A nonprofit corporation is a business with assets and liabilities just like any other business. When a nonprofit runs into financial trouble, its creditors usually do the same thing as creditors of a for-profit business: they seek to liquidate the assets to satisfy as much of their debts as possible. There can be another wrinkle for nonprofits: sometimes, a separate charitable foundation provides financial support to the nonprofit. In such circumstances, creditors sometimes seek to satisfy their debts out of the assets of the supporting foundation.
For example, some supporting foundations are created and exist solely to support one specific nonprofit corporation. Herein lies a potential problem. If the nonprofit runs into financial trouble, a lack of separation between the charitable foundation and the nonprofit could result in the foundation being on the hook for the nonprofit’s debts. It is in both the foundation’s and the nonprofit’s best interests to take steps to limit the possibility of the nonprofit’s debts becoming the debts of the foundation (i.e., to preserve the assets for the desired charitable purpose). If the supporting foundation is organized properly, this risk can be minimized.
To prevent the financial difficulties of the nonprofit from infecting the charitable foundation, it is essential to implement and maintain appropriate separation between the two. Separation can be achieved through a variety of means.
First, consider appointing a different board of directors for the two entities. If the same board controls the foundation and the nonprofit, it creates the perception that they are effectively operating as one entity.
Second, consider designating a second beneficiary for the supporting foundation. If the foundation supports both Charity A and Charity B, and Charity A encounters financial distress, the foundation could more persuasively argue that it is not merely an extension of Charity A, but rather, an independent foundation with obligations to both charities.
Third, consider including a provision in the supporting foundation’s bylaws that limits the nonprofit’s access to the foundation’s assets. Preventing the nonprofit from having unfettered access to the foundation’s assets would strengthen the argument that the two are separate, independent entities. This can be achieved by different methods. The foundation’s bylaws could provide that it would only distribute funds to the nonprofit at the foundation’s discretion. Alternatively, the foundation’s bylaws could provide that the nonprofit would receive a limited, specified amount of support each year, e.g., income earned on the foundation’s assets without any access to principal.
Whether you are in the process of forming a nonprofit or modifying the bylaws and practices of one already in existence, implementing one or more of these strategizes may protect the supporting foundation’s assets in the event that the nonprofit runs into financial trouble. However, nonprofits and their supporting foundations should evaluate the level of protection that is appropriate based on their specific circumstances. The need to protect the foundation’s assets should be balanced with the increased administrative and operating costs of utilizing these practices. Nonetheless, for purposes of protecting the charitable assets of the supporting foundation in the circumstance of a financially troubled nonprofit, an ounce of prevention is worth a pound of cure.