January 2003

The Role of Professional Associations

By William E. Shafer and Dwight Owsen

Public confidence in the professionalism of auditors is precariously low, thanks to the Enron, WorldCom, and other well-publicized audit failures. The Sarbanes-Oxley Act now places greater restrictions on the ability of CPA firms to provide both auditing and consulting services to the same clients and moves a number of professional activities once performed by the AICPA to the newly created Public Company Accounting Oversight Board (PCAOB), which will operate with public money and under tight supervision from the SEC.

The Role of Professional Associations

The most basic functions of any professional association are self-regulation of its members and the support of individual professional members. Effective self-regulation helps ensure high-quality services and maintains public confidence in the profession, both critical for continued public support of the professional franchise. Because their core mission is to provide services such as self-regulation and advocacy for professional members, such organizations have historically operated as nonprofit entities. Such services provide no immediate or measurable profit, and possibly no immediately discernible revenue stream, but their benefits should accrue to all members of the profession in the long term by maintaining and enhancing the reputation of the profession. Services such as self-regulation are public goods in the sense that, regardless of whether individual members contribute a fair share of resources to self-regulatory efforts, they can enjoy the reputational benefits such efforts provide. By organizing in the nonprofit form, professional associations both enhance their legitimacy and enjoy a favorable tax status that accrues from the public recognition that the association serves a public, social welfare purpose rather than a private, wealth-creation purpose.

The legitimacy of any professional association in the eyes of the public and its members is critical to its success and survival. Professionals would be very reluctant to pay voluntary dues to an organization with the power to distribute its assets to organizational insiders. This issue is exacerbated by the fact that evaluating the quality of complex services such as member advocacy and self-regulation is often difficult, particularly in the short term. Operating as a nonprofit entity provides members with some assurance that their dues will be used appropriately, because nonprofits are prohibited from distributing their assets for the private benefit of organizational insiders. This “nondistribution constraint” against private inurement is the defining characteristic of nonprofit enterprises.

The appropriateness of commercialism by nonprofit entities has been debated for many years. Some argue that if nonprofits are allowed to pursue commercial activities in the same way as for-profit entities, they are likely to become increasingly commercial in their orientation, thus undermining their basic role in society. Consequently, commercial activity by nonprofits is generally viewed as permissible only for the purpose of fulfilling the organization’s core mission. Most professional associations take on some strictly commercial activities on behalf of their members, but account for them separately for unrelated business income tax (UBIT) purposes and proceed cautiously, to ensure that those activities neither jeopardize their tax-exempt status nor create an overly commercial culture.

For-Profit Subsidiaries

The appropriateness of converting all or part of a nonprofit organization to for-profit corporate status has long been a controversial issue. For a professional association to spin off a for-profit subsidiary for some portion of its exempt activity is common in order to deal with certain UBIT issues. For example, a professional association whose magazine sells advertising often finds it advantageous to operate the magazine as a for-profit corporation. Any plan that effectively transfers tangible or intan-gible assets to a for-profit entity in exchange for stock in this entity, however, inevitably raises policy issues similar to those raised by other nonprofit conversions, including compensation of nonprofit managers and directors; protection of nonprofit assets; organizational governance; distraction from the nonprofit mission; and the need for oversight and transparency.

Compensation of Managers and Directors

To ensure that nonprofit managers act in their fiduciary capacity and are motivated to promote only those conversions they perceive to be in the best interest of members and the public, they should not receive any personal financial gain from conversion transactions. If nonprofit managers are significantly rewarded for facilitating a transfer of control or helping establish the terms of the deal, there is a strong potential that their decisions will be biased and it cannot be known whether the plan promotes the public interest or is simply an attempt to subvert the nondistribution constraint.

Protection of Nonprofit Assets

A closely related issue that arises in conversion transactions is the preservation of assets. Issues relating to asset preservation frequently arise when nonprofit assets are purchased by the organization’s managers or directors as part of a conversion. In these situations, there is an obvious risk that the assets will be transferred at less than fair market value to organizational insiders. An essential part of avoiding these conflicts of interest is for the conversion terms to be objectively established, and it is widely recommended that a nonprofit solicit competitive bids whenever selling assets.

Organizational Governance

To avoid conflicts of interest, successor for-profit organizations and their predecessor nonprofits should be independent. If the two organizations share common management or directors, the core mission of the predecessor nonprofit may be compromised. Also, if managers or directors of a predecessor nonprofit hold equity interests in a newly created for-profit venture, they will be more likely to act in the interests of the for-profit company, even if those interests conflict with the social welfare goals of the parent nonprofit. Ideally, control of newly formed for-profit entities and their predecessor nonprofits should be completely separate.

Distraction from the Nonprofit Mission

A common allegation is that when a nonprofit enterprise starts to place too much emphasis on commercial activities, it loses focus on its core mission. The most common concern is that after the nonprofit converts to for-profit status it will reduce or eliminate the services designed to promote social welfare. For instance, it is often claimed that when hospitals convert to for-profit status, they curtail the provision of indigent care and other unprofitable services. A comparable example in the accounting field would be the ongoing controversy over the AICPA’s for-profit entity established to provide member services and products, CPA2Biz.
Although the primary rationale for permitting nonprofit enterprises to engage in profit-generating activities is to cross-subsidize programs that advance the organization’s mission, the pursuit of commercial initiatives will obviously be counterproductive if they distract nonprofit managers from the primary mission of the enterprise, or, worse yet, the activities are actually inconsistent with that mission.

Oversight and Transparency

The high likelihood of conflicts of interest arising from nonprofit conversions makes effective oversight of such transactions absolutely essential. Some states have enacted legislation designed to prevent common abuses of conversion transactions; however, these statutes usually apply only to sales or dissolutions, not to partial transfers or other restructuring arrangements. All too often, however, there is little opportunity for affected parties to intervene in conversion transactions, unless they are watchful, diligent, and well financed. Professional members must rely on the governance structures of their association to provide the checks and balances required to maintain the appropriate focus.

William E. Shafer is a professor at Pepperdine University and Dwight Owsen is a PhD candidate at the University of Portsmith, United Kingdom.
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