Disposing of assets of a nonprofit corporation, whether tax-exempt or taxable—or liquidating or dissolving such an entity—can be wrought with traps for those unfamiliar with the additional legal regimes and other considerations that overlay nonprofit organizations. Unlike their for-profit brethren, which include corporations, limited liability companies, and partnerships, nonprofit corporations are not free to dispose of assets with just a vote of equity holders. There are, however, paths that allow for the orderly sale of assets and liquidations as well as alternative structures available to financially distressed nonprofit corporations to navigate.
Most, if not all, state statutes governing the formation, operation, and dissolution of nonprofit business corporations (sometimes called nonstock corporations) grant a state agency oversight authority over the operations and dispositions of such organizations. However, according to “State Regulation and Enforcement in the Charitable Sector,” a September 2016 research report published by the Urban Institute: “No single state law of charities oversight exists; instead, oversight involves a complex mix of substantive areas, including charitable trust law, governance, criminal law, solicitation and registration requirements and compliance, corporate transaction review, and conservation easements.” This morass of state regulation becomes even more difficult to navigate for financially distressed nonprofit organizations.
The rationale behind the additional layer of regulation imposed on nonprofit organizations results from the fact that such entities do not have “owners” or equity holders to whom management is accountable. Nonprofit organizations are structured and operate for the benefit of the public at large or for a specific group of people, with no individual having the right to demand or expect some sort of financial return on investment. In lieu of equity holders who are due certain fiduciary obligations from management, a state regulatory authority is charged with being the voice and actor for the public writ large.
Having members does not eliminate this construct of public accountability for a nonprofit organization. Typically, the agency with oversight responsibility for nonprofits is the state attorney general. In some states, however, a specific charities division may exist, either within the attorney general’s office or as part of another agency. Generally, state oversight agencies also scrutinize how nonprofit organizations raise money from the public and how they use that money for the benefit of the public.
Taking into account this background, it should come as no surprise that the disposition of assets held by a nonprofit organization is subject to scrutiny. Under most state statutory frameworks,1 a nonprofit corporation cannot sell or dispose of its assets outside of the ordinary course without obtaining approval from either a court or a state’s attorney general or charities division. In addition, Section 12.03(b) of the Model Nonprofit Corporation Act states: “A person who is a member or otherwise affiliated with a nonprofit corporation may not receive a direct or indirect financial benefit in connection with the disposition of assets unless the person is a charitable [tax-exempt nonprofit] corporation or an unincorporated entity that has a charitable purpose.”
Most states enact some form of these restrictions in their nonprofit laws such that nonprofit assets or property held in trust as a charitable asset is protected from being diverted from its original restricted purpose. In practice, these restrictions of transfer and disposition result in a reporting regime that imposes notice, approval, and waiting period requirements on just about any nonprofit corporation that wishes to or needs to sell or dispose of its assets.
Generally, the assets of a nonprofit corporation can be sold. In completing such a sale, however, notice must be given to the attorney general and in some circumstances, approval must be obtained. Figure 1 sets forth the general requirements, summarizing the general rule. State law governing a particular nonprofit must be reviewed and considered before action can be taken.
Attorneys general or other designated regulatory agencies have the authority to review a proposed transaction between a nonprofit corporation and any buyer that is not a nonprofit tax-exempt corporation, and there is no certainty that the transaction will be approved. If a transaction is completed after the time allotted for regulatory review of the deal has expired, an attorney general may still come back after the fact and oppose the transaction.
Most notification statutes require that the selling nonprofit corporation disclose its full economic situation, including descriptions of its debts, obligations, and liabilities. If a proposed transaction does not result in proceeds that satisfy its debts, obligations, and liabilities, a nonprofit corporation may not be able to dissolve under state law because most state dissolution statutes require a dissolving entity to state that the debts, obligations, and liabilities have been paid and/or discharged or that adequate provisions have been made to satisfy them.
With respect to financially distressed nonprofit corporations, the best course of action when selling or liquidating assets is for such organizations to engage in transactions with other tax-exempt nonprofit corporations. If, however, there are potential buyers for assets that are not tax-exempt nonprofit corporations, careful consideration must be given to the terms of the transaction. Of key concern are the following: Is the amount being paid for the assets fair market value? Is the person buying the assets an independent third party? Is selling the assets in the best interest of the nonprofit corporation? If these key concerns cannot be affirmatively supported in the judgement of a reviewing attorney general, another option may need to be considered.
When Selling Isn’t an Option
Financially distressed nonprofit corporations often find that they cannot simply sell their assets and dissolve. This happens either because the information provided in the notice filings does not result in the attorney general approving the transaction or there is no buyer for the assets, given the financial condition of the nonprofit corporation.
In many cases, the volunteer boards that run financially distressed nonprofit corporations move the liquidation process along as far as possible and then abandon these organizations. Ignoring any issues of personal liability for volunteer board members of nonprofit corporations, sometimes it is just easier for these board members to walk away. Eventually, a nonprofit corporation that fails to file its annual certificates with the state formation office will be statutorily dissolved, and the Internal Revenue Service will revoke the tax-exempt status of an organization that fails to file a Form 990 for a period of years.
There are other ways to wind down a financially distressed nonprofit corporation as well. Most nonprofit corporations become financially distressed because (1) they are having difficulty competing in the marketplace for fee-for-service dollars or charitable donations, or (2) the money they can earn for their programming is insufficient to cover all administrative costs of operating a nonprofit corporation. When a nonprofit corporation is struggling financially because its administrative costs are too high, there are often opportunities to structure transactions with complementary or competitive nonprofit organizations in the sector. These transactions can be structured to avoid the disposition of assets, merger, or consolidation transactions that require attorney general notifications.
The “control” of a nonprofit corporation can be effected in one of two ways. First, if a nonprofit corporation has members, a transaction can be undertaken to transfer or consolidate membership in another entity without entering into a full-blown member exchange. Given that membership in a nonprofit corporation cannot generally be for economic reasons (unless the member is another nonprofit tax-exempt organization), membership interest can be altered by amending governing documents. Second, if a nonprofit corporation is board-governed and does not have members, a control transaction can be accomplished by simply amending governing documents.
Control transactions can result in a consolidation of operations that sets a struggling nonprofit corporation’s programs up for a better future. These transactions, however, do not necessarily alleviate financial distress, and the administrative managerial staff of the financially distressed nonprofit will probably not be employed going forward.
Financially distressed nonprofit corporations must manage through both an economic and legal labyrinth. Advisors to such organizations must keep in mind all of these pitfalls and opportunities as they counsel participants in the nonprofit sector.
This article can be found at the following link:
Kim Lowe serves nonprofit corporations throughout their life cycles. In addition to her legal practice, Kim serves on Minnesota's Nonprofit Business Corporation Act drafting committee and as a member of the American Bar Association's Model Nonprofit Corporation Acting drafting committee. She is also a Uniform Laws Commissioner.