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Reducing Legal Liability for Nonprofit Board Members

Reducing Legal Liability for Nonprofit Board Members

Risk is relative.  For some people, jumping out of an airplane is a typical weekend adventure.  For others, driving 5 miles per hour over the speed limit makes your pulse quicken and beads of sweat break out on your forehead.  No matter your tolerance level for it, some risks are unavoidable.  The same is true for serving on a nonprofit board of directors.  The risk certainly doesn’t rise to the level of skydiving, but it’s there.

In this article, we’re going to focus on several areas where this liability can be significantly reduced.

Incorporate Your Nonprofit

This is always the first line of defense.  As it is, the IRS limits the possibilities to only 4 entity types:  1) corporations, 2) trusts, 3) unincorporated associations, and 4) LLCs.  We can eliminate 2 of those pretty quickly in this conversation.  Trusts are complex legal entities that are only appropriately used for 501(c)(3)s in a tiny percentage of use cases, primarily private foundations.  LLCs really cannot qualify for 501(c)(3) status unless all members of the LLC are themselves already established and recognized 501(c)(3) organizations, not individuals (making this a joint venture, of sorts).  That leaves corporations and unincorporated associations.  These 2 make up the vast majority of 501(c)(3) organizations.

Incorporating creates a legal entity that exists apart from the individuals who created it.  As such, corporations provide a critical layer of liability protection to their board members.  Unincorporated associations, on the other hand, provide no such protection.  While these organizations can qualify for 501(c)(3) status, there is no legal distinction between the nonprofit and those who govern it.  That leaves an unacceptable level of exposure to board members.

Bylaws and Indemnity

I didn’t include this as an entirely separate topic from incorporation, though I easily could have.  Nonprofit corporations must have bylaws, which are the rules by which the nonprofit is governed by its board of directors.  One of the common clauses in most nonprofit bylaws is the indemnity clause.  This is usually relegated to one of the last few citations and is sometimes glossed over by board members who don’t understand what it means.  Generally speaking, a good indemnity clause is a statement that the corporation itself will protect board members from individual loss or liability that may arise due to their board service.  Such indemnity stops at gross negligence and criminal behavior, however (see D&O insurance segment below.

For more on this topic, check out “Should I Incorporate My New Nonprofit?”

Consider Getting Directors and Officers Insurance

The overall risk to board members is generally low, but this type of insurance can buy peace of mind for your directors.  Commonly referred to as D&O insurance, directors’ and officers’ coverage provides another layer of protection to your board.  It doesn’t cover such things are fraud or criminal activity by a board member.  It will, however, protect board members from personal loss associated with legal suits brought against the nonprofit for other reasons.

There are multiple types of coverage available, depending upon the degree to which the nonprofit already indemnifies the board members from exposure.  The cost of coverage is usually quite reasonable, but check around with multiple insurance providers for the best rates and coverage.

Foundation Group does not endorse or recommend any particular provider of D&O insurance.

Have Great Policies In Place

Your nonprofit’s policies and procedures can go a long way toward reducing risk.  But it’s not enough just to have the policies.  Your board must understand those policies and work to ensure they are understood and consistently followed by officers, directors, employees, and even volunteers.

We encourage 6 key policies, though there are others that can be brought into the equation, as well.  Those are:

  1. Conflict of interest policy
  2. Whistleblower policy
  3. Records retention and destruction policy
  4. Employee compensation policy
  5. Gift acceptance policy
  6. Fiscal management policy

Each of these essential policies adds certainty and consistency to your operations and helps to limit risk.

We recently covered each of these policies in detail, so check it out:  “6 Operating Policies Your Nonprofit Must Have”

Gross Negligence Concerns

Gross negligence that results in legal exposure is one of those things that rarely happens to a nonprofit.  It can also be somewhat difficult to anticipate and prevent, primarily because it involves the actions of people.  People are fallible and even smart, well-meaning people can make mistakes.

Examples of gross negligence can include:

  • Failure to de-ice a sidewalk
  • Leaving young children unattended
  • Exceeding a fire marshall’s occupancy limits
  • Not conducting background checks on childcare workers

The list can go on and on.  The problem posed by gross negligence is that it is notoriously difficult to insure against.  Literally, insurance often won’t cover issues of gross negligence, at least not fully.  It can even expose those in governance to legal liability if they allow a preventable situation to exist that could be reasonably foreseen.  All the more reason why great policies are important (see above).

Have Great Checks and Balances

There’s some crossover with policies and procedures with this one.  In fact, many of your best strategies for this should be spelled out in your policies.  Things like:

Check-and-balance concerns are not limited to the financial part of your nonprofit, but it’s probably where it is most important.

Conclusion

I think it’s important to say again that the overall risk to nonprofit board members is low.  Over 99% of nonprofits will NOT likely be sued for anything.  That said, liability isn’t non-existent.  To the degree it’s there, it is essential that nonprofits do what they can to protect those who volunteer to serve in governance.

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Greg McRay is the founder and CEO of The Foundation Group. He is registered with the IRS as an Enrolled Agent and specializes in 501(c)(3) and other tax exemption issues.

This Post Has 2 Comments

  1. Questions:
    A scenario about a donation: The Nonprofit – name redacted by Foundation Group for privacy is fully organized with state of Massachusetts and with approved IRS Determination Letter in place. I belong as one of member of directors:
    Mission: To promote the welfare of individuals with cancer and their family members through awareness, participation and education. This foundation has 7 objectives on how accomplish its mission.
    Now, the current President, received a $2000 donation (check or cash), from a donor who is close friend of the President and the Auditor. The donor specifically requesting the $1000 be written or provided to the Donor’s niece who is supposedly inflicted with cancer. I raised a flag that this is not what I understood about a nonprofit organization tax-exempt organization should conduct business – organize, raised funds for members or I mentioned the Conflict of Interest issue (by the Policy is not in place yet; it is on hold for better understanding what this policy should really for redacted. It has been debated by commenting the redacted mission is to support cancer patients. Bear in mind none in the contents of the bylaws (7 objectives) mention provided monetary to a cancer patient (mission?). Last year, the same individual donor made this deal (stipulation) with the president ($2000 received by redacted – a $1000 check provided to the donor’s niece. This happen about the same time – Nov – December last year. And she’s asking the President what is the hold up on this matter. Please provide the right way to handle this situations. Thank you.

    1. This sort of thing happens a lot, Bill. And you are correct to raise a flag. While it may not be completely illegal, it is unethical. There’s nothing stopping the donor from giving directly to the niece. Running it through the nonprofit probably allows him to give what amounts to a personal gift tax deductibility. I’m sure the President doesn’t want to miss out on the other $1,000, so he goes along with it. He shouldn’t. Pass-through gifts like this are not considered by the IRS to be donations, nor tax deductible. If necessary, the board should put its foot down and require this activity to stop.

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