Responsibilities of Non-Profit Board Members
In one of our recent newsletter articles, we highlighted some legal potholes that could harm your non-profit organization and how you can alert your board of directors to these risks. This article turns the lens inward and addresses the risks to board members, if duties are not performed properly.
The board of a non-profit serves a unique role. It is not synonymous with, nor tasked with, management of the non-profit. On the other hand, it is not a one-and-done catalyst that only serves to host the organizational meeting.
Proper Role of a Board
The importance of an active and informed board cannot be overemphasized. Left unchecked, even minor board neglect can intrude upon the accountability and effectiveness of the ministry. In contrast, an active and informed board will hold to the mission, protect the integrity of ministry objectives, and ensure consistent adherence to board policies.
Governance is not management. Having an enthusiastic, well-informed, and committed board should not, except in certain circumstances (e.g., the temporary lack of a chief executive officer [CEO], president, or other emergency), translate into involvement in the daily management of affairs. Rather than manage the organization itself, the board should assure that the organization is well-managed. The board should be diligent in maintaining a strong relationship with the CEO. The board that adheres to accountability in its relationship with the CEO will operate with greater confidence and trust, will ensure compliance with performance criteria, and will avoid detailed involvement in the organization’s day-to-day operations.
It is important to note that, although a board is not generally concerned with the day to day operation of the ministry, the board does have fiduciary duties that require it to fulfill an oversight role. Specifically defining the responsibilities of the board is important for insuring the dependable governance of the organization and gives the directors greater confidence in fulfilling their duties.
Fiduciary Responsibilities
Historically, board members of a corporate entity—whether for-profit or non-profit—are responsible to the entity to fulfill “fiduciary” duties. A fiduciary is a position where there is a “peculiar confidence” between the parties, like a trustee who has to manage money in an estate for someone else’s benefit.[1] The duties of this position originate from the Latin verb for trust, signifying that a fiduciary holds powers and assets “in trust” for someone else’s benefit and not their own.[2]
One of the broadest fiduciary responsibilities is described simply as “due care.” Courts have described this duty as a requirement not to abdicate a director’s “supervisory role” by, for example, ensuring the director finds and acquires the information necessary to supervise the corporation.[3] A director breaches these duties when he does not perform his duties with a “reasonable amount of diligence and care.”[4] This includes attending board meetings regularly, knowing the governing documents and procedures of the corporation, and finding the information needed to make decisions in the best interests of the entity. For example, if a board member approves a real estate transaction for non-profit corporation or church, but fails to investigate whether or not the deal is at market rate, he could potentially be liable to the corporation for failing to exercise due care in seeing whether the deal was market rate. Ignorance is not bliss, nor is it grounds for plausible deniability. A board member has a duty to know what he needs to know to supervise the affairs of the corporation with reasonable care. Although a director is not liable for simple mistakes in his judgment, he cannot commit gross mismanagement of the corporation or neglect the corporation’s affairs.[5]
Although this is a broad duty, it encompasses some common sense, basic duties of a board member. A board member will exercise due diligence and care, acting as an ordinarily prudent person would act under similar circumstances, if he generally takes steps to be involved in prudent management, including the following:
- Reviewing and approving strategic and operating plans;
- Evaluating senior leadership performance;
- Evaluating and approving senior leadership compensation;
- Overseeing the financial reporting and audit process;
- Reviewing and approving the annual budget in advance and maintaining oversight of its implementation;
- Overseeing legal compliance, including reviewing legally binding and significant obligations;
- Selecting the organization’s independent auditor;
- Assuring perpetuation of an independent board not dominated by family or staff interest;
- Approving and modifying, if necessary, the corporate structure and corporate policies; and
- Knowing and monitoring the organization’s mission and purpose.
Another type of fiduciary duty is often referred to as the “prudent investor” rule and is typically related to financial decisions. Once again, while a director doesn’t have to make perfect decisions all the time, he is required to exercise the care that an ordinarily prudent person would exercise in a similar position and under similar circumstances. Clearly, this is a circumstantial test that changes depending on the facts. Meeting this standard involves knowing and following the governing documents and policies of the corporation; avoiding investments that are high risk or questionable in their promises of soaring success; establishing an investment policy that has pre-approved guidelines; and avoiding investments in companies or projects in which a fellow board member has a personal interest. These requirements are heightened if board members are also designated as trustees for a specific sum of money or piece of property.[6] While many of these rules seem to be common sense, courts have found officers and board members in violation due to shockingly misguided assumptions, highlighting the need for care and thoughtfulness in carrying out board duties.[7]
As a corollary to the prudent investor rule, many states have codified a version of the “Uniform Prudent Management of Institutional Funds Act” (UPMIFA), which applies to investment of monies held by charitable institutions. If your state has a version of this act, it will clarify what factors play into an analysis of whether board members of a non-profit have prudently invested funds on behalf of the corporation. For example, under the UPMIFA, if a board member has special skills or expertise, they are responsible to use those skills in investing the entity’s funds prudently.
