by Lisa A. Runquist
Business Law Today, Volume 4, Number 2, November/December 1994
You are the volunteer legal advisor and a director of Feeding the Homeless, a nonprofit. In between swigs of coffee at breakfast, you notice an item in the morning paper. The headline: “Feeding the Homeless fees itself.” Seems a reporter found out about your annual board dinner last night – at the finest restaurant in town.
You and the board may not be liable for wrongdoing since you each bought a ticket for $100, but the exclusive venue the night before could raise eyebrows in some groups that hold your organization accountable.
What should you be doing as a conscientious legal adviser or director? How can you avoid this type of surprise?
Nonprofits are a big business in the United States. According to a House Ways and Means subcommittee hearing last June, there are more than 1.2 million organizations exempt from Federal income tax, not including an estimated 340,000 churches. These organizations annually generate $500 billion in revenues, have assets of approximately $1 trillion, and employ about 7 million people. In recent years, tax-exempt organizations have been the fastest growing sector in the U.S. economy.
One of the unique aspects of American society, is the vast numbers of voluntary, nonprofit charitable organizations that address a specific area of concern, or provide some benefit that would otherwise be a responsibility of government. It is substantial participation by the public, both through providing financial support and by volunteering their time and effort, that makes these organizations viable.
Generally, the formation and operation of such an organization proceeds without regard to any potential liability that may result from its activities. Even if liability had crossed their minds, the organizers might have thought they wouldn’t have to worry about it. Although this once may have been a reasonable position, the doctrine of charitable immunity has long been relegated to history. Both the charity and its directors need to be concerned with the issue of potential liability arising out of the organization’s activities. Although this is also true of business corporations, a nonprofit’s directors must understand specific issues unique to their special world. So what does set them apart? What should the lawyer advising these special corporation keep in mind?
Purpose. The principal difference between a nonprofit and a business corporation is the purpose. With a business corporation, its principal if not only purpose, is to make money for its shareholders. A nonprofit corporation, however, must be organized and operated to advance some specific charitable purpose. All directors should be aware of this purpose and each decision they make should advance it.
- To that end, counsel for nonprofits need to make sure that articles and bylaws state the purpose broadly enough to allow actual and planned activities, but narrowly enough to assure the organization’s tax-exempt status.
- Counsel must guide the organization so that it stays within the defined purpose. Engaging in operations outside the purpose may result in unrelated business taxable income, and possibly revocation of the tax-exempt status.
Exempt Status of the Organization. Nonprofit does not equal tax-exempt. There are many types of tax-exempt organizations. A large percentage of nonprofits are exempt under Section 501(c)(3) of the Internal Revenue Code. This is the most advantageous exemption, because the organization is exempt from taxation and donations to the organization may be deductible as charitable contributions. Organizations exempt under other provisions of the Code are exempt from taxation, but contributions are not deductible as charitable contributions although they may be deductible as business expenses (such as dues to your local chamber of commerce). To obtain an exemption under Section 501(c)(3), most nonprofits must apply by filing Form 1023 with the IRS. Some groups, such as churches and very small nonprofits, are not required to establish their exemption. If they do not, however, then it is the responsibility of the donor to prove that he or she gave to an exempt organization to which contributions are deductible.
WHAT YOU NEED TO OBTAIN THAT TAX EXEMPT STATUS
Section 501(c) of the Internal Revenue Code contains 25 possible tax exempt categories, each with its own special rules. Other exemptions are available under other sections of the code for certain religious and cooperative corporations and for homeowners associations. Most organizations seek exemption under Section 501(c)(3), which confers tax exempt status on any corporation that is:
“… organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes .
… or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda or otherwise attempting to influence legislation, and which does not attempt to participate or intervene in any political campaign.”
Other commonly recognized exemptions include social welfare organizations [Section 501(c)(4)], business leagues and chambers of commerce [Section 501(c)(6)], and social clubs [Section 501(c)(7)].
Some of the specific requirements of a nonprofit organization exempt from taxation under Section 501(c)(3) are:
- The purpose must be charitable, educational, religious, scientific, etc.;
- The organization must be organized and operated for the specific exempt purpose;
- Assets of the organization cannot inure to the benefit of a private individual;
- Only limited lobbying is permitted ; and
- No political activity (such as support of a candidate for public office) is allowed.
Many states rely on the federal exemption, in granting exemption from state income taxes. However, some states, notably California, require a separate application and approval before the corporation will be considered exempt. State laws also determine whether and to what extent property owned by the nonprofit will be exempt from taxation. Generally, the determining factor is not that the property is owned by a nonprofit but the nature of the activities conducted on the property.
Make sure your corporation has established its exempt status. Understand the requirements for maintaining the exempt status and do nothing that would violate these requirements.
