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Tips on avoiding these common nonprofit legal pitfalls

1. Contracting mistakes

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 an informal, non-binding memorandum of understanding (MOU), without ever formalizing the terms into a complete contract.

While it may not be practical to have every agreement reviewed by a lawyer, 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 reasonable methods to terminating 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 over broad or inapplicable to the activity. For example, I'm 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 mistakes include:

  • Carefully reading and understanding contracts before signing
  • Noting auto-renew terms
  • Consulting counsel for large transactions or lengthy commitments
  • Ensuring terms are understandable and there is a clear method to terminate the contract
  • Not indemnifying others for activities outside the organization's control

2. Misclassifying employees

Treating workers as independent contractors when they are properly classified as employees is a common mistake that can have grave consequences for nonprofits and for-profits alike. Misclassification can lead to payroll tax liability and penalties. It can also lead to lawsuits because the organization may lack workers' compensation coverage for workers it treats as independent contractors. If someone 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)
  • Relationship (contracts and benefits) with the person doing the work

3. Monitoring third-party fundraisers

Increasingly, charities are attracting third parties 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 they dream up.

However, there have been cases where unauthorized individuals held themselves out as fundraising for a charity without ever forwarding the funds to charity. 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 third-party fundraiser guidelines and an agreement.

The guidelines and agreement should cover the following:

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

4. Monitoring gift restrictions

Many nonprofits assume that there are no rules if a donor does not provide any details about the investment, timing or use of a restricted gift. In reality, the management of donations and grants are controlled by default rules set out in the Arizona Management of Charitable Funds Act, which is based on a uniform law that has been adopted in most states.

In most cases, a well drafted "gift instrument" (which includes virtually any record) will override these rules — but where none exists, the nonprofit must follow the statute.

The most common challenge posed by a restricted gift is 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 are frequently unaware of legal requirements in other states. At a bare minimum, nonprofits operating outside of their home state must 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 operates
  • Needs to register to solicit funds in the new state
  • Has payroll and workers' compensation considerations for employees working in the new state
  • Has corporate supporters that need to register as commercial co-ventures in the new state
  • Is required by the new state to conduct audits

Nonprofits are more highly regulated than ever before 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 toward protecting their interests and avoiding legal problems.

For more from Ellis Carter, visit CharityLawyer.

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MissionBox editorial content is offered as guidance only, and is not meant, nor should it be construed as, a replacement for certified, professional expertise.

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Charity lawyer focused on simplifying nonprofit law