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Why Nonprofits Should Not Make Loans to Directors and Officers

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why nonprofits should not make loans to directors and officers by davis law group pc in chesapeake, virginia

Why Nonprofits Should Not Make Loans to Directors and Officers

May 8, 2024 Davis Law Group

Nonprofits generally should avoid making loans to officers and directors even though Virginia does not prohibit such loans.

In fact, under Va. Code § 13.1-826(9), nonstock corporations explicitly have the power to lend money and credit to directors and officers.

Even though making loans to officers and directors is allowed under Virginia law, nonprofits that are exempt from federal income tax under 501(c)(3) must comply with the IRS’s prohibitions on private inurement and excess benefit transactions. Essentially, these prohibitions prevent nonprofits from giving their resources and funds directly or indirectly to benefit private parties as opposed to the public. Private parties include insiders, such as directors and officers. Nonprofits can reasonably compensate directors and officers for their services, but directors and officers may not receive additional benefits without providing commensurate consideration in return.

If a nonprofit violates the prohibition on private inurement, it could lose its tax-exempt status. If it violates the prohibition on excess benefit transactions, the nonprofit and the individual receiving the benefit could face a fine ranging from 25% to 200% of the value of the benefit. For example, if a nonprofit gives an excess benefit of $10,000 to a director, the director may be fined $2,500. This fine is in addition to returning the excess benefit to the nonprofit. If the director does not return the excess benefit within a statutorily defined period, the IRS can increase the fine to $20,000 and impose additional fines on the nonprofit and any managing individual who authorized the excess benefit.

A loan could potentially count as private inurement or an excess benefit if its terms are not fair or reasonable to the nonprofit. Therefore, nonprofits should adopt certain policies and procedures to ensure that any loans made to directors or officers are fair and reasonable.

Having and following a conflict-of-interest policy can increase the likelihood that any transaction with a director or officer is fair to the nonprofit. All directors have a duty of loyalty to the nonprofit. This duty requires directors to make decisions in the best interest of the organization. When a nonprofit considers making a loan to a director, this presents a conflict of interest because the director, in his individual capacity, will want to negotiate terms that favor himself. However, in his capacity as director, he also has a duty to negotiate terms that favor the nonprofit. A conflict-of-interest policy ensures that directors continue to make decisions in the best interest of the nonprofit even when personal interests are involved.

The policy should require that only disinterested directors consider and vote on whether to make the loan. The interested officer or director must disclose all material facts so that the disinterested directors can make an informed decision. The voting directors should document their decision-making process and record all the sources they consult. They should ensure that the loan is comparable to loans made by similar organizations in that industry and area. This could require consulting common rates, values, terms, and practices. The disinterested directors should make the terms as favorable as possible to the nonprofit and act as if they were negotiating with a third party.

Even before a situation arises in which the nonprofit must decide whether to make a loan to an insider, each director and officer, upon first taking office, should certify in writing that they will comply with the conflict-of-interest policy. Upon any re-election or re-selection, the directors and officers should re-certify that they agree to abide by the policy.

It is important to note that the IRS requires nonprofits to report all loans that they have made during a fiscal year on Form 990. Form 990 is the tax form that exempt organizations must file with the IRS every year. Once on file with the IRS, this form is available to the public. So, any prospective donor (or even opponent of the nonprofit) can discover to whom the nonprofit has made a loan and how much the loan was. A loan to a charitable insider may also draw the IRS’s attention, which may result in an audit. Therefore, although it is possible for a nonprofit to make a loan to an officer or director under certain conditions, it is likely in the best interest of the nonprofit to avoid such a conflict of interest.

Davis Law Group Can Help

If you have any nonprofit needs ranging from entity creation to dissolution and everything in between, make an appointment with our experienced nonprofit attorneys today. We can provide expertise on legal matters that are critical to the function and success of charitable, nonprofit organizations in Virginia. Contact us today.