Legal Pitfalls Every Nonprofit Should Be Aware Of
There are a lot of rules governing nonprofits, many of them written by the IRS because they’re related to an organization’s tax-exempt status. In our years of practicing nonprofit law, we’ve pretty much seen it all when it comes to missteps and mistakes by nonprofits. Here are some of the most common legal pitfalls we see and how to avoid them.
Form 990 requirements
Every nonprofit regardless of how much money they bring in is required to file a Form 990 tax return with the IRS annually. It doesn’t matter if you make $500 that year or $20 million that year—you have to file the Form 990. There are three types to choose from:
The Form 990 postcard is for organizations that make $50,000 or less every year. It’s pretty simple overall and can be filed online, but we always recommend having a CPA review it to be sure everything’s correct.
The longer Form 990 is for 501(c)(3) public charities.
This version includes Schedule A to show that you’re meeting the public support test. That means one-third of your income has to come from the public and must be documented on Schedule A. If you make an error on the form or if you’re not raising enough money to offset large donations or grants, you could be reclassified as a 501(c)(3) private foundation instead of a public charity.
Schedule B is the donor list, which the IRS will remove before posting your 990 publicly. Sometimes a major donor will want to see your Form 990 to ensure you’re meeting the public support test before making a substantial donation. If that’s the case, be sure to send them the one posted publicly by the IRS or send your own copy but remove Schedule B first to protect the identify of your donors.
Form 990-PF is for private foundations specifically.
If you fail to file a Form 990 three years in a row, the IRS will remove your 501(c)(3) status and you’ll then be subject to taxation like corporations. Fixing that and regaining your nonprofit status will cost about $5,000 in legal fees at minimum, so be sure to invest the time to file your 990 every year.
Form 1023 applications
Form 1023 is the form you file to apply for exempt status under section 501(c)(3), which could be either a 501(c)(3) public charity or a 501(c)(3) private foundation. Basically, the IRS is going to default to classifying you as a private foundation unless you can prove that you’re a public charity, and there are certain things they expect to see on that form. If the answers don’t line up with what they’re expecting, you could be misclassified.
Filing a Form 1023 is not something you should do yourself. It’s a costly mistake to get reclassified later, so you want to be sure your forms are correct the first time by engaging an attorney who specializes in nonprofit law.
Advertisements versus sponsorships
This legal pitfall mostly applies to public charities, but it can apply to other types of organizations as well. The rules state that money flowing from your organization can’t benefit a for-profit company or non-charitable individual. If you’re advertising for them, you’re giving them an impermissible private benefit, and that’s a problem.
Legally, an advertisement is an identification plus a call to action. For example, saying you should go shop at XYZ Store and get 25% off. Or saying that a particular dealership is the best place to buy cars.
Sponsorship, on the other hand, is just the designation. It’s the simple acting of listing your sponsors on your website or on a handout at your event. You’re not making a call to action; you’re just identifying them as a sponsor.
There are some ways you can legally still do advertisements, but you should talk to an attorney who specializes in this area of law and your CPA, as it impacts your Form 990 tax return as well.
Unrelated business income
Unrelated business income occurs when an organization sells materials in such a way that it competes with for-profit businesses and isn’t related to their charitable purpose. When that happens, you have to pay tax on that income.
If a nonprofit runs a mentorship program for kids but also happens to have a furniture store to help fund their organization, all income from the furniture store is unrelated business income. But if your nonprofit focuses on job training and runs a furniture store to train people on building and selling furniture, then it’s not unrelated business income because it’s directly related to your charitable purpose.
This category is very specific and based on your charitable purpose and charitable programming plus what you’re selling and how you’re selling it. This is definitely a place where you need to call an attorney who specializes in nonprofit law.
Oh, taxes. Everyone’s favorite subject, right? There are a lot of cases where private foundations and public charities can be subject to taxes. You could be subject to an excise tax when selling private stock. If something’s donated to your organization and you turn around and sell it, you could be taxed on that sale. If you’re selling t-shirts or other branded products, you have to collect and remit sales tax to the state of Oklahoma. As a tax-exempt organization, you don’t have to pay sales tax, but you do have to collect and remit it if you’re selling goods. However, certain exemptions to sales tax may apply. You should check with your attorney to determine whether or not you fall into one of these exceptions.
And, of course, you are subject to payroll taxes like any other organization that has employees. If you fail to pay those, it’s one of the few cases where the IRS will reach into your board member’s pockets to collect those funds, so be sure you’re not overlooking payroll taxes.
These are just a few of the legal pitfalls we’ve seen nonprofits face, though there are certainly others. When in doubt, it’s a good idea to seek legal counsel to be sure you don’t jeopardize your nonprofit status.