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Authoritative answers to the most important questions on business, tax, legal, and fundraising practices for nonprofit organizations
Written in the inviting style of Bruce Hopkins, the nation's leading legal authority on nonprofit organizations, 650 Essential Nonprofit Law Questions Answered is a must-have guide, developed specifically to help nonprofit managers and advisers harness the latest trends and developments in nonprofit law.
Presented in a convenient question-and-answer format, 650 Essential Nonprofit Law Questions Answered offers real-world solutions to the most common challenges facing nonprofit organizations, including:
* Intermediate sanctions
* Competition and commerciality doctrines
* Partnerships and joint ventures
* Private foundation rules
* Disclosure and distribution rules
* Annual report requirements
* Planned giving
650 Essential Nonprofit Law Questions Answered is the nonprofit professional's best resource for understanding statutes, regulations, and other laws governing tax-exempt organizations.
A lawyer representing nonprofit organizations faces, on a daily basis, a barrage of questions about the rules governing the organizations' formation, administration, operation, and management. Some of these questions may be answered using state law rules, some with federal law rules. More frequently than nonlawyers might suspect, there is no law on the particular point.
These questions may require answers from an accountant, a fundraiser, an appraiser, or a management consultant, rather than a lawyer. For example, a lawyer is not professionally competent to answer these questions: "How much can I be paid?" or "How much is this gift property worth?" Even regarding matters that are within the lawyer's province, however-legal standards-the law is often very vague. Much of the applicable law is at the state level, so there can be varied answers to questions. Yet federal law on the subject is building.
Here are the questions most frequently asked about general operations of a nonprofit organization-and the answers to them.
Q 1:1 What is a nonprofit organization?
The term nonprofit organization is a misleading term; regrettably, the English language lacks a better one. It does not mean that the organization cannot earn a profit. Many nonprofit organizations are enjoyingprofits. An entity of any type cannot long exist without revenues that at least equal expenses.
The easiest way to define a nonprofit organization is to first define its counterpart, the for-profit organization. A for-profit organization exists to operate a business and to generate profits (revenue in excess of costs) from that business for those who own the enterprise. As an example, the owners of a for-profit corporation are stockholders, who take their profits in the form of dividends. Thus, when the term for-profit is used, it refers to profits acquired by the owners of the business, not by the business itself. The law, therefore, differentiates between profits at the entity level and profits at the ownership level.
Both for-profit and nonprofit organizations are allowed by the law to earn profits at the entity level. But only for-profit organizations are permitted profits at the ownership level. Nonprofit organizations rarely have owners; these organizations are not permitted to pass along profits (net earnings) to those who control them.
Profits permitted to for-profit entities but not nonprofit entities are forms of private inurement (see Chapter 6). That is, private inurement refers to ways of transferring an organization's net earnings to persons in their private capacity. The purpose of a for-profit organization is to engage in private inurement. By contrast, nonprofit organizations may not engage in acts of private inurement. (Economists call this fundamental standard the nondistribution constraint.) Nonprofit organizations are required to use their profits for their program activities. In the case of tax-exempt nonprofit organizations, these activities are termed their exempt functions.
NOTE: The prohibition on private inurement does not mean that a nonprofit organization cannot pay compensation to its employees and others. The law requires, however, that these payments be reasonable.
Consequently, the doctrine of private inurement is the essential dividing line, in the law, between nonprofit and for-profit organizations.
Q 1:2 Who owns a nonprofit organization?
For the most part, a nonprofit organization does not have owners who would be comparable to stockholders of a for-profit corporation or general partners in a partnership. There are some exceptions: a few states allow nonprofit corporations to be established with the authority to issue stock.
NOTE: This type of stock does not pay dividends, because that would contravene the prohibition on private inurement (see Q 1:1). The stock can be transferred to others, however, by sale, gift, or otherwise.
Stock in a nonprofit organization is used solely for purposes of ownership. Any person (an individual, a business entity, or another nonprofit organization) can be a shareholder under this arrangement.
TIP: When a nonprofit organization is being established and those forming it want to ensure their control of it, irrespective of the composition of the board of directors, setting up a stock-based nonprofit organization often is the answer (see Q 1:23).
Q 1:3 Who controls a nonprofit organization?
It depends on the nature of the organization. Usually, control of a nonprofit organization is vested in its governing body, frequently termed a board of directors or board of trustees. Actual control may lie elsewhere-with the officers or key employees, for example. It is unlikely that control of a large-membership organization would be with the membership, because that element of power is too dissipated. In a small-membership entity, such as a coalition, control may well be with the membership.
