Universities’ Exempt Status: Political Threat

University and Exempt Status

It was September 8, 1971.  

In the Oval Office, Richard M. Nixon chatted with his chief domestic-policy adviser, John Ehrlichman, about the upcoming 1972 election still fourteen months away. Mentioning potential Democratic rivals by name, the President asked: “Are we going after their tax returns? I … you know what I mean? There’s a lot of gold in them thar hills.” 

We know about this incident and Nixon’s express directive to weaponize the Internal Revenue Service because – (to paraphrase a more recent government official) – “Lordy,” there were “tapes.” These secret recordings were among the evidence used to support the 1974 Bill of Impeachment including Article II: “He has, acting personally and through his subordinates and agents, endeavoured to… cause, in violation of the constitutional rights of citizens, income tax audits or other income tax investigations to be initiated or conducted in a discriminatory manner.”

Fast forward almost fifty years. 

Now there are presidential tweets: out in the open, an undeniably direct line from the Oval Office to the Treasury Department and the Internal Revenue Service:  “Too many Universities and School Systems are about Radical Left Indoctrination, not Education. Therefore, I am telling the Treasury Department to re-examine their Tax-Exempt Status … and/or Funding, which will be taken away if this Propaganda or Act Against Public Policy continues. Our children must be Educated, not Indoctrinated!” 

Tweets come and go, of course, but this one from the morning of July 10, 2020, did not quickly evaporate into the fog of the 24/7 news cycle. There have been concerning developments.  Despite reassurances from leading experts that there are legal barriers to any real tax-exemption jeopardy from the Administration, the nation’s colleges and universities – and, indeed, the nonprofit community generally – have felt a distinct chill in the air well in advance of the official date when summer turns to autumn.  

       Universities Push Back 

The Tweet in Question surfaced against a backdrop of rising tensions between higher education and the Administration including presidential rhetoric on Independence Day at Mt. Rushmore and other recent comments complaining “about schools being driven by what he describes as a radical left-wing ideology” and “‘far left-fascism’ controlling American schools, newsrooms and other institutions.” 

On July 6, 2020, the Administration (through the U.S. Immigration & Customs Enforcement) announced an abrupt change in policy on the status of international student-visa holders. Despite assurances the government offered earlier in the COVID-19 pandemic, there was to be a new rule that these students would have to attend at least one in-person class in the upcoming semester in order to stay in the United States. (Many colleges and universities had announced plans to hold online-only courses in the fall.) 

“Trump’s tweets set off a firestorm of reactions focusing on the implicit political threat against free speech.” The higher-education community pushed back immediately including well-publicized tweets from individual professors vowing to hold at least one in-person class in the coming semester even if it meant everyone would be sitting outside in the snow. And by July 14th, a group of 20 colleges and universities in the Western U.S. filed a lawsuit over this rule change. (That same day, “… what Trump had dubbed “Propaganda” resulted in his administration changing its policy.”) 

In the July 10th Tweet, the president did not name specific institutions whose tax-exempt status he wants the Treasury Department to review. And notwithstanding that the Administration later officially withdrew the immigration-rule change, the threat remained to review tax-exemptions and also withdraw federal funds. 

Among those asking for specifics – and perhaps reassurances that this matter would not be pursued any further – was Rep. Richard Neal (D-MA), chair of the House Ways and Means Committee. On July 15th, he sent letters to the Internal Revenue Service and to the Treasury inspectors general

In their formal written responses at the end of July, these officials, in appropriate bureaucratese, hemmed and hawed about what had happened or what may happen. For instance, the Deputy General Counsel replied that “the Secretary of the Treasury expects that Treasury’s Office of Tax Policy will conduct a policy review of the generally applicable regulations and guidance implicated by the President’s comment.”  And, on July 31st, Treasury Secretary Steven Mnuchin announced there would be some kind of “review” coming, and that the issue of federal funding had been forwarded to the Department of Education for consideration. 

Representative Neal wrote back to Treasury making clear he is not pleased with this state of affairs. 

       Legal Obstacles and Defenses

In Trump tweets, tax law and alleged university ‘propaganda’ (7/19/20) Professors Ellen P. Aprill and Samuel D. Brunson, provide an important and detailed legal analysis of the issues arising from, and defenses to, this threat to meddle.

A few weeks later, on August 2, 2020, Professor Brunson posted additional thoughts, summarizing the key points made earlier; see IRS Investigation of Universities’ Tax-Exempt Status, Nonprofit Blogger. The “…Treasury and the IRS face three significant problems in investigating universities.” 

First, “…even if you assume that universities are politically biased–and even if you assume they teach that bias to students–that doesn’t mean they can’t be exempt. Tax-exempt educational institutions can endorse particular viewpoints.” 

Second, Internal Revenue Code section 7217, “… prohibits the President from requesting that the IRS audit a particular taxpayer.” (No “particular taxpayer” was mentioned in The Tweet; nevertheless, they explain how this statute generally applies; Rep. Neal also mentions this statute in his letters to the IRS and Treasury.) 

Third, “… the Consolidated Appropriations Act, 2020 … prohibits the IRS from targeting groups for regulatory scrutiny on the basis of their ideological beliefs.”

Professors Aprill and Brunson include additional arguments as well in support of their analyses. 

[Update 9/17/20]: This article has just been published, with additional detail, on SSRN under the title: The University, Ideology, and Tax Exemption.


