Top Five Nonprofit Legal Risks

We recently presented a program on Top Nonprofit Legal Risks. In preparing for the presentation, we thought hard about the issues that we see over and over in our law practice. What follows is, at least from our perspective, the most common nonprofit legal risks and some tips on how to avoid them:

1. Contracting Risks

Too often, we see nonprofits signing contracts that are presented to them by vendors without appropriate legal review. Many vendors use form contracts that are extremely one-sided in the vendor’s favor on the theory that many clients will sign whatever is given to them without scrutinizing the terms. Nonprofits are also prone to relying on informal nonbinding MOUs without ever formalizing the terms into a complete contract.

While it may not be practical to have every agreement reviewed by an attorney, those with serious consequences such as high dollar amounts or lengthy terms need to be reviewed.

We also see contracts with missing terms or copied and pasted terms that have been written for another transaction. Key contracting terms to be aware of include the price and duration of the contract, the responsibilities of each party, and a reasonable method to terminate the contract.

Parties should also pay special attention to indemnification provisions to ensure they are only indemnifying the other party for risks they control and that the indemnification provisions are mutual where possible.

Very often participation and liability waivers include provisions that are overbroad or inapplicable to the activity. For example, I am not going to assume the risk of death for my toddler to participate in preschool. I think I’ll find a less risky school thanks! This is just one of many real-life examples where the risks being assumed were not reasonably tailored to the actual risks involved in the activity.

Tips to avoid contracting risks in a nonprofit

  • Carefully read and understand contracts before signing
  • Note auto-renew terms
  • Consult counsel for large transactions or lengthy commitments
  • Ensure terms are clear and there is a clear method to terminate the contract
  • Do not indemnify others for activities outside the organization’s control

2. Misclassifying Employees

Treating workers as independent contractors is a risky business. Misclassifying workers as independent contractors when they are properly classified as employees is a common nonprofit mistake that can have grave consequences. Misclassification can lead to payroll tax liability and penalties.

However, it also can lead to lawsuits because the organization may lack workers’ compensation coverage for the workers it treats as independent contractors. If a worker is injured on the job and files a workers’ compensation claim, the state agency that administers workers’ compensation may sue the employer for reimbursement of claims.

As a refresher, the distinction between an employee and an independent contractor is not based on what the employer and worker agree to or put in their contracts. Those factors may be evidence to support their characterization but ultimately whether a worker qualifies as an employee or an independent contractor depends on a study of several factors analyzing the employer’s control over that worker. These factors include:

  • Behavioral Control (how they get their work done);
  • Financial Control (tools and expenses); and
  • Relationship (contracts and benefits) with the person doing the work.

3. Monitoring Third-Party Fundraisers

Increasingly, charities are attracting third party fundraisers who want to help raise money for their cause. Third-party fundraisers can range from a simple house party to sporting events, motorcycle rides, and anything else your fans can dream up.

However, letting unrelated third-parties hold funds or create an impression they are affiliated with a nonprofit is risky. We are aware of cases where unauthorized individuals have held themselves out as fundraising for a charity without ever forwarding funds to charity and it turned out to be a big nonprofit mistake.

It is prudent to get in front of these efforts to reduce fraud, manage risk, and ensure compliance with fundraising and tax laws. One approach to managing third-party fundraisers is to create and post Third Party Fundraiser Guidelines and a Third Party Fundraiser Agreement.

The Guidelines for a Third-Party Fundraiser Agreement

  • License to use nonprofit’s name and logos;
  • Timeframe for donations to be turned over to the nonprofit;
  • Restriction of activities (political, dangerous or otherwise unsavory, etc.);
  • Approval of messaging;
  • Who will send acknowledgments (if third party, must be authorized to act as nonprofit’s agent); and
  • Where solicitations may occur (to ensure any required charitable solicitation registrations are in place).

4. Monitoring Gift Restrictions

Another common nonprofit mistake is losing track of gift restrictions. Many nonprofits assume that if a donor does not provide any details regarding the investment, timing, or use of the restricted gift that there are no rules. In reality, the management of donations and grants are controlled by default rules set forth in the Arizona Management of Charitable Funds Act (Act). The Act is based on a uniform law that has been adopted in most states.

In most cases, a well-drafted gift instrument will override these rules but where none exists, the nonprofit must follow the statute. A gift instrument includes virtually any record. If no record exists, the terms of the solicitation control.

The most common challenge posed by a restricted gift is those with ambiguous terms. It is important to understand the donor’s intent with respect to the timing, use, and investment of funds. Where the donor’s intent is unclear from the gift instrument, nonprofits must look to the law to fill in the blanks. Common areas of confusion include the following:

  • Whether gifts are properly classified as permanently restricted or temporarily restricted
  • Investment and expenditures from endowment funds
  • Borrowing from endowment funds

5. State Law Compliance

Nonprofits operating outside their state of domicile frequently make the mistake of being blissfully unaware of legal requirements in other states where they solicit funds or operate. At a bare minimum, nonprofits operating outside of their home state need to consider whether they need to register to solicit funds and whether their activities rise to the level of doing business in that state such that they need to register as a foreign corporation conducting business in the state. Key considerations include whether the nonprofit:

  • needs to obtain authorization to do business in the state;
  • will need a registered agent in the state;
  • will have a duty to file annual reports in both its state of domicile and other states where it operations
  • needs to register to solicit funds in the new state
  • are there payroll and workers comp considerations for employees working in the new state
  • has corporate supporters that need to register Commercial Co-Ventures in the new state
  • is required by the new state to conduct audits?

Nonprofits today are more highly regulated than they have ever been and there is far more to know and keep track of than the five areas noted above; however, nonprofits that get these five things right will go a long way to protecting their interests and avoiding legal problems.

Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.

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