The Personal Liability Risks of Nonprofit Board Service
Serving on the Board of Directors of a nonprofit organization can be a rewarding experience that offers the chance to give back to a meaningful cause while providing a learning experience and opportunities to deepen one’s connections and stature within the community. However, this positive experience comes with a level of personal liability exposure under certain circumstances. It is important to be aware of the different personal liability risks that Board service entails, as well as the legal protections that apply to Board members and best practices that will mitigate these risks.
1. Standards of Conduct
To properly understand the personal liability risks of serving on a nonprofit Board of Directors, it is first necessary to understand the standards of conduct required of Board members (also called “directors” or sometimes “trustees”). Board members who fall short of these standards are at much greater risk for becoming personally liable.
These standards are generally expressed as a Board member’s fiduciary duties. Under state nonprofit corporation law, nonprofit Board members owe two distinct fiduciary duties to the organization: a duty of care and the duty of loyalty. Some practitioners also point to a third duty: the duty of obedience to the organization’s mission, Articles of Incorporation and Bylaws, policies, and applicable laws, rules, and regulations (although the duty of obedience is often viewed as a part of the duty of loyalty).
The duty of care is typically codified in the applicable state nonprofit corporation law as a requirement that Board members discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.
In practice, this generally means that directors must: (1) attend Board and Committee meetings regularly; (2) stay adequately informed about the organization’s activities and finances (particularly major transactions and potential liabilities), such as by reviewing corporate documents, meeting materials, and financial statements, and asking questions when appropriate; (3) make reasoned and deliberate decisions, consulting experts when necessary, and (4) adequately hire and supervise officers and management staff.
The duty of loyalty is typically codified in the applicable state nonprofit corporation law as a requirement that Board members discharge their duties in good faith and in the manner the Board member reasonably believes to be in the best interests of the corporation.
In practice, this generally means that directors must: (1) avoid entering into transactions with the organization that contain terms that are more favorable to the director than to the organization; (2) avoid diverting to themselves opportunities which in fairness ought to belong to the corporation; (3) fully disclose to the other Board members all information that is relevant to the Board’s decision-making or oversight functions; and (4) maintain the confidentiality of information the person knows or has reason to know is confidential.
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2. Sources of Personal Liability Exposure
Board members can generally be held personally liable for breach of fiduciary duties, particularly in cases involving egregious neglect of the Board member’s oversight responsibilities or the receipt of a personal benefit from the organization’s assets or resources (sometimes referred to as “private inurement”). State nonprofit corporation law generally specifies when the misconduct has risen to a level that can trigger personal liability.
Enforcement actions involving a breach of fiduciary duties can be brought by the state attorney general, and sometimes, depending on the nature of the misconduct, by the IRS and other federal agencies. In certain circumstances, the organization’s other directors, officers, or voting members can bring a lawsuit on behalf of the organization to enforce breaches of fiduciary duties through a “derivative action.” Occasionally, other individuals or stakeholders with a special relationship to the organization may have standing to sue for breaches of fiduciary duties, but this is relatively rare.
Another major area of personal liability risk involves federal tax laws. Most significantly, Board members can be personally liable for an organization’s failure to timely file and pay payroll taxes (similar provisions often apply at the state level). This is an area of aggressive IRS enforcement, so Board members should pay close attention to make sure payroll taxes are timely filed and paid, and workers are properly classified as employees rather than independent contractors when appropriate.
Board members can also be personally liable for their involvement in “excess benefit transactions” under federal tax law. An excess benefit transaction is a financial transaction between a “disqualified person” (e.g. a director, officer, substantial contributor, or top management level employee) and a 501(c)(3) public charity (or certain other types of tax-exempt organizations), in which the disqualified person receives more benefit from the transaction than does the organization. In other words, a financial transaction with terms that are more favorable to the disqualified person than fair market value would generally be considered an excess benefit transaction. Similar, but more stringent, rules apply to 501(c)(3) private foundations, which in many cases totally prohibit financial transactions between the organization and disqualified persons regardless of whether the transaction is for fair market value.
If a transaction is determined to be an “excess benefit transaction,” the persons involved in the transaction are personally subject to excise taxes called “intermediate sanctions.” The disqualified person who received the benefit must pay an excise tax in the amount of 25% of the “excess benefit,” and this percentage balloons to 200% if the excess benefit is not promptly corrected after a notice of deficiency is issued by the IRS. Additionally, other directors or officers who knowingly approved or participated in the excess benefit transaction can be personally subject to an excise tax in the amount of 10% of the excess benefit (subject to a cap of $20,000 per transaction).