“Congressional restrictions—in addition to other legal issues—could make Trump’s directive illegal and in violation of the First Amendment, tax and non-profit groups say.” For instance, Mark Mazur, director of the Tax Policy Center and former assistant secretary of tax policy within the Treasury Department under then-President Barack Obama, agrees: “The tax code’s clear that educational institutions generally qualify for tax-exempt status,” adding “It’s not, ‘except the ones I don’t like.’” 

In What a Direct Attack on Free Speech Looks Like (July 10, 2020), The Atlantic, David Graham emphasizes the danger that should make us all shiver. In The Tweet (which he notes had that first day accumulated over 80,000 likes and 30,000 retweets), the President “… is making a bona fide threat against First Amendment speech itself, trying to use the power of the government to punish people whose expression he finds objectionable.”

Long-Awaited ERISA Decision Reached

Late last year, we previewed a pending Supreme Court case involving pension plans of religiously affiliated nonprofits.
On June 5, 2017, the ruling was issued: All eight justices participating in Advocate Health Care Network v. Stapleton agreed that the “church plan” exception to ERISA coverage for employees is broad enough to include all religiously-affiliated facilities including ones that were not originally established directly by a church. New Justice Gorsuch was not involved in this decision.
This is good news for hospitals, universities, and other religiously affiliated nonprofits who will save money by not having to abide by the worker-protection rules of the Employee Retirement Income Security Act.  Of course, the losing side – a group of current and former employees of these institutions – are not pleased at all. These plaintiffs had argued that allowing their employers to opt out of the worker-protection ERISA rules has a detrimental financial effect on them and perhaps some hundreds of thousands of others similarly situated.

When Does ERISA Apply?

InSupreme Court Will Decide ERISA Church Plans Exception,” we explained that the federal Employee Retirement Income Security Act (ERISA) protects pension benefits of most American workers:

Without ERISA, your pension may be at risk without you ever knowing it.  If you are a participant in a defined benefit plan covered by ERISA, federal rules specify the amounts that employers are required to contribute on an annual basis so that your plan has enough money to pay you benefits when they are due. Further, through the federal Pension Benefit Guaranty Corporation (PBGC) participants are guaranteed a level of retirement benefits if for any reason the employer defaults on its obligation to pay benefits. In other words, in a plan covered by ERISA, your benefits are insured by the PBGC in the same way your balance in a federally insured bank account is insured by the FDIC.
If a plan is not subject to ERISA, there is no such federal protection. Uncovered plans are subject only to the terms of the plan document. While the ‘rights of employees and retirees are determined by state law,’ there isn’t the same level of protection. ‘That’s why ERISA was enacted in the first place.’

In addition, “among the provisions set by ERISA are requirements that pension plans meet certain minimum funding requirements, and that plans do not discriminate in their benefits by doing such things as providing comprehensive health insurance coverage for men but not women.”
On December 2, 2016, the Supreme Court issued writs of certiorari in 3 consolidated cases involving religiously affiliated, nonprofit, healthcare employers. This issue had been bubbling up for some time, and the lower courts hearing these cases did not agree on the outcome; that is, the proper scope of the “church-plan exception” to ERISA. This is a typical situation in which the U.S. Supreme Court steps in to resolve the dispute.

  ERISA Exception for “Church Plan”

Since ERISA is intended to provide broad protection for workers, there are just a few exceptions written into this landmark federal statute. One key exception is for “church plans”; that is, plans intended to apply to clergy and other church employees.

When Congress enacted ERISA in 1974, it exempted church plans because it felt that federal regulation might ‘be regarded as an unjustified invasion of the confidential relationship that is believed to be appropriate with regard to churches and their religious activities.’

There are certain requirements to meet this exception. Originally, the plan had to be “established by a church.”
ERISA, though, has been amended a number of times. The current question is whether the language changed enough to now include nonprofits that are religiously affiliated even if they weren’t originally created by a church.

  High Court Approves Broad “Church-Plan” Exception

Although this litigation involves religious hospitals and healthcare facilities, the outcome doesn’t turn on the “religion” aspect. Instead, it’s a matter of the interpretation of the language of the ERISA statute; that is, “statutory construction.” (It also isn’t limited to the healthcare field, but can include other religiously affiliated institutions including – for instance – universities.)
In other words, did Congress intend to broaden the “church-plan” exemption beyond the original requirement that a plan be established by a church, and does it now apply to institutions formed by nonprofit organizations instead of directly by a church?
The United States Supreme Court says yes: Under the “plain language” of the current statute, religiously affiliated hospitals and healthcare organizations can fit into the “church- plan exception” even if they were created by nonprofit organizations.
Certain issues remain unsolved due to the complexity of the ERISA statute.
And while these nonprofit employers may, under the rules of statutory construction, qualify under this available exception, it’s clear from the opinions that some of the justices – Sonia Sotomayor, in particular – have concerns “about the potential consequences of leaving employees of these organizations unprotected by ERISA.”
Some commentators on this decision leave no doubt about their reactions; see, for instance, an article titled Supreme Court Ruling Could Let Catholic Hospitals ‘Pocket’ Millions in Retirement Funds”: “The impact of the decision means Catholic hospitals, which employ tens of thousands of low- to middle-income workers, can now generally avoid the pension and health insurance protections required by federal law.”


The question before the courts – which had produced uneven results in the past – has been resolved as a matter of law. Nevertheless, this resolution has unsatisfying ramifications which Congress may or may not choose to remedy by legislation.

Yes, Nonprofits Sometimes Do File Bankruptcy

Although it’s a step rarely discussed in the philanthropic community, filing for federal bankruptcy relief is not uncommon and is a way to resolve the status of a nonprofit in serious financial difficulties. As with individuals and for-profit businesses, sometimes this drastic remedy is necessary.

