Wednesday, February 25, 2015

What is Charity?


Section 501(c)(3) organizations are commonly known as “charities.”  As such, they qualify for exemption from income taxes, and their donors may claim tax deductions for contributions.  Other tax benefits may apply as well, such as exemptions from state property and sales taxes.  But what is “charity”?  How can reviewing its core underlying principles help organizations dedicated to doing good?

For IRS purposes, the term “charity” is broadly defined to include many organizations committed to improving the world, such as through caring for the needy, providing medical services, engaging in religious activities, educating the public on a host of issues, erecting and maintaining public works and promoting environmentalism.   Many states define “charity” more narrowly, restricting charitable exemptions to organizations that either: (a) freely distribute goods and services; or (b) charge fees only to cover actual expenses and, in connection therewith, generously provide financial assistance. 

Legal scholars and courts most often reference the British Charitable Uses Act of 1601 (Statute of Elizabeth I) as the first codification of the term “charity” in English law.  It is also interesting to see the term’s origin in most, if not all, of the world’s major religions.  
           
In the Judeo-Christian tradition, for example, the word charity is rooted in the biblical concepts of love and grace.  Taking these two concepts together, charity is giving at a cost to oneself, in love, regardless the merit of the recipient. 

Charity’s Legal Grounding

For federal tax law purposes, the term “charity” – simply put – means “public benefit.”  The sine qua non is that the organization is not privately owned but instead is organized and operated for the public good. 

Under state law, as mentioned above, states typically define charity more narrowly.  For example, in the seminal 1867 case of Jackson v. Phillips, a Massachusetts appellate court explained the legal standard as follows.

A charity, in a legal sense, [is] a gift, to be applied . . . for the benefit of an indefinite number of persons, either by bringing their hearts under the influence of education or religion, by relieving their bodies from disease, suffering or constraint, by assisting them to establish themselves for life, or by erecting or maintaining public buildings or works, or otherwise lessening the burdens of government. 

This definition has been adopted in Illinois and elsewhere, thereby embracing a broad scope of beneficial activities generally for the public good. 

Governance Lessons from Modern-Day Charity

Charities today can range from highly sophisticated, multi-million dollar operations to very small nonprofits, any of which may be focused on specific benefits to society (e.g., distributions of humanitarian aid, cultural enrichment, religious activities, educational improvement).  Some may rely exclusively on contributions for their revenues, while others may rely on revenues from program activities.  With many organizations facing challenging fundraising environments, they may seek both contributions and fee-based revenues for economic sustainability.  Still another charitable model is to rely on government grants and other payments, wholly or in part to fund charitable programs. 

Regardless of a nonprofit’s economic engine, it is helpful for both federal and state law purposes (and perhaps to better satisfy donors) to keep the following well-developed and broad-based charitable questions and related principles in mind.

1.              How does the organization’s activities benefit society?  As a charity, its focus should mostly be on helping others.  All nonprofit leaders should have answers ready that impress donors and satisfy government regulators.
2.              Who is benefitting?  Typically, a legitimate charity benefits a wide range of the public, with only incidental private benefits to individuals and absolutely no insider abuse of charitable resources.
3.              What is the organization giving away?  State government exemption agencies particularly like to see “free soup.”  Donors tend to like helping beneficiaries gain access to charitable programs (as opposed to funding general operations).  So offer fee-based charitable resources through financial assistance, fund such assistance (e.g., through a special donor appeal), and keep track of the numbers.  Such approach may be critical for state exemption qualification.
4.              How much does your organization rely on donors’ contributions? This element is a state exemption hallmark of charity.  In our current era of shrinking government budgets, it is more important than ever to cultivate generous donors and to increase private contributions. 
5.              Why does your nonprofit exist?  Above all, stay focused on the organization’s charitable mission (and make sure it is accurately stated).  The mission should drive everything that the organization does, including governance, operations, and fundraising.

