Nonprofit organizations are an essential business sector that focus on not only raising awareness for honorable causes but also on generating enough revenue to continue their outreach and compensate their employees. As is the case with anyone who hires a workforce and relies on external funding to operate, there are potential legal risks and compliance violations that can unexpectedly arise. To help nonprofit organizations focus on helping their communities, we’ve put together the top 10 legal risks facing nonprofits and how to avoid them:
1. Conflict of Interest Policies
Conflicts of interest are a common issue in every workplace. Simply put, a conflict of interest occurs when an individual’s personal interests compromise the best interests of the company. Examples include nepotism, accepting gifts from potential vendors, or sharing confidential information. These situations are not only a violation of nonprofit compliance, but almost always result in a loss of public respect and a damaged reputation.
The federal law requires nonprofit organizations to have a written conflict of interest policy and thoughtfully doing so can protect you from a slew of consequences. Adopting a policy that prohibits a variety of conflicts of interest will show that your organization is doing everything it can to avoid impropriety. For extra assurance, establish a self-monitoring system for your board of directors to circumvent any potential conflicts.
2. Tax Exemption
Under subsection 501(c) of the IRS tax code, nonprofits are given the option to apply for exemption from federal income tax. Approval for exemption is a privilege that can easily be revoked if the charitable purposes guidelines are not being followed. If, for any reason, the IRS suspects that a nonprofit is abusing its financial benefits, they will be subject to pay the income taxes in question and they could lose their tax-exempt status for good.
Utilizing charitable income for private benefit or inurement, not complying with acceptable lobbying guidelines, failing to meet annual reporting requirements, and deviating from your organization’s original purpose are just a few activities that could lead to more serious litigation. If you are concerned that your exemption status may be at risk, we encourage you to refer to Form 990 and contact a nonprofit attorney as well as your CPA to review your finances and compliance.
3. Employee Misclassification
Employment misclassification is one of the most common nonprofit legal compliance risks affecting organizations today. Understanding the difference between whether or not an employee is exempt or non-exempt from overtime wages is crucial and can save your nonprofit a significant amount on IRS penalties, back taxes, and back payments.
Nonprofits are subject to the same classification regulations that for-profit businesses are, and not complying with these will lead to hefty fines that tax-exemption status does not prevent. Adhering to and understanding California labor law and the Fair Labor Standards Act (FLSA) with due diligence will help to mitigate these common risks. This goes for both the classification of employee versus independent contractor (which we will dive into more next) and exempt versus non-exempt.
4. Independent Contractors
An organization may try to intentionally classify an employee as an independent contractor to get out of following wage responsibilities, payroll taxes, social security, and other benefits that employees are entitled to. Doing so is in direct violation of Assembly Bill 5 (AB5), a recent independent contractor law that will protect workers from this type of financial abuse.
AB5 is based on the 2018 case, Dynamex Operations West, Inc. v. Superior Court of Los Angeles County, where the California Supreme Court established new standards that protect employees (W2) from being classified incorrectly as independent contractors (1099). It resulted in the court requiring the strict, three-pronged ABC test to be used as a way to determine independent contractor classification. Before hiring anyone in your nonprofit, you must use the ABC test to avoid fines for unfiled W-2 forms, penalties of wages and taxes, and even criminal penalties. While there are some exemptions to AB5, it is best to consult with legal counsel before assuming any worker fits within an exemption.
5. Unpaid Internships
Bringing on an intern to assist your team’s capacity can be a terrific asset to your charitable organization’s growth. To help businesses determine whether or not their interns are entitled to compensation, the US Department of Labor developed this fact sheet that can be applied to both for-profit and nonprofit sectors. However, California labor laws are more strict and non-compliance with certain internship regulations can lead to overtime or wage violations.
Clarity is key to avoiding litigation. Letting the potential intern know upfront that the position is unpaid and that their experience will be solely for educational purposes is the first step to staying compliant. For the safety of your organization, it might even be best to classify them as “volunteers.” If you do choose to classify them as interns, be sure you have reviewed both the federal rules and your state’s rules. Ultimately, you will need to make sure that the intern is not carrying out the same duties that a paid employee in your organization would and that it is tied to an educational program.