   Bankruptcy As an Option for Troubled Nonprofits

Bankruptcy can become an option for a variety of reasons – some avoidable and others the result of outside, unexpected forces like a serious economic recession or sudden dry-up in government funding.

Nonprofits have an aversion to using bankruptcy as a tool. While nonprofit organizations constitute 30 percent of all corporations, they represent only 1 percent of corporate bankruptcy cases. I suspect the gap is indicative of their morality rather than their durability. Nonprofits are so anxious about reputation that they prefer risking liquidation to admitting financial distress.

“Non-profits can benefit from the bankruptcy process, either by restructuring debts and continuing to operate, or by providing a method to transfer valuable assets to another entity which can continue to make use of them.”  There are, however, restrictions that apply in case of a nonprofit entity “transferring its property.
Section 541(f) of the Bankruptcy Code provides that a “non-profit entity can transfer property only to the same extent it could if no bankruptcy had been filed.”
These issues can include, for instance, “analysis of legal or donor restrictions on the transfer of property owned by a nonprofit.” In certain industries, like healthcare, there are additional statutory obstacles, or there may be non-transferable licenses, or contracts with government or insurance companies.

  Nonprofit Bankruptcy: Example

The Tumbleweed Center for Youth Development had been in operation for some 45 years. It had been serving “hundreds of homeless people ages 12-25 each year with resource centers, emergency and transitional housing, life counseling and other programs,” as well as “services for youth refugees and unaccompanied minors from outside the U.S.”
By December 2016, though, the directors made the decision to file for bankruptcy. The group “was having severe cash flow difficulties and what became insurmountable debt.” Earlier in the year, there had several key resignations: the CEO and not one, but two, CFOs. “New interim leadership determined that the organization was ‘grossly overspending.’”
What made the difference in terms – primarily – of the needy client population that about to be deprived of critical services was that a “handful of private foundations donated hundreds of thousands of dollars as the bankruptcy was declared to allow for an orderly transition even while programs continued to function.”
Under the court proceedings, all of the programs will be transferred to other nonprofits over several months as Tumbleweed liquidates assets to pay off its debts.
With this assistance from the charitable community as well as good planning, this important service-provider was “able to close up without the pain and chaos that often surrounds an abrupt shutdown.”


Sometimes, a bankruptcy decision does not mean that closure is the end result. There are options,  under certain circumstances, that include reorganization and eventual continuation of operations.

California Property Tax Exemption for Charities: A Primer

Around the nation, there are frequent news stories about the dire financial straits of state and local governments. Beleaguered officials and legislators desperately seek ways to limit the money-flow out of government coffers and to spot ways to increase revenue.
It’s no wonder, then, that there’s been a lot of interest in recent years in the philanthropy sector and its generous tax breaks.
At the federal level, the 501(c)(3) income tax exemptions along with the  related charitable deduction benefits to charity donors account for huge amounts of money lost to the U.S. Treasury. But any such diverted monies would have gone, if collected, into the general fund of the United States government.
It’s an entirely different situation with property taxes; that’s a matter for states and their subdivision counties and municipalities. Although each state has its own laws and rules on collection and allocation of property taxes, this stream of income is critical – everywhere – to providing key local services including police, fire, public works, and social service programs.
Property tax exemptions, then, remove many key parcels of otherwise taxable real estate. This is a particular drain in communities with one or more large universities and health care institutions.
In “Local Governments Eager to Snag Revenue from Nonprofits,” we explained how politicians around the nation have been creative in squeezing the nonprofit sector. In particular, there has been a proliferation in recent years of “special fees,” “payments in lieu of taxes” (PILOTs), and assaults on property tax exemptions.
It’s happening here in California, too. But a special feature of the Golden State’s property-tax exemption law makes it more difficult for legislators put a big bulls-eye on our philanthropic organizations for budget enhancement. California’s exemptions are constitutional, instead of merely statutory. That’s not the case, generally, around the nation, so lawmakers there have an easier time of diluting or eliminating property tax breaks.  

 The Welfare Exemption

The California Legislature has the authority to exempt property (1) used exclusively for religious, hospital, or charitable purposes, and (2) owned or held in trust by nonprofit organizations operating for those purposes. This exemption is known as the Welfare Exemption and was first adopted by voters as a constitutional amendment on November 7, 1944. When the Legislature enacted section 214 of the Revenue and Taxation Code to implement the Constitutional provision, a fourth purpose—scientific—was added to the three mentioned in the Constitution.

There are certain key limitations, though, including:

(1) The owner is not organized or operated for profit. [There are certain looser restrictions for hospitals.]

(2) No part of the net earnings of the owner inures to the benefit of any private shareholder or individual.


(3) The property is used for the actual operation of the exempt activity, and does not exceed an amount of property reasonably necessary to the accomplishment of the exempt purpose.

An important additional restriction is “the charitable [and/or other exempt] activities must be found to primarily benefit persons within the geographical boundaries of the State of California.”
Qualification for the Welfare Exemption sounds a lot like 501(c)(3) qualification, but the property tax exemption is much more restrictive. Put another way, all successful Welfare Exemption applicants are 501(c)(3)s, but not all California 501(c)(3)s are eligible for the Welfare Exemption.  And waving the 501(c)(3) determination letter – alone – is not enough to make an an organization or its property exempt from California property taxes.
Of course, the devil is in the details; there are many hoops to jump through to establish the organization’s eligibility.
There are some additional exemptions available to select organizations.

