GPSolo Magazine - April/May 2004
Nearly Everything You Want to Know about Nonprofits
The legal representation of nonprofit organizations is filled with many misconceptions. Attorneys sometimes think that representing nonprofits is easier than representing for-profit businesses—that staff and volunteers at nonprofits pull together in support of the mission, minimizing politics and business disputes. The representation of nonprofits in many respects is actually more challenging. Volunteer leaders cycle in and out of officer and director positions, often without sufficient background in nonprofit business issues to provide the necessary input for governance and operations; rotating boards often create frequent changes in direction. In addition, nonprofit staff often come to the business office from the mission’s field, and many do not have business backgrounds. These factors create a need for additional judgment and vigilance on the part of lawyers overseeing the organization’s legal compliance.
A nonprofit organization simply is one incorporated under the nonprofit laws of a state. Many people believe nonprofits are limited in the amount the organization may earn. This is not true. A nonprofit organization may earn unlimited profit, but the money must stay within the organization and be used for the support of the mission. Profits are not distributed to owners—in fact, a nonprofit organization has no owners. It may have members, officers, and a board of directors, but these parties do not own the organization. The assets of the organization in essence are held in trust for the support of the mission.
Some statutes refer to nonprofit organizations by slightly different names, such as “not-for-profit” organizations. The terms are interchangeable (although when working with a nonprofit incorporated in a state, it would be politic to use the term utilized by that state). An additional category of nonprofit organizations is “unincorporated association with nonprofit purposes.” Unincorporated associations generally form for a purpose that complies with the nonprofit corporate statute of the state of operation, but the organization does not incorporate.
This is a vital step. Only a few states have statutes that protect members of unincorporated associations from liability. If an unincorporated nonprofit organization operates in a state that has no statutory protection for members, the members could be personally liable for the debts or other obligations of that association.
This issue is particularly problematic for small chapters of national organizations. National organizations sometimes are reluctant to include a chapter and its activities within the national corporate umbrella because it doesn’t want to be liable for the chapter’s debts and obligations. Remaining unincorporated, however, puts the chapter’s members at risk for personal liability.
In addition to articles of incorporation, a nonprofit organization should have bylaws that include procedures for election of directors, admission of members, signature authority, and other important points of governance. If the nonprofit organization is incorporated, state law provides default provisions for many but not all procedures.
• Tax-exempt status: Most nonprofit organizations may utilize either IRS Form 1023 (501(c)(3) organizations, discussed below) or Form 1024 (most other organizations) to obtain tax-exempt status. It’s usually best if legal counsel participates in completing and submitting the IRS forms because many of the questions contain technical terms that require equally legalistic responses.
• Tax exempt vs. tax free: One of the most common misconceptions about tax-exempt status is that it exempts an organization from all taxes. This is not the case. Tax-exempt status means that an organization does not pay corporate federal income tax on income from activities that are substantially related to the purposes for which the organization was given exempt status. The organization does pay that tax on other types of income called “unrelated business income.”
• Unrelated business income: Not all business income is subject to tax-ation; unrelated business income as defined in the Internal Revenue Code (Code) is determined by three factors: The income must be (1) from a business (2) that is regularly carried on and (3) is unrelated to the organization’s exempt purpose. The IRS has put substantial gloss on each of these tests. Sections 511-513 of the Code and the regulations thereunder provide guidance on each of the factors.
• Fund raising: Income from fund-raising projects may be taxable because the IRS looks at the source of the revenue, not the use of the revenue. If the fund-raising activity involves the exchange of goods or services for revenue, is regularly carried on, and does not promote the organization’s mission except to raise money for it, the profit is taxable unless a special exception applies under Sections 511-513.
• State tax exemption: States generally provide exemption from income tax for nonprofit organizations to the same extent as does the federal government. Most states do not require a separate application for state exemption.
• Sales tax: One common nonprofit error is assuming that exemption from state income tax includes state sales taxes. This is not the case. Most states require separate application for exemption from state sales taxes, and the tests are very different from the tests for federal income tax exemption. Typically it’s harder to obtain a state sales tax exemption than it is to obtain a federal income tax exemption because state requirements are more stringent.
• Categories of federal income tax exemption: Congress established several categories of organizations exempt from federal income taxes, which usually are referred to by the pertinent Code sections. Among the more commonly used categories are the following:
Section 501(c)(3): charitable, educational, and religious organizations
Section 501(c)(4): social welfare organizations
Section 501(c)(5): agricultural organizations
Section 501(c)(6): trade associations, professional societies, and chambers of commerce
Many additional categories of exemption exist for special-purpose entities such as voluntary employee beneficiary associations, cooperatives, and other unique organizations.
