This post provides an overview of conflicts of interest through a legal lens by briefly discussing what a conflict of interest is, the legal implications, and the tax implications.
What is a Conflict of Interest?
A conflict of interest, broadly, is any situation in which a decision-maker for an organization has a financial or other interest in, or relationship with, an entity or person that does business with the organization.[1]
Legal Overview of Conflicts of Interest
There are legal restrictions on certain types of conflicts that are important for your organization to keep in mind. The law regarding conflicts of interest stems from a variety of sources: common law (law that is derived from court cases), state statutes, the federal Internal Revenue Code, Treasury Regulations, and Internal Revenue Service publications.[2] An overview of some of these laws follows.
Common Law
Directors of nonprofit organizations are bound by the common law duties of care, loyalty, and obedience. The duty of loyalty requires directors to faithfully pursue the interest of the organization they are serving, rather than protecting or enhancing their own interest or those of another person or organization.[3] The duty of loyalty is implicated when conflict of interest issues arise.
Michigan Statute
The duty of loyalty is further enhanced by statute. Michigan has established standards of conduct for directors of non-profit organizations in its Nonprofit Corporation Act. Amongst other standards, the Act requires directors and officers to discharge their duties “in a manner he or she reasonably believes is in the best interests of the corporation.”[4]
The Act also provides guidance as to when liability attaches to “interested” transactions.[5] A transaction is “interested” if a fiduciary has an interest in the matter due to a personal financial benefit he or she will receive from the transaction.[6] However, if an interested director or officer can establish one of the following, an organization is not legally liable for an interested transaction under the Nonprofit Corporation Act:
(a)
The contract or transaction was fair or reasonable when it was
authorized, approved, or ratified by the nonprofit corporation;
(b)
The material facts of the director’s relationship or interest as to
the contract or transaction were disclosed or known to the board and the
transaction was approved by the board without counting the vote of the
interested director or directors;
(c) The same material facts were known to, and the contract or transactions was approved by, the members of the nonprofit corporation.[7]
Under this framework, your organization can take steps to avoid liability for interested transactions by ensuring: 1) the transaction is fair or reasonable; 2) material facts regarding the interest have been disclosed to the organization’s board/members; 3) the interested director does not have a vote in the matter.
Federal Tax Laws
Of major concern to many nonprofit organizations is maintaining 501(c)(3) tax-exempt status. Your organization could lose its tax-exempt status due to conflict of interest issues or be heavily penalized.
Losing Tax-Exempt Status
The Internal Revenue Service (IRS) can revoke a charity’s tax-exempt status if the charity is not being operated exclusively for charitable purposes under the doctrines of private benefit and private inurement.
Private Inurement
According to the IRS, no part of the net earnings of a section 501(c)(3) organization may inure to the benefit of any private shareholder or individual.[8] Private inurement occurs when “an insider with financial control over a charitable organization is using the organization’s assets for the insider’s personal gain.”[9] Any amount of private inurement will jeopardize a charity’s tax-exempt status. Even small, trivial benefits can result in revocation.[10] This private inurement restriction effectively extends the state-imposed duty of loyalty.[11]
Private Benefit
The IRS also considers another doctrine called private benefit. This doctrine requires a charitable organization to serve “a public rather than a private interest” and “establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.”[12] A private benefit may include an advantage, profit, fruit, privilege, gain, or interest.[13] An incidental benefit to a private individual may not jeopardize a charitable organization’s tax-exempt status if that benefit is conferred in connection with an activity conducted in pursuit of exempt purposes. However, if that activity constitutes more than an “insubstantial” part of an organization’s activities, the IRS may view the organization as not operating exclusively for exempt purposes, jeopardizing its tax-exempt status.[14]
Excise Taxes
The IRS can also impose excise taxes to sanction your organization if it finds that excessive economic benefits were provided to an insider (insiders are people who exercise a substantial level of control over the charity).