The duty of loyalty is another key aspect of fiduciary duties and prevents a board member from transacting business with the entity that is not fair or reasonable to the corporation. The general rule is that any transaction between a board member and the corporation must be fully disclosed, must be approved by the board without the vote of the interested member, and must be fair and reasonable to the corporation.
Although this duty is one of the more common sense duties of a board member, it can be deceptively easy to slip into transactions that benefit an individual board member at the expense of the non-profit. These transactions usually appear, at first blush, to make perfect sense for all the parties. And while, in the end, many of these transactions do work out to the benefit of both the corporation and the board member, the board will breach its duty of loyalty if it cannot show that it investigated the transaction without bias before-hand. For example, a church board member may want to use his solely-owned construction business to build a new church worship center. Unless the board accepts various market-rate bids for the project, they would not fulfill their duty of loyalty to show that giving the job to the board member’s company was truly in the church corporation’s best interests.
The rule of loyalty also requires that a board member or officer act in the best interests of the entire corporate entity, and not just particular parts of the entity, and that they disclose important and vital information to the corporation.[8] This is a key point to remember when there are disputes or disagreements in a corporation and board members feel tugged in various directions. Loyalty must lay with the corporation itself, not just its employees, volunteers, donors, or other participants.
An essential part of fulfilling the duty of loyalty is having a robust conflict of interest policy in place. This is actually a question on Form 1023, the application form for tax-exempt status with the IRS.[9] This policy can be incorporated into the bylaws, as well as serve as a stand-alone policy. A good policy will:
- Require officers/directors/employees to act for the benefit of the non-profit without regard to personal interests;
- Establish written procedures for determining whether a relationship, financial interest, or business affiliation is or could be a conflict of interest;
- Prescribe a course of action in the event a conflict is identified;
- Require from board members an annual disclosure of any known interest in an entity that transacts business with the non-profit.
The final fiduciary duty is described as the duty to ensure that the non-profits mission is achieved, otherwise referred to as the duty of obedience. Under this rule, a Director must be “faithful to the purposes and goals of the organization,” since “[u]nlike business corporations, whose ultimate objective is to make money, nonprofit corporations are defined by their specific objectives: perpetuation of particular activities are central to the [reason for existence] of the organization.”[10] This rule often comes into play for donations and decisions about their use. Directors must use donations for the exempt purposes of the organization, and must honor donor intent within the context of the exempt purposes. This can be a difficult balance and is best navigated under the direction of carefully-worded policies about the use of donations, benevolence programs, and refunding donations.
No Private Inurement/Excess Benefit Transactions
The IRS prohibits a non-profit from allowing any part of their income or assets to flow through or be transferred to the benefit of one or more private shareholders or individuals, unless it is for their reasonable compensation for services rendered to the non-profit. This rule is absolute—the amount of reasonableness of the benefit is irrelevant. This rule also only applies to those inside the organization. Additionally, a violation of this rule may implicate not only the benefiting individual, but any managers, directors, officers, or other supervisors who knew of and approved the transaction.
This rule is often known as a prohibition against an “excess benefit transaction.” This is a transaction where the value paid to an insider exceeds the true market value of the services or product they provided to the non-profit. For example, this may apply whenever an insider buys the non-profit’s assets for less than market value, or when an insider is allowed to use the non-profit’s property for their personal benefit for no cost or for a below-market rate. This rule definitely applies when a non-profit decides to pay the personal expenses of an insider when no services were rendered to the non-profit. All of these situations may jeopardize the non-profit’s tax-exempt status because they allow an individual to leverage a public status for private benefit. This undermines the entire theory behind a tax-exemption, namely, providing publicly available charitable services.
The most common violation of the excess benefit transaction rule is when a non-profit pays unreasonably high compensation to its CEO or President. In this area, the IRS is looking for whether the non-profit is paying an amount that is ordinarily paid for similar services under similar circumstances; i.e. the market rate. It is key to remember that when examining the compensation “package,” the IRS will look at nearly every kind of benefit received by the employee in exchange for their services, including cash, non-cash, bonuses, severances, deferred compensation, medical and dental plan payments, life insurance payments, disability payments, expense allowances, other fringe benefits, and even the economic benefit of a below-market loan. All of these items can be part of the compensation analysis.
