A legal audit is an overview of an organization’s non-financial compliance, governance and risk management issues. Organizations typically consider a legal audit when new management takes over and wants to ensure they are starting with a clean slate or the in the wake of a costly mistake. A typical legal audit will include a review of the following:
1. Corporate Status. Incorporating a nonprofit organization helps to protect the directors, officers, and members from personal liability; however, to reap the benefits of incorporating, the corporation must remain in good standing. Reviewing corporate status typically requires a review of articles of incorporation, bylaws, and minutes as well as corporate filings. This review is to ensure the organization is not only in good standing, but is also operating in a manner that is consistent with the law and its governance documents. Finally, significant operations in other states may trigger a duty to register to “do business” as a foreign corporation in that state. Corporate filings can be done quickly and correctly across state lines, for example if you have to file a corporation in California but you live in Arizona, it is a great idea to utilize a reputable document service company such as Sundoc.
2. Chapters and Affiliates. If your organization has chapters or other affiliates, the organization’s bylaws should be clear about authority to create chapters. In addition, there should be a charter and license or similar agreement in place outlining the terms of the relationship.
3. Governance Policies. Over the last decade, nonprofits have been formalizing more of their policies and procedures. This trend is due in part to the IRS’ encouragement of certain policies. The Form 990 references a number of governance policies and requires organizations to disclose whether they have been implemented. Accordingly, it is a good idea to review governance policies periodically. This review should consider which policies exist, if additional policies make sense for the organization, whether the policies are reasonable and whether they are consistent with existing practice.
4. Tax-Exempt Status. An important part of any tax-exempt nonprofit’s legal audit is a review of its tax-exempt status. A key consideration is whether the organization is properly classified with respect to its tax-exemption and its public charity status. The reviewer should also consider whether the organization’s activities are still within the scope of its ruling. This requires an analysis of the application for recognition of exemption, the IRS determination letter, and the Form 990s. Changes to governing documents and significant changes in sources of support, programs, purposes, etc. must be reported to the IRS on the organization’s Form 990.
5. Other Federal Tax Matters. A review of the federal information and unrelated business income tax returns (Forms 990 and 990-T) is important because, in addition to tax compliance, the Form 990 is a publicly available document. A legal analysis of tax forms focuses on the accuracy of the information reflected on the returns in light of the other information gleaned from the legal audit as well as the presentation of the overall return.
6. State Taxation Issues. It is a good idea to review any property tax and/or sales tax exemptions from time to time to determine whether the organization still qualifies for exemptions. It is also a good idea to consider the exemptions that are available and whether the organization qualifies for exemptions it has not applied for before.
7. State Charitable Solicitation Requirements. No legal audit is complete without a review of whether the organization is complying with the various regulations that govern fundraising. This entails a review of the jurisdictions where the organization is actively fundraising. Once the jurisdictions where the organization is soliciting are known, the next step is to examine the status of the organization’s registrations in each jurisdiction.
8. Gift Administration Issues. Many nonprofits do not adequately monitor the restrictions on their restricted gifts. Accordingly, we recommend a periodic review of gift instruments to ensure funds are properly classified with respect to time, use or other restrictions and that the terms and restrictions are being honored. A legal audit should also include a review of gift acceptance policies as well as substantiation and acknowledgement forms.
9. Insurance Policies. From time to time, organizations should review their insurance policies (e.g. general liability, officers and director’s liability, errors and omissions, etc.) to determine whether the organization’s activities are adequately covered.
10. Volunteer and Participant Waivers. Depending upon the nature of the organization’s activities, the organization should have waivers and participation agreements whereby volunteers and participants accept any risks and release the organization from liability. A legal audit should consider whether appropriate releases and waivers exist, whether they are adequate, and whether procedures have been implemented to ensure they are consistently used.
11. Contractual Obligations. For organizations with significant contracts, they should be reviewed to ensure notice and termination dates are properly monitored as well as to ensure compliance with any restrictive covenants.
Depending on the size of the organization and its activities, a legal audit may also consider personnel policies, intellectual property issues, real estate issues, etc. Like a financial audit, a legal audit can be tailored to cover areas of particular concern. The audit can also be conducted at one time or divided into phases. While nonprofits are used to financial audits to ensure the integrity of their financial statements, a periodic overview of legal matters is just as crucial to ensuring the integrity of the organization.
Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.