  Two-Tiered Procedure for Welfare Exemption

There is a two-tiered system for determining eligibility for the Welfare Exemption. It involves both the California Board of Equalization (BOE) and the Assessors’ Offices of each county.
Organizations claiming eligibility for a property tax exemption apply first apply to the Board of Equalization for an “Organizational Clearance Certificate.”  The role of the BOE is to determine if the applicant-organization, itself, is a qualified, eligible applicant.
Next, an approved organization applies to the Assessor’s Office of the county in which the particular real estate parcel in question is located or being used for a determination that the property, itself, meets the stated criteria.  The County Assessor may deny any exemption claim if the proposed or actual use does not meet the qualifications.
Eligibility for California’s property tax exemption is on a year-by-year basis; claims must be filed annually.  
By the way, revenue from collection of property tax remains with the county in which it’s collected and is available for exclusive use by local governments. “State laws control the allocation of property tax revenue […from the key fund, the “1 percent rate”…] to 4,000 local governments with K-14 [school] districts and counties receiving the largest amounts. The distribution of property tax revenue, however, varies significantly by locality.”


The Board of Equalization publishes detailed information on its website, including  “Publication 149 – Property Tax Welfare Exemption,” several other helpful guides, forms, order forms, and county assessors’ information.

What is an Executive Committee?

In “Lessons for Charity Governance From Sweet Briar and San Diego Opera,” we highlighted two instances in which, under the prior leadership just ousted, it was clear that a small group of insiders had dominated and overwhelmed the boards of directors almost off the proverbial cliff.
So what exactly is a corporate executive committee?  Is it necessary? Is it a valuable element of governing any corporation, including a nonprofit one, or has it outlived its traditional usefulness?
The corporate governance model is similar around the United States, but each jurisdiction has its own precise laws and rules.

Executive Committees under California Law

The California Nonprofit Public Benefit Law is the statutory scheme that governs most of this state’s organizations that have 501(c)(3) federal tax exemptions.
The key governing principle is that “[e]ach corporation shall have a board of directors.” Generally, “…the activities and affairs of a corporation shall be conducted and all corporate powers shall be exercised by or under the direction of the board….” (Section 5210 of the California Corporations Code; emph. added) The “shall” language means that it’s mandatory.
But – and this is a big “but” – “[t]he Board may delegate the management of the activities of the corporation to any person or persons, management company, or committee however composed, provided that the activities and affairs of the corporation shall be managed and all corporate powers shall be exercised under the ultimate direction of the board.”
And there’s more: Either under authority of the corporate bylaws, or by a resolution adopted by a majority vote, “[t]he board may, … create one or more committees, each consisting of two or more directors, to serve at the pleasure of the board….” Section 5212(a).
These are known as “board committees” and that can be structured to have all of the board’s usual power and authority, except to do certain important things, for example:

  • change the bylaws
  • fix the compensation of directors
  • fill board vacancies

Such a “board committee” would include a so-called executive committee.
Within certain limits, California public benefit corporations have a lot of leeway to structure a governance system that works for them.  But what can be created can also be changed – if it turns out to be a bad idea.

Are Executive Committees Obsolete?

Traditionally, executive committees were useful and necessary because they have the authority to act (on most issues) in between regularly scheduled full board meetings or  “in an emergency whenever quick and decisive action is called for.”
But in today’s world of email and videoconferencing, there’s a legitimate argument that executive committees have have become “obsolete.”  There are helpful analyses here, here, and here from respected and knowledgeable experts on the relative pros and cons of the modern-day executive committee.
The biggest danger is that, all too often, a strong executive committee (usually combined with a dominant chief executive officer) will run amok:

In almost every board with a strong, active Executive Committee, the board as a whole is disengaged. That should come as no surprise – the board’s role has been usurped by the Executive Committee! When the Executive Committee has already discussed the ‘good stuff,’ the only remaining role for the board as a whole is to act as a ratifying body.


That’s what happened at Sweet Briar College and at the San Diego Opera, and countless other well-meaning organizations that have made a wrong turn. The good news, though, is that this imbalance of power can – and should be – corrected.

Whistleblower Policy for Nonprofits

It’s not uncommon these days to read news reports about corporate whistleblowers.

Since 2002, these brave people who report wrongdoing have had substantial protection under the federal Sarbanes-Oxley Act. That landmark legislation emerged in the aftermath of high-profile corporate corruption cases in the early 2000s; most notably, Enron. Whistleblowers were key to taking down these economic giants who were guilty of massive frauds.

In California, workers have rights as well under the state’s whistleblower statute. Even before significant amendments effective January 1, 2014, California Labor Code section 1102.5 included protections broader than in the federal statute. 

Sarbanes-Oxley and Nonprofits

We already discussed some of the history of Sarbanes-Oxley in “Written Governance Policies: Which Ones Should a Nonprofit Organization Have?”   The primary focus of Sarbanes-Oxley has been publicly traded companies. But two of its criminal provisions apply to nonprofits as well: one section “prohibit[s] retaliation against whistleblowers and [another section] prohibit[s] the destruction, alteration or concealment of certain documents or the impediment of investigations.”

In this post, we’ll discuss the whistleblower protections, leaving the document retention issue for later.

Section 1107 of H.R. 3763 (Sarbanes-Oxley) amended the existing federal obstruction of justice statute, section 1513 of title 18 of the United States Code. Sarbanes-Oxley added a new section (e):

Whoever knowingly, with the intent to retaliate, takes any action harmful to any person, including interference with the lawful employment or livelihood of any person, for providing to a law enforcement officer any truthful information relating to the commission or possible commission of any Federal offense, shall be fined under this title or imprisoned not more than 10 years, or both.