• Time limits: Income tax exemptions are not permanent. The IRS has the right to review (i.e., audit) the activities of every tax-exempt organization and to revoke tax-exempt status. The IRS imposes this ultimate penalty sparingly because it is the equivalent of the death penalty for nonprofit organizations. Activities that might lead to revocation of tax-exempt status include using funds or other resources of the nonprofit for private purposes, failing to keep operations within the boundaries of permitted activities for the applicable category of exemption, or engaging in lobbying or political activities beyond permissible extents.
• Restrictions on lobbying and political activities: The most stringent restrictions affect Section 501(c)(3) organizations, which cannot engage in political activities at all, even to support or oppose candidates for public office or permit their resources to be used for this purpose. Section 501(c)(3) organizations may engage in lobbying to a limited extent. To qualify, the organization must hold a special election under Section 501(h) of the Code, and then if it passes, a percentage of mission-related resources based on a sliding scale can be used for lobbying each year. If the special election is not made, lobbying expenses must remain “insubstantial,” which most practitioners interpret to mean 5 percent or less of mission-related expenses for the year.
Antitrust concerns are important for nonprofit organizations, especially business and professional organizations. When competitors join together to set standards, operate certification programs, provide guidelines for industry operations, or simply discuss common problems, the federal government grows suspicious of opportunities for price fixing, group boycotts, and other antitrust violations. Indeed, the federal courts have referred to trade associations as “walking conspiracies.”
To avoid antitrust problems, knowledgeable legal counsel or staff should be present whenever competitors get together to discuss business issues. Legal counsel should review minutes of meetings to prevent activities that might cause antitrust problems from going forward.
Even knowledgeable members of trade associations may unknowingly cross a line and find themselves involved in antitrust violations. A common occurrence is when facilities of trade associations are used to encourage a vendor to the industry to change its policies so they will be more favorable to industry members. This type of activity can easily cross the line and become a group boycott, which violates antitrust laws. It’s wise to err on the side of careful scrutiny of proposed activities to avoid investigation by the Department of Justice or the Federal Trade Commission.
Copyright violations are common occurrences in the nonprofit world. Both volunteers and business people often do not understand the basic principles of copyright law, which in a thumbnail boil down to this: Almost everything belongs to somebody else. Workers often appropriate portions of existing materials and incorporate them into their own presentation, article, or design—usually with no conscious thought of plagiarizing. This results in fairly frequent infringement claims against nonprofit organizations.
Education is key. Both staff and contributing volunteers should have a clear understanding of what is and is not “fair use” of a copyrighted work. They must not assume that appropriating the work of another is allowable because it’s being used to promote a nonprofit (i.e., humane, moral, charitable) cause. Written permission to use someone else’s work must be obtained— before it’s incorporated into any work published or promoted by a nonprofit organization.
The ubiquity of the Internet has made this problem even more common, owing to the widespread misconception that everything on the Internet is “free” for everyone and can be used without permission. This is not the case. Copyright laws apply to works on the Internet the same way they do to “nonvirtual” creations. Users must have written permission to “borrow” the work.
Another area in which nonprofits frequently require legal assistance is contracting. Nonprofits face the same contracting questions as do for-profit businesses: When is a “letter of intent” a binding contract, when are oral contracts binding, which jurisdictional law governs a contract, and so on.
Nonprofits have the added problem of volunteer leaders who assume real or perceived authority accompanies their role. A volunteer who is treasurer or chair of the conference committee may assume she has the right to sign a contract for meeting space because of her title. Unfortunately, she may fail to coordinate with staff and obtain legal review of the complicated indemnification and insurance provisions buried in the contract’s back pages. Even when the contract is unfavorable, the association may well be required to fulfill its terms because the volunteer’s title indicated “apparent authority” to sign the contract.
Representing nonprofits can be one of the most rewarding areas of legal practice. It is great to go home at the end of the day and know that a charitable, educational, or associational goal was furthered by your legal work. The variables posed by rotating boards, volunteer leaders, and misconceptions about basic legal issues heighten the challenge of this area for any lawyer—and we know how lawyers love a challenge.
Paula Cozzi Goedert is Chair of Association Practice Attorneys at Jenner & Block LLC in Chicago, Illinois. She can be reached at email@example.com.