For further guidance on legal aspects of charity including exemption qualification under federal and state law, please contact an attorney in our office at info@wagenmakerlaw.com or 312-626-1600.

Thursday, February 19, 2015

Clergy Discipline – What May Be Disclosed to Others?


            Most issues within churches and other religious institutions typically stay within such organizations as their own business.  But what happens when a pastor or other spiritual leader engages in misconduct or otherwise demonstrates unfitness for such religious leadership?  May the religious organization’s governing leaders share these shortcomings with others? 

            When a worshipping body becomes aware of problems, its governing leaders generally handle such issues in-house.  Under certain limited circumstances, however, disclosure of disciplinary actions to others may be proper.  First, if the spiritual leader’s misconduct is criminal in nature (e.g., sexual abuse), such information should not be kept secret but instead should be reported to the appropriate authorities.  Second, clergy problems are sometimes disclosed beyond an individual church or other local body, such as to denominational leadership that may consider disciplinary sanctions or to other churches that may be interested in hiring the clergyperson.  Religious institutions should be cautious, however, because speaking to others about clergy misconduct may give rise to potential liability for both the organization and its governing leaders.  Civil wrongs (in legal parlance, “torts”) may be actionable such as defamation, invasion of privacy, and intentional infliction of emotional distress.  In such cases the issues can become quite complex.

Church No. 1 and Church No. 2 – Religious Leadership Matters?

            Consider the following true example of disclosures that resulted in liability for the church.  Church No. 1 ordained a member as its minister.  He later resigned.  Eight years after his departure from Church No. 1, its governing leaders sent a letter to the minister, requesting that he respond to “disturbing reports” they received from a third party about the minister's conduct.  Church No. 1 threatened to rescind the minister’s original ordination if he did not respond to the allegations.  In response, the minister explained that Church No. 2 had investigated the allegations and determined them to be false.  Additionally the minister asserted that Church No. 1 no longer had authority over him, because he had resigned long ago.  Church No. 1 then wrote the minister, informing him of his ordination revocation, asking him to refrain from pastoral designations, and instructing him to inform Church No. 2 about such actions by Church No. 1.  Church No. 1 also sent this letter to three leaders of Church No. 2.  The minister sued Church No. 1, its senior pastor, and chairman of the elder board for claims of conspiracy and false light invasion of privacy.  See Duncan v. Peterson, 359 Ill. App. 3d 1034, 835 N.E.2d 411 (2005). 

            The case ostensibly involved only spiritual, non-legal matters, but a court was willing to consider the case – and even grant the minister relief.  Why?  And what can other governing leaders of religious institutions learn from this disturbing case?

Ecclesiastical Abstention Vs. Neutral Principles

            As a threshold issue, the Illinois court considered whether the suit’s subject matter precluded judicial intervention on grounds of “ecclesiastical abstention.”  This is a judicial doctrine under which courts are prohibited from involvement with a religious institution’s worship, theological traditions, or internal religious governance (e.g., interpretation of canonical texts or hierarchical denominational decisions).  The basis for such doctrine lies within the First and Fourteenth Amendments’ protection for religious institutions, as recognized by the U.S. Supreme Court’s decision in Serbian Eastern Orthodox Diocese v. Milivojevich, 426 U.S. 696 (1976), in which the Court refused to disturb an ecclesiastical tribunal’s final decision about one of its spiritual leaders.  Under this constitutionally-grounded doctrine, religious institutions thus may freely determine their own matters of doctrine and worship.

