Prompted by a conversation among nonprofit leaders about the public’s and media’s general lack of knowledge about nonprofits, this article targeted at journalists briefly discusses some basics of federal tax laws applicable to 501(c)(3) organizations and common state corporate and charitable trust laws applicable to nonprofits.
Internal Revenue Code Section 501(c)(3)
A 501(c)(3) organization must have one or more of the following exempt purposes: religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.
A 501(c)(3) organization must be operated primarily (despite the use of the word exclusively in the statute) for one or more exempt purposes. If it is operated for other purposes (e.g., to conduct an unrelated business), such activities must be insubstantial in relation to the exempt function activities.
Private Benefit Prohibition
A 501(c)(3) organization may not confer upon any individual a benefit that is more than incidental, quantitatively and qualitatively, to the furthering of its exempt purposes. Reasonable compensation for necessary services would not confer a prohibited private benefit on an employee or contractor. But gross overpayment to any individual or entity would violate the private benefit prohibition, which under egregious circumstances could result in revocation of the organization’s tax-exempt status.
Private Inurement Prohibition
A 501(c)(3) organization may not confer upon any insider in a position to influence or control use of the organization’s assets (like a director or officer) any part of its gross or net earnings without equal value in return. Like the private benefit prohibition, the prohibition against private inurement is not violated by reasonable compensation to an insider for necessary services. But gross overpayment to an insider could be deemed a violation of the private inurement prohibition, which would result in revocation of the organization’s tax-exempt status.
Excess Benefit Transactions (Public Charities)
A transaction in which a 501(c)(3) public charity confers upon a disqualified person (e.g., an insider like a director or officer ) a benefit that exceeds the value of what such person is providing to the organization in return is an excess benefit transaction. An excess benefit transaction can result in a penalty tax imposed upon the disqualified person (who must also return the excessive portion to the organization) and, in egregious circumstances, upon directors who approved the transaction knowing it would result in an excess benefit conferred upon the disqualified person. Organizations have to be careful with no- or low-interest loans to insiders, excessive compensation, and compensation (including bonuses) for past services for which the organization has no obligation to pay. Whether compensation is reasonable or excessive depends on all the facts and circumstances, including the size of the charity. And reasonableness may, in certain circumstances, be extremely generous (e.g., college football coaches).
Self-Dealing (Private Foundations)
A transaction between a 501(c)(3) private foundation and a disqualified person (e.g., an insider or substantial contributor), including compensation paid by the private foundation to the disqualified person, may be a prohibited self-dealing transaction subject to penalty taxes. But there are several exceptions, including compensation paid to a disqualified person for personal services reasonable and necessary to carrying out the exempt function of the private foundation (e.g., management, legal, accounting) if the compensation is not excessive. Note that private foundations are subject to more restrictions than public charities because of the lower likelihood and expectation of public accountability where the donors are the same persons or related to the same persons who control the private foundation.
Lobbying (Public Charities)
A 501(c)(3) public charity may engage in lobbying activities subject to certain limitations. Lobbying cannot be a substantial part of its overall activities. But for organizations that have made the very simple 501(h) election, whether lobbying is substantial is measured only by its expenditures and not by its volunteer activities. Moreover, the level of lobbying permissible under 501(h) is relatively generous (e.g., 20% of its first $500,000 of exempt purpose expenditures).
Political Campaign Intervention
A 501(c)(3) organization may not engage in political campaign intervention, including endorsing or otherwise supporting (or opposing) a candidate for public office. Certain voter education or registration activities may not violate this prohibition if conducted in a non-partisan manner. On the other hand, lobbying activities on wedge issues separating two candidates timed to take place only immediately before an election may be considered political campaign intervention.
A 501(c)(3) organization that is required to file with the IRS (most 501(c)(3) organizations other than churches) must make publicly available its Form 1023 exemption application and, generally, its Form 990 annual information returns for the past three years.
Checking Whether an Organization is Exempt Under 501(c)(3)
Exempt Organizations Select Check is a valuable online tool for checking whether an organization is exempt under 501(c)(3). It is updated regularly and generally a better way to verify whether an organization is currently exempt than a review of its IRS exemption letter (which may be very old) or past filed Forms 990 (which you can do for free on Guidestar). Churches are exempt from filing for recognition of 501(c)(3) status and may not be listed on EO Select Check or Guidestar.
State Corporate Laws
The articles of incorporation and bylaws are the main governing documents of a nonprofit corporation. A corporation must act consistent with the provisions in its governing documents.
Boards of Directors
A nonprofit corporation is governed by its board of directors. While the board may delegate management to the corporation’s officers, committees, employees, or management company, the board is ultimately responsible for all of the activities and affairs of the corporation and for the exercise of all corporate powers.
Power of a Director
Individually, a director has no inherent power other than to vote on matters before the board and to inspect and copy corporate books, records, and documents. Collectively, as the board, directors have ultimate authority and power over a corporation, subject to certain limitations (including membership rights for corporations with voting members) which may be codified in the corporation’s governing documents. But some directors may hold other positions (e.g., officer positions) that have been delegated with individual authority.
Each director owes fiduciary duties of care and loyalty to the corporation. Generally, the duty of care requires each director to act with reasonable care in governing the corporation, including in providing financial and programmatic oversight, taking steps to ensure compliance with external laws and internal policies (duty of obedience), protecting charitable assets from misuse or waste, and setting the future course of the corporation. The duty of loyalty requires each director to act in good faith in the best interests of the corporation, including where the director has a conflict of interest in a particular matter or is exposed to confidential information.
Self-Dealing (Corporate Law)
A director may be prohibited under state corporate laws to enter into a transaction with the corporation in which the director has a material financial interest except under certain conditions and pursuant to certain procedures. Generally, a majority of the directors (not including the vote of the interested director) must approve such transaction after disclosure of the director’s interest. In addition, either (1) the board must have considered and in good faith determined after reasonable investigation under the circumstances that the corporation could not have obtained a more advantageous arrangement with reasonable effort under the circumstances or (2) it must be shown that the corporation in fact could not have obtained a more advantageous arrangement with reasonable effort under the circumstances.
State Charitable Trust Laws
Generally, a charitable nonprofit corporation may not use its assets inconsistent with its stated charitable purpose (mission). Accordingly, if a corporation’s mission is restricted to arts education in California, it cannot use its assets to provide earthquake relief in Nepal.
Changing the Mission
A charitable nonprofit corporation may be able to change its mission by amending its governing documents, but this doesn’t mean that its previously acquired assets can be used for the new mission. Accordingly, if a corporation changed its mission from supporting arts education in California to supporting science education throughout the United States, its assets acquired before the change in mission may be restricted to use in furtherance of its original mission.
If a charitable nonprofit corporation accepts a gift that is restricted to a specific use by the donor, the corporation must ensure such restriction is observed. Accordingly, if the gift is restricted to use in San Francisco, the corporation cannot use the gift to fund programs in Oakland or to fund its general administrative costs if the corporation operates in part outside of San Francisco.
A nonprofit must comply with applicable fundraising laws when engaging in charitable solicitations, including registering with the state charity official (typically, the Attorney General) when required, and ensuring the truthfulness of communications by or on behalf of the nonprofit. Charitable solicitations in a state other than the state of incorporation may require registration in such state, but the enforcement of such laws may be uneven and lax, in part because the laws appear ill-suited and overly burdensome for internet-based solicitations not specifically targeting residents in those foreign states by smaller nonprofits (see Charleston Principles).