6. Minimum Wage Compliance
Minimum wage laws vary by state but are generally a sensitive topic no matter where you are. The federal minimum wage is currently $7.25/hour and in California, there is currently a steady annual increase that will reach $15/hour for all businesses by 2023. Nonprofits are not exempt from honoring these laws and should be prepared to stay consistently compliant to avoid lawsuits and penalties.
There are a few exceptions both on the federal and state levels that should be considered. Employees with mental or physical disabilities are exempt from minimum wage restrictions as supported by the California Labor Code in sections 1191 and 1191.5. It should also be noted that independent contractors and volunteers do not fall under these regulations as they are not registered employees and it is up to the discretion of the nonprofit organization to determine fair compensation.
Politicians can often be a charitable organization’s biggest advocate and are a great asset for increased awareness. That being said, lobbying in support of a specific candidate or legislative campaign has restrictions and significant legal implications. Section 501(c)(3) of the IRS tax code warns charities that they may lose their tax-exemption status if they are found to be involved with any activities meant to influence legislation by urging the public, members, or employees to support or oppose a matter of legislation. However, this law can be a bit confusing, as it does also say that there can be “some lobbying.”
The IRS recognizes that advocacy is an important activity for nonprofits and lobbying is a subset of that. Therefore, it will take into consideration the context of the situation before incurring penalties. For example, an organization whose main purpose is to raise awareness about the rights of homeless veterans may hold educational meetings or distribute pamphlets with helpful facts without the actions violating the tax code. This area can be sensitive and it is best to consult a nonprofit legal team before engaging in outreach.
8. Restricted and Unrestricted Funds
Charitable organizations heavily rely on the support of donors to continue outreach and keep operations afloat. These donations have strings attached though and are designated as restricted and unrestricted. Restricted funds have stipulations and can only be used for purposes that the donor explicitly allows. Adversely, unrestricted funds can be used for any purpose within the organization as long as they do not violate any of the tax-exemption guidelines.
To stay compliant, you must track and report the donation in your financial statements. The IRS takes violations of restricted funds very seriously and will do more than just revoke the tax-exemption status. They will also disallow deductions for future contributions and impose excise taxes on donor-advised funds. The easiest way to avoid this situation is to abide by the honor system and be diligent with your financial records.
9. Copyright and Trademark
Since much of a nonprofit’s success relies on outreach through marketing efforts, copyright and trademark infringement will always be a lingering risk. Both protecting your own organization’s intellectual property and avoiding infringing on others are vital to avoiding legal issues. It may be easy to quickly copy-and-paste any relevant text, graphics, photos, or music, but it is strictly prohibited to do so unless the asset is in the public domain or royalty-free. Being vigilant on these matters will prevent others from filing civil and criminal infringement lawsuits against you.
An opposing risk also stands with a nonprofits’ written and creative content (copyright) and the names and symbols that represent it (trademark). Nonprofit directors and boards should take the necessary steps to protect their work from being stolen through the United States Patent and Trademark Office.
Attracting the attention of third-party advocates is a great way to expand your cause’s reach and leverage more support. However, it is very important that nonprofits be selective about which organizations they partner with and accept support from. Allowing unrelated third-party funders to hold fundraisers or affiliate their name with yours can be a detriment to both your reputation and your financial stability. Ensure that the organizations that you partner with for your fundraising efforts are reputable, trustworthy, and willing to follow federal and state fundraising laws and regulations.
Charitable solicitation requirements will vary by state. In the state of California, nonprofit organizations are required to register revenue made through charitable purposes with the Attorney General’s Registry of Charitable Trusts within 30 days of receiving it. In addition to ensuring your fundraising efforts are compliant, you should also make sure that they are ethical. Being transparent about fundraiser costs and outcomes will develop trust with your donors and the IRS.
Navigating this vast realm of legal risks can be overwhelming. It is important to recognize the legal risks that you could face if you are not diligent with your financial records and employment classifications. Consider consulting a nonprofit attorney to take the right steps toward protecting yourself and your employees. If you need assistance with nonprofit compliance or any other employment matter, please contact Hackler Flynn & Associates.
DISCLAIMER: Content within this post should not be considered legal advice and is for informational purposes only. Communications made through this post do not create an attorney-client relationship. Hackler Flynn & Associates is not responsible for any content that you may access from third-party resources that may be accessed through or linked to this post. Hackler Flynn & Associates is only licensed to practice in California.
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