by Lisa A. Runquist
Note: This is simply a summary of the law in California concerning nonprofit corporations.
It is not intended to be a complete statement of the law, and should not be relied upon as such.
I. General Corporate Law
A corporation begins its legal existence by filing its Articles of Incorporation with the Office of the California Secretary of State. California law requires only that the articles include the name of the corporation, a brief statement of its purposes and the name and address of its initial agent for service of process. See California Corporations Code Section 5130. Depending upon the tax exempt status desired by the nonprofit corporation, other provisions may be required in the articles, such as a clause irrevocably dedicating the organization’s assets to public or charitable purposes. Such a charitable dedication clause is required of nonprofit corporations seeking an IRC e501(c)(3) tax exempt status.
Filing all of the proper documents to incorporate a nonprofit enterprise for California corporate law purposes does not make the entity automatically exempt from State taxation. For most California nonprofit corporations, including all charitable organizations, if the organization desires preferential tax treatment it must apply to the State Franchise Tax Board for a determination of the entity’s exempt status. There is no exception for churches and church affiliated organizations from this requirement. In addition, California has no group exemption application for corporations. If a corporation organized under the Nonprofit Corporation Law to pursue charitable objectives fails to obtain a favorable determination of its tax exempt status it will be taxed on the same basis as a business corporation.
All nonprofit corporations must annually file a Statement by Domestic Nonprofit Corporation with the Secretary of State, along with a filing fee of $10.00. [Note: this is now a biannual filing with a $20.00 filing fee.] If this is not done in a timely manner, the Secretary of State will notify the Franchise Tax Board, and the corporation will be suspended.
B. Overview of California’s Nonprofit Corporation Law
1. California’s Nonprofit Law, Generally. The California Corporations Code contains a completely separate law for nonprofit corporations (the California Nonprofit Corporation Law; Cal. Corp. Code e 5000, et seq.) which is divided into three parts, namely the Nonprofit Public Benefit Corporation Law (Cal. Corp. Code ee 5110-6815), the Nonprofit Mutual Benefit Corporation Law (Cal. Corp. Code ee 7110-8817), and the Nonprofit Religious Corporation Law (Cal. Corp Code ee 9110-9690). The Nonprofit Public Benefit Corporation Law regulates corporations formed for any public or charitable purpose. The Nonprofit Religious Corporation Law applies to corporations formed primarily or exclusively for religious purposes and the Nonprofit Mutual Benefit Corporation Law applies to corporations formed to pursue a nonprofit purpose which is not charitable, religious or public in nature, but which is of common interest to the members such as a social club, a trade association or a community association.
2. Regulatory Difference Between Nonprofit Corporations. Under this tripartite structure, it can generally be said that Public Benefit Corporations receive the most public regulation and scrutiny (from the IRS, the State Franchise Tax Board and the State Attorney General), Mutual Benefit Corporations are treated in many respects identically to business corporations and Religious Corporations are accorded the greatest degree of autonomy and non-interference by public regulatory agencies (although such organizations are not entirely free of regulations). The justification for the high degree of public scrutiny for public benefit corporations is that such organizations are required to be organized exclusively for charitable or public purposes and it is also required that no part of their net earnings inure to the benefit of any private person.
3. Attorney General Jurisdiction. Because the principal beneficiaries of any charitable enterprise are supposed to be the members of the general public, the Attorney General’s office is given broad supervisory authority to assure that this “charitable trust” is carried out. Public Benefit corporations are required to file annual CT-2 forms with the Attorney General. See Gov. Code e 12581 et seq. If the annual filing is not made, the exemption from taxation will be disallowed. (see Revenue and Taxation Code e 23703). Religious corporations are specifically exempt from making annual filings with the Attorney General (Gov. Code e 12583).
In addition, the Attorney General has authority, at all times, to examine the business and affairs of public benefit corporations (Cal. Corp. Code e 5250) and must be notified of many significant actions, such as the sale of all or substantially all of the corporation’s assets (see,e.g., Corp. Code e 5913). If a Mutual Benefit corporation holds assets in charitable trust, it is subject to the same requirements (see Cal. Corp. Code ee 7238 and 7240). Although a religious corporation is required to notify the Attorney General of the sale or other disposition of its assets (see Cal. Corp. Code e 9633), it is not subject to the same level of ongoing supervision.
