All too often, whether a nonprofit corporation is legally compliant in its operations receives attention only after a conflict or issue arises. Instead, a nonprofit corporation can better prevent such conflicts and protect itself through regular legal audits of its corporate governance, federal and state tax exemption, other federal tax law matters, employment and volunteer issues, intellectual property, and facilities. Financial audits alone, while important, will not sufficiently account for the larger issue of overall compliance with federal, state, and local laws.

A legal audit will include a wide range of information-gathering and reviewing. In auditing the following areas, questions should look both backward (i.e., have we done what is required?) and forward (i.e., what else can we do?). Nonprofit should keep accurate and organized files so that various organizational documents and financial statements are up to date and easy to access.

The following areas and documents should be reviewed for compliance when conducting a legal audit:

Corporate Governance

1. Articles of Incorporation (and any amendments)
2. Bylaws (and any amendments)
3. A list of current board members, officers, and (if applicable) members
4. Meeting minutes (board, membership, annual, special, committee, etc.)
5. Copies of governance-related policies (e.g., conflict of interest policy for directors and officers)
6. Copies of financial statements and budgets
7. Copies of any contracts for services to be rendered or received
8. Copies of any leases and subleases for real or personal properties
9. Copies of insurance policies

Questions to Consider:

• Do the Articles and Bylaws correctly describe the nonprofit corporation as it operates today? Do the Articles and Bylaws comply with applicable tax and corporate laws?
• Do the Articles and Bylaws state the same or similar purpose statements that are consistent with each other?
• Have all board resolutions been properly taken and documented?
• Have all elections been properly held and documented?
• Have governance policies been reviewed for consistency with practice?
• Have any officers or directors disclosed a conflict of interest, and if so, was it properly recorded and voted upon, in accordance with the corporation’s conflict of interest policy and applicable laws?
• Does the corporation have directors and officers (D&O) insurance? What types of acts and omissions are covered and not covered?
• Does the corporation have commercial general liability insurance? What types of acts and omissions are covered and not covered?

Federal Exemption Filings

1. Application for 501(c)(3) tax-exempt status (IRS Form 1023)
2. IRS determination letter granting 501(c)(3) tax-exempt status
3. Copies of IRS Form 990 (for at least three years)
4. Copies of any communications with the IRS

Questions to Consider:

• Are the nonprofit corporation’s Form 1023 and past three filings of Form 990 available for inspection at the principal location?
• Has the purpose or activities of the corporation changed significantly since applying for tax-exempt status? Have such changes been reported to the IRS?

Other Federal Tax Law Issues

1. Private benefit and private inurement (see Private Benefit Rules – Part I: Private Benefit Doctrine; Part II: Private Inurement Doctrine; Part III: Excess Benefit Transaction Rules)
2. Lobbying (see Introduction to Lobbying by Public Charities; The Value of Making the 501(H) Election; Lobbying & Grants to Non-501(c)(3) Entities: Know The Rules)
3. International activities (see Nonprofits – International Charity Activities)
4. UBIT (see Unrelated Business Income Tax Explained; Unrelated Business Taxable Income – What Doesn’t Count?)
5. Public support tests (see Public Charity: Public Support Test Part I; Part II) or private foundation rules (see Private Foundation Rules)

Questions to Consider:

• Do the directors and officers of the nonprofit corporation understand the restrictions under 501(c)(3)?
• Is the corporation engaged in any unrelated business activities? If it is, are such activities substantial in relation to the corporation’s overall activities and is the corporation paying unrelated business income tax and filing IRS Form 990-T, as required?
• If the nonprofit corporation is engaged in international grantmaking, does it use expenditure responsibility or properly vet the grantees with an equivalency determination (required for a private foundation, generally recommended for a public charity)?
• Is the nonprofit continuing to meet certain critical financial ratios (e.g., solvency, public support test)?
• Does the corporation send written acknowledgements and disclosures to donors in accordance with IRS regulations? See IRS Publication – Charitable Contributions: Substantiation and Disclosure Requirements

