May 05, 2013

Transparency and Lower Donor Tax Breaks Can Keep Telemarketers in Check

The inefficient use of professional fundraising companies has become a serious problem for the nonprofit world.

It’s time to change how things work—both to protect donors who end up getting misled by companies that don’t pass along very much to charities they raise money for and the American taxpayers, who are in essence subsidizing fundraising companies through the charitable deduction.

Nonprofits often dismiss stories about fundraisers charging excessive fees to raise money as anecdotal and a problem that affects just a few small fly-by-night charities.

However, recent reports by the attorneys general of Michigan and New York have made the scale of the problem quite apparent. In the case of New York, fundraising campaigns by professional fundraisers (some of which were nationwide campaigns that included appeals in New York) accounted for $240-million in 2012, with only 38.5 percent of the money raised ultimately reaching the charities.

A similarly sobering result played out in Michigan, where only 35 percent of donations processed through professional telemarketing and direct-mail companies were remitted to the nonprofits.

These are not just small charities desperate for cash. Some of the worst offenders are well-respected national charities. The Alzheimer’s Association, the American Diabetes Association, ALSAC/St. Jude, the American Lung Association, Easter Seals, and Smile Train are just a few of the organizations the Michigan report listed as using solicitors to raise at least $1-million from donors but receiving less than 35 percent of the total collected.

This is not to say that the use of professional fundraisers is inherently wrong. In fact, the notion of hiring outside companies makes sense for achieving greater efficiency: They can often exploit economies of scale and have particular expertise in soliciting donations, enabling the charity to focus entirely on its mission.

Unfortunately, that has not worked so well in practice, since all too often more money goes to the fundraising companies than the charities. Presuming both the fundraising companies and the charities know what they’re getting into, the fact that charities continue to participate in these activities suggests that possible solutions to the problem need to come from other sources.

One way to solve the problem is to give donors more information, making the charitable system operate more like America’s financial system. Another would be to take away the financial incentives by changing the tax code to penalize donors who subsidize inefficient fundraising approaches.

The idea of giving donors more information has a lot of appeal, because it would allow each charity supporter to make up his or her mind with a minimum of regulation.

It could also be very effective in reducing inefficiencies. The vast majority of donors would hang up the phone or throw away their direct-mail appeals if they knew responding to them would yield only 40 cents on the dollar (or less) for the intended charity.

Yet donors rarely have that information at their disposal. True, most nonprofits are required to file financial information with the IRS (and they usually do), and some states have disclosure requirements for solicitations by nonprofits. However, the information is filed so late and is often so incomplete and inaccurate, there’s no way for it to tell a donor anything useful at the moment when it matters most.

Today’s approach to charity disclosure is eerily similar to the information environment surrounding solicitations for the sale of securities in the United States before the market crash of 1929 (when such activities were governed primarily by laws of individual states).

The securities acts of 1933 and 1934 drastically changed that environment, requiring registration, independent audit, and disclosure of key financial information to the public for securities solicitations. Those laws, plus subsequent regulatory efforts aimed at public transparency, have been credited with helping develop a robust and fair capital market in the U.S.

Now let’s bring such a spirit of disclosure and accountability to charities by requiring key disclosures to be part of solicitation campaigns.

To really help donors, we may also need to require more than just the kind of reporting contained on charity informational tax returns, such as the percentage of budget spent on fundraising versus programs. As with the securities acts of 1933 and 1934, requiring these disclosures to be audited by independent auditors may be necessary. After all, a 2008 study in The Accounting Review found that among charities that hire professional solicitors in California, Connecticut, Indiana, Massachusetts, New York, North Carolina, Ohio, and Vermont, over 70 percent did not properly reflect the amounts paid to fundraisers as fundraising expenses on their IRS filing.

Such high rates of misrepresentation are unheard of in the business world, which are more likely to use reputable independent audits.

While giving donors knowledge is important, that alone might not change everybody’s behavior.

That’s why it’s important to consider how taxpayers feel about subsidizing wasteful charitable fundraising campaigns through the charitable deduction.

After all, if a donor gives $100 to a telemarketing campaign and only $40 makes its way to the charity, the donor still claims a tax deduction for the $100 donation. This means that taxpayers are subsidizing a $60 gift to a for-profit fundraising company

Many states already require professional fundraisers to submit reports showing how much was raised and passed along to charities; since little has changed, it’s clear that more rigorous steps are needed.

For example, perhaps fundraising companies should be required to send donors a report detailing how much of their contribution actually ended up in the charity’s hands.

An even more powerful incentive might be for the federal government and the states to allow donors to claim charitable deductions only on the portion of their contribution that ended up in the charity’s coffers.

To be sure, this approach adds to charities’ reporting burdens because they would be required to report the exact amount that is deductible to donors. However, charities already must send receipts for gifts of $250 or more and tell donors the value of gifts they receive, such as a fancy dinner at a fundraising gala, so this isn’t a big deal.

Such a change would mean that taxpayers would no longer be subsidizing the for-profit fundraising businesses. But it would also inform donors about the cost of giving and help them see why it is better for the causes they care about if they give in cost-efficient ways (say, an online donation with a credit card).

Both approaches have their virtues, and we may need to take them together to truly make a difference. But even if we try just one, the time is now to ensure that our charitable donations do what they are intended to: ensure that money flows to groups that are solving real problems and making our communities more vibrant.

Brian Mittendorf is associate professor of accounting at Ohio State University’s Fisher College of Business.