II. Franchise Tax Exemptions.
A. Comparison of Federal and State Exemptions. Just because an organization is considered exempt under federal law, it will not necessarily be exempt under state law. For example, corporations organized under an act of Congress, including federal credit unions, state chartered credit unions, benevolent life insurance associations, and group legal services plan organizations, among others, are not exempt under California law. When applying for exempt status, the specific section of the California law should be reviewed to make sure that the organization is exempt under that provision. (see Rev and Tax. Code e 23701 et seq.)
Organizations exempt under Section 501(c)(3) of the Internal Revenue Code will generally be exempt under Section 23701d of the Revenue and Taxation Code. It should be noted that these must be public benefit or religious corporations; mutual benefit corporations, by definition, cannot include in their articles, the necessary provisions to qualify for tax exemption under Section 510(c)(3).
Organizations exempt under Section 501(c)(4) will generally be exempt under Section 23701f of the Revenue and Taxation Code, organizations exempt under Section 501(c)(6) are exempt under Section 23701e, and organizations exempt under Section 501(c)(7) under Section 23701g.
B. Filing for Exemption in California. Exemption from taxation in California is obtained by filing Form FTB 3500. This should be filed with the Franchise Tax Board along with a filing fee of $25.00. This exemption application can be filed either before or after the Articles of Incorporation are filed. If the application is not filed until after the Articles are filed, then the corporation must pay the $800 minimum franchise fee at the time of filing the articles; this fee is then refunded at the time the exemption is granted. If the application is filed before the Articles, then the $800 minimum franchise fee need not be paid, but the Articles will not be filed and the organization’s existence will not begin until after the exempt status is granted.
If the corporation is a foreign corporation, it may apply for exemption, either before or after it qualifies to do business in California (by filing a Statement and Designation by Foreign Corporation with the Secretary of State). As with a domestic corporation, if the organization establishes its exempt status before filing, it does not have to pay the minimum franchise fee, whereas if it files before establishing its exempt status, it will have to pay the minimum franchise fee.
The information needed to complete the Form FTB 3500 is substantially the same as the information required by IRS Form 1023 or Form 1024. Sometimes the exemption is granted, contingent upon the organization applying for and receiving exemption from the IRS as well.
C. Reporting Requirements. Annual informational forms must be filed with the Franchise Tax Board by most exempt nonprofits by the 15th day of the fifth full calendar month following the close of the income year. Revenue and Taxation Code e23772. The exceptions from filing are churches, their integrated auxiliaries, and conventions or associations of churches, organizations that are not private foundations with gross receipts of $25,000 or less, and exclusively religious activities of any religious order. However, the Franchise Tax Board may, but need not, require these organizations to make a limited filing to determine if any unrelated business income might be present. Revenue and Taxation Code e23774. Failure to file may result in suspension of the corporation. Revenue and Taxation Code e23775.
Sections 512, 513, 514 of the Internal Revenue Code, concerning unrelated business taxable income, applies to exempt organizations in California, except as otherwise provided. See Revenue and Taxation Code ee 23732, 23734, 23735. If a tax is due, a return must be filed. Revenue and Taxation Code e 23771.
Charitable organizations must file Form CT-2 annually with the Attorney General; if they do not do so, their exempt status will be disallowed. Rev & Tax Code e 23703.
III. Property Tax Exemptions.
The property tax treatment of exempt organizations depends on the use which is made of the property. This aspect of taxation is exclusively a matter of state law and in California the issue is addressed in Article XIII of the California Constitution and Revenue and Taxation Code Sections 214-215. The Constitution makes certain property tax exemptions mandatory and allows for issuance of a welfare property tax exemption to other entities on a discretionary basis. For example, public schools, colleges and universities are eligible for a property tax exemption by virtue of Article XIII, Section 3(d) of the Constitution, as are libraries and museums. Church property used exclusively for religious worship is exempt under Article XIII, Section 3(f) and cemeteries are exempt under Article XIII, Section 3(g). If church property is also used for a school, the religious exemption is available under Revenue and Taxation Code Section 207.
Most other charitable organizations must seek a property tax exemption under the “welfare exemption” found in State Constitution Article XIII, Section 4(b) and related provisions of the Revenue and Taxation Code (Sections 214 and 215). This exemption is available to property used exclusively for religious, hospital or charitable purposes and owned by a nonprofit organization organized exclusively for such purpose, no part of whose net earnings inure to the benefit of any private individual. The welfare tax exemption is not constitutionally mandated; rather the Legislature has the discretion to exempt eligible organizations. See Nat. Charity League, Inc. v L.A. County (1958) 164 Cal.App.2d 241. In order to be eligible, the charitable, religious or hospital organization’s articles of incorporation must contain a provision which irrevocably dedicates the entity’s property to religious or charitable purposes upon dissolution (i.e., a “charitable dedication clause”). Furthermore, in order for certain exempt organizations to qualify for a property tax exemption, the county assessors’ offices require that the entity’s articles of incorporation contain a specific reference to the Revenue and Taxation Code section which qualifies the entity for the exemption.
