The Problem of Risk to Nonprofits
Lawyers often advise to “separate valuable assets from risky activities.” It’s a legal maxim with which nonprofit directors and officers should be familiar. Keeping valuable assets away from risky activities may provide an organization with protection in the event of a lawsuit or other liability. Exempt organizations have sometimes used 501(c)(2) title-holding corporations or other tax-exempt corporate structures to provide such protection. Nonprofit leaders should be aware of the protections available through such risk management options.
Consider the following scenario: A terrible accident occurs on the grounds of a nonprofit preschool. Multiple parties later sue the preschool for accident-related injuries. The preschool has substantial and valuable real property holdings. If the preschool is held liable for damages resulting from the accident, the outcome for the church may be catastrophic. The organization’s insurance protection may be stretched beyond policy limits. If the insurance coverage limits are reached or portions are outside the scope of the coverage itself, the organization is ultimately responsible. In a worst-case scenario, a court may order liquidation of the organization’s real property to pay the judgment.
Mitigating Risk and Other Benefits – the 501(c)(2)
Dating back to 1916, Congress has provided nonprofit entities with a means to mitigate risk. Presently, the 501(c)(2) title-holding corporation provides such protection. A 501(c)(2), like its section 501(c) siblings, is exempt from federal income tax. The (c)(2), however, has a single limited purpose: to hold title to property on behalf of another exempt entity. A (c)(2) is generally controlled by a parent tax-exempt organization, and the (c)(2) holds title to property (which can be real, personal, or intellectual property), which may be used for the parent’s exempt purposes. Income from the (c)(2) passes to the parent. In theory, if the parent organization is sued, as in the above example, its liability from potential damage suits should be limited to the organization itself, and not the separate legal entity that holds title to the property held. In reality, the limitation of liability will depend on several variables, such as proper legal structuring of the entities and the organizations’ observance of corporate formalities. Before structuring such an arrangement, interested entities should consult with experienced legal counsel.