Nonprofit Legal Compliance: Why It matters

As tax season draws to a close, I’m reminded of a discussion I had with a colleague not too long ago about a small charitable organization. Unfortunately, what often happens is that people with good intentions decide to create nonprofits, but they do not realize the special obligations that come with entities that do not pay tax, which is a privileged status intended for social good.

Zero Financial Firewall

A colleague of mine who once worked as a fundraising consultant was contracted by a small nonprofit, which wanted to grow to scale and move beyond the city where it operated. The organization was doing great work with the youth in the community and had a founder who was charismatic and well connected with affluent people.

However, as often happens when nonprofits focus on fundraising, it inevitably led to reviewing and having an understanding of the financials of the organization.

When charities are seeking to obtain major gift money, it’s even more critical to understand the finances of a group because, with higher-level gifts, there are often discussions about the fiscal wellbeing of nonprofits. Major donors, as with any contributor, do not want to throw good money after bad.

Within days, it was clear to the fundraising consultant that there were no financial firewalls between the finances of the organization, its founder and its executive director. The fundraising work discontinued until the organization created tight financial controls because this could have caused legal exposure to all concerned.

Fundraising Is a Regulated Activity

The consultant created a document that developed strategies the founder could use to proceed in ensuring strict financial policies for the organization and also for the work it was going to begin with a concerted major gifts fundraising program.Why was there an abundance of caution on the part of the fundraising consultant? The answer is simple. As a veteran fundraising consultant, she understood that fundraising was a regulated activity, which necessitated transparency and regulatory compliance.

How Your Nonprofit Is Regulated

If you’re a nonprofit manager or board member, you have obligations. As the leader of a charitable organization, you should be aware of the following aspects of the work or board service that you do for a nonprofit.

Federal and state regulations: Because charitable groups, depending on the structure and activities, do not pay taxes, they have reporting to do for the fundraising dollars they raise for the purposes stated in their organizational documents. Charities have obligations to the federal government, through the IRS and the filing of their 990s and annual returns. They also have responsibilities to their respective state governments, all which vary and can also affect out-of-state donations, which are a part of the revenue streams of most organizations in the digital era.

Classification of workers: Like other types of businesses, nonprofits have obligations to classify those who work with them. In other words, consultants must meet the legal definition of contractors. On the other hand, people who work for nonprofit groups, where they are typically only working for one organization and the charity is directing how and where they do their work, are usually considered employees and must be designated as such.

Registration of fundraising consultants: It’s important for nonprofit leaders to understand the state laws governing any fundraising consultant who they may hire. Some states require that these professionals be registered with the state before they begin any fundraising solicitation activities on behalf of the nonprofit.

The legal name of these professionals (e.g. “professional fundraiser,” “fundraising counsel”) can be regulated as well, depending on the state. Although an employee who is a fundraiser may not have to register with the state for fundraising activities, a nonprofit may have to register with the state before any fundraising is done.

Payment of taxes on unrelated activities: Nonprofits are required to pay taxes on unrelated activities. What this means is that if nonprofits have earned income that exceeds $1,000, they must pay taxes on this income to the IRS, and, perhaps, also to their state.

The IRS defines these unrelated activities as having to meet three requirements, which include: “1) it is a trade or business, 2) it is regularly carried on and 3) it is not substantially related to furthering the exempt purpose of the organization.”

Nonprofits and politics: In 1954, the Johnson Amendment was made law, which prohibits nonprofits from galvanizing politically in support or opposition of political candidates. There has been tension since, with the current presidential administration stating that it will work to repeal it in favor of churches and nonprofits to get involved politically in public discourse as a matter of freedom of speech.

While the administration would need the support of two-thirds of the states to call for a constitutional convention for starters, it remains dicey for nonprofits to get involved in political activities and fundraising.

Why Compliance Matters

While some nonprofit leaders, such as the one I referenced earlier in this piece, may not realize their obligations, it's important to remember that ignorance of the law, ignorantia juris non excusat, is not a defense. Therefore, nonprofits are legally required to comply with federal and state laws, including registering, if necessary, before any fundraising activities. It's also important to recognize that compliance is one of the main purposes of board activities.

It's vital for nonprofits to have an experienced and competent attorney on board who understands nonprofit law. Aside from the earlier points described, legal compliance for nonprofits, depending on their state, also include good record keeping, conflict of interest policies––especially around payment of directors and officers, and of course, the payment of taxes on unrelated nonprofit activities.