It may not be the responsibility of an HR manager in the nonprofit sector to be aware of all of the laws that apply to nonprofits. However, there are some laws that have impact specifically on matters within the purview of the HR department that are worth being aware of. Here, we will briefly discuss a few of the laws that might most frequently apply to the work of an HR manager at a Section 501(c)(3) public charity.
Prohibitions Against Private Inurement, Private Benefit, and Excess Benefit Transactions
Private Benefit Doctrine
To qualify as exempt under Internal Revenue Code (“IRC”) Section 501(c)(3), an organization must be operated for the benefit of the public and cannot serve a private interest—a requirement referred to as the private benefit doctrine. The concern behind the doctrine is that, by providing more than an incidental private benefit to an individual or entity, the organization may not be operated primarily for an exempt purpose, as Section 501(c)(3) requires.
The private benefit doctrine does not entirely prohibit an organization from conferring benefits on individuals; rather, it requires that such benefits to individuals must be incidental, both quantitatively (i.e., the private benefit is not excessive in amount) and qualitatively (i.e., the private benefit is a mere byproduct of the public benefit), to furthering of the organization’s exempt purposes. The doctrine is the broadest of the private benefit rules that apply to IRC Section 501(c)(3) organizations in that it covers any individual on whom the organization may confer a benefit and includes both monetary payments and other benefits.
Facts and circumstances that may raise a concern regarding the provision of a prohibited private benefit include entering into transactions or providing payments on unreasonable or unfavorable terms to the nonprofit; conferring benefits on private parties beyond what is necessary to further the nonprofit’s exempt purposes; establishing exclusive business dealings with a particular for-profit business; failing to consider alternative sources or comparable prices when purchasing goods or services; and serving too small of a class of beneficiaries.
A 501(c)(3) exempt organization is similarly prohibited from allowing any part of its net earnings to inure to the benefit of any private shareholder or individual, a rule known as the private inurement doctrine. The private inurement doctrine generally prohibits a nonprofit from using its assets to provide an unjust enrichment to a person having a personal and private interest in the organization’s activities.
The private inurement doctrine is narrower than the private benefit doctrine in that it applies only to insiders of the organization (i.e., a director, officer, or key employee or other person in a position to influence or control use of the organization’s assets), rather than any individual receiving an impermissible benefit. However, the restriction on private inurement is absolute, meaning there is no such thing as incidental private inurement, and the penalty for an organization that engages in a private inurement transaction is much stiffer: the potential revocation of its exempt status.
The private inurement doctrine does not bar a nonprofit from entering into any and all transactions with insiders. Rather, it requires the nonprofit to ensure that it is not providing such insiders with a disproportionate share of benefits based on what the organization is receiving in return.
From an HR perspective, concerns regarding the private benefit and private inurement doctrines are most likely to arise around issues involving compensation. Some examples of situations in which private inurement violations may be found include:
- Compensation arrangements with an insider that do not include an upper limit or cap;
- Compensation arrangements based on factors extrinsic to performance at and benefit provided to the organization; and
- Payment of more than fair market value for goods or services provided by an insider.
Nonprofits should also be careful when considering entering into transactions that, due to their complexity or uniqueness, may be more difficult to analyze for potential private inurement violations, such as:
- Compensation arrangements that include considerations such as deferred compensation, bonuses, fringe benefits, or retirement or severance packages;
- Arrangements that involve assigning rights to intellectual property developed by insiders and funded, in whole or in part, with organizational assets; or
- Use of organizational assets to support, fund, or otherwise invest in an insider’s business.
Nonprofits may be able to help mitigate against the risk of providing a prohibited private benefit or entering into a transaction involving private inurement by having and using a well-drafted conflict of interest policy and obtaining the assistance of experienced counsel.