As with the definition of organizations eligible for a section 501(c)(3) tax exemption, each of the terms used in defining and delimiting the property tax welfare exemption has been subjected to extensive definition. Special rules also exist for the property tax treatment of facilities under construction and for facilities and property which also are used for purposes unrelated to the owner’s charitable mission on an incidental or occasional basis. See, R&T Code Section 214.l and Cedars of Lebanon Hospital v L.A. County (1950) 35 Cal 2d 729.
It should not be assumed that the property of an exempt organization is automatically exempt. A yearly filing must be made for each of the exemptions claimed. The deadline for filing Welfare Exemptions and the educational property exemption is March 15 of each year; the deadlines for filing notice of the Church and Religious Exemptions is March 31 of each year. If the deadline is not met, the exemption will be deemed to be waived. A late filing may be made, but the full exemption will not be granted.
If a portion of the property is used for the production of unrelated business taxable income, then the organization will only be entitled to a partial exemption.
IV. Sales and Use Taxes.
There is no blanket exemption from sales and use taxes for nonprofit organizations. Although there are a number of specific exemptions, these are all very limited (e.g. clothing distributed free to school children – see Rev. and Tax C Section 6375.5; rummage sales by auxiliaries of public museums – see Rev and Tax C Section 6370.5, etc.). Generally, nonprofit organizations must pay sales and/or use taxes in the same manner as individuals and business entities. See Rev. & Tax C ee 6001 et seq.
V. Business License Taxes.
Profits exempt under Section 501(c)(3) and Rev & Tax C e23701d are not required to obtain a business license. Rev & Tax C e7284.1 has been recently amended to make it clear that municipalities may not require business licenses from these organizations. This does not prohibit municipalities from requiring business licenses from non-501(c)(3) organizations.
VI. Volunteer protection.
California law limiting liability of directors and officers leaves much to be desired. The leading case in this area is Frances T. v. Village Green Owners Assn. The facts of this case, as summarized by the California Supreme Court are:
On the night of October 8, 1980, an unidentified person entered plaintiff’s condominium unit under cover of darkness and molested, raped and robbed her. At the time of the incident, plaintiff’s unit had no exterior lighting. The manner in which her unit came to be without exterior lighting on this particular evening forms the basis of her lawsuit against the defendants.
Throughout 1980, the Project was subject to what plaintiff terms an `exceptional crimewave’ … All of the Project’s residents, including the board, were aware of and concerned about this `crimewave’. … In early 1980 the board began to investigate what could be done to improve the lighting … Plaintiff’s unit was first burglarized in April 1980. … In May 1980 plaintiff and other residents of her court had a meeting … [and] transmitted a formal request to the Project’s manager with a copy to the board that more lighting be installed in their court as soon as possible. Plaintiff submitted another memorandum in August 1980 because the board had taken no action on the previous requests. … By late August, the board had still taken no action. Plaintiff then installed additional exterior lighting at her unit, believing that this would protect her from crime.
Unfortunately, the additional lighting was found to violate the CC&R’s, and plaintiff was directed to remove the additional exterior lighting and was told that:
…pending their removal, she could not use the additional exterior lighting. … In order not to use her additional lighting, plaintiff was required to forego the use of all of her exterior lights. … plaintiff complied with the board’s order and cut off the electric power on the circuitry controlling the exterior lighting during the daylight hours of October 8, 1980. As a result, her unit was in total darkness on October 8, 1980, the night she was raped and robbed.
In the past, as long as a director performed his or her duties in accordance with the standard of care specified in Corporations Code Section 5231, the director would “have no liability based upon any alleged failure to discharge the person’s duties as a director.” This exemption, which is commonly referred to as the “business judgment rule,” applies even when the director’s actions or omissions exceed or defeat the corporation’s charitable purpose.
