Select Page

Nonprofit Organizations
Drexel University School of Law
Field, Richard I.

NONPROFITS
Remember no private benefit/inurement intersect with state law—duty of loyalty, etc.
1 • BACKGROUND
 
I.        Theories of Nonprofits
A.     “nonprofit” – a misnomer, as NPs can make a profit
1.      bound by nondistributional constraint – all profits must go towards the exempt charitable purposes of the org, cannot inure to those in control of the org. Can, however, pay reasonable compensation to people for labor or capital they provide, whether or not that person exercises control over the org. 
a)      not barred from earning profit. Many have surpluses, just can’t distribute the profits. Net earnings must be retained and devoted to financing further services
b)      NDC is a condition under which incorporated NPs get their corporate charter. When not incorporated, but a trust, control over the org. lies with trustees and the NDC is imposed by law of trusts (reasonable compensation). 
B.     Rationales:
1.      Historical: English Statute of Charitable Uses
2.      Contract Failure: Owing either to nature of service in question or circs under which produced or consumed, ordinary k-ual devised don’t provide consumers with adequate means for policing performance of producers
a)      ex: nursing care or anytime bargaining powers are unequal. (health care, bank mortgage). Buyer is vulnerable in medicinal and legal issues and people trust NP because they have fiduciary responsibility.
b)      NPs lack the incentive to raise prices and cut quality b/c those in charge are barred from taking any of the resulting profits
c)      producer acts as fiduciary to purchasers, giving them greater assurance that the services they desire will in fact be performed as they wish
3.      Market Failure; Collective goods/public good: The essential role for the nonprofit organization is to serve as a fiduciary for its patrons and serve mission. So can help with free-rider problem like clean air or street-lighting. All benefit from it, no way to charge so either the gov’t or a np needs to do it. Gov’t collects taxes from people. NP get grants and donations for society’s use. 
4.      Gov’t Failure to Respond b/c of constitutional limitations on gov’t provision of programs supported by majority. Also Political limitations on gov’t provision of programs/services to un/underrepresented constituencies
a)      Gov. v. NP: Gov: when will help everyone—street lights or env. protection or when majority or incredibly vocal minority (orphan drugs and medical research). NP: when smaller group of people, like immigrants for ex.
Ÿ NP flexible and non-beaurecratic            
Ÿ NP quicker, don’t need legislation
Ÿ NP innovative because not accountable politically
5.      Protection of Freedom: Gov’t watchdog – most likely to be first to say “the emperor has no clothes”
6.      Gardner article: quid pro quo theory: emphasizes secondary community benefits
a)      contributions to a robust and pluralistic society, relative freedom from constraints and resulting pluralism (idea that a free nation should be hospitable to many sources of initiative, institutions, conflicting beliefs and competing economic units. No need to be backed by constituency, just a handful of people can start it.
b)      hospitable to innovators and efficient providers of public benefits—doing things better, differently. The gov. just can’t do this. Virtually all significant social idea in past century was nurtured by the NP sector; preserves initiative/responsibility, enhances creativity and enlivens communities, nurtured ind. responsibility, stirs life at grassroots, improve life together, reminds us, dramatically, that we were born free—distinctly American!
C.     Nonprofits vs. For-Profits
1.      look at goals of founders
a)      FP trying to make money, raise equity capital from investors
b)      nonprofit – focused on tax benefits, altruistic motives
2.      Non-distribution constraint!
a)      FP profit paid to shareholders with dividends v. NP where can either keep surplus or donate to charity but cannot give to a private entity.
3.      constraints on profits made by NPs
a)      must further the mission; upon dissolution, assets remaining must go to a charitable purpose
b)      salaries must be “reasonable comp” – based on comparables in for-profit sector
c)      can still charge fees, don’t have to give discounted services – as long as fees go to mission
4.      other benefits of NPs
a)      low-interest loans
b)      “halo” effect – can facilitate endorsements, grants, etc.
c)      while technically, NPs are more heavily regulated, in reality, there may not be anyone (state AG, IRS) to actually monitor/regulate
Ÿ also, no shareholder scrutiny in NP sector
5.      benefits of §501(c)(3) nonprofits specifically
a)      can receive tax-deductible donations, under §170 – makes fundraising much easier
b)      states offer property/sales/gift tax exemptions
c)      postal rate deductions
d)      right to issue tax-exempt bonds – charity thus pays less interest
D.     countervailing considerations re: downsides to NPs
1.      inefficient, duplicate missions, loss of tax/revenue so unfair.
2.      curtailment of profit motive may lead to reduced incentives for cost efficiency, responsiveness to consumers, and expansion in response to increasing demand
3.      inability to raise equity capital through the issuance of stock – could severely hamper ability to meet needs for new capital
4.      only when contract failure is relatively severe is it likely that the fiduciary advantage will clearly outweigh these corresponding advantages
 