Q 1:4 Sometimes the term not-for-profit organization is used instead of nonprofit organization. Are the terms synonymous?
As a matter of law, no. People use the two terms interchangeably in good faith, but the proper legal term is nonprofit organization.
The law uses the term not-for-profit to apply to an activity rather than to an entity. For example, the federal tax law denies business expense deductions for expenditures that are for a not-for-profit activity. Basically, this type of activity is not engaged in with a business or commercial motive; a not-for-profit activity is essentially a hobby.
The term not-for-profit is often applied in the nonprofit context by those who do not understand or appreciate the difference between profit at the entity level and profit at the ownership level (Q 1:1).
Q 1:5 How is a nonprofit organization started?
Nearly every nonprofit organization is a creature of state law (or District of Columbia law). (A few nonprofit organizations are chartered under a federal statute.) Thus, a nonprofit organization is started by creating it under the law of a state.
There are only four types of nonprofit organizations: corporations, unincorporated associations, trusts and limited liability companies. The document by which a nonprofit organization is formed is generally known as its articles of organization. For a corporation, the articles are called articles of incorporation. For an unincorporated association, the articles are in the form of a constitution. The articles of a trust are called a trust agreement or a declaration of trust.
Most nonprofit organizations also have a set of bylaws-the rules by which they are operated. Some organizations have additional rules: codes of ethics, manuals of operation, employee handbooks, and the like.
A nonprofit organization formed as a corporation commences its existence by filing articles of incorporation with the appropriate state. Some states require the filing of trust documents. It is rare for a state to require the filing of a constitution or a set of bylaws as part of the process of forming the organization. (Bylaws and similar documents may have to be filed under other state laws, however.)
NOTE: These observations pertain to the filing of the document as part of the process of creating the nonprofit organization. An entity that is soliciting contributions is likely to have to file its articles of organization and bylaws in every state in which it is fundraising, as part of the solicitation registration requirements (Chapter 13).
Following the creation (and, if necessary, the filing) of the articles of organization, the newly formed entity should have an organizational meeting of the initial board of directors. At that meeting, the directors will adopt a set of bylaws, elect the officers, pass a resolution to open a bank account, and attend to whatever other initial business there may be.
Q 1:6 How does a nonprofit organization incorporate?
The state usually has a form set of articles of incorporation. A lawyer who knows something about nonprofit organizations can prepare this document or the incorporators can do it themselves. They need to agree on the organization's name, state the corporate purposes, list the names and addresses of the directors, name a registered agent, and include the names and addresses of the incorporators. The incorporators are the individuals who sign the articles.
TIP: This is not entirely a matter of state law. What is in or not in a set of articles of organization (Q 1:5) can be determinative of whether the organization is able to become tax-exempt under federal law. The two most important elements are the statement of the organization's purpose and, in the case of charitable entities, the inclusion of a clause preserving income and assets for charitable purposes.
Q 1:7 Who are the incorporators?
Under the typical legal requirement around the country, anyone who is 18 years of age and a U.S. citizen can incorporate a nonprofit corporation. Each state's law should be confirmed on the point, however. The initial board members can be the incorporators. Many states require three incorporators.
Some groups are very sensitive to the matter of who is listed as an incorporator. They see the articles of organization as being of great significance to the organization-a document to be preserved and treasured for posterity. Others prefer to let the lawyers working on the case be the incorporators. No particular legal significance is attached to service as an incorporator.
Q 1:8 Can the same individuals be the directors, officers, and incorporators?
Generally, yes. Again, the law of the appropriate state should be reviewed.
Q 1:9 What about the registered agent?
Typically, the registered agent must be either an individual who is a resident of the state or a company that is licensed by the state to be a commercial registered agent.
Q 1:10 What does the registered agent do?
The registered agent functions as the corporation's point of communication to the outside world. Any formal communication for the corporation as a whole is sent to the registered agent. Thus, if the state authorities want to communicate with the corporation, they do so by contacting the agent. If someone wants to sue the corporation, the agent is served with the papers.
Q 1:11 Does the registered agent have any liability for the corporation's affairs?
No. The registered agent, as such, is not a director or officer of the corporation. Thus, the agent has no exposure to liability for the corporation's activities. The agent would be held liable for his or her own offenses, such as breach of contract.
Q 1:12 Can the same individual be a director, officer, incorporator, and registered agent?
Yes, unless state law expressly forbids such a multirole status, which is unlikely. The registered agent-if an individual-must be a resident of the state in which the entity is functioning (Q 1:9), but the requirement of residency is not applicable to the other roles.
