Serving Your Community Without Being Served a Summons: Fiduciary - PDF document

Serving Your Community Without Being Served a Summons: Fiduciary Responsibilities of Not-for Profit Boards N. Elizabeth McCaw, Esq. Retired Shareholder, Stokes Lawrence, P.S., Seattle I. Introduction Service on the Board of Directors of a Washington not-for-profit organization is a complex compilation of a variety of duties, obligations and activities, some fiduciary and others purely volunteer. This paper provides an overview of some of the key legal fiduciary duties mandated by Washington state law as well as tips for fulfilling those duties and limiting your personal liability as a director or officer of a Washington not-for-profit corporation. For a more comprehensive discussion of the subjects of forming and governing a not-for-profit corporation in the State of Washington, please see the Washington Nonprofit Handbook available online in the “Legal Resources” section of the website of Washington Attorneys Assisting Community Organizations (www.waaco.org). A. Tax-Exempt Status - What Does 501(c)(3) Mean? The majority of laws that pertain to the creation, organization, and administration of a not-for-profit organization are state laws. Almost every not-for-profit organization is formed under a state statute (few, such as the American Red Cross, are chartered by federal law). However, federal law governs whether or not an organization will be tax-exempt and because tax-exempt status and the attributes that go along with tax-exempt status are essential elements to the organizational structure and operation of a not-for-profit organization, it is helpful to start with a basic understanding of the federal tax laws that determine tax-exempt status. A “tax - exempt organization” refers to a not-for-profit organization that is exempt from federal income taxation. There are approximately 30 categories of tax-exempt organizations defined under the Internal Revenue Code (the “Code”). From a fundraising standpoint, the most preferred category is described in section 501(c)(3) of the Code, because contributions to a 501(c)(3) organization are deductible by the donor for income tax purposes. Thus, “charities” as you most likely think of them are 501(c)(3) organizations. Code section 501(c)(3) recognizes as tax- exempt “[c]orporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or education purposes, or to foster national or international sports competition..., or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the private benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on any propaganda, or otherwise attempting to influence legislation..., and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for political office. IRC § 501(c)(3). -1- 1123204.1

There is no entitlement to tax exemption. A not-for-profit organization that claims exemption from federal income taxation under section 501(c)(3) of the Internal Code must apply to the Internal Revenue Service for recognition of its exemption by filing IRS Form 1023 (Application for-Recognition of Exemption under Section 501(c)(3)). All not-for-profit organizations that are recognized as tax-exempt are classified by the IRS as either private foundations or publicly supported organizations (or “public charities”) . Most tax-exempt not-for-profit organizations are classified as public charities under Code sections 509(a)(1) and 170(b)(1)(A)(vi) or Code section 509(a)(2). Private foundations are subject to greater federal regulation. Donations to private foundations are not tax deductible to the same extent as donations to publicly supported organizations. A not-for-profit organization that wishes to qualify as a public charity must pass a “public support test , ” whic h is determined based upon the financial information reported to the IRS annually. B. Summary of Tax-Exempt Basics  A not-for-profit organization must make application to the Internal Revenue Service in order to qualify for tax-exempt status.  If proper application is made to the Internal Revenue Service within 15 months after the not-for-profit organizat ion’s date of formation, the not -for-profit organization will be treated as tax-exempt for federal income tax purposes from the date of formation. Otherwise, the not-for- profit organization’s exemption will not become effective until the issuance of a determination letter by the IRS.  A tax-exempt not-for-profit organization is exempt from paying federal income taxes. Other federal taxes for unemployment insurance programs, social security, an d Medicare must be paid by “tax -ex empt” not -for-profit organizations.  Tax-exempt not-for-profit organizations must withhold income taxes from employees’ wages.  Not-for-profit organizations may be subject to state sales and use taxes, state and city business and occupation (B&O) taxes, and state, county and city real and personal property taxes and leasehold excise taxes. Limited exemptions and deductions may apply but not all are automatic based upon federal tax status.  Directors should ensure that the not-for-profit corporation has applied for all applicable tax exemptions at the federal, state and local levels.  If the not-for-profit profit organization regularly carries on an activity that is not substantially related to its tax-exempt purposes, it may be have to pay federal income taxes on this “unrelated business income” (UBI). -2- 1123204.1

 Directors must ensure that the not-for-profit organization complies with its annual tax reporting and payment obligations (IRS Form 990 and state and local filings). Failure to do so may result in substantial penalties, including criminal penalties (fines and imprisonment) for certain willful violations of tax law. Directors can be held personally liable for certain taxes and penalties. II. Organizational Structure The Internal Revenue Code does not identify any specific organizational structure that an entity must take to qualify for tax-exempt status. However, the choices of legal form are (1) not- for-profit corporation, (2) trust or (3) unincorporated association. Rev. Proc. 822, 1982-1 C.B. 367. Those who govern nonprofit corporations are called directors. Although the terms “director” and “trustee” may be used interchangea bly by not-for-profits, the state laws applicable to trusts and trustees are different than those applicable to corporations and directors. Since it most common for a not-for-profit organization to be organized as a corporation, we will be focusing on the state laws governing nonprofit corporations and boards of directors. A. Washington Not-for-Profit Laws Washington has several not-for-profit enabling statutes. Most not-for-profit corporations are organized under the Washington Nonprofit Corporation Act (RCW 24.03). To incorporate, the not-for-profit organization must file articles of incorporation with the Washington Secretary of State. The Washington Nonprofit Corporation Act dictates what must be set out in the articles of incorporation. See RCW 24.03.025. But note that what is required under Washington law may not be sufficient to qualify for federal tax-exempt status. Therefore, be careful when drafting articles of incorporation using “model forms,” including the one produced by the Washington Secretary of State, if the organization intends to apply for tax-exempt status under Code section 501(c)(3). The Washington Nonprof it Corporation Act defines a “nonprofit corporation” or a “not for profit corporation” as “a corporation no part of the income of which is distributed to members, directors, or officers.” RCW 24.03.005(3). This definition illustrates the primary differen ce between “nonprofit” and “not for profit” corporations a nd for-profit corporations. Not-for-profit corporations may earn profits. The distinction lies in what the corporation is required, by law, to do with its profits. The business of a for-profit corporation is the generation of profits for the benefit of its owners, it shareholders, in their private capacity. The business of the not-for-profit corporation is the generation of profits for the benefit of society and the general public. A not-for-profit corporation is prohibited by federal and state law from using its net earnings to benefit the individuals, which control the not-for-profit corporation, meaning its directors and officers. The Washington Act specifically prohibits not-for-profit corporations from having or issuing shares of stock. RCW 24.03.030(1). The purposes for which a not-for-profit corporation may be organized under the Revised Code of Washington are somewhat broader than those specified in section 501(c)(3) of the Code. Under Washington law, not-for- profit corporations may be organized “for any lawful purpose or purposes, including without being limited to, any one or more of the following purposes: -3- 1123204.1