Nonprofit Accounting Basics

Personal Liability Exposure from Serving on a Nonprofit Board

Author: 

Benjamin Takis

Tax-Exempt Solutions, PLLC

Serving on the board of directors of a nonprofit organization can be a rewarding experience that offers the chance to contribute to a meaningful cause and deepen one’s connections and stature within the community. However, the directors on a nonprofit board can be exposed to personal liability under some circumstances, so it is important to be aware of the legal risks and responsibilities that board service entails, as well as the ways to mitigate these risks.

Fiduciary Responsibility-The Duties of Care, Loyalty and Obedience

The main source of personal liability exposure stems from a director's fiduciary duties. Under state nonprofit corporation law, directors generally owe a duty of care, duty of loyalty, and a duty of obedience to the organizations on whose boards they sit. The duty of care requires directors to stay reasonably informed of the organization's activities, to exercise oversight, to attend and to prepare for board meetings, to ensure the organization's records are accurate, and to generally act in good faith and with the care an ordinarily prudent person would exercise in comparable circumstances. The duty of loyalty requires directors to act in the interest of the organization rather than in their personal interest. Finally, the duty of obedience requires directors to adhere to the organization’s mission and comply with applicable laws and with the organization's governing documents. Directors can be held personally liable for breach of these fiduciary duties.

These duties can be enforced by fellow directors, as well as the organization's officers, members, and in rare circumstances by other individuals or stakeholders with a special relationship to the organization. Fiduciary duties are also enforced by the state attorney general. Directors can be protected from fiduciary liability by obtaining directors & officers (D&O) insurance and by requiring the organization to indemnify its directors against attempts to hold them liable. D&O insurance and indemnification generally protect directors in most situations except those involving fraud, criminal activity, or the director's improper receipt of a personal benefit.

Liability for Debts, Acts or Omissions

Outside of their fiduciary duties, directors are not generally held personally liable for the debts, acts or omissions of a nonprofit organization. Nonprofits are typically organized as “nonprofit corporations” under state law, which are considered legal entities separate and distinct from the individuals who run them. Accordingly, claimants who sue an organization under contract laws, personal injury, employment discrimination, and other laws generally cannot reach the personal assets of an organization’s individual directors and officers. The rare exception, a situation referred to as “piercing the corporate veil”, is in cases involving fraud, or if the formalities required of a corporation (keeping separate bank accounts, following bylaws, having board meetings and keeping minutes, etc.) are not followed.

As with fiduciary liability, though, directors can generally be further protected against liability for the acts or omissions of the organization by requiring the organization to indemnify its directors against attempts to hold them liable, and by maintaining insurance covering errors and omissions and/or employment practices liability.

Tax Liability

Additionally, there are also circumstances under which directors can be held personally liable under certain tax provisions. Nonprofits qualifying as 501(c)(3) or 501(c)(4) organizations are subject to "intermediate sanctions" rules under section 4958 of the Internal Revenue Code. The intermediate sanctions rules relate to conflicts of interest, and impose penalty excise taxes on financial transactions between organizations and "disqualified persons" (i.e. directors, officers, key employees, and other insiders of the organization) under which the disqualified person receives more value than he or she confers on the organization. These excise taxes apply personally to the disqualified persons who received the benefit of the transaction, and on any directors or officers who willfully and knowingly participated in the transaction. Similar but more stringent rules apply to 501(c)(3) organizations that are classified as “private foundations.” Lastly, directors can be held personally liable for failure to pay federal payroll taxes owed by the organization.

 

While serving on a board of directors carries some risk of personal liability, the risks are minimal for directors who are aware of their legal responsibilities, exercise diligence, and ensure that they are adequately protected by insurance coverage and indemnification clauses.