Note that the filings with the IRS are matters of public record, and must be made available for inspection by any interested party.
Accountability. Directors of business corporations are accountable principally to their shareholders; most lawsuits against directors involve the violation of some duty owed to the shareholders. Nonprofits generally do not have shareholders. Instead, there are many groups to which the directors may have to answer:
- The first group to which directors of nonprofits may be accountable are the members (if the corporation has members). With nonprofit mutual benefit corporations, such as condominium homeowners associations or social clubs, the members may have an interest in the assets of the organization. As such, they may be similar to shareholders. Membership in other nonprofit corporations does not result in a property interest, but may still provide the member with certain rights, such as the right to inspect the records, to vote for the directors, and to vote on significant corporate reorganizations, mergers and dissolution. Derivative actions by members are often allowed by state law.
- Another significant group is the donors. They may include individual contributors, federal or state governments, business corporations, or other nonprofit organizations such as private foundations and trusts. Donors are particularly important, especially since the nonprofit is normally dependent on receiving regular donations for its continuing existence.If a donor becomes disillusioned with the activities or conduct of the organization, he or she can cut off donations, sometimes producing an immediate, and harmful, effect. If a donor made a contribution to the corporation for a specific purpose, the donor may also have the ability to sue the corporation and the directors to compel the donation to be used for the specific purpose, or to obtain restitution from the nonprofit (from the directors or the recipient of the funds) if the assets were used for another purpose.
- The directors are also accountable to the appropriate governmental agencies. Clearly the IRS has great authority over tax-exempt organizations. In addition to the state taxing authority and the IRS, the nonprofit corporation and its directors are normally answerable to the state attorney general. The attorney general is usually charged with seeing that the organization fulfills its charitable purposes (for the benefit of the public), since there may be no other individual or agency that is able to bring such an enforcement action. Many state attorneys general have taken their responsibilities very seriously, and have gone after directors who have not.
- Directors may also be accountable to constituents served by the organization. For example, if the organization is organized to provide health services to poor people in a certain area and instead the organization decides to concentrate on advancing the arts, then the constituents have a right to challenge this change in purpose. It should be noted that the constituents may not be able to sue the organization or the directors directly; however, by their objections they may spark action either the donors or governmental agencies to whom the organization reports.
- In addition to the constituents who might benefit from the nonprofit’s activities, the community at large often has an interest, not because the individuals will personally benefit, but because the community itself benefits. In fact, the IRS is now applying a “community benefit” standard in determining the eligibility of a hospital to be tax exempt. This group, like the constituents, may have substantial indirect influence.
- Another group to which the directors must pay specific attention are the employees. Most of the lawsuits against directors of nonprofit corporations involve employment matters. These issues involving nonprofits do not differ significantly from employment issues faced by corporations generally (except perhaps for those involving volunteers and religious discrimination by religious organizations). The need to develop and follow employment policies and procedures is crucial for nonprofits.
- One aspect of this sometimes proves significant: An employee of a nonprofit will often work for wages below what would be available in the business community, because of the employee’s dedication to the purpose of the organization. The organization may recognize this and use the term “family”, or a similar term to describe the relationship. I have seen this treatment often result in a reluctance to discipline an employee, or give the employee a less than satisfactory review.
- When the relationship goes sour, as often it does, all of these factors result in an individual who not only is now unemployed but also feels he or she has been betrayed and will use whatever means are in his or her power to strike back. And because of the failure to treat the employee as an employee, with regular and objective reviews, etc., the organization and its directors may be poorly equipped to defend themselves.
- Before leaving the issue of employees, it should also be emphasized that employees are not volunteers. Employees should not be expected to volunteer to work extra time without pay. If an employee wishes to volunteer time outside of normal working hours, this should be carefully reviewed to make sure that the employee is clearly a volunteer and is not being pressured to work these additional hours. At a minimum, he or she should not be allowed to volunteer to perform his or her normal duties.
- Unrelated third parties that may be adversely affected by an activity of the corporation have also been known to sue, not only the nonprofit corporation, but the directors that authorized the activity. If there is a chance that an individual will be harmed, the directors should evaluate this issue carefully and take whatever steps are necessary to limit or eliminate such possibility of harm: 1) identify the group to which your organization is accountable, and 2) take steps to see that the concerns of this group are met.
Responsibilities of Directors: A director of a nonprofit corporation is not involved in its day to day activity, any more than a director of a business corporation is so involved. As with the business corporation, the nonprofit’s directors develop policy and provide the general direction. The officers are then responsible for implementing the broad directions of the board through the day to day activities, with the chief executive officer reporting back to the board on the results.