Board members who willfully fail to file Forms 990 or approve fraudulent tax returns (or submit other fraudulent documents to the federal government, such as grant applications or SBA loan applications) can also be subject to fines and even imprisonment.
Additionally, Board members can be held personally liable if they are personally and directly responsible for injuring someone, damaging their property, or infringing on intellectual property rights (even if this act or omission was in connection with an organization activity).
And in relatively rare circumstances, a Board member can be personally liable for an organization’s debts or liabilities if a court decides that the organization’s corporation status is a sham due to failure to follow basic corporate formalities (keeping separate corporation bank accounts that are adequately funded, following the Bylaws, having Board meetings and keeping minutes, etc.). This situation is called "piercing the corporate veil."
3. Limits on Personal Liability
The most fundamental protection for nonprofit Board members stems from structuring the organization as a “nonprofit corporation.” A corporation’s Board members are generally insulated from the debts and liabilities of the organization, except in the circumstances described above. This will protect Board members from liability for most of the organization’s day-to-day operations.
In addition, there are federal and state law protections for nonprofit “volunteers,” which generally covers Board members and other volunteers who are not compensated for their service (except for reimbursement of reasonable and proper expenses, which does not disrupt volunteer status).
The federal Volunteer Protection Act generally makes nonprofit volunteers immune from civil liability unless the action was outside the scope of the volunteer’s authority, or the harm was caused by the volunteer’s willful or criminal misconduct, gross negligence, reckless misconduct, or a conscious, flagrant indifference to the rights or safety of the individual harmed by the volunteer. However, additional conditions may apply, and this law does not make Board members immune from liability to the organizations whom they serve.
Similar protections for volunteers often apply at the state level, as set forth in applicable state nonprofit corporation law. State law volunteer immunity provisions typically exclude willful misconduct, criminal activity, transactions that result in an improper personal benefit of money, property, or service to the volunteer, and bad faith actions that are outside the scope of the volunteer’s authority. Importantly, it is an often a prerequisite to volunteer immunity that the organization maintain an adequate level of liability insurance coverage (which is advisable as a best practice regardless).
Nonprofit organizations can (and sometimes must) provide additional liability protections to their Board members. State nonprofit corporation law usually addresses the circumstances in which a nonprofit corporation “indemnifies” its directors and officers. Indemnification refers to reimbursing directors and officers for the costs of defending lawsuits involving actions taken in their official capacity on behalf of the organization.
State nonprofit corporation law typically provides that a nonprofit corporation must indemnify a director’s and officer’s reasonable expenses to the extent the director or officer is successful in defending himself/herself in a lawsuit or other proceeding involving corporate acts or omissions. And a nonprofit corporation usually may indemnify in other cases unless there is a judgment that fiduciary duties were breached, such as cases involving fraud, criminal activity, or the director's improper receipt of a personal benefit.
Many nonprofit organizations obligate themselves to indemnify their directors and officers to the fullest extent permitted under the law, and this indemnification is typically funded by “Directors and Officers Insurance” (or “D&O insurance”) maintained by the organization.
Planning Tip — It is highly recommended that all organizations maintain D&O insurance. While this article details numerous ways in which Board members are protected from personal liability, this will not necessarily stop people from attempting to sue Board members. Defending even a frivolous lawsuit will require significant upfront costs. D&O insurance provides this crucial protection. And insurance brokers are often a great resource to help you determine the right level of coverage, navigate tricky situations before a lawsuit occurs, and provide advice about best practices that can mitigate risk.
Lastly, depending on the applicable state nonprofit corporation law, a director may be immune to liability to the organization on whose Board the director serves in addition to immunity from liability to third parties as described above (regardless of whether the director is a volunteer). These statutory protections typically exclude the usual egregious circumstances, such as fraud, criminal activity, or the director's improper receipt of a personal benefit. In some cases, this particular immunity applies automatically, and in other cases the organization must directly specify in its Articles of Incorporation that this immunity applies. Therefore, it is important to review the applicable state nonprofit corporation law closely.
While serving on a nonprofit Board of Directors can be a rewarding experience, there is some risk of personal liability. However, the risks can be minimized for Board members who are aware of their legal responsibilities, actively exercise diligence, and ensure that they are adequately protected by insurance and indemnification.
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