Chapter 1: Understanding Your Nonprofit’s Risks
Part 1: What Is a Liability?
“Liability” is one of those words that both for-profit and not-for-profit organizations hear all the time. But what exactly does it mean?
A liability is your legal responsibility for people, property, and other situations. A nonprofit that maintains an office is responsible for making sure no one is injured on its property. An organization that supplies grief counseling is responsible for the quality of the therapy it offers. When an organization fails to meet its responsibility — whether it’s by creating an unsafe environment or delivering unsatisfactory services — it can be sued.
Any situation that can lead to a lawsuit is considered a “liability.”
But those aren’t the only situations that can lead to a lawsuit. One of the reasons the term “liability” can be confusing is because it applies to so many situations. For example…
- Your management can be liable for its financial decisions.
- Your organization can be liable for its employees’ errors.
- You business can be liable for injuries others suffer on your premises.
Basically, any time someone can be sued for making a mistake or not preventing a mistake, you’re dealing with “liabilities.”
Which Liabilities Do Non-Profits Face?
Here are some common liabilities that most nonprofit businesses may encounter:
- Liability for third-party bodily injuries. When a deliveryman falls down your stairs and dislocates his shoulder, you can be held liable for medical expenses. You might be thinking, isn’t it the deliveryman’s fault for falling down the stairs? Maybe. But the law doesn’t treat it that way. When people get injured on your property, you can be held responsible for creating an environment where the accident occurred. (For more on this, jump to the section on General Liability Insurance.)
- Liability for damaging someone else’s property. Let’s say your organization runs a homecare service that visits the elderly people. Visiting someone else’s home means that you could potentially damage their property. Here’s an example: while helping a patient out of bed, your volunteer knocks a glass of water onto the new computer their grandchildren gave them. Though these accidents are sometimes unpreventable, you can still be held responsible for the cost of replacing the damaged property. (General Liability Insurance covers this liability.)
- Digital security liability. A nonprofit with financial and personal information on its computers and networks can be held responsible for misuse of this data. If a hacker breaks into an NPO’s computers, you’d be liable for the cost of credit-monitoring services for the people affected by the breach. (You can protect your organization with Cyber Liability Insurance.)
- Board members and officers liability. Financial planning errors or employee conflicts can lead to lawsuits filed against your organization. (See Directors and Officers Insurance for more information.)
- Professional liability. No matter what services your nonprofit offers, you can be sued for making errors or failing to deliver an expected result. These lawsuits are more a reflection of a patron’s attitude rather than the quality of your work. For example, parents could sue a charter school for making an error on a child’s transcript, claiming the oversight was the reason their child was rejected by a college. (For more information on professional liabilities, check out the section on Errors and Omissions Insurance below.)
You can be legally liable for hacks to your computer system.
Does the Law Protect Non-Profit and For-Profit Businesses the Same Way?
Though a non-profit’s mission is different than that of a for-profit business, the founders of a both types of organizations are protected from lawsuits the same way. That’s because when your started your organization, you “incorporated.” Maybe you did this with the help of a lawyer, or perhaps you did it through a legal service website.
Legally speaking, being a corporation protects your nonprofit in certain ways. Namely, an incorporated organization is legally responsible for its employees’ and volunteers’ actions. In most cases, you cannot be personally sued for the things you do as part of your organization.
You’re also protected from financial responsibility for your organization’s debts. So if your non-profit is sued and found liable for $1 million in damages but can only afford half of that sum, you won’t be personally responsible for repaying the rest of the debt. The organization could file bankruptcy and / or go out of business, but you won’t be on the hook for the remaining $500,000.
Though a non-profit is different than a for-profit enterprise, you still have the same legal protection from organizational debts related to liability lawsuits.
Part 2: Liabilities Unique to Non-Profit Organizations
Each industry’s liabilities vary depending on the services they offer. For nonprofits, their unique liabilities stem from the board’s responsibility to maintain the organization’s tax-exempt status as a 501(c) organization. That means…
- Board members can’t vote on their own compensation.
- Business arrangements can’t have conflicts of interest.
- Business deals can’t unfairly reward a private party.
- Transactions must be at “arm’s length.”