Self-dealing of public charities is regulated by Code section 4958. This section permits the IRS to impose excise taxes when a public charity has provided an “economic benefit,” directly or indirectly, to or for the use of any disqualified person where the “value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.”[15]
Disqualified
persons include:
(a)
An individual who was “in a position to exercise substantial
influence over the affairs” of the public charity at any time during the 5-year
period ending on the date of the transaction;
(b)
Family members of such persons;
(c) Certain entities controlled by other disqualified persons.[16]
Summary of
Legal Liabilities
As the legal survey above indicates, conflict of interest issues can lead to real-world consequences for nonprofit organizations. Legal liability in the form of damages, injunctions, revocation of tax exemption, and excise taxes are all possible consequences of conflicts of interest violations.
How Can Organizations Avoid Conflict of Interest Issues?
Adopting
a conflict of interest policy is the best practice for non-profit
organizations. The IRS’ Sample Conflict of Interest Policy incorporates three
steps to ameliorate conflict of interest issues. This model policy helps
organizations to comply with legal obligations, and as a practical matter, can
provide your organization with clear steps to follow in determining whether you
have a conflict of interest issue and how to proceed if so. The IRS’ policy includes:
(1) A duty to disclose by the interested person;
(2)
Uninterested directors deciding if a conflict of interest exists;
(3)
Further procedures for addressing the conflict of interest.[17]
These further procedures include investigating alternative transactions that would not cause a conflict of interest.
Conclusion
While the policy above is just a model, it is instructive in the kinds of safeguards that can ensure legal compliance when conflict of interest issues arise.
Consulting
with an attorney is in your organization’s best interest to ensure that you
have an adequate conflict of interest policy in place to protect you from legal
problems.
By Anna Harkness
[1] Ben W.
Blanton, NONPROFIT CONFLICTS OF INTEREST -
SIX DEGREES OF SEPARATION,
2007 WL 5269551.
[2] Id.
[3] Id.
[4] Mich. Comp. Laws Ann. § 450.2541.
[5] Mich. Comp. Laws Ann. § 450.2545(a).
[6] Ward v. Idsinga, No. 302731,
2013 Mich. App. LEXIS 1427, at *11-12 (Ct. App. Aug. 15, 2013).
[7] Clark Hill, The
Responsibilities of Service: A Guide for Directors of Nonprofit Organizations
in Michigan (Oct. 12, 2020),
https://www.clarkhill.com/uploads/medium/resource/854/Clark_Hill_Nonprofit_Guide_for_Directors_of_Nonprofit_Organizations_in_Michigan_2019.pdf.
[8] 26 U.S.C.A. § 501(c)(3).
[9] NOTE: A PATH TO "INURE" PEACE:
CONSOLIDATING THE PERPLEXITIES OF THE PRIVATE INUREMENT AND PRIVATE BENEFIT
DOCTRINES, 92 Wash. U. L. Rev. 227, 235.
[10] Id. at 234.
[11] Ben W. Blanton, NONPROFIT CONFLICTS OF INTEREST - SIX DEGREES OF
SEPARATION, 2007 WL 5269551.
[12] Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) (2012).
[13] Am. Campaign Acad. v. Comm'r, 92 T.C. 1053,
1065-66 (1989) (alteration in original) (quoting Retired Teachers Legal Fund v.
Comm'r, 78 T.C. 280, 286 (1982)).
[14] NOTE: A PATH TO "INURE" PEACE:
CONSOLIDATING THE PERPLEXITIES OF THE PRIVATE INUREMENT AND PRIVATE BENEFIT
DOCTRINES, 92 Wash. U. L. Rev. 227, 236.
[15] 26 U.S.C.A. § 4958(c)(1)(A).
[16] 26 U.S.C.A. §4958(f)(1)(D)-(F).
[17] Internal Revenue Service, Appendix
A: Sample Conflict of Interest Policy – IRS Instructions for Form 1023,
(Oct. 12, 2020),
https://fredla.org/wp-content/uploads/2016/01/sample-conflict_of_interest-policy.pdf.