This new section has “very significant implications,” adding “…protections for whistle blowers and criminal penalties for actions taken in retaliation against whistle blowers”:

It is illegal for a corporate entity—for-profit and nonprofit alike—to punish the whistle blower in any manner. [A company is not allowed to] “… fire, demote, suspend, harass, or fail to promote any employee who reports improper activity – even if the report turns out to be unfounded. The only requirement is that the employee had a reasonable belief or suspicion that wrongdoing had occurred at the time they made their complaint.

California Law: Stronger Than Sarbanes-Oxley

The pre-2014 version of California Labor Code section 1102.5  had already “prohibited employers from retaliating against employees who reported reasonably-believed violations of state or federal laws, rules, or regulations to a government or law enforcement agency.

The amended statute includes an important extra dimension: It extends whistleblower “protection to employees who report suspected illegal behavior: (1) internally to ‘a person with authority over the employee’ or to another employee with the authority to ‘investigate discover, or correct’ the reported violation; or (2) externally to any ‘public body conducting an investigation, hearing, or inquiry.’ Additionally, [it] declares unlawful any employer’s rule, regulation, or policy that prevents the disclosure of reasonably-believed violations of local (in addition to state and federal) laws, rules, or regulations.” (emph. in orig.) 

This change is significant because it expands the time-frame and circumstances of the whistleblowing process, from “reasonably-believed violations” to possible wrongful behavior that is merely suspected. 

The amended section 1102.5 also “imposes liability where any person acting on the employer’s behalf retaliates against an employee who engages in protected whistleblowing activity. In addition, employers and persons acting on their behalf may not retaliate against an employee for disclosing such information or because the employer believes the employee has disclosed or may disclose the information externally or internally.” (emph. in orig.) This new liability for “anticipatory retaliation” is a highly significant expansion; it extends protection to when an employer, or any person acting on its behalf, takes “… adverse action against an employee based on the mere belief that the employee has disclosed or might disclose information about a reasonably-believed violation of federal, state, or local law.”
California employers must now post a notice at the workplace: 

1102.8: An employer shall prominently display in lettering
larger than size 14 point type a list of employees’ rights and
responsibilities under the whistleblower laws, including the
telephone number of the whistleblower hotline . . .  

A violation of any part of revised Labor Code section 1102.5 is a serious matter for employers, who can incur significant civil penalties of up to $10,000 per violation.

What Does This Mean for Nonprofits?

The corporate scandals that prompted the passage of the federal Sarbanes-Oxley Act involved publicly traded, for-profit corporations. Nevertheless, the inclusion of the two criminal statutes that apply to nonprofits was a huge wake-up call to the philanthropic community.

Since then, philanthropy leaders and respected watchdog groups have repeatedly emphasized the importance of responsible corporate governance and oversight.  Government officials have jumped on the bandwagon, too. A key example is the 2008 overhaul by the IRS of the Form 990.  There are tough questions on that annual information return, including about an organization’s whistleblower policy and procedures.  An organization “must develop, adopt, and disclose a formal process to deal with complaints and prevent retaliation.” It must “take any employee complaints seriously, investigate the situation, and fix any problems or justify why corrections are not necessary.”  

California organizations that don’t already have a written whistleblower policy in effect should not rely on sample, online, whistleblower templates – even from respected sources. These examples likely reflect only the federal statute, which is narrower and less stringent than either the former California whistleblower law or the amended version, effective in 2014. 

If an organization already had a whistleblower policy in place when the California Legislature amended and expanded Labor Code section 1102.5, it should review and revise that document to reflect these substantial changes.


Adoption of an explicit whistleblower policy and procedure document is only part of the picture.

First, the organization should carefully review the adequacy of its internal controls – so that opportunities for fraud and misdeeds are lessened or eliminated:

Nonprofits must start by protecting themselves. They must eliminate careless and irresponsible accounting practices. A nonprofit organization would benefit from an internal audit that brings to light weak spots and installs processes that are not vulnerable to fraud and abuse. Written policies that are vigorously enforced by executive staff and the board send a message that misconduct is not tolerated.

Second, in order to comply with both the letter and spirit of anti-retaliation, whistleblower-protection laws, an organization should take steps to mold a new corporate culture: one in which whistleblowers are viewed not as troublemakers or malcontents, but as vital to the honest and efficient operation of the group and achievement of its mission.

The Fourth Way to Sink Your Tax Exemption: Too Much Unrelated Business Income

In “5 Ways to Sink Your Tax Exemption,” we listed the sure-fire ways to jeopardize your 501(c)(3) tax-exempt status.

We’ve already introduced four of them: (1) political activity; (2) too much lobbying; (3) not filing Form 990s; and (yeah, we didn’t post them in order) (5) too much private benefit.

So what’s number four? Actually, you might easily overlook it, too.  It’s too much unrelated business income.

What Does “Unrelated Business Income” Mean?

Many 501(c)(3) public charities receive their support from donations from the general public or government grants. But what happens when these groups generate income from business-type activities — like selling products or services, for example?

Generally, it’s legal, and the organization will not be taxed on this income if the activity is “substantially related” to the charity’s exempt purposes. This revenue remains exempt from income tax even if the activity looks like a business.

But if the group regularly runs a trade or business that is “not substantially related” to its exempt purposes — (except that it provides funds to carry out those purposes), the organization is subject to a special tax called the unrelated business income tax.

The devil is in the details, though, and many of the tricky issues arise in connection with the definition of what is or is not “substantially related” to an organization’s exempt purposes.