However, many nonprofits, especially those that are small, have “working boards” that function not only as board members, but actually carry out the activities of the corporation. These activities should be carefully distinguished, because some states limit the liability of directors for actions taken as a director, but do not address the liability for other activities.
A common problem at the other end of the scale is that some directors of nonprofits consider themselves to be more like members of an advisory board. They see their role as helping and confirming the decisions of the chief executive officer, rather than understanding that, just as with a business corporation, the chief executive officer reports to them, and it is their responsibility to make broad decisions about the activities and direction of the corporation. Although directors have no individual power, but must act together, they are individually legally accountable, and are responsible to see that the organization’s purpose is fulfilled.
The standards of conduct to be complied with in making each decision are generally the same that apply to directors of business corporations: Act in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the director reasonably believes to be in the best interests of the corporation.
WHAT SHOULD A BOARD DO?
The Board of Directors is normally concerned with items such as:
- Review/evaluation of executive director
- Review of auditor/audit
- Long-range and short-range planning
- Budgeting, funding
- Risk exposures and insurance
- For the corporation
- For the director
- Quality control
- Corporate policies
- Employee appeals
In developing an agenda for a board meeting, you might want to consider including:
- Notice of meeting
- Copy of minutes of the last meeting
- Current members, directors, officers
- Financial reports
- Checking and savings accounts/other investments
- Check signers
- Remodeling or repairs to corporate property
- Equipment purchased / Assets transferred
- Inventory of personal property assets
- Proposed building program/property purchase research
- Loans (to and from corporation)
- Property leases
- Annual filings
- Income tax filings (Form 990, Form 990-T)
- Inquiries from tax authorities
- Salaries paid by corporation subject to withholding
- Federal 1099 and W-2 Forms filed
- Registered agent
- Deeds, mortgages, trust deeds, land contracts
- Corporate agents
- Related activities of the corporation
- Unrelated activities of the corporation
- Report of activity on actions approved or directed at last meeting
- Communications with directors since last meeting
- Election of new directors, officers
- New agenda items
Board Compensation. Reasonable compensation of board members is generally allowed, unless prohibited by the articles or bylaws of the corporation. In some circumstances, this may be the only way that some people may be willing to serve.
However, there are reasons why compensation of directors may not be wise. To begin with many state statutes that have been passed to limit the liability of directors of nonprofit corporations have been limited to volunteer directors. Therefore, if directors receive compensation for serving on the board, then there may not be any limitation of liability.
Apart from this issue, if too large a portion of the funds of the nonprofit is spent on the board and its activities, this raises the issue of private inurement, which can endanger the exempt status. Further, if too much is spent on the board and its activities, certain types of funding may be jeopardized.
It is important to keep in mind that the purpose of the organization as well as serving on its board are not to benefit or provide perks to the directors, but to advance the purpose itself. Therefore, any funds that are used on board activities are not available for the true purposes of the organization. This does not mean that money cannot be spent on board activities, but that each expenditure must be justified in light of the corporate purpose.
Director succession. Directors of business corporations are elected by the shareholders. If a nonprofit corporation has members, then the directors are generally elected by the members. However, if there are no members and no other way of choosing the directors, such as through the use of delegates, then the directors of the nonprofit are responsible for choosing their own successors. This, as with all other decisions of the board, must be done to advance the interests of the nonprofit, rather than the interests of the individual director.
In determining the composition of the board, it is recommended that the directors include individuals with varying backgrounds and abilities. It may be appropriate to include representatives from various groups to whom the directors are accountable. Composition is sometimes mandated by government if the organization receives government funding, or by the corporate bylaws. In order to avoid self-perpetuating boards, it may be appropriate to prohibit multiple consecutive terms of membership.
If the corporation depends on the good will of the community, it may be important for the selection process to be perceived by the community as open. The board must take steps to assure that there is no actual or perceived bias in the directors chosen, and that no preference is given to individuals already known by members of the board or its nominating committee.
Ultimate Avoidance of Liability. If a director is to avoid potential liability, he or she must be prepared to pay attention to the nonprofit, obtain the necessary information to make an informed decision, and on the basis of this, take responsible action. This should be done in a manner that advances the best interest of the nonprofit, and avoids, as much as possible, any self dealing.
The easiest way to decide if an action is appropriate is to remember that breakfast setting at the beginning of this article. Picture a report of the action of the board on the front page of your local newspaper, written by someone not sympathetic to your cause. If you would be proud to see the organization reported as having engaged in this activity, then it is likely to be okay. If you would be embarrassed to see it reported on the front page, then you might want to re-examine whether the action is really appropriate for your organization. Sooner or later, it will be brought to light, and you, as a director or legal counsel of the organization, may be called on to defend it.