            But the ecclesiastical abstention doctrine is not an absolute bar from judicial intervention in church matters.  Rather, where such disputes involve matters of corporate governance, or the conduct of worshipping entities in view of obligations to third parties, courts frequently use “neutral principles” of law to determine the validity of such actions.  Accordingly, while courts may not interpret a worshipping group’s sacred texts, courts do have broad powers to ensure that such worshipping bodies play by the rules.  More specifically, courts may require worshipping nonprofits to follow their own properly adopted bylaws, policies, and other governing documents, as required under applicable state nonprofit law.  Further, courts can hold worshipping groups liable for not properly withholding employment taxes or for other tax-related noncompliance entirely on “neutral principles” grounds. And as illustrated in the case below, worshipping groups may be held liable for breaches of legal duties.  In other words, except with respect to religious doctrinal matters and strictly “in-house” leadership matters (ecclesiastical abstention), a court may get involved and decide rights and liabilities of religious institutions (neutral principles).

Spiritual Leadership and Sanctions: Must a Court Keep Out?

            How do these legal principles apply to Church No. 1 and its former minister?  Church No. 1’s decisions to revoke the minister’s ordination and send the letter were consistent with its sincerely held beliefs.  Indeed, like all religious institutions, Church No. 1 had a right to spiritually oversee the actions of individuals it had ordained.  Church No. 1’s senior pastor further argued that, since Church No. 1 had ordained the minister, he was obligated to abide by its standards for as long as he was ordained.  Such obligations were assumed from Church No. 1’s interpretation of Biblical leadership standards, however, rather than reflected in any written contract or elsewhere.  Accordingly, Church No. 1 argued that the ecclesiastical abstention doctrine applied to this essentially theological dispute.

The court disagreed.  Instead, the court concluded it would not “need to inquire into or interpret religious matters to decide whether … the letter was false and misleading and was a tortious invasion of privacy.”  Significantly, the court distinguished between Church No. 1’s right to revoke its ordination and the way in which its leaders revoked the ordination.  Whether Church No. 1 had the right to revoke may have been an issue precluded under the ecclesiastical abstention doctrine.  But whether Church No. 1 was liable for invasion of privacy in the way it revoked the ordination was fair game.  More specifically, the court ruled that it could consider whether Church No. 1’s leaders had conspired to harm the minister’s reputation and whether its letter put the minister in a false light. 

Lessons Learned

Religious institutions can overestimate their First Amendment protections under the ecclesiastical abstention doctrine.  To be sure, ordained clergy are always subject to the governing ecclesiastical bodies that ordained them – at least insofar as such rules so provide.  When such clergy commit acts inconsistent with the religious tradition’s teachings and beliefs, these governing entities may impose sanctions including revocation of ordination or licensure credentials.  Imposition of sanctions is often regarded as a spiritual duty or matter of obedience, even an act of worship.  But such sanctions also may conflict with certain common law prohibitions, as Church No. 1 learned by being held liable for tortious invasion of privacy. 

            In holding ordained clergy accountable, what should responsible governing leaders of churches and other religious institutions do? The following specific guidelines should help religious institutions to keep such matters within appropriate ecclesiastical boundaries and away from judicial scrutiny (and therefore potential legal liability).

(1)  Describe the religious institution’s disciplinary procedures in detail, and in writing.
(2)  Expressly tie such disciplinary procedures to the group’s sacred texts, theological works, or scriptures, such as with citations.
(3)  Require candidates’ written agreement to submit to such written disciplinary procedures as a condition of ordination.
(4)  In the event of disciplinary action, meticulously follow the organization’s own written procedures.
(5)  Release information related to a clergy person’s censure only to specific individuals or groups as identified in the disciplinary procedures document.  For example, affiliated churches may list other affiliate churches as proper recipients of information.  A church’s governing leaders should be extremely careful – and follow appropriate confidentiality boundaries – in sharing such sensitive information with others, including its own parishioners. 