2 • SPECIFICS OF NPS
 
II.     2 Categories of Nonprofits
A.     public-serving – generally formed for public charitable purposes
1.      include charities, social welfare orgs (§501(c)(4)), political orgs, etc.
a)      examples: Foundations, religious congregations, healthcare, education/research, religious orgs, social and legal services. 
2.      members have no ownership int
3.      assets held for public charitable purposes, can’t be distributed to members, directors, or officers, even upon dissolution
4.      members’ right to vote on amendments to bylaws not as broad as those of mutual benefit orgs (where members have economic int at stake) and board is self-perpetuating, it elects own members.
5.      restrictions on the type of corps with which they can merge and conditions of merger
6.      there may be no one with econ incentive to review decisions made by directors
a)      Revised Act seeks to fill this void by clarifying existing common law and statutory authority of AG – authorizes AG to monitor and exercise oversight powers over public benefit corporations
7.      NOTE: if looking out for public good and getting tax break for free-loaders, needs to aply to everyone or have rational basis for exclusions (hospitals for sickies; nursing home for oldies) but restrictions can’t occur for no reason.
8.      Contentious example:  NYT article about the hotel for politicians. Have religious sevices but exclusive and can be limited based on social status/income but NOT for indigents, the other way. So other hotels would object for sure. Tax-payer dollars used to subsidize a something that’s clearly not needed (free accommodations for wealthy, privileged people rather than an underserved population). Also DC would object about not getting prime property taxes. This is a private benefit.
B.     mutual benefit (member-serving) – formed principally to further common goals of members
1.      e.g., groups with an economic nexus: NFL, chambers of commerce, boards of trade, labor unions
2.      e.g., groups with a social nexus: fraternal orgs, social clubs
3.      examples: country clubs (501(c)(7)), trade unions (501(c)(6)), social clubs (as long as not too educational), NFL, NBA, AMA, ABA, Elks, etc.
4.      note: many orgs have members, but don’t exist primarily to serve needs of the members (e.g., Met, PBS) – still public serving
5.      members may have econ int – can’t receive distributions while the NP is operating, but membership ints may be sold or transferred to the corp or third parties
a)      upon dissolution, members may receive distributions
6.      members have broad rts to vote on bylaw amendments – protect econ and other ints
7.      may operate with a self-perpetuating bd of dirs
a)      individuals can be called “members” even if they don’t have rt to vote for directors, but won’t be treated as members under Revised Act
C.     exception to this dual scheme – houses of worship
1.      generally considered to fall under public serving (allow non-members to worship, contribute to public charity causes), and yet they operate for benefit of members
2.      (even though the property has been conveyed to the charitable corporation)
III.   Forms of Nonprofits
A.     charitable trusts
1.      fiduciary relationship w/r/t property arising as a result of the manifestation of an intention to create it
2.      differ from private trusts – object to benefit the community; assets must be irrevocably dedicated to the purposes of that trust
a)      enforced by AG rather than trust beneficiaries
b)      can be of unlimited duration, unhindered by rule against perpetuities
c)      often used for private foundations engaged solely in making grants
3.      pros – great if there are no liability issues, just trying to give out money
a)      easier/faster to set up – no need for prior approval, no requirement of identifiable beneficiaries
b)      administration with fewer formalities than nonprofit corporations
c)      perpetual or indefinite period of existence
d)      possibility of continuing control by grantor
e)      may be less expensive to maintain than a for-profit corporation
4.      cons – rates are higher if other business taxes imposed, or give money overseas
a)      UBIT – trust rate gets higher a lot faster than for corporations
5.      instrument – names the trustees; states the charitable purpose; est. policies for administration, distribution of assets and dissolution; names successor trustees and method of selection; duration
a)      management rests in trustees – may be selected by selecter, court, and may be self-perpetuating if trust instrument so provides
B.     unincorporated associations – many smaller NPs, labor unions, and political orgs
1.      pros – informality and flexibility
a)      no govtal approvals must be obtained to form or dissolve
b)      no const or bylaws needed (unless seeking 501(c)(3) exemption, which you would want to get to accept contributions from individuals/foundations)
Ÿ if you don’t want to apply for 501(c)(3) but still want to get donations, can use a fiscal agent – donors give to the 501(c)(3) agent, get their tax deductible donation, then the (c)(3) grants the money to the unincorporated assn, keeping a 5-10% fee
Ÿ if have budget over $5K/year and want to get grants directly – need (c)(3) status
c)      good for newly formed entities, or those commencing incorporation process
Ÿ those with uncertain prospects, limited expected duration, or founders who are unlikely to bring the activity/project to fruition
2.      cons – outweigh the benefits!!
a)      liability – no separate legal existence apart from the members, so individual members have personal liability
b)      can’t receive or hold property, or contract in the assn’s name
c)      banks, creditors, other vendors may be reluctant to conduct business with an unincorporated assn
3.      upon dissolution – members are entitled to their pro rata share of assets, unless articles say otherwise
C.     nonprofit corporations
1.      must conform to more formalities in

