At one of the Nonprofit Organizations Committee meetings held during the April 2016 ABA Business Law Section Spring Meeting, a discussion developed about the errors, mistakes, and missed opportunities nonprofit organizations commonly encounter when they have not had the benefit of representation by legal counsel expert in the laws applicable to tax-exempt organizations. The conversation eventually veered to how such organizations can avoid this type of situation. One important way is through the business lawyers who may be called upon to help these organizations. If those lawyers are better able to recognize when a nonprofit expert is needed, then they will be able to either seek the relevant expertise themselves or refer the organization to practitioners who focus on nonprofit organizations.
To that end, we decided to collect stories from nonprofit organization lawyers that would illustrate these common mistakes and problems. When we put out our request—and I thank all contributors for their excellent submissions—the response was immediate and certain themes emerged. It is clear that this is a common and persistent issue, and addressing it would greatly benefit our clients and our industry.
This article is aimed at the business lawyer who provides much needed work (often on a pro bono basis) to nonprofit organizations. That advisor is in a unique position to identify troubling situations and to ensure the nonprofit client has appropriate advice to avoid falling into common traps. It is our hope that this article will help business lawyers identify when to seek expert assistance, or perhaps avail themselves of the Nonprofit Organizations Committee’s educational resources (e.g., our Webinar series for the “non” nonprofit lawyer and other committee publications). We only want to stress that, when issues specific to nonprofit organizations arise, proper expertise should be consulted. As you will see, to do otherwise is to invite chaos and confusion.
Let us begin at the beginning. Nonprofit organizations often seek pro bono help to incorporate, apply for tax exemption, and launch operations. Well-meaning law firms often assign such matters to junior associates with little or no experience. Even seasoned practitioners often make mistakes when forming nonprofit organizations, including the following:
- Formation documents that do not meet IRS requirements and must be amended. This is a relatively benign but extremely common mistake. Although generally it is easy to amend formation documents, it is nonetheless an added cost and an additional delay in getting started. Similarly, law firms tend to use forms of by-laws without any regard to the differences between nonstock, nonprofit corporations, and for-profit businesses, resulting in confusion and added legal costs.
- Believe it or not, there are practitioners out there who believe that simply forming an organization as a nonprofit, nonstock corporation is enough, and they neglect to then apply for and obtain a determination from the IRS of recognition as a tax-exempt organization. (Although certain tax-exempt organizations may “self-declare” as tax-exempt, charitable organizations described in section 501(c)(3) of the Internal Revenue Code may not.) Easier to imagine is the less egregious, more common (but still problematic) fact that many practitioners, even if they apply for and obtain the federal exemption, do not realize the extent to which—and the processes by which—state and local exemptions may be obtained.
- Even when lawyers know a tax exemption application is needed, we find that a common mistake made on such applications is requesting the wrong category of tax exemption, i.e., private foundation vs. public charity. An organization that applies for and receives private foundation tax status, when it could or should have qualified as some type of public charity, will see significant effects on funding opportunities. In addition, it is expensive and time consuming to go through the process with the IRS to have the status changed. (Hint: it would have been much easier to get it right the first time.)
As outside general counsel to many of our clients, we handle day-to-day issues that range from mundane to extraordinary, and there are always issues to spot that are unique to tax-exempt organizations that might not be easily recognized by business lawyers. Although I received information about all sorts of transactions, I have focused on three popular areas of complaint for purposes of this section: contracts, charitable solicitation regulation, and employment matters.
All operational organizations encounter contracts of all kinds on a daily basis, and most likely are not subject to outside review. However, there seem to be a few common issues for which organizations and their representatives should be on the lookout. For example, one contributor noted that there are many contractors and vendors that include “donations” as line items in their proposals, presumably intending to deduct them as if cash donations (or possibly treating them “creatively” in some other way). Accordingly, practitioners must educate clients (and business vendors) on the problem with conflating donations with contractual consideration, and charities may not issue donation receipts where that would be inappropriate. We also heard about parties who attempted to characterize rent payments and other property consideration as donations. It seems that businesses and other individuals think there is carte blanche on donation characterization when making payments (of any sort) to charitable organizations. Please do not do that.
Another issue that arises with some regularity is when business consultants engaged by a charity advise on ways to increase revenues and, accordingly, attempt to make their nonprofits clients function more like businesses. These advisers do not understand the potential repercussions of commercial activity and excessive activity unrelated to charitable purposes (see more on UBIT below).