            To be sure, the sincerely held religious convictions of a worshipping group may sometimes directly conflict with certain duties required of the organization under the law.  A worshipping body may feel conscience-bound to inform others of its disciplinary actions.  In such cases, the organization should, in consultation with qualified legal counsel, tread very carefully to ensure that the organization understands any legal risks of disclosure and handles such matter with appropriate confidentiality.  The worshipping group should seek to honor its spiritual convictions in such a manner as to minimize the organization’s legal exposure.  For further information regarding these important governance and liability matters, please contact one of our attorneys at 312.626.1600 or info@wagenmakerlaw.com, or visit us on the web at www.wagenmakerlaw.com

Monday, February 16, 2015

Nonprofit Merger Essentials


It is not uncommon for a nonprofit’s leaders to consider at some point whether to combine operations with another organization. Perhaps the nonprofit is experiencing financial troubles or a serious leadership vacuum.  A vibrant nonprofit may become interested in absorbing a smaller organization. Or maybe two organizations realize that they can be more effective through joining forces, such as to better position themselves for grant opportunities and to more productively leverage their workers and charitable assets.

What elements should a nonprofit’s leaders consider for a potential merger? What are the appropriate merger steps? This article provides a brief overview of critical elements and major steps for the merger process. 

As an initial matter, it is important to understand what a merger is and what it is not. When two nonprofits merge, the “mergee” corporation - together with its assets and liabilities - are transferred by operation of law to the surviving corporation. Thus, there are no deed transfers or corporate dissolutions. Rather, the “mergee” corporation effectively continues its existence through the surviving corporation. As a result, any bequests, gifts or contract rights belonging to the “mergee” corporation become those of the surviving corporation. Correspondingly, any liabilities of the “mergee” corporation are inherited, so to speak, by the surviving corporation.

In light of these legal consequences, the key to any successful merger is due diligence. The potential surviving corporation’s leaders should thus undertake due diligence sufficient to confirm that the resulting asset value and operational benefits will exceed the potential liabilities and other drawbacks. If the risks are too great, other asset transfer options may provide better alternatives.

A nonprofit board’s initial merger consideration steps include the following:
1.     Evaluate the nonprofit’s goals (e.g., expand into new areas, develop new programs, eliminate “competitors”, increase assets).
2.     Begin assessing how the organization and operations will work post-merger.
3.     Gauge each other’s needs and interests, with prudent and creative diplomacy as needed.
4.     Carefully consider the labels used. The terms “merger”, “reorganization” or “takeover” may be uncomfortable for the nonprofit being absorbed into the surviving corporation.
5.     Use a non-disclosure agreement to protect confidential organizational information.
6.     A letter of intent or similar preliminary initial agreement may be useful to identify the parties’ goals and to establish a merger timeline.

In addition, specific state laws affecting nonprofit mergers warrant careful evaluation by experienced legal counsel. Multiple jurisdictions may be involved, with varying legal requirements for board and membership approval. In particular, careful attention needs to be paid to notice and voting requirements, to ensure legal compliance and to avoid potential later challenges. If charitable assets are involved, approval of the state Attorney General is required in some jurisdictions.

The due diligence process is likewise a critical component for a merger. Through such process the surviving corporation’s leaders should develop a comprehensive understanding of all assets and liabilities prior to consummating the merger, as well as other issues that may affect post-merger operations. Due diligence includes not only legal aspects, but also evaluation of cultural, financial, operational, governance and fundraising concerns. A detailed list should be used for the numerous due diligence items to be considered. A board committee may be a useful tool for working through such items with guidance from legal counsel.

At the end of the due diligence process, the parties’ boards should have a solid understanding of whether or not to merge and how to do so. It may be more appropriate to use an asset transfer arrangement so that the surviving corporation can carry on the other nonprofit’s activities and/or receive its assets but not its liabilities. Alternatively, restructuring the “mergee” entity such as a subsidiary entity allows both corporations to continue, which may be better from a wise management standpoint or to address governance goals.

And then there is the final corporate paperwork to be completed. A written plan of merger must be developed and approved as required by state law and the nonprofits’ bylaws. In addition, articles of merger must be filed with the applicable state’s (or states’) Secretary of State office.