ilanthropy doesn’t count)
Ÿ In re Buck – trust set up to care for the needy in Marin County; trust assets grew way beyond what testator had anticipated; too much money to spend in Marin, so petition to modify purposes to extend to other locations (Oakland) instead of building another bike path.
Ÿ ct denied petition for cy pres – trust purposes could still be carried out; no impracticability as required for cy pres
Ÿ class: kinda silly because US subsidizing bike path then though also makes sense that don’t want to jeopardize future of philanthrophy. 
4.      ct must determine whether any general purpose of disposition still may be achieved by some alteration in the administration or application of the charitable distribution
a)      not sufficient that accomplishment of the trust’s purposes has become more difficult – accomplishment of purpose must have ceased
5.      if legatee refuses to accept donation b/c of a restriction, cts may remove offending provision to validate gift, hold it for another inst, or give it to testator’s next of kin
a)      US v. Cerio – Coast Guard alum devised trust to give huge monetary award to highest grade in class; CG claimed that unless the trust was modified in cy pres proceeding, it would refuse the gift
Ÿ claim that as written, it was impossible to perform – would seriously disrupt Academy’s operations, interfere with the attainment of its purposes (i.e., commitment to teamwork) undermine comraderie
Ÿ ct applied cy pres – found that testator primarily desired to foster academic excellence; peculiar manner in which trust was to be performed was secondary; modified trust to provide more modest awards as well as science fellowships/visitorships
6.      cy pres will also be applied when purpose provisions violate constitution/public policy or illegal
a)      e.g., appeal to remove “white” from scholarship for “female white students”
b)      ct must find that a general charitable intent (to fund education) on part of the testator outweighs the impermissible provision
c)      note: cts less likely to apply cy pres to cases of gender discrim
d)      cts also unwilling to apply cy pres to religiously restrictive char. trusts, absent state action
e)      but will apply when someone gives 2K for a home for cats.
7.      If no cy pres then goes out of business or orphans court decides. 
C.     Difference between cy pres and deviation: difference is nebulous but it you can convince the court it’s about administration of trust rather than underlying purpose, you stand better chances. 
D.     doctrine of deviation – ct may alter the administrative or distributive provisions of a trust
1.      Needs to be substantially similar. Mission still makes sense but can’t use the same method of accomplishing (hospital received $ for purpose but wanted to use for mortgage to keep open–ok.)
a)      difference is nebulous but it you can convince the court it’s about administration of trust rather than underlying purpose, you stand better chances. 
2.      applied when “it appears to the ct that compliance is impossible or illegal, or that owing to circs not known to the settler and not anticipated by him, compliance would defeat or substantially impair the accomplishment of the purposes of the trust”
3.      ct cannot change the original charitable objective, or divert the bequest to an entity with a purpose different from the purpose set forth in the trust instrument
a)      not changing the established purpose, but modifying the administration
4.      used where a term of the trust is illegal, changed circs have occurred, or to escape investment restrictions on sale of property even though such sales are unauthorized or forbidden by trust terms
5.      Broad:Barnes Mission was a art school and not a museum for general public- wanted to teach art in his own way. Glanton, president of board says have offer they can’t refuse. 2 issues: board issue and condition of the donation which is that they move. Argument is for devation bc continued administration is impossible and that this is administrative change which has nothing to do with the mission. Opponents say there are many other options. Ct said this was not a gross violation of Doc Barnes bc primary purpose was education and that will be maintained/respected in the move.  
IV. Dissolution and the Distribution of Assets
A.     trusts – should be established with the broadest purposes possible, so if the need goes away then the money can go elsewhere without being a different purpose
1.      put clause in trust doc to permit trustee to dissolve when she wants
a)      or, variance clause – allows trustee to change the purpose w/o going to ct