Charitable Solicitation Regulation
This is a big topic. The legal regime governing charitable solicitations is among the most (unnecessarily) burdensome and the most often ignored. Organizations themselves, especially small and/or new organizations, often are shocked to learn the level of state regulation over charitable solicitations (especially regarding professional fundraisers), and lawyers from other practice areas are more often than not blissfully ignorant of the rules. Even if a lawyer from another practice area has educated him- or herself regarding these rules, there is immeasurable value that comes from working within the regime and experiencing the rules firsthand. We in the nonprofit world have learned the best way to follow these rules without overly burdening the organization, and we also are familiar with the state agencies (often even the individuals working within the local offices) in order to more easily and efficiently handle matters when problems arise. With the quickly growing popularity of online fundraising tools like crowdfunding, text to donate, and other charity apps, it is increasingly important to be aware of these rules, as the following examples illustrate.
- Cause-related marketing/commercial co-ventures. These fundraising activities (where proceeds of a product are donated to a charity) are probably the most ignored within the already overlooked field of charitable solicitation regulation. We have all seen promotions that we know are not done correctly—I know I cringe a little whenever I see an advertisement for a product that simply says “a portion of the proceeds goes to….” The fact is, regulation of commercial co-ventures is a consumer protection issue that cannot be ignored simply because the business is trying to do a good thing. Most business lawyers have no idea about the commercial co-venture requirements (including state registration, public disclosures, and mandatory contract provisions) of the various states, which do vary, are changing all the time, and are, in fact, enforced. Accordingly, it is important for both the charity and the business to consult an expert when engaging in a significant cause-marketing campaign. A common example of lack of knowledge is the business lawyer who drafts a cause-related marketing agreement and includes in it the requirement that the charity not only grant to the commercial entity the right to make use of the name and mark of the exempt organization in connection with the charitable sales promotion, but also requires the exempt organization to take part in the marketing of the promotion. This reflects ignorance of the unrelated business income tax (UBIT) rules and the fact that tax-exempt treatment for royalties is lost if the exempt organization-licensor provides “services.” (See more on this below under UBIT.)
- Charitable raffles. Charitable raffles generally are an exception to the illegal lottery laws and are regulated locally (likely in order to keep them small). In some jurisdictions, the regulation is extremely specific and can be a bit burdensome. I would venture to guess that this is an area of which only nonprofit experts are acutely aware, and it likely is a safe assumption that those practicing outside our area would be surprised to learn the degree of regulation surrounding charitable raffles. For example, there are always clients seeking to hold a large-scale raffle through the mail or over the Internet, and, practically speaking, neither of those options is valid because: (a) it would be virtually impossible to comply with all applicable jurisdictions’ raffle regulations; and (b) at least some (perhaps all) jurisdictions restrict raffles to cash propositions.
At my law firm, I am incredibly fortunate to have the support of colleagues in other fields who “speak the language” of nonprofit organizations. In particular, our labor and employment and employee benefits groups come to mind as lawyers who are uniquely aware of the differences between nonprofit and for-profit entities when it comes to employment issues. I know that not everyone is as lucky, as evidenced by the following examples:
- Bonus, severance, and retirement payments. Many employment lawyers who normally serve for-profit businesses do not realize the potential problems with revenue-based bonus structures for tax-exempt organizations. They also often do not realize that bonuses, severance payments, retirement benefits, and other deferred compensation must all be considered in determining reasonable compensation. The most serious problem that I have encountered (more than once in the past several years) is deferred compensation plans designed for tax-exempt organizations by lawyers who are unaware that tax-exempt organizations are subject to different rules than businesses. (They may know 409A, but they have not heard of 457(f).) In these cases, vested benefits resulted in immediate taxability to the executive. You can imagine how much fun it is to deliver that news.
- Mistaken belief that the FLSA and other wage and hour laws do not apply. In general, nonprofits are subject to the Fair Labor Standards Act (FLSA) if they are “enterprises engaged in commerce,” meaning that they engage in activities in competition with the private sector above a certain annual financial level. Even if the organization is not an enterprise engaged in commerce, individual employees could still be entitled to the FLSA’s protections if their job duties involve instrumentalities of interstate commerce. Further, in New York, even if an organization is not subject to the FLSA, the New York State Labor Law makes no distinction between for-profit entities and not-for-profits. These are rules of which not all practitioners are aware.
Similarly, we received accounts of organizations having been advised that tax-exempt status extends to payroll and other employment-related taxes, which is simply not true, and so they did not pay these taxes for several years. (Take note: directors and officers can be held personally liable for willful failure to pay federal withholding or employment taxes.)
Not all lawyers who represent tax-exempt organizations are tax lawyers per se, but all of us necessarily are fluent in the unique tax laws applicable to exempt organizations that relate to all aspects of nonprofit operations. Here are just a few examples of where representatives who are not well versed in the tax-exempt tax laws tend to fall short.