State-related Documents

1. State tax-exempt status determination letter and initial filings
2. Copies of annual state filing requirements (e.g., Franchise Tax Board)
3. Copies of communications with the Secretary of State and/or Attorney General (or other appropriate state charity official)
4. Registrations to engage in charitable solicitations (where applicable)
5. Certificates of authority to conduct business in a jurisdiction
6. A list of jurisdictions in which the corporation conducts business, solicits funds, etc.
7. Records of gross receipts from sales and total purchase prices of all tangible personal property purchased for sale or consumption for sales and use tax purposes (if applicable)
8. Seller’s permit, if such is required for a retailer of tangible personal property subject to sales tax

Questions to Consider:

• Is the nonprofit corporation registered and current with applicable state agencies? In California, this includes the Secretary of State, Attorney General, and Franchise Tax Board.
• Is the corporation in compliance with charitable solicitation laws and registrations in all jurisdictions in which it solicits funds?
• Has the corporation determined whether its purchases are subject to tax or whether it should collect taxes on its sales? Unlike many other states, California does not provide a blanket exemption from its sales and use taxes to charitable organizations.

Employment & Volunteer Issues

1. Copies of employment contracts and time sheets
2. Copies of employee or independent contractor eligibility verifications
3. Records of taxes withheld
4. Copies of meeting minutes where executive or other employee compensation was reviewed
5. Copies of HR-related policies (e.g. hiring processes, performance management, preventing discrimination and harassment, termination processes)
6. Copies of volunteer and participant waivers or agreements (if applicable)
7. Training materials for board, management, staff, and volunteers

Questions to Consider:

• Is the nonprofit corporation correctly characterizing its workers as employees or independent contractors? See Topic 762 – Independent Contractor vs. Employee
• Does the corporation post the required notices in the workplace?
• Has the corporation reviewed the overall compensation to any employee to ensure that it is reasonable? For executives, was the compensation package approved in advance by an independent body, who reviewed appropriate comparability data and concurrently documented its decision? See Executive Compensation – The Legal Issues
• Does the corporation have an orientation process for board members? Do board members understand their fiduciary duties?
• Does the corporation properly screen prospective employees and volunteers, including background checks when appropriate?
• Are the volunteer and participant releases and waivers used consistently? Do they adequately protect the corporation from liability?

Intellectual Property

1. List of copyrights, trademarks/servicemarks, patents, and registrations (if any)
2. Description of trade secrets (including donor lists) and protective steps to ensure they remain trade secrets
3. Any policy documents regarding using other intellectual property (“IP”) and/or protecting the corporation’s IP
4. Copy of website domain name agreement

Questions to Consider:

• What are the nonprofit corporation’s risks of infringement of the intellectual property rights of other parties?
• How does the corporation protect its own intellectual property?
• Is the corporation complying with any provisions in third party agreements regarding non-disclosure of confidential information?
• Is the information on the corporation’s website up-to-date and accurate and does the corporation have the requisite authority to publish all of the content (including photos and videos) on its website?

Facilities

1. Copies of the lease agreement(s) and any subleases to tenants
2. Copies of any original applications for property tax exemption and copies of annual assessor filing requirements (where applicable) (e.g., Board of Equalization and County Assessor)
3. Copies of insurance policies
4. Copies of any zoning ordinances or regulations that affect the corporation’s location

Questions to Consider:

• Is the nonprofit corporation complying with the terms of its lease agreement? Is the corporation subleasing to other tenants? Is that sublease permitted under the master lease?
• Does the corporation have sufficient insurance related to its properties and facilities?
• Is the corporation in compliance with various workplace laws applicable to it (e.g., OSHA, ADA)?

Local Issues

1. Copies of any city and county registrations
2. Copies of lobbying registrations and periodic reports (if applicable)
3. Copies of property tax reporting/payments (if applicable)

While the beginning steps of a legal audit can seem overwhelming, that should not be a reason to avoid it. The benefits of a legal audit are two-fold—not only does it bring a sense of reassurance but it may also help a nonprofit corporation determine whether its current way of conducting business “makes sense.” In turn, a nonprofit corporation can reform or correct past practices—improving record keeping procedures, restating a patchwork of Bylaws or Articles amendments into one clean document, instituting a new filing system, and the like—to help facilitate rather than hinder the ability to undergo a legal audit in the future.