By Zackary Rhodes May 19, 2026
Nonprofit organizations operate with a level of public trust that for-profit businesses are rarely required to maintain, and the legal framework that governs their activities reflects this elevated accountability. The tax-exempt status that allows donors to deduct their contributions and that allows the organization to avoid income tax is not a permanent entitlement but a conditional privilege that depends on the organization continuously meeting specific legal requirements around governance, financial management, program activity, and regulatory compliance.
The majority of nonprofit legal risks problems faced are unintentional; they result from the organization’s conduct not being compliant with the law due to ignorance of the compliance officers and the amount of work involved in running an organization. Penalties levied on nonprofits for failing to comply with the law include monetary fines imposed by the IRS for non-filing and self-dealing activities and loss of tax-exempt status if nonprofits cannot keep up with the minimum criteria for maintaining exemption.
These penalties impact not only the financial standing of the organization but also its effectiveness in achieving its goals and its relationships with donors who fund the nonprofit. The errors made by charities in compliance are usually similar to those committed by other organizations that should have been prevented if they had more detailed information about the law affecting them.
Failure to Maintain Corporate Formalities
One of the most foundational legal mistakes that nonprofits make is neglecting the corporate formalities that are required to maintain the organization’s legal standing as a validly existing nonprofit corporation. Nonprofit legal risks arising from failure to maintain corporate formalities include the potential loss of corporate status, which could expose board members to personal liability for organizational obligations, and the invalidation of contracts and other legal transactions entered into by an organization that has lost its good standing.
Most states require nonprofit corporations to file annual reports with the state secretary of state’s office, to maintain a registered agent with a valid address in the state of incorporation, and to hold annual meetings of the board of directors with proper notice and quorum requirements. Legal issues nonprofit organizations create by neglecting these requirements include the loss of good standing that occurs when annual reports are not filed, which in many states eventually leads to administrative dissolution of the corporate charter.
An organization that is still operational and accepting donations even though it was administratively dissolved under the corporate charter does not consider itself as a corporation but as an unincorporated association, thus exposing its officers and board members to different liabilities compared to corporations. Getting back to good standing after being administratively dissolved can take time since it involves filing the necessary documents such as annual reports, paying the necessary fees, and in some instances re-registering the corporation, thus resulting in a great administrative challenge that can be totally avoided simply through filing the required annual reports.
Members of the board that make sure that the corporation is still in compliance with its formalities, such as by assigning one individual to do the filing of the annual report, manage to avoid such legal challenges through organizing rather than using their knowledge in law.
Self-Dealing and Conflict of Interest Violations
Self-dealing is one of the most serious categories of nonprofit legal risk because it strikes at the heart of the fiduciary duty that board members and officers owe to the organization, and the IRS treats self-dealing transactions involving private foundations with particular severity, imposing excise taxes on both the self-dealer and the foundation managers who knowingly participated in the transaction. Self-dealing occurs when a disqualified person, which includes directors, officers, substantial contributors, and their family members, enters into certain prohibited transactions with the organization, including selling or leasing property to the organization, lending money to the organization, providing goods or services to the organization for compensation, or using the organization’s income or assets for personal benefit.
Public charities, which is the form of organization that small nonprofits tend to take, have relatively lax self-dealing regulations in comparison to private foundations but must nonetheless handle conflicts of interest through conflict of interest policies as well as procedures that identify and mitigate conflicted transactions. The errors that public charities commit regarding conflicts of interest include having no formal conflict of interest policy in place, not requiring yearly conflict of interest declarations from all members of its governing body and its officers, and ignoring the procedures for the recusal and approval of such conflicted transactions prescribed by the policy itself.
Possible punishments for self-dealing among nonprofit organizations may consist of an excise tax on the illegal transaction, the imposition of individual liability for the amount of the transaction on the disqualified individual, and extreme penalties such as the revocation of tax-exemption. The way to avoid being found liable for self-dealing in nonprofit organizations is the combination of having an effective conflict of interest policy and annual declarations thereof, along with board commitment to its ethical nature.
Improper Compensation Practices
Compensation for executives and key employees of nonprofit organizations is one of the most legally sensitive areas of nonprofit operation because the prