In one such case, the California Attorney General secured a Stipulated Judgement against The National Cancer Coalition (NCC) related to what it described in a March 12, 2018 press release as a "misleading financial reporting scheme" that "relied upon vastly overvalued Gifts-in-Kind donations by pharmaceuticals." The charity "improperly used U.S. market prices to value pharmaceuticals that were shipped overseas and were restricted for international use only. The result was highly inflated revenue and program expense figures in its public financial reporting, which violated California law," according to the California Attorney General's press release. Overvaluation of GIK is common under current accounting rules which provide only very general guidance for how a charity's management is allowed to value such donations in its financial reporting. For this reason, overvaluations rarely result in successful legal action.
Attempts to regulate such overvaluations more broadly have been unsuccessful. In 2019, California Assembly Bill 1181 was vetoed by then-California Governor Newsom. If passed, it would have prevented charities from using one of the common methods charities apply to overvalue their gifts-in-kind contributions by requiring valuations to be based on the markets of distribution. Newsom commended the California Attorney General's actions to "hold charities accountable when they mislead donors and the public," but stated that the bill as written may cause "burdensome implementation challenges for the charities impacted by its provisions."
Legal Manipulation of Financial Reporting - Joint Costs
In nonprofit financial reporting, the funds a charity spends on telemarketing, direct mail, or other solicitation activities that also include an "action step" or "call to action" are referred to as "Joint Costs." For example, a charity may pay millions of dollars to a for-profit, direct mail company to send out fundraising letters that include 5 or 6 requests for a donation. As long as the letter also includes an action step, such as "get your annual breast exam" or "don't forget to buckle your seatbelt," and meets other simple requirements for "purpose," "audience," and "content," the charity can claim that a primary purpose of these letters is to educate you. On this basis the charity can claim that a significant portion of what it spent to design, print, and mail these letters to you and other potential donors is a program expense, not a fundraising expense, even though the letters included multiple requests for a donation.
Charities often use joint costs as a way of inflating their reported charitable program spending and deflating their reported fundraising costs. Although the use of this accounting "trick" is often perfectly in line with the accounting rules for the reporting of joint solicitation costs (AICPA SOP 98-2 / ASC 958-720), these rules allow for many interpretations and judgments that can produce questionable results. The criteria for determining what expenses qualify as joint costs are subjective in nature and therefore leave room for biased interpretation by the charity. More specifically, while a charity may contend that portions of its solicitation materials qualify as a call to action with a purpose that promotes the charity's mission to an appropriately targeted audience, another interpretation of the purpose, audience, or content may result in a different conclusion.
For instance, if a fundraising letter from a genetic disorder charity includes educational information for the potential donor about healthy eating and exercise, the charity likely is applying joint costs. This means that the charity is reporting a portion of the cost to prepare and send that fundraising letter as a charitable program expense because the solicitation includes an educational component about healthy eating and exercise. Most donors who give to a genetic disorder charity likely think their contributions will be used for research grants or patient care, not for educating potential donors on diet and exercise, which seemingly would have very little if any influence over whether a person becomes afflicted with the genetic disorder.
The California Attorney General's office has echoed CharityWatch's concerns, saying that this accounting treatment "can be abused to reduce reported fundraising expenses. If a charity spends most of its money to fundraise, you probably would not donate to that charity...The improper use of Joint Cost Allocation results in a false report of a charity's finances and misleads potential donors and others into believing that the charity operates more efficiently than other charities."
Non-Disclosure of Major Funders
In 2021 the SCOTUS debated the merits and constitutionality of a limited disclosure rule designed to aid state charity regulators in their enforcement of laws governing nonprofits. The case centered on whether a non-public disclosure schedule that charities are required to file with their IRS Form 990 returns each year, Schedule B, Schedule of Contributors, can also be required by state charity regulators. Schedule B requires public charities that receive a substantial concentration of support from any one contributor during the reporting year, defined as the greater of $5,000 or 2% of total contributions, to disclose to the IRS the names of these donors and the amount of cash or non-cash support donated. Unlike the core IRS tax Form 990 and other supporting schedules that can be accessed by the general public, Schedule B is not open for public inspection.
A consensus exists within the nonprofit sector that requiring charities to publicly disclose their donors would have a chilling effect on free speech, including speech expressed by individuals via the charitable causes they choose to support. In particular, charities working in more controversial causes could lose significant support if donors had to put themselves at risk by exposing their personal information, donating habits, or political leanings to the public as a condition of making contributions. CharityWatch generally agrees with the existing rules that don't require charities to publicly disclose their major supporters.
The question that was at hand in this case for the SCOTUS, however, was not if the public should have access to data about a charity's major donors, but whether state regulatory bodies should be allowed to continue to demand confidential disclosure of such information as part of their oversight of nonprofits soliciting the public within their borders. As the National Council of Nonprofits (the Council) argued in its Amicus Brief in support of the disclosure:
"Charitable nonprofits make considerable efforts to ensure they operate ethically and in compliance with the law. But charitable organizations do not have the authority, capacity, or scale to go after bad actors or suspected fraudsters. To have faith in a system, the public must believe that participants are playing by the rules. That requires law enforcement. If the public believes that there is inadequate oversight allowing some to 'game the system,' then people will lose faith in that system and then withhold their support of time and money, damaging the ability of charitable nonprofits to deliver on their missions for the millions of people who depend on them. That is why deterrence of bad actors and fraud is such a weighty factor."