Excess Benefit Transactions
A transaction between a nonprofit and one or more insiders who are disqualified persons may also constitute an excess benefit transaction. Similar to the private inurement doctrine, the excess benefit transaction rules deal with a certain subset of individuals with particular relationships with the nonprofit. The excess benefit transaction rules, however, are slightly different in terms of their applicability, the potential penalties, and available protections.
According to the Internal Revenue Service (“IRS”), an excess benefit transaction is “any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.” A disqualified person is any person in a position to exercise substantial influence over the affairs of the organization at any time during the five-year look back period from the date the excess benefit transaction occurred.
Whether a person is considered a disqualified person depends on the actual powers and responsibilities the person has with respect to the organization, as opposed to her title. It is likely that the organization’s directors and those individuals responsible for implementing the decisions of the board of directors, such as the President, Executive director, and Chief Financial Officer, will be considered disqualified persons regardless of their actual titles. There are also some individuals who are automatically considered disqualified persons, such as the family members of a disqualified person or an entity in which a disqualified person owns at least 35%. Other factors that tend to show substantial influence sufficient for an individual to be considered a disqualified person include:
- The person founded the nonprofit;
- The person has authority to determine a substantial portion of the nonprofit’s capital expenditures, operating budget, or compensation for employees;
- The person manages a discrete segment of the nonprofit, but it represents a substantial portion of the activities, assets, income, or expenses of the organization; or
- The person’s compensation is primarily based on revenues generated from the activities of the nonprofit, or of a particular department of the nonprofit, that the person controls.
If an excess benefit transaction occurs, the nonprofit, the disqualified person, and even board members who knowingly approved the transaction, may be subject to significant penalty taxes (often referred to as intermediate sanctions). In addition to requiring the return of the excess benefit, the IRS may impose a tax of 25% of the amount of the excess benefit, and an additional 200% tax if the violation is not corrected within the taxable period, on the disqualified person. The IRS may also impose a tax of 10% of the amount of the excess benefit on the directors who approved the transaction knowing it to be an excess benefit transaction, up to a maximum of $10,000. These intermediate sanctions have often been imposed by the IRS as an alternative to revocation of the nonprofit’s exempt status for private inurement. However, the IRS can both impose intermediate sanctions under the excess benefit transaction rules and revoke the nonprofit’s tax-exempt status for permitting a private inurement for the same unlawful transaction.
Often the same circumstances that would raise a private inurement concern will also give rise to an excess benefit transaction concern. From an HR perspective, compensation arrangements may be particularly problematic. A nonprofit may be able to partially insulate itself from excess benefit transaction violations by following the rebuttable presumption of reasonableness procedures, which are discussed further in the following section.
Approval of Executive Compensation
As mentioned above, compensation arrangements likely present the largest risk for nonprofits with respect to excess benefit transactions. However, the Regulations provide a mechanism by which a nonprofit may create a rebuttable presumption that a compensation amount is reasonable as to the organization. By default, if the IRS accuses a nonprofit of having engaged in an excess benefit transaction, the burden is on the individual receiving the excess benefit and the directors who willfully approved the excess benefit transaction to prove that the compensation arrangement was reasonable. However, if a nonprofit follows the rebuttable presumption of reasonableness procedures, the burden instead shifts to the IRS to establish that the compensation arrangement was excessive.
Creating a rebuttable presumption of reasonableness as to a compensation arrangement requires three steps:
- The compensation arrangement is approved in advance by an authorized body of the nonprofit, such as the board of directors or an authorized committee, composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement;
- The authorized body obtained and relied upon appropriate comparability data prior to making its determination; and
- The authorized body adequately documented the basis for its determination concurrently with making that determination.
Using the rebuttable presumption of reasonableness procedures to approve compensation arrangements can help a nonprofit to ensure that it is paying appropriate compensation to its key employees and is avoiding excess benefit transactions. As a best practice, nonprofits may also wish to apply the rebuttable presumption of reasonableness procedures in approving any transaction with a disqualified person or other individual with a potential conflict of interest in the transaction.