If any of these policies is violated, your nonprofit — and specifically your board members — could face a liability lawsuit. Let’s take a closer look at these legal obligations.
501(c) status comes with unique legal liabilities.
Incorporation protects you from financial responsibility for your organization’s debts.
Board Members Can’t Be Involved with Decisions about Their Compensation
If a board member is involved in a decision about their compensation, your non-profit could lose its tax-exempt status. Here’s how this situation often comes up:
Many nonprofits are small organizations with few employees. Frequently, the founder of the organization is an employee who also serves on the board. If the founder is a part of the voting, discussion, or decision-making process about their own salary, then the IRS may consider this a violation of its conflict-of-interest regulations and could revoke the non-profit’s 501(c) status. The organization would lose its tax-exempt status and be responsible for paying back taxes.
Because it was the board’s mistake that caused the nonprofit to lose its charity status, donors could sue the organization.
Non-Profits Must Avoid Conflicts of Interest
Nonprofits can’t sign contracts with private parties that have a special relationship with people in the organization. If you sign a contract with a company that also donates to you, the IRS could argue that you are unfairly rewarding the company for its contributions.
Here’s another example. The brother-in-law of a member of your board runs a catering business. If you hire him to supply the food for a fundraising event, this could be considered a conflict of interest.
For more information, check out the New Mexico United Way Center for Nonprofit Excellence’s guide, “How to Avoid Conflicts of Interest .”
Special Non-Profit Concerns about Compensating Business Partners
Nonprofit organizations have to be careful not to compensate their vendors or employees too much. Doing so could cost them their tax-exempt status and lead to a lawsuit alleging the board mismanaged the organization’s financial resources.
You may be asking yourself, is the law telling me I can’t pay my employees well? But that’s not what is going on. You can, of course, compensate your employees fairly. On the other hand, no one should get rich off of your nonprofit (not that you expected that to happen anyway).
The law is in place so that nonprofits are not involved with transactions that unfairly benefit private parties. In practice, this means you can’t pay your board members / employees too much money or offer them unreasonable benefits / travel allowances / housing allowances. Some major nonprofits pay their CEOs a million-dollar salary, but even then, it is usually what someone in a similar position would make at a for-profit company.
Nonprofits can get into legal trouble if their board members and employees enjoy inflated benefits and salaries.
How Arm’s-Length Transactions Work
The law requires that all of a nonprofit’s transactions be conducted at “arm’s length.” This is another one of those tricky legal terms. In essence, an arm’s-length transaction is when neither party can pressure the other into the deal or feel pressured because of a past or potential relationship. This may mean your organization must avoid business deals with donors, family members, and other people involved in your work.
But sometimes these definitions can get blurry — especially in the case of gifts. Here’s an example from The Non Profit Times about an ongoing legal battle involving the definition of an arm’s-length transaction:
Johns Hopkins University was given a 150-acre piece of land in rural Maryland by a benefactor named Elizabeth Banks, who also left special instructions before she died for how the land was to be used.
What complicates this issue is that Johns Hopkins actually purchased this land, but for a value far below the market price — just $5 million for a piece of land worth $54 million. Johns Hopkins claims that because they purchased the land, it is an arm’s-length transaction and they don’t have to follow Ms. Banks’s instructions about the land use. JHU wants to develop the land into commercial property, while Ms. Banks wanted it to be used for academic buildings.
Ms. Banks’s family sued Johns Hopkins over their plan to commercially develop the property. Now the courts must decide whether this constitutes an arm’s-length transaction or a gift. On the one hand, the university paid for it. On the other hand, the price was far below the land’s market value, which could mean it was a gift and Ms. Banks had the right to stipulate how it’s used.
This situation is a good example of board liability. Financial planning can quickly lead to legal fiascos that drain your resources and put your plans on hold. Gifts from donors and money left in wills often lead to difficult financial decisions and extra scrutiny — both of which can easily result in a lawsuit against your nonprofit.
That’s why it’s essential to have adequate liability insurance in force throughout the life of your organization. The appropriate policy can help your organization pay for legal defense and other court courts arising from board liability claims. In the next chapter, we’ll explore some of the insurance policies that can protect your social service organization and its hard-earned funds.
Next: Chapter 2: Understanding Nonprofit Insurance Coverages