The Council described opponents of such limited disclosure as supporting a case of campaign finance "cloaked in charity law clothing" given that the Petitioners, Americans for Prosperity Foundation and Thomas More law Center, are not representative of "typical" charities."Most charitable nonprofits are small in size, with 92 percent spending less than $1 million annually and 88 percent spending less than $500,000," according to the Council. By contrast, the Council stated in its Brief, "In 2018, Petitioner Americans for Prosperity Foundation ('AFP Foundation') spent $18.8 million, and Americans for Prosperity ('AFP'), a related corporate entity with which it shares extensive interlocking and overlapping directors and officers, spent $89.6 million, for a total of $108.2 million in spending under largely common control, according to their most recent Form 990..." AFP is also related to a political action committee entity called Americans for Prosperity Action, Inc. ("Prosperity Super PAC"), which "reported spending more than $47.6 million in independent expenditures to influence elections during the 2019-2020 election cycle," the Council stated in its Brief.
CharityWatch also filed an Amicus Brief with the SCOTUS communicating our concerns that allowing public charities to hide information about their major donors from state regulators could allow them to more easily be misused for the purpose of funneling money into lobbying efforts that align with a particular candidate's political positions.
In addition, CharityWatch argued that nonprofit trade associations are not doing a good job of filling the accountability gap caused by inadequate regulation. It is incredibly difficult for the average donor to understand in a very basic way whether a particular charity will use their donations responsibly and efficiently, let alone take on the highly specialized task of rooting through years of audited financial statements and tax filings and applying the necessary expertise to detect potential fraud. When donors attempt to do their own research prior to donating to a charity, they are often overwhelmed by information of questionable quality and independence proliferated by charities and their trade associations that in some cases leads them to donate to the very charities they were trying to avoid. The general public relies on regulators to police the nonprofit sector in a meaningful way that cannot be replaced by online aggregator or crowdsourcing websites like Charity Navigator (at charitynavigator.org) or Candid (at guidestar.org) that publish ratings of charities that are based totally or primarily on the face value of what charities report about themselves.
As stated in CharityWatch's Brief:
"Many independent organizations have formed to address the lack of accountability mechanisms in the charitable sector. The rigor of their approaches, though, is highly variable. Certain independent organizations have created online databases and crowdsourcing websites that encourage charities to upload information about themselves, such as descriptions of their programs and self-conducted impact evaluations. Some of these organizations also generate ratings. These websites make researching nonprofits more convenient for donors by housing large volumes of charity information in centralized locations. However, most organizations do little to help donors independently vet charities' self-reported information, and some compilations can even undermine donors' vetting efforts by allowing charities to game the ratings.
"For example, uploading data is sometimes treated as an end unto itself, resulting in a nearly immediate rating improvement without any scrutiny of what [ ] the data reveals, let alone a check for basic completeness or accuracy. Thus, although these information aggregators and ratings agencies can give donors a sense of security and create an impression among the general public that the nonprofit sector is subject to robust private oversight, they in fact do little to combat ineffective or abusive practices."
Aside from rooting out wrongdoing, Schedule B information also provides a valuable tool for confirming that a nonprofit is correctly reporting itself as a public charity versus a private foundation. Public charities must meet an ongoing public support test in order to maintain their "public charity" status and avoid the somewhat stricter governance and financial regulations imposed upon private foundations, including stern restrictions on self-dealing, limits on stock holdings and investments, and tight regulations on compensation to staff and board members. As stated in CharityWatch's Brief, "Prohibiting California from requiring that charities confidentially provide Schedule B to regulators would undermine the State's ability to pursue these important interests and embolden people...who want to use charities as vehicles for self enrichment or self-interest."
It is important to point out that allowing states to require a copy of Schedule B from the charities soliciting donations within their borders would impose no undue burden on those charities given that they are already required to submit Schedule B annually to the IRS. CharityWatch expressed concerns in our Brief that allowing charities to hide information about their major donors from state regulators would undermine the ability of these regulators to protect the public by rooting out wrongdoing like conflicts of interest, self-dealing, and tax evasion.
In July 2021, the SCOTUS ultimately deemed that state laws requiring nonprofits to submit Schedule B to state regulators were unconstitutional on First Amendment grounds.
It is important for donors to not make the false assumption that a particular charity will use their donations efficiently simply because it is properly registered and in good standing with government regulators. Donors should also be cautious and not take charity ratings published by nonprofit trade associations or others at face value without first understanding the method, rigor, and independence of the process used to compute those ratings. Visit charitywatch.org for tips on giving wisely and to stay up-to-date on CharityWatch's latest ratings and research.