Distinguishing Between Employees and Independent Contractors
Classifying an individual who is really an employee as an independent contractor is a common, and potentially costly, mistake that many nonprofits make. Knowledge of the federal and state laws that inform how a worker must be classified can be useful in helping to avoid this mistake. Although determining whether an individual worker is properly classified as an employee or an independent contractor will depend on the facts and circumstances of the particular working arrangement, there are certain factors that, if present, indicate that the individual is likely an employee, including:
- The individual works full-time for the nonprofit
- The working arrangement is for an indefinite duration
- The individual is employed exclusively for the employer
- The nonprofit has the right to direct and control what work the individual does and how she does it
- The nonprofit provides training regarding required work procedures and methods
- The individual receives benefits, such as insurance, paid leave, or pension, from the nonprofit
- The working arrangement is not documented in a negotiated written contract
If an employer misclassifies an employee as an independent contractor, the employer may be subject to fines for failure to withhold employment taxes, may breach wage and hours laws (e.g., laws regarding minimum wage, overtime, and mandatory breaks), and may fail to implement and/or enforce applicable anti-discrimination and retaliation laws that may apply only to employees. Moreover, an employer may find that it is unprotected against potentially very expensive workers’ compensation claims. Any person required to collect payroll taxes, potentially including a nonprofit’s directors, may also be held personally liable for willfully failing to withhold such taxes. Accordingly, it is important for nonprofit HR managers to ensure that their organizations are properly classifying individuals as either employees or independent contractors.
Nonprofits that have previously misclassified employees as independent contractors may have the option of participating in the IRS Voluntary Classification Settlement Program (“VCSP”). The VCSP is a voluntary program that allows an employer to reclassify its workers as employees for employment tax purposes for future tax periods while providing partial relief from prior federal employment taxes. In order to be eligible to participate in the VCSP, the employer must have consistently treated the workers whose classification it wishes to change as independent contractors (including having filed all required Form 1099s with the IRS) and cannot be under employment tax audit by the IRS or audit concerning the classification of the workers by the Department of Labor or a state government agency at the time it applies. In exchange for agreeing to reclassify workers going forward, an employer who participates in the VCSP is required to pay 10% of the employment tax liability that would have been due for the reclassified workers for the most recent tax year, is not liable for any interest and penalties on the amount that would have been due, and will not be subject to an employment tax audit with respect to the worker classification of the reclassified workers for prior years.
Distinguishing Between Employees, Volunteers, and Interns
Many nonprofits utilize volunteers to assist the organization in a variety of ways. While distinguishing between an employee and a volunteer often seems simple enough, there are certain circumstances in which that distinction may not be as easy to make as it seems. For instance, what if a nonprofit provides a volunteer with a “stipend” of some sort? If the stipend is compensation for services, the individual may not be a volunteer and, if the payment is for regularly provided services, may in fact be an employee. However, payment of a stipend to a volunteer may not cause the volunteer to be classified as an employee if the stipend is considered reimbursement for certain expenses, is a de minimis fringe benefit, or is a nominal fee for service. Although less common, improperly classifying an individual who is in fact an employee as a volunteer may have some of the same risks and consequences as discussed above with respect to independent contractors.
Similarly, interns can be a great asset to a nonprofit. However, it is important for nonprofits to clarify whether their interns are unpaid volunteers or paid employees. If they are volunteers, paying them a stipend may raise concerns as mentioned in the last paragraph. There is also an exception to the rules for paying employees under the Fair Labor Standards Act for trainees if certain criteria are met, although the determination of whether an internship program meets the criteria for this trainee exception depends on all of the facts and circumstances of the program.
Ambiguity about whether an individual is an employee, volunteer, or intern can be particularly risky for nonprofits and it is often beneficial to document the nature of the relationship clearly in writing so that both parties understand the obligations and benefits under such relationship. It may also be wise for a nonprofit that is paying stipends to its volunteers or hiring interns to consult with an employment law attorney for counsel regarding these issues.