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.