Q 1:13 How does a nonprofit organization decide the state in which to be formed?
Generally, a nonprofit organization is formed in the state in which it is to be headquartered. Most frequently, this is the state in which those who are forming the entity and who will be operating it are residents and/or maintain their offices. An organization can be formed in only one state at a time.
Occasionally, however, another state's law contains attributes that are desirable for those who are forming a nonprofit organization. For example, only a few states permit the creation of a nonprofit corporation that can issue stock. An organization seeking this feature can be formed in one of those states and then qualified to conduct its activities in the state where its principal operations will be (Q 1:23).
TIP: A nonprofit organization (particularly a nonprofit corporation) must be qualified to do business in every state in which it has an operational presence. In some states, for purposes of this qualification, the solicitation of gifts (irrespective of the means) is considered doing business.
An entity that is formed in one state (the domestic state) and is doing business in another state (the foreign state) is regarded, by the latter state, as a foreign organization.
Q 1:14 How does a nonprofit organization qualify to do business in another state?
A nonprofit organization qualifies to do business in another state by filing for a certificate of authority to do business in the state. The process of obtaining this certificate is much like incorporating in a state. Also, the entity is required to have a registered agent in each state in which it is certified to do business (as well as in the domestic state).
TIP: The law of each state should be checked to see what persons qualify to be registered agents (Q 1:9). An organization that is doing business in several states may find it more efficient to retain the services of a commercial firm licensed to function as a registered agent in all of the states.
Q 1:15 What is the legal standard by which a nonprofit organization should be operated?
It depends on the type of organization. If the nonprofit organization is not taxexempt, the standard is nearly the same as that for a for-profit entity. If the nonprofit organization is tax-exempt, but is not a charitable organization, the standard is higher. The legal standard is highest for a tax-exempt charitable organization. In general, the standard is easy to articulate, but often difficult to implement.
Q 1:16 What is the standard for an organization that is tax-exempt and charitable?
The legal standard by which all aspects of operations of the organization should be tested requires reasonableness and prudence. Everything the organization does should be undertaken in a reasonable manner and to a reasonable end. Also, those working for or otherwise serving the charitable organization should act in a way that is prudent.
The federal tax exemption granted to charitable and certain other forms of taxexempt organizations can be revoked if the organization makes an expenditure or engages in some other activity that is deemed to be not reasonable. The same is likely true at the state level: unreasonable behavior may cause the attorney general to investigate the organization.
Q 1:17 What is the rationale for this standard for charities?
The principles underlying the laws concerning charitable organizations, both federal and state, are taken from English common law, principally those portions pertaining to trusts and property. The standards formulated by English law hundreds of years ago for the administration of charitable trusts were very sound and very effective, and they underpin the laws today. The heart of these standards is the fiduciary relationship.
Q 1:18 What does the term fiduciary mean?
A fiduciary is a person who has special responsibilities in connection with the administration, investment, and distribution of property, where the property belongs to someone else. This range of duties is termed fiduciary responsibility. For example, guardians, executors, receivers, and the like are fiduciaries. Trustees of charitable trusts are fiduciaries. Today, a director or officer of a charitable organization is a fiduciary.
Indeed, the law can make anyone a fiduciary. As an illustration of the broad reach of this term, in a few states, professional fundraisers are deemed, by statute, fiduciaries of the charitable gifts raised during the campaigns in which they are involved.
Excerpted from 650 Essential Nonprofit Law Questions Answered by Bruce R. Hopkins Excerpted by permission.
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Chapter 1: General Operations of a Nonprofit Organization.
Chapter 2: Boards of Directors and Conflicts and Liability.
Chapter 3: Corporate Governance Principles.
Chapter 4: Acquiring Tax-Exempt Status.
Chapter 5: Annual Return Preparation.
Chapter 6: Private Inurement and Private Benefit.
Chapter 7: Intermediate Sanctions.
Chapter 8: Lobbying.
Chapter 9: Political Activities.
Chapter 10: Public Charity Status.
Chapter 11: Private Foundation Rules.
Chapter 12: Charitable Giving Rules.
Chapter 13: Fundraising Regulation.
Chapter 14: Unrelated Business Activities.
Chapter 15: Subsidiaries.
Chapter 16: Partnerships and Joint Ventures.
Chapter 17: Competition and Commerciality.
Chapter 18: Disclosure and Distribution Rules.
Chapter 19: IRS Audits of Nonprofit Organizations.