There are several misconceptions about the legal requirements of non-profits that not only pervade the general public, but also creep their way into the media and in non-profit governance and management. Below are a few such myths followed by a debunking overview.
Myth #1: Non-Profits Cannot Run a Yearly Surplus
Although 501(c)(3) corporations cannot distribute surplus funds to board members or employees, and do not have share-holders, owners, or partners as do various types of business entities, they can run a yearly surplus and will be healthier if they do so. So, for example, suppose that non-profit X has expenses in one year of $1,000,000 and brings in revenue in that same year of $1,500,000. With the surplus of $500,000 non-profit X cannot distribute such money, as a surplus, to board members, employees or any other persons (note that employees and board members can be paid reasonable compensation by the non-profit in that year). With the $500,000 non-profit X can: 1) Carry the funds over to use as revenue for a future year’s budget on any allowable expense; 2) Hold the funds in savings as “reserves;” 3) Use it as seed funding for a board restricted endowment; 4) Set it aside for a future major expense; or 5) Invest the funds with the goal of procuring additional currently expendable revenue.
Myth #2: Non-Profits Cannot Pay Employees Competitively
Although some non-profit corporations facilitate their mission entirely by relying upon volunteers, there is no regulatory bar to paying employees in order to attract and retain talented personnel for the sake of executing the mission. In fact, most nonprofits will not be able to sustain themselves without paid staff. However, the IRS requires that employees be paid reasonably according to “the amount that would ordinarily be paid for like services by like enterprises, whether taxable or tax-exempt, under like circumstances.” Non-profit executive compensation is especially subject to regulatory and public relations scrutiny, and thus boards of directors should follow and document governance best practices in setting executive compensation. See our post Setting Nonprofit Executive Compensation for a detailed outline of such best practices.
Myth #3: Non-Profits Cannot Pay Board Members
Perhaps more pervasive than the myth that employees cannot be paid, is the idea that non-profit board members cannot be paid for their services as board members. First, non-profits can—and many do—enact board reimbursement policies for reasonable expenses incurred in the performance of board duties, such as travel to organization events, purchasing supplies for board business out of pocket, etc. Second, although most non-profit board members serve as volunteers, board members can be paid as board members for their services. However, there are several considerations that non-profits should consider before compensating directors/trustees as directors/trustees. First, some states, such as California, restrict board member compensation. Second, board compensation is a conflict of interest that must be managed. For example, if a board member is paid for services, there should be a strong conflict of interest policy in place that requires the board member to be recused from the discussion and vote on the compensation arrangement. If all board members are being paid, recusal may not be possible. In such cases, the Board can rely on a reasoned opinion from an independent qualified compensation consultant. Finally, depending upon the law of the state of non-profit incorporation, a paid board member may have greater exposure to liability than a volunteer board member.
Myth #4: CEO/Executive Directors Cannot Sit on a Non-Profit Board
Employees of a non-profit may sit on the board of directors/trustees, but the IRS recommends that a board “not be dominated” by employees as by their nature they are not independent since they have an employment relationship with the organization. Any official board member has a right to vote on board proceedings and thus, if a CEO or Executive Director does sit on the board of directors/trustees, it is important that the board have a strong conflict of interest policy in place such that the CEO/ED does not participate in decisions regarding his/her/their compensation or other decisions that may directly benefit him/her/they.
Myth #5: Non-Profits Can’t Engage in Revenue Producing Business Transactions Such as Selling Goods or Services
In general, non-profits are free to sell goods or services for income to support their mission. However, if the business is regularly carried on and unrelated to the non-profit’s mission, it will generally be subject to unrelated business income tax (UBIT). In short, income from the sale of goods or services that are closely related to the non-profit’s mission is not taxable, while business transactions unrelated to the mission are taxable. (See our post Can Nonprofits Earn Business Revenue?)
Ellis Carter is a nonprofit lawyer with Caritas Law Group, PC. To contact Ellis, call 602-456-0071 or email us at firstname.lastname@example.org.