Of course, because the question is how the income-generating activities relate to a particular exempt organization’s purposes, it is a highly fact-specific determination that takes into account all of the circumstances.

Here’s how the IRS explains this third part of the three-prong test:

A business activity is not substantially related to an organization’s exempt purpose if it does not contribute importantly to accomplishing that purpose (other than through the production of funds).

Well, that helps, doesn’t it? Not much? Here’s more:

Whether an activity contributes importantly depends in each case on the facts involved.

Still not much help. Here’s even more:

In determining whether activities contribute importantly to the accomplishment of an exempt purpose, the size and extent of the activities involved must be considered in relation to the nature and extent of the exempt function that they intend to serve. For example, to the extent an activity is conducted on a scale larger than is reasonably necessary to perform an exempt purpose, it does not contribute importantly to the accomplishment of the exempt purpose. The part of the activity that is more than needed to accomplish the exempt purpose is an unrelated trade or business.

These rules are probably best explained by examples. Here are a few from the same IRS publication. In each situation, the activity is “substantially related” to the organization’s exempt purpose, so there is no unrelated business income tax.

Halfway House Workshop:

An organization’s stated exempt purpose is to provide a supportive, therapeutic residence for people discharged from alcohol-treatment centers. It operates a furniture shop to provide them full-time employment. Profits from the shop are applied to cover operating costs of the halfway house.

This activity “contributes importantly” to the purpose of aiding the residents’ transition from treatment to a normal and productive life, so there is no unrelated business income tax.

Hospital Sales of Hearing Aids:

A tax-exempt rehabilitation hospital tests and evaluates patients with hearing problems. It sells hearing aids to them.

This activity is an “essential part” of the hospital’s program, and “contributes importantly” to its exempt purposes, so there is no unrelated business income tax.

Youth Residence by Welfare Organization:

A youth-welfare group runs on-site social, recreational, and guidance programs managed and supervised by trained professionals. It also rents out rooms in its building to people primarily under age 25.

This rental activity “contributes importantly” to its exempt purposes, so there is no unrelated business income tax.

New California Worker Laws: How Do They Affect Nonprofits?

Sheepherders in California are special.

They have their own minimum wage. On July 1, 2014, the rate jumped to $1,422.52. That’s a monthly amount, presumably because sheepherding is not your typical, 9-to-5, clock-in/clock-out, kind of gig.

The minimum wage for most other California “employees” is calculated on an hourly basis. And it applies to workers of just about every employer in this state: for-profit, nonprofit, and public/government.

Minimum Wage Rates and Facts

California’s general minimum wage rate went up to $9.00 per hour on July 1st, 2014, and will increase again – to $10.00 per hour – on January 1, 2016.

Who is an “employee” under this labor law?  Outside salespersons aren’t – along with family members of the employer, apprentices regularly indentured under the State Division of Apprenticeship Standards, and “learners,” regardless of age, who may be paid not less than 85% of the minimum wage rounded to the nearest nickel during their first 160 hours of employment in occupations in which they have no previous similar or related experience.

There’s also an exception carved out for nonprofits like sheltered workshops or rehab facilities – under a special license – for mentally and physically disabled workers.

An employee may not agree – or be asked to agree – to work for less than the minimum wage. It’s an obligation of the employer that can’t be waived by any understanding or contract, including a collective bargaining agreement.

It’s also not ok to try squirming out of the minimum wage obligation by characterizing an employee as an independent contractor. There are strict rules about which category applies to a particular person who provides services; there are serious consequences for any mischaracterization.
What about interns or volunteers, you ask?

We’ll get to that a in a few paragraphs, because there’s another new labor law that all employers including nonprofits must follow.

Mandatory Paid Sick Leave

Governor Jerry Brown signed into law on September 10, 2014 the new Healthy Workplaces, Healthy Families Act of 2014.

It takes effect July 1, 2015. Any employee who works in California for 30 or more days within a year from the commencement of employment is entitled to paid sick days, to be accrued at a rate of no less than one hour for every 30 hours worked.

There are detailed rules about the purposes for which this leave may be used, when it is accrued, how the employer must post notices and keep records about this new mandatory benefit, and the procedures and penalties that apply for failing to abide by the law.

The law applies broadly to most private, nonprofit, and public employers: “’Employer” means any person employing another under any appointment or contract of hire and includes the state, political subdivisions of the state, and municipalities.”

It applies to all “employees” except for a few highly specific categories of workers: employees covered by union agreements already providing for paid sick days or equivalent benefits; certain construction-industry workers; in-home supportive home-services providers; and certain air carrier workers.

If your employees don’t fit into any of these narrow categories, the law applies to you and to them.

What about “Interns” and “Volunteers”?

In “The Crackdown on Unpaid Internships: Do Nonprofits Have to Worry?,” we introduced this topic.

In the for-profit sector, the determination of who is an “employee” for purposes of labor and tax laws is a bit simpler than in the nonprofit sector.  True independent contractors are excluded precisely because they are not employees. So that leaves “interns.”  Bona fide, true interns are also outside the definition of “employees” under these laws.

In the nonprofit sector, “employee” doesn’t include true independent contractors and doesn’t include true interns. Then there are volunteers: true “volunteers” are not employees, either.

A lot of unnecessary confusion is created when organizations casually use terms like “volunteer interns” or “intern volunteers.”   It’s important to keep the titles straight.

An intern is not a volunteer (although he or she is not being paid) and a volunteer is not an intern, unless that worker’s activities are truly and exclusively designed to train and educate that person. They are distinct categories – analyzed differently to determine whether general labor and other laws applicable to “employees” apply.

In the earlier post, we defined these two important terms, and included links to primary sources and more information.

