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How to Avoid “Conflict of Interest” on a Nonprofit Board of Directors

How to Avoid “Conflict of Interest” on a Nonprofit Board of Directors

Many of us have encountered the fact that a Google search will produce an overwhelming amount of information that is misleading, outdated, or just dead wrong when it comes to nonprofits. 

Perhaps the biggest informational minefield in the nonprofit world is the topic known as "conflict of interest". So before approaching the finer points, let's just start with some straight talk about the most persistent myths regarding Conflict of Interest.

Myth #1: It's not OK for friends, family, colleagues and partners serve on a Board of Directors or as an Officer of the Corporation

In a word, this is "hogwash". The IRS absolutely does NOT prohibit family members, partners or others who have a relationship outside the Board of Directors.Just because a "potential conflict of interest" exists, does not mean that such an arrangement is prohibited by the IRS.

Myth #2: It' not OK for someone to be employed by an organization while also serving member of the Board of Directors, or an Officer

Again, this is absolutely untrue - in fact, the Founder is often the first person to be on the Board, the best person to be President (or serve in another officer position), and would clearly and obviously be the best person to be the first paid hire for the organization! While any nonprofit should always be sure to adhere to its Conflict of Interest Policy (get your free copy using that link), don't let any misinformation to the contrary stop you from achieving your nonprofit dreams!

Finally, Myth #3: The Directors serving on the Board must be rotated out annually

Refer to your state law to determine rules about periodic board elections, but know there is no "hard and fast" rules mandating regular rotation off theBoard of Directors. Generally, having your directors serve for multiple years can help preserve insitutional knowledge in the organization.

Here are some key points to consider about the guidelines, no matter who is on your board:

1. Duty of Loyalty: Directors of nonprofit organizations, like those of for-profit corporations, owe a fiduciary duty of loyalty to the organization. This means they must act in the best interests of the nonprofit and avoid conflicts of interest that could compromise their impartiality and judgment. Serving on the same board with family members or business partners could potentially raise concerns about conflicts of interest, but at InstantNonprofit, we provide every customer a Conflict of Interest policy that prevents running afoul of trouble.

2. State Laws: Nonprofit corporations are generally formed under state laws, and these laws may vary from one jurisdiction to another. Some states have laws that specifically address conflicts of interest and the composition of nonprofit boards, but these laws typically emphasize the importance of avoiding conflicts rather than prohibiting specific relationships.

3. IRS Regulations: Nonprofits that qualify for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code must adhere to certain IRS regulations, including requirements related to governance and avoiding private inurement (benefitting private individuals over the organization's mission). While the IRS doesn't explicitly prohibit family members or business partners from serving on the same board, it may scrutinize large transactions and relationships that could result in private inurement.

4. Common Governance Practices: Many nonprofit organizations adopt governance practices that promote transparency and minimize conflicts of interest. They often have conflict of interest policies, disclosure requirements, and recusal procedures in place to address situations where family members or business partners serve on the board together.

What are the potential conflicts of interest know as “Common Control“ and “Close Connection“?

When one or more people who exercise substantial influence over your decisions (especially expenditures) stand to benefit from your organization’s activities, a potential conflict of interest exists.

The IRS grants tax-exempt status to serve the “public interest”—and they are wary of any appearance otherwise.

That’s why it’s best to avoid common control and make sure that your board of directors do not have outside interests that could potentially damage your candidacy for IRS tax-exempt status.

The IRS is primarily concerned with:

  1. An organization or individual using a tax-exempt organization (i.e. your non-
    profit) to accomplish activities defined as “impermissible” for an exempt organization.
  2. A nonprofit may not “inure benefit”— bring profit or benefit in some way that may or may not have to do with monetary—to a particular person or set of individuals.

The IRS is also wary of a 501(c)3 sharing board members or employees with a political organization such as a 527 political group, or with a for-profit company, in a way that unduly benefits the a non-exempt organization.

For example, a nonprofit art gallery could lose their nonprofit status by paying an administrative employee full-time, if that employee was actually spending a good part of the week “volunteering” for the founder’s for-profit art production company.

It’s not always easy to find enough people to be on your initial board of directors, or to find people who are willing to make a serious commitment.

It’s probably more important early on to make sure your board is understanding and loyal to you, and respects your vision for your nonprofit, than to get “important” board members. As you bring on more experienced (and maybe even deep-pocketed!) directors, you can take the time to learn more about avoiding various kinds of conflicts of interest.

Finally, understand that it’s not usually a problem to have shared directors whose only connection is membership on another board of directors. If your church is starting a separate soup kitchen ministry, it’s probably OK to have the exact same board makeup—as long as it is disclosed. But avoiding such a situation eliminates the need to explain. Keep it simple!