Even if these payments are high, however, the non-profit will be entitled to a rebuttable presumption that the payments are not excess benefit (i.e. they are market rate), if they meet the following three requirements:
- The payments (compensation or purchase) are approved, in advance, by the governing/authorized body or the non-profit, excluding any member who has a conflict of interest;
- The governing/authorized body of the non-profit obtained and relied upon appropriate data as to comparability prior to making its determination about the transaction; and
- The governing/authorized body adequately documented the basis for its determination concurrently with making that determination.[11]
Under the second factor, the IRS needs to see that any decisions on compensation or other payments were made with sufficient information to show the arrangement was fair market value. This includes looking at compensation paid by similarly situated organizations, compensation surveys done by independent firms, and the availability of similar services in the non-profit’s geographic area of operation.
No Private Benefit
The IRS also prohibits any private benefit, which occurs when “non-incidental benefits [are] conferred on disinterested persons that serve private interests.”[12] Unlike the private inurement rule, this IRS rule prohibits only non-incidental/substantial benefit from flowing to an exclusive, non-public group of individuals. For example, if a non-profit starts a community center in a private, gated residential community where only residents of that neighborhood will have access, they have conferred a substantial private (i.e. non-public) benefit and have endangered their tax-exempt status. However, if the community center is a non-gated/private residential community, then the benefit conferred to the houses closest to the center—who would have more direct access—is only incidental and does not endanger tax-exempt status. This rule is important to keep in mind as directors think about the direction of the non-profit in light of its exempt purposes. As directors brainstorm for ways to increase donations/profits, it is a short step to thinking about providing more exclusive services, in exchange for support, which don’t serve the general public. This does not mean, however, that all exclusive services are prohibited, but it cannot allow the net earnings of the non-profit to privately benefit those with an interest in the non-profits activities. For example, a tax-exempt social or recreational club (under 501c7) is allowed to charge fees or dues for its members and the perks they are offered without triggering private benefit. However, the organization could not establish a “decrease in membership dues or an increase in the services the club provides to its members without a corresponding increase in dues or other fees paid for club support.”[13]
Conclusion
While these duties may seem dry and tedious, complying with them relates directly to protecting your non-profit’s tax-exempt status and avoiding personal liability. For example, approving an unreasonably high rate of pay for a President or CEO may not only put the non-profit at risk, but may subject board members who were involved with or approved the transaction to personal liability in the form of an “intermediate sanction,” which is essentially a monetary penalty.[14] Moreover, failing to invest responsible time and effort in serving on the board dilutes and undermines the mission of the non-profit or church, and can be a poor way to reflect the values of the organization to the community. Fulfilling fiduciary responsibilities is not only legally required to sustain tax-exempt status and avoid personal liability; it is critical to effective long-term ministry.
Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum. Please contact Robert Showers or Daniel Hebda at djh@simmsshowerslaw.com for legal advice that will meet your specific needs.
[1] See 26 CFR § 301.7701-6.
[2] See Ip v. United States, 205 F.3d 1168, 1176 (9th Cir. 2000).
[3] See Stern v. Lucy Webb Hayes National Training School for Deaconesses & Missionaries, 381 F. Supp. 1003 (D.D.C. 1974).
[4] Armenian Genocide Museum & Mem., Inc. v. Cafesjian Family Found., 691 F. Supp. 2d 132, 148 (D.C. 2010).
[5] See In re Heritage Village Church & Missionary Fellowship, Inc., 92 B.R. 1000, 1002 (Bankr. D.S.C. 1988) (discussing fiduciary shortcomings of televangelist Jim Bakker, including fostering an environment where people were scared to give him bad news about the finances of the corporation).
[6] This typically takes place in the context of a church’s receipt of a large donation or money or property. It can also apply in states, like Virginia, for an unincorporated church that only holds property through court-approved trustees.
[7] See Spitzer v. Lev, 2003 N.Y. Misc. LEXIS 830, *1 (N.Y. Sup. Ct. June 5, 2003) (finding officer clearly breached his duties to the non-profit by assuming that he could charge personal expenses to the non-profit and then pay them back later, like a revolving line of credit.).
[8] See Shepherd of the Valley Lutheran Church v. Hope Lutheran Church, 626 N.W.2d 436 (Minn. App. 2001) (finding an officer of a church corporation board breached his duty of loyalty to the entire church when he organized secret meetings with members of a faction within the church and ultimately led the faction to break off from the church and obtain the church’s assets).
[9] IRS Form 1023, Section V, question 5a. http://www.irs.gov/pub/irs-pdf/f1023.pdf.
[10] Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 186 Misc. 2d 126, 152 (N.Y. Sup. Ct. 1999) (internal citations omitted).
[11] See 26 CFR § 53.4958-6.
[12] American Campaign Academy v. Commissioner, 92 TC 1053 (1989).
[13] See IRS Publication 557, at 50. http://www.irs.gov/pub/irs-pdf/p557.pdf.
[14] See IRC § 4958.