In a nutshell, and to recap:


Over the years, there’s been a general misunderstanding by many employers – for-profit and nonprofit – about so-called internships.

A company or organization can’t simply announce an “internship program,” launch it, and expect it to fly without any interference or questions.  Many summer or seasonable hirings, in particular, are just free grunt work wrapped up in pretty packages called “internships.”’  Taking out the trash, fetching coffee, or doing work that otherwise would have to be performed by a paid employee, is not an internship under current law and standards of the federal Department of Labor (Fair Labor Standards Act) and the California Division of Industrial Relations (California Labor Code).

A true, qualified  internship is a program designed and carried out to further the education and training of the intern – not to meet any of the labor needs of the sponsoring company or organization.

The Department of Labor has issued a strict 6-point test, and California’s labor administrators have issued an additional 5-point test that California internship programs must meet.

If each and every one of these 11 criteria are met, then a program is a true and legitimate internship.  Interns in these programs are not “employees” under the federal and state labor laws, and so the sponsor may pay a little bit less than minim wage, much less than minimum wage, or nothing at all.

Otherwise, whether or not these workers are called “interns,” the sponsor must abide by all of the rules and regulations relating to “employees,” including minimum wage and overtime laws, and now the mandatory sick pay law.


Federal and state officials recognize the long, honored history of volunteerism in philanthropic organizations, and the valuable role that volunteers play in advancing the charitable mission.

Nonprofits and government entities may have “volunteers: individuals who perform “hours or service . . . for civic, charitable, or humanitarian reasons, without promise, expectation or receipt of compensation for services rendered.”
If It’s a true volunteer situation, then laws like minimum wage, overtime, and paid sick leave do not apply.

Congress did not intend to discourage or impede volunteer activities undertaken for civil, charitable, or humanitarian purposes, but expressed its wish to prevent any manipulation or abuse of minimum wage or overtime requirements through coercion or undue pressure upon individuals to “volunteer” their services.

Both the federal Fair Labor Standards Act (FLSA) and California wage and hour laws define what constitutes a volunteer. The definitions are not identical and are a bit vague, but they do provide some guidance.

Under the federal test of what is  “ordinary voluntarism”a variety of factors are considered, including whether the services are of the kind typically associated with volunteer service, whether the activity is less than full-time and ongoing (rather than seasonal or short-term), and whether regular employees are displaced.

Volunteers may be paid small amounts only, including reimbursement of reasonable expenses, other minor benefits, and minimal stipend amounts. (This is unlike the internship situation, where the intern may be paid more than small amounts, but still less than the full minimum wage.)
Two additional points. First, an employer cannot ask an employee to volunteer some extra hours doing the same work for which he or she is paid. Second, if an individual volunteers in a part of a nonprofit that is commercial and that serves the public, such as stores or restaurants, that person is no longer a “volunteer” and must be paid at least minimum wage.


If, next summer, students come knocking at your organization’s door looking for work, be careful and proceed with caution.

If the work these people perform is ordinary volunteerism, and they don’t expect any compensation, you may be able to classify them as volunteers. If the purpose and nature of the work is education and job-training – rather than benefiting your organization or the public – then you may be able to legitimately classify them as interns.

If the situation doesn’t fit within either of these categories – or it’s a bit of both! –  then no matter what you call it, the job is minimum-wage employment, and you have to dot all the Is and cross all the Ts of the labor laws, including payment of minimum wage and overtime, compliance with payment deadlines and record-keeping, and sick-pay accrual if the time frame is long enough.

"Inurement and Private Benefit Have Often Been Confused"

That’s what the Exempt Organizations Division tells its people who are tasked with approving (or denying) section 501(c)(3) tax exemption applications.

It’s also why our last blog post was titled “How to Torpedo Your Tax Exemption: The Fifth Way” instead of “How to Torpedo Your Tax Exemption: The Fifth (Private Benefit) and Sixth (No Inurement) Ways.”

Although they are distinct rules – and each can stand alone as a reason for denying or revoking a 501(c)(3) tax exemption – some of our posts, like this one, will cover them together. All too often, an organization violates both rules with the same (prohibited) practices and activities.

And whether or not they occur together, commentators often mix up the terminology and glop them together anyway.

Violating Both Prohibitions: The Case of the Gallery Guys

Here’s an example right out of the Treasury Regulations on section 501(c)(3) of the Internal Revenue Code.

A group of art enthusiasts got together to create a museum to display works of art to the general public. They formed a nonprofit corporation, applied for and received tax-exempt status under section 501(c)(3), and spent the first two years raising funds, and selecting, acquiring, and outfitting a suitable facility.

By the third year, new directors were elected. These new folks, though, had a special motivation for serving on the board of trustees. Each was a local art dealer.

The trustees authorized the organization to use most of its revenue to buy artwork from their own galleries – at higher than fair market value. The art was, indeed, on display for the general public to enjoy, but it was also available for sale to these patrons.

If the organization had proposed this type of operation on its application for tax exemption, it would never have made it through the initial IRS screening. But it has morphed significantly from the original plans. As it currently operates, it is just like any commercial art gallery. It’s no longer organized and operated exclusively (or primarily) for “exempt purpose”: running a public museum.  Its activities are substantially for the private benefit of the trustees in their individual capacities as art dealers. And, since the organization bought the artwork at inflated prices from the trustees, the net earnings improperly “inured” to the benefit of these insiders.

So, here, there is both substantial private benefit along with inurement of net earnings away from the organization and into the pockets of the trustees. Both are prohibited; each is prohibited.