Last, diverse legal and operational matters will remain to be addressed post-merger. Among other things, new employment law considerations may apply, particularly with an increased employee census that may trigger previously inapplicable employment discrimination, unemployment, health benefits, and pension benefits laws. In addition, final tax reports may be due for the merged corporation, such as an IRS Form 990, W-2s and 941s. Real estate tax exemption should be reviewed as well, with either clarifying affidavits of ownership or new exemption applications filed as required by law. Assumed name registrations may be appropriate too, especially so that bequests and other gifts to the “mergee” corporations can find their way to the surviving corporation.

Nonprofit mergers and other strategic consolidations may well be worth serious consideration. When proceeding forward, a prudent and responsible nonprofit board should well understand the goals involved, the potential risks and rewards, the due diligence needed upon appropriate evaluation, the accompanying procedural steps, what will happen post-merger, and available alternatives. For further guidance on mergers and other nonprofit legal matters, please contact an attorney in our office at info@wagenmakerlaw.com or 312-626-1600.

Sunday, February 8, 2015

When Volunteer Leadership Goes Bad: Personal Liability


Can nonprofit volunteer leaders ever be held personally liable in relation to their work for an organization?  Unfortunately, the answer is emphatically yes.  Most state nonprofit laws protect directors and officers from personal liability for acts performed in such volunteer capacities, but significant limitations exist.  Leaders need to be attentive to applicable legal requirements, to govern their organizations well, and to pursue available protections such as directors’ and officers’ insurance and other risk management measures. 


Liability for Violating Fiduciary Duties

Under well-established legal principles, leaders of not-for-profit organizations serve as stewards of organizations’ assets and other interests.  Because charitable assets are by definition intended for public benefit, they belong to no private person and thus must be guarded carefully for the public’s interest.  Nonprofit leaders thus owe certain fiduciary duties to their organizations.  The term “fiduciary” simply means that these individuals are entrusted with accountability for the organization’s well-being.  Breaches of their fiduciary duties may result in personal liability.  Thus, wise directors and officers take their duties seriously and strive at all times to act responsibly in the organization’s best interests.  Nonprofit leaders’ fiduciary duties generally fall within the following three categories:

Duty of Care.  The duty of care requires directors and officers to exercise reasonable diligence and due care in conducting the nonprofit’s affairs.  For example, they must stay informed about the activities and finances of the organization by regularly attending corporate meetings, actively examining and evaluating the records made available to them by staff, and understanding how the organization functions under its bylaws.  Board members must act in good faith as they make decisions and seek to avoid the misuse or waste of its assets.  When a decision involves complex matters, the board should engage subject matter experts, community representatives, and professional advisors if the directors lack the requisite skills to make an informed decision.

The duty of care is typically evaluated according to the "business judgment rule," under which directors and officers are presumed to make decisions on an informed basis and in good faith.  This presumption may be overcome upon a showing of gross negligence or willful misconduct, with resulting personal liability.  (And if they are paid leaders, the legal standard is lowered to “ordinary negligence.”)  To stay within the business judgment rule’s protection, directors and officers must act with the care that an ordinary and prudent person would exercise under similar circumstances. 

One potent example of personal liability within the duty of care is if a director, officer, or other key employee knowingly allows employment tax funds to be used for other purposes.  This is highly problematic because the funds legally belong to the government.  Resulting personal liability may be statutorily mandated, but it results fundamentally from a lapse of a leader’s judgment and responsibility for nonprofit financial oversight – i.e., due care.

Duty of Loyalty.  The duty of loyalty prohibits directors and officers from using their position of trust for personal advantage at the expense of the not-for-profit corporation.  In negotiating business transactions, directors and officers must ensure that their families, friends, or others who have a significant interest in the organization do not receive special benefits due to their own position of trust.  This is not to say that all such contracts are prohibited.  Whenever personal and business relationships co-exist, however, the highest loyalty must be demonstrated to protect the corporation.  The most common transactions that risk a breach of this duty are transactions involving conflict of interest, misuse of the organization’s information or opportunities, and misappropriation of the organization’s assets.  