But remember…..

If you do not properly disclose and the IRS finds out, they will perform an investigation that relies on facts and ircumstances. The problem? In the process of ruling, guess who determines the facts and circumstances? The IRS. And, for all your good intentions, you do not want to be on the ‘business end’ of that kind of IRS proceeding!

Rule #1 of nonprofit formation—If you want to be a legal tax-exempt entity, you better act like one.

In summary, below are some guidelines that will offer smooth sailing around the rocky shoals of the IRS and connection/control conflicts of interest.

There are no “hard-and-fast” rules to go by. The IRS Exempt Organizations Department agents are bureaucratic, but they’re not unreasonable.

For example, they understand and even expect, that your initial board will likely include friends and family.

That said, let’s look at some ways to assess where you’re at….

How do I avoid “Conflict of Interest”?

Avoiding the majority conflict of interest issues is easy. Use the “smell test”:

If you try to explain a business or other close connection between your key directors or staff to a lay person and it takes a lot of explaining, think twice about making those arrangements.

Additionally, here’s a self-assessment of your nonprofit’s level of conflict of interest. Answer the questions, then check your score. The lower your score, the lower your level of conflict of interest. The higher your score, the more concerned you should be—and the more you should consider making some changes to your structure, unless you’ve got a very good reason.

  1. What percentage of your organization’s board of directors are also paid employees of the organization?
    A. All of them (4 points)
    B. Between 50-99% (3 points)
    C. Between 25-49% (2 points)
    D. Between 1-24% (1 point)
    E. None (0 points)
  2. What percentage of your organization’s board of directors are related to each other by blood, marriage or common ownership of an outside business?
    A. All of them (4 points)
    B. Between 50-99% (3 points)
    C. Between 25-49% (2 points)
    D. Between 1-24% (1 point)
    E. None (0 points)
  3. Does (or would) your nonprofit ever buy goods or services from a business controlled by a board member or key employee?
    A. Yes, regularly (4 points)
    B. Yes, occasionally (2 points)
    C. Yes, but only when necessary (1 point)
    D. Never (0 points)
  4. Does (or would) your nonprofit ever promote the goods or services of a business controlled by a board member or key employee?
    A. Yes, regularly (4 points)
    B. Yes, occasionally (2 points)
    C. Yes, rarely (1 point)
    D. Never (0 points)
  5. Does (or would) your nonprofit ever sell goods or services that result in direct financial benefit (royalties, commissions, etc.) to an insider?
    A. Yes, regularly (4 points)
    B. Yes, occasionally (2 points)
    C. Yes, rarely (1 point)
    D. Never (0 points)
  6. Does (or would) your nonprofit ever lease property (land, buildings) from a board member or key employee?
    A. Yes (3 points)
    B. Yes, but only if no other suitable property was available (2 points)

Now, let’s see how you did. If you scored 0, congrats! You’ve done a great job of avoiding conflict of interest. If you scored between 1 and 7, you’re in pretty good shape. Scores between 8 and 15 mean you have some things to examine. If your score is between 16 and 23, you may have some serious issues that need evaluation.

What’s most important in this area is to be sure not to appear to be leaving any important information out of your application. Neglecting to disclose situations can appear as intent to hide even if you had no intention or awareness of doing so.

There’s nothing the IRS likes more than an independent board. In practice, nonprofits of all kinds that have a good reason have been known to share the exact same board of directors – it’s not a “per se” violation—but you’re leaving yourself open to trouble.

Bottom Line….

You’ll get faster tax-exempt approval if you have an independent board with little or no outside family and business connections among directors and/or key paid staff.

Get your nonprofit 501(c)3 status first— then you can learn more about this topic as your organization grows!

Action Steps:

If you haven’t selected your nonprofit Board of Directors, do the following:

1. Write down the names of potential board members.

2. Rate them on:
A) Level of trust: yours in them, theirs in you
B) Their availability to help you or bring needed expertise
C) Their willingness and ability to support the organization financially – and/or to ask others to do so.

3. Assess any problematic “close connections” (family or financial relationships). Starting with the best-rated candidates, call and ask them if they would consider joining your board. Tell them you will let them know your decision after considering all factors.

4. Choose between three and five people to serve on your board. A small board is more manageable early on to make sure the controlling body of the organization is aligned with the founder’s intentions.

I hope you find this information useful and that it serves you on your nonprofit journey. If you’ve got questions, you’re welcome to schedule a free consult call with a concierge here

To your mission,

Jacqui Long | Communications | Yippiekiyay

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