The transactions  – each purchase of artwork from a trustee at the inflated price – is also an “excess benefit transaction” that would subject the organization and the individual trustees to penalties and would be independent, additional grounds to revoke the tax exemption.

Distinctions Between Private Benefit and Inurement

The Private Benefit Rule and the No Inurement Rule can – and often do – coexist, although they are not identical.

The No Inurement Rule involves the diversion of funds from the organization to one or more “insiders.”  And it applies even when the diversion is small, or a one-time matter. There is no de minimus exception.

The Private Benefit Rule “does not necessarily involve the flow of funds from an exempt organization to a private party.” The benefit can be intangible and not monetary at all. Also, private benefit – if it is substantial enough – can trigger denial or revocation if it’s aimed at any group of designated people, not just insiders.

“Of course, in most cases, private benefit occurs with respect to entities or person that have some relationship with the persons controlling the exempt organization. “

Excess Benefit Transaction Penalties

Almost 20 years ago, Congress added an extra weapon in the arsenal against dodgy practices by wayward 501(c)(3) organizations and insiders. Internal Revenue Code section 4958  adds intermediate sanctions for “excess benefit transactions.” The penalties may be imposed by the IRS either in addition to revoking an organization’s tax-exempt status, or instead of it, when the excess benefit “does not rise to a level where it calls into question whether, on the whole, the organization functions as a charitable . . . organization.”

In the Gallery Guys example, the excessive purchase/sale price of artwork by and from the trustees would trigger serious penalties under section 4958 in addition to triggering grounds of revocation of the tax exemption.

"Uh Oh. It’s the End of the Year and We Have Money Left Over!"

You’re a nonprofit. You’re panicking.

That November fundraiser was a huge success.  You have money to burn. But will your tax exemption go up in smoke on December 31st?

No — so relax.

Clarification: When you and we and almost everyone else in the nonprofit community use the word “nonprofit,” it usually means the type of organization that has successfully jumped through the proper state and federal hoops to receive the most favored, section 501(c)(3), tax-exempt status.

That’s the one that lets you off the hook for regular income taxes and makes you eligible for grants and tax-deductible contributions.


But it doesn’t mean that — by one minute before New Year’s Eve — you have to spend every last cent that you’ve taken in.

It’s the Nonprofit, Charitable Purpose that Counts

A nonprofit can make a profit.

Simply put, even though a nonprofit is not created for a profit-making purpose, it is allowed to make some profits along the way to fund its good works.

 State corporate law

Under state law — California’s, for example — the key distinction between a nonprofit corporation and a for-profit corporation is the reason why it was formed.

A traditional for-profit exists to make money for its shareholders. (There are now new forms of hybrid, for-profit corporations — social enterprises — but more about that in later posts.)
A nonprofit is different: Its purposes must be “public or charitable” instead of profit-centered for the benefit of private individuals.

Under California law, a nonprofit is allowed to carry on “…a business at a profit as an incident to the main purposes of the [nonprofit] corporation.” And, of course, having the good fortune to collect more in donations than is needed in a particular year to cover expenses, is also ok.

Federal tax law

An organization that wants the prized, 501(c)(3), federal tax exemption must first show that it is formed for nonprofit purposes under state law.

Then, it must demonstrate that it is “organized and operated exclusively” for one or more “exempt purposes” — and not for the benefit of private interests.

There is a long paragraph in the tax code with examples of “exempt purposes” —  but it boils down to roughly the equivalent of the state’s definition; namely, “charitable and public” purposes.

That doesn’t mean though, that a nonprofit can never have a surplus. It can receive grants and donations, and can have activities that generate income, so long as these dollars eventually are used for the group’s tax-exempt purposes. If there is money left over at the end of a year, it can be set-aside as a reserve to cover expenses in the next year or beyond.

Spending Down All Income Each Year is Fiscally Irresponsible

So having some money in the nonprofit’s bank account at year’s end is not only allowed — it’s the prudent way to run the organization.

For instance, if a nonprofit had to spend 100% of its funds each year, it would have no way to pay ordinary operating expenses coming due in early January.  There would be a frantic race each December to use existing funds — down to the last penny — for the tax-exempt purposes, followed by a massive fundraising campaign each January 1st.

Maintaining a financial cushion is good money-management and it’s legal.

It Can’t Really be That Simple, Right?

Right. There are a few “buts.”

Generally, a nonprofit can safely make a profit, as long as its primary purpose is to carry on and advance its tax-exempt goals and activities.

But, sometimes, the income from certain types of money-making activities may be taxed. These rules came about because for-profit businesses that ran the same type of profit operations as nonprofits wanted to level the playing field.

So which circumstances will trigger this tax obligation?  It all depends on whether the nonprofit makes a profit from a “related” business activity or an “unrelated” business activity.

If the activity is “related” to the nonprofit’s stated (exempt) purposes, then the money received is not usually taxed. But if the activity is “unrelated,” the profit is subject to a special tax called the “unrelated business income tax.”

Those are some fairly complicated rules that we won’t cover right now.  Here is a handy, comprehensive IRS publication that gives a useful introduction to this complex topic. We’ll just point out that nonprofits spend a lot of time and money trying to persuade the IRS that their income-generating activities are related to, and advance, their exempt purposes.

One More Thing

If  a nonprofit’s unrelated money-making activities get too big and swallow up the charitable goals, then the organization can lose its tax exemption. The IRS comes to the conclusion that it wasn’t organized and operated exclusively for charitable purposes after all. There are mechanisms that can be used to address this scenario – including forming a profit making subsidiary or joint venture. More on that in a later post.