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CHAPTER 1
Nonprofit Organizations Law Generally
A lawyer representing nonprofit colleges, universities, and other nonprofit organizations faces, on a daily basis, a barrage of questions about the rules governing the organizationsâ formation, administration, operation, management, and compliance with federal and state laws, including the tax laws. More frequently than nonlawyers might suspect, there is little or no law on a 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 questions such as: âHow much can I be paid?â or âHow much is this gift property worth?â Even regarding matters that are within the lawyerâs province, howeverâlegal standardsâthe law is often vague. Much of the applicable nonprofit law is at the state level, so there can be varied answers to questions. Yet federal law on the subject of nonprofit law is building, and not just in the tax law arena; the best case in point is governance (Chapter 5).
Here are the questions most frequently asked about general operations of a nonprofit organization, including private colleges and universitiesâand the answers to them.
NONPROFIT LAW BASICS
1.1 What is a nonprofit organization?
The term nonprofit organization is somewhat misleading; regrettably, the English language lacks a better one. It does not mean an organization that cannot earn a profit. Many nonprofit organizations are realizing profits, in the sense of revenues exceeding expenses. Colleges and universities exemplify this point. Using data for institutionsâ tax years ending in 2006, the average amount of net revenue received by small colleges and universities (2.34) was $11 million, by medium-size institutions (2.35) was $33 million, and by large institutions (2.36) was $87 million (2.50). 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 organizationâs 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 are forbidden to 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. For colleges and universities, the principal exempt function is the education of students; collateral functions include sports programs, research, and community service activities.
Consequently, the doctrine of private inurement is the essential dividing line, in the law, between nonprofit and for-profit organizations.
1.2 Sometimes the term not-for-profit organization is used instead of nonprofit organization. Are the terms synonymous?
As a matter of law, the terms not-for-profit and nonprofit do not mean the same. The two terms are often used interchangeably, but the proper legal term in this context is nonprofit organization (1.1).
The law employs 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.1 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 often is 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 (1.1).
1.3 What are the types of nonprofit organizations?
The principal type of nonprofit organization is the nonprofit corporation. Private colleges and universities, and organizations related to them (such as a development foundation (2.68)), usually are organized as nonprofit corporations; some may be chartered directly by a state. The other types of nonprofit organizations are trusts, unincorporated associations, and limited liability companies.
1.4 What is the appropriate form of nonprofit organization?
Many factors need to be taken into account in determining the appropriate form of a nonprofit organization. One of the reasons the corporate form is prevalent is that nearly every state has a nonprofit corporation act that provides law underlying most aspects of the corporationâs operations. Also, the corporate form offers directors and officers protection against personal liability in connection with their involvement in the organizationâs affairs. This is why just about every private college and university, and related entities, are structured as nonprofit corporations. (Public colleges and universities are established pursuant to a state constitution or statute.)
To be a corporation, however, the entity must file articles of incorporation with the appropriate state (1.11). Annual reports most likely also are required. These are public documents. Thus, those forming an entity that want more privacy for it may steer away from the corporate form.
Small organizations, less concerned with issues of liability and formality of organization, may be content with the unincorporated association form. In some instances, the appropriate form is dictated by law, such as employee plans (which are usually trusts) and planned giving vehicles (which also are often trusts, most notably the charitable remainder trust (12.62)).
1.5 How is a nonprofit organization started?
Generally, a nonprofit organization is formed in adherence to the law of the appropriate state (or District of Columbia). (A few nonprofit organizations are chartered by Congress. As noted (1.4), public colleges and universities are formed in accordance with a constitution or statute, being governmental instrumentalities or agencies.) In general, a nonprofit organization is formed by the filing or execution of a set of articles of organization.2
Thus, if the organization is to be a corporation, it commences its existence by filing articles of incorporation with a state (1.6). If the entity is a trust, it is formed by executing a declaration of trust or a trust agreement (1.14). An unincorporated association is established by execution of a constitution (1.15). A limited liability company is formed by execution of articles of organization (followed by adoption of an operating agreement governing operations, relationships among members, distributions, sharing of income and losses, and the like).
The federal tax law also will, assuming the nonprofit organization is to become a tax-exempt organization, require and encourage various provisions of the articles of organization. The law in this context is termed the organizational test (1.35).3
Most nonprofit organizations also have a set of bylawsâthe rules by which they are operated. Some organizations have additional rules, such as codes of ethics, manuals of operation, and employee handbooks as well as a variety of policies and procedures (5.29â5.37).
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 should adopt a set of bylaws, elect the officers, pass one or more resolutions to open bank and investment accounts, and attend to whatever other initial business there may be.
1.6 How does a nonprofit organization incorporate?
A nonprofit organization incorporates by filing a document with the appropriate state (1.11), usually termed articles of incorporation. State law likely will dictate some of the contents of these articles. At a minimum, the articles of incorporation will state the corporationâs name, describe its corporate purposes, list the names and addresses of the directors, name a registered agent (1.7), and recite the names and perhaps the addresses of the incorporators (1.10).
The articles of incorporation likely will be filed with the secretary of stateâs office in the state. If that office determines that the articles qualify under the law, the state will issue a certificate of incorporation. The entity becomes a corporate as of the date on the certificate.
1.7 What is a 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.
1.8 What does the registered agent do?
The registered agent functions as the corporationâs 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.
1.9 Does the registered agent have any liability for the corporationâs 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 corporationâs activities. The agent would be held liable for his or her own offenses, such as breach of contract.
1.10 Who are the incorporators?
The incorporators are the individuals who technically create a corporation. (They may or may not be the corporationâs true founders.) They execute the articles of incorporation. Under the typical legal requirement around the country, anyone who is 18 years of age and a U.S. ...