Probably the most common and most dangerous mistake is where organizations’ advisors do not educate their client about how to maintain its tax-exemption—specifically regarding the automatic revocation process now in place at the IRS. The Pension Protection Act of 2006 put in place a system by which tax-exempt organizations’ tax-exempt status would be revoked automatically if the organization failed to file three consecutive information returns (IRS Forms 990, 990-N, 990-EZ, or 990-PF). According to the IRS, 275,000 organizations had been revoked by 2011; a report by two senators in February 2015 had the number at 584,000. Since then, we have all had the experience of applying for reinstatement, a process virtually identical to applying for tax exemption at the time of the organization’s launch, with the added bonus of defending the organizations’ missing returns and seeking the reinstatement retroactively so that there is no gap in the tax-exempt status.
Automatic Excess Benefit Transactions
In general, when a disqualified person who is an employee of an applicable tax-exempt organization receives something of value from the organization without paying for it, the transaction generally is considered an exchange arising out of the employment relationship. However, if neither the organization nor the disqualified person can demonstrate that they clearly intended to treat the economic benefit provided by the organization to the disqualified person as compensation, then the value of the disqualified person’s services provided in exchange for the economic benefit is deemed to be zero, and the entire amount of the economic benefit is treated as an automatic excess benefit transaction. One practitioner wrote to us about a client that was audited by the IRS, and because of bad recordkeeping and a lack of receipts for business expenses, three of its officers were assessed significant excise taxes for excess benefit transactions. The original counsel failed to advise the client of the possibility of an excess benefit assessment or the importance of proper recordkeeping. (The original counsel also failed to appropriately respond to IRS requests for information and then to properly file an appeal with the tax court; consequently, the officers had to pay more than $200,000 in taxes and penalties.)
Unrelated Business Income Tax (UBIT)
Although most lawyers likely are aware that unrelated business activities could generate taxable income for a tax-exempt organization, lawyers who do not practice in the exempt organizations world are not generally expert in the nuances of UBIT. Some common examples of this include:
- Corporate sponsorship. I mentioned above the UBIT issue where a charity is required to provide marketing services in connection with a commercial co-venture. Similarly, charities usually are so grateful to receive corporate sponsorship that they are unaware that providing advertising to the sponsor could result in taxable income. “Qualified sponsorship payments” are not subject to the tax on unrelated business income. For a payment to be a “qualified sponsorship payment,” there must be no arrangement or expectation that the corporate sponsor will receive any “substantial return benefit” in exchange for making the payment. If the sponsor receives the benefit of having its product advertised, for example, then that is considered a substantial return benefit and the sponsorship payment to the charity is taxable to the charity.
- The rental exclusion. Where an activity for which space is rented is unrelated to the organization’s purposes, the rental income still may not generate UBIT if the rental arrangement satisfies the “rental exclusion” for passive rental income. An organization can lose the benefit of the rental exclusion under several different circumstances, including where the determination of the amount of rent depends in whole or in part on the income or profits derived by any person from the property leased.
- Real property tax exemption. Personally, I cannot tell you how many times organizations and their representatives seem to be unaware of the New York rules applicable to real property tax exemption. Specifically, New York tax-exempt organizations may not charge above a relatively minimal amount of rent (maintenance, depreciation, and carrying charges) and still maintain their property tax exemption. This is true regardless of the nature of the lessor and the activities for which the property is used. I can only assume there is similar ignorance in other jurisdictions (one lawyer actually wrote to me, “Don’t even get me started on property-tax exemption issues!”). In that regard, we were also told of a client that had been mistakenly advised by a real estate attorney that property the client had purchased for improvement would not qualify for a religious use exemption. The nonprofit experts consulted after the fact were able to obtain the exemption, saving the client over $1,000,000 in property taxes over a 10-year period.
I will end by noting that these types of issues also come up for lawyers serving on boards of directors of nonprofits who want to help with the occasional piece of legal advice. Clients often turn to these lawyers or their firms for free advice rather than pay outside counsel to handle a particular matter. Lawyers serving on these boards should encourage their organizations to seek expert advice, even where there must be some expenditure. A quote by Brent S. Kampe, staff counsel with The Salvation Army, reprinted with permission, drives the issue home:
… if my organization didn’t have attorneys with nonprofit expertise spotting issues on our side (and often bringing them to the other parties’ attention), then there would be a lot more unlawful activity going on. I truly think that a lot of legal practitioners and businesspeople try to wing transactions without sufficient knowledge to properly conduct them (both on their end and for the nonprofit) all the time. What’s been an even more frightening realization is how infrequently regulators ever learn of these violations. Here’s hoping that you gain some traction in evangelizing the importance of nonprofit expertise, and that nonprofits learn that sometimes it is important to pay for such expertise, rather than just relying on the advice of the litigator (or practitioner in a different unrelated practice area) who sits on their advisory board or board of directors.