A strong conflict of interest policy can help the organization guard against such practices by identifying potential problem areas and establishing frameworks to govern how potential conflicts are to be handled.  Through compliance with such a policy, directors avoid activities that might later expose them to liability.

Some conflicts of interest may result in automatic personal liability.  For example, many state nonprofit laws specifically prohibit loans to non-employee directors and officers, due to the inherent conflict of interest regarding use of a nonprofit’s financial resources.  In addition, federal income tax law imposes “excess benefit transaction” penalties on financial transactions that are unduly favorable to a nonprofit insider, and therefore in conflict with the organization’s best interests.  Consequently, if a director votes for or assents to such transactions, then he or she may be held personally liable to the corporation for repayment of wrongfully paid funds and other penalties. 

Duty of Obedience.  The duty of obedience requires leaders to adhere to the not-for-profit organization’s corporate purposes.  In a well-run organization, the directors and officers may serve as “bumper guards.” That is, they oversee the staff and make sure that the corporation follows its articulated vision and complies with its legal obligations.  To do so, the board members should be well aware of the corporation’s purposes as stated in its articles and bylaws, they should ensure that the organization’s activities are consistent with these purposes, and they should shape the organization’s plan in accordance with them.  For purposes of potential personal liability, this duty is closely related to the other duties.  For example, authorizing corporate action that is far beyond the nonprofit’s mission could reflect a gross lapse in the duty of care.  In addition, it could demonstrate loyalty to an insider and his or her agenda, rather that to the organization’s narrower mission focus. 


Liability Under State Trust Laws
State trust laws may impose additional, higher legal burdens on nonprofit leaders.  For example, while the Illinois General Not For Profit Corporation Act (“NFP Act”) shields volunteer directors from being held personally liable for damages caused by an executive director’s falsification of financial records (absent their own willful or wanton conduct), such limited immunity does not apply to actions against them brought by the Attorney General under the Illinois Charitable Trust Act (“Trust Act”).  Under the Trust Act’s higher standard, a nonprofit corporation and its directors are treated as trustees holding charitable assets for the benefit of the public.  As Illinois courts have ruled, directors are thus obligated to act  “with the highest degrees of fidelity and good faith” in carrying out the organization’s purposes. 


Indemnification/Insurance

Indemnification is the legal procedure by which a corporation agrees to hold harmless directors, officers, and other agents, and provide reimbursement for liabilities, expenses, and other losses incurred in the event of a lawsuit or other proceeding.  These important protections should provide great comfort to the organization’s leaders.  Under the NFP Act, a corporation may indemnify certain individuals, including officers, directors, and employees when sued in relation to their role with the organization.

In the case of a suit brought by anyone other than the corporation (a “direct suit”), indemnification is allowed so long as the individual acted in good faith and in a manner he/she reasonably believed to be in (or at least not opposed to) the best interest of the corporation.  In a criminal case, there is an additional requirement that the individual had no reasonable cause to believe his/her conduct was unlawful.  These indemnification provisions may be further limited under the NFP Act in cases of a derivative suit (when an individual(s) brings suit based on the rights of the organization to do so).

Additionally, if an individual who may be indemnified is successful in defending an action against him/her, the NFP Act requires the organization to indemnify the individual.  Directors should be aware of this requirement, as it means the organization should be very careful in deciding to sue such individuals.

For optimal protection, these indemnification protections should be buttressed with ample directors’ and officers’ insurance.  Such insurance should cover both potential personal liability and the legal defense expenses that may be required to defend against a lawsuit or other claim. 


Concluding Remarks

Nonprofit leaders need to carefully and responsibly serve their organizations, not only for the organizations’ overall benefit but also for their own legal protection.  For further guidance on nonprofit governance and related personal liability considerations, please contact an attorney in our office at info@wagenmakerlaw.com or 312-626-1600.