The California Supreme Court held in Frances T. that the business judgment rule of Corporations Code Section 7231 is not a bar to individual director liability if a director participates in tortious conduct, even if the director is acting in his or her official capacity. In the Frances T. case, the plaintiff alleged that: (i) the association directors owed a duty to her; (ii) they had specific knowledge that a hazardous condition existed which threatened her personal safety; and (iii) they failed to take action to avoid the harm. In ruling that the plaintiff had stated a cause of action against the directors as individuals, the Supreme Court stated that:
Directors are liable to persons injured by their own tortious conduct regardless of whether they acted on behalf of the corporation and regardless of whether the corporation is also liable…. Directors owe a duty of care, independent of the corporation’s own duty, to refrain from acting in a manner which creates an unreasonable risk of personal injury to third parties…. A distinction must [also] be made between the director’s fiduciary duty to the corporation (and its beneficiaries) and the director’s ordinary duty of care not to injure third parties. The former duty is defined by statute [i.e., Corporations Code Section 7231], the latter by common law tort principles.
To maintain a tort claim against a director, individually, the Frances T. court held that the plaintiff must show that: (i) the director specifically authorized, directed or participated in the tortious conduct; or (ii) the director knew or should have known that a condition under the board’s control was hazardous and could cause injury and yet the director negligently failed to take action to avoid the harm; and (iii) an ordinarily prudent person, possessing the same knowledge as the director, would have acted differently.
The California Supreme Court specifically noted that individual directors named in a personal injury suit have a defense against personal liability if their conduct was not clearly unreasonable under the circumstances or if they reasonably relied on expert advice or the decision of a subordinate who was in a better position to act. In light of the court’s specific rejection of the business judgment rule as a shield from personal liability, this confirmation that directors have a defense to personal liability if they can prove that they reasonably followed expert advice or reasonably delegated decisions to a subordinate or committee seems inconsistent, yet beneficial. The Francis T. court also held that any director who did not vote in favor of the action which caused the injury would have a defense to personal liability.
Legislative Response to Frances T.
The Frances T. case understandably caused consternation throughout the nonprofit community. The court expressly acknowledged that the defendants had fulfilled their fiduciary duties to the plaintiff in her capacity as a member of the corporation. Yet the Court ruled that those same directors could be held liable to the same plaintiff for the personal injuries she had suffered.
Following publication of the Frances T. case, the California Legislature enacted and amended various code sections, such as Code of Civil Procedure Section 425.14 and Corporations Code Sections 5047.5 and 5239 and other similar provisions extending some measure of protection to directors of public benefit, mutual benefit and religious corporations.
These inconsistently worded liability protection statutes, with curious categories of included and excluded organizations, is indicative of hastily negotiated compromises reached by lobbyists for various segments of the nonprofit community. The subparagraphs that follow describe the principal liability “protections” presently available to directors of California charitable corporations.
Corporations Code Section 5047.5. Section 5047.5 is found in Part 1 of the Nonprofit Corporations Law which presents defined terms and other provisions which typically apply to corporations in all three nonprofit categories (i.e., public benefit, mutual benefit, and religious). Because of its location, Section 5047.5 should apply to all categories of nonprofit corporations, yet by its terms the Section is restricted to Internal Revenue Code Sections 501(c)(3) and 501(c)(6) organizations, and then only to those that are organized for religious, charitable, literary, educational, scientific, social and other forms of public service purposes. The section purports to protect “uncompensated” directors of covered entities from personal liability for monetary damages on account of negligent acts or omissions occurring within the scope of the person’s duties as an uncompensated director or officer and in the exercise of his or her policy-making judgment so long as the act or omission was in good faith and in a manner the director or officer believes to be in the best interests of the corporation.
Specifically excluded from the liability protection benefits of section 5047.5 are:
- Actions alleging that the director or officer is guilty of self-dealing as defined in Corporations Code Section 5233.
- Actions maintained by the Attorney General against the director or officer.
- Liabilities arising from intentional, wanton or reckless acts, gross negligence, fraud, oppression or malice on the part of the director or officer.
Before an uncompensated director or officer who clears all the hurdles described above can claim protection under Section 5047.5, the corporation he or she serves must maintain general liability insurance applicable to the claim with minimum coverage of at least $500,000 if the corporation has an annual budget under $50,000; or $1 million if the corporation’s annual budget equals or exceeds $50,000. Because a general liability insurance policy will almost never be applicable to a claim against a director or officer, this provision makes any protection afforded by this statutory provision totally illusory.
Further, there is nothing in the statute to limit the suits that are brought against the directors. Even uncompensated directors and officers who arguably fall under the statute’s umbrella of liability protection are likely to face ongoing litigation exposure as they challenge pleadings alleging bad faith, or reckless, willful, wanton, or intentional conduct. Thus, it is likely that nonprofit corporations included within the scope of Section 5047.5 and their directors and officers will continue to be faced with providing a defense of directors and officers named in liability suits.
To make matters worse, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
With regard to the issue of compensation, many directors serve as volunteer directors, but may receive compensation for other services rendered. A director who receives no compensation for service as a director, but who receives compensation for other services rendered, does not fall within the statute’s protection.
The standard of care as set forth in Section 5047.5 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, section 5047.5, which is supposed to afford more protection, may actually result in less protection to the directors to whom it applies.
In conclusion, Section 5047.5 contains so many exceptions, exclusions and qualifications that the protection it appears to provide is largely illusory.
Corporations Code Section 5239. Section 5239, applicable to nonprofit public benefit corporations, relieves volunteer directors and volunteer executive officers of such corporations from personal liability for damages caused by the director’s or officer’s negligent act or omissions in the performance of duties as a director or officer. The officers included in the definition of “executive officer” are the president, vice-president, secretary or treasurer. Cal. Corp. Code e 5239(c).
To be eligible for this statutory protection, damages caused by the act or omission must be covered by a policy of insurance issued to the corporation or directly to the director or executive officer. Section 5239 does not specify any minimum level of insurance coverage nor does it address the issue of insurance deductibles, and therefore an ambiguity is created with respect to the requirement that damages be “covered” by insurance. Does the phrase mean complete coverage or reasonable coverage, given the nature of the corporation and its activities? If no insurance is applicable to the claim, the director or executive officer may still gain protection from liability by establishing that both the board and the director or officer made “all reasonable efforts in good faith to obtain available liability insurance.”
The protections of Corporations Code Section 5239 are not available if a director or officer receives any salary, fee or other consideration of any kind (other than a per diem or expense reimbursement). Second, directors or executive officers seeking liability protection under the Section must prove that: (a) the act or omission was within the scope of the officer’s or director’s duties; (b) the director or officer acted in good faith; (c) the act or omission did not involve self-dealing (as defined in Corp. Code e 5233); and (d) that the act or omission was not reckless, wanton, intentional or grossly negligent. A director or executive officer is likely to remain mired in the litigation for many months, while his or her lawyers seek to establish that all of the requirements for statutory liability protection have been met and that none of the exceptions apply.
As with Section 5047.5, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
Again, as with Section 5047.5 the standard of care as set forth in Section 5239 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, Section 5239 affords less protection to directors than does Section 5231.
Finally, it should be noted that the personal liability protections afforded by 5239 have no application in the context of any action or proceeding brought by the Attorney General or any action claiming that the director engaged in a prohibited self-dealing transaction.
Code of Civil Procedure Section 425.14. The last liability protection provision which appears to apply to uncompensated directors and officers of nonprofit corporations organized for “charitable, educational, social, scientific or public service” purposes is California Code of Civil Procedure Section 425.14. What Section 425.14 purports to do is create what is commonly described as a “pleading hurdle” to shield qualified nonprofit directors and officers from suits based on claims arising out of negligent acts or omissions by the director or officer within the scope of the person’s duties as such. Such a claim can only be included in a complaint following a judicial determination (based on a verified petition and supporting affidavits) that evidence exists which substantiates the claim.
Unfortunately, Section 425.14 has as many exceptions, exclusions and qualifications regarding coverage as the two Corporations Code provisions described above. For example:
- Despite the broad reference to “charitable, educational…and scientific” organizations, the pleading hurdle of Section 425.15 is not available to Internal Revenue Code Section 501(c)(3) charitable or educational organizations. Instead, the Section’s coverage is limited to organizations which qualify for exemption under Internal Revenue Code Sections 501(c)(1) (exempt credit unions), 501(c)(5), 501(c)(7) or 501(c)(19).
- The director or officer of a listed exempt organization can receive no compensation.
- The filing of a petition pursuant to Section 425.15 (seeking approval to sue the director or officer) tolls the running of any applicable statute of limitations and requires a vigorous defense of the petition’s allegations.
As can be seen, therefore, from a review of these statutes, the “volunteer protection” afforded directors and officers of nonprofits in California is largely illusory. The potential liability of directors of nonprofits is greater than the potential liability of directors of business corporations. To date, the legislature has resisted adopting any legislation that would adequately protect directors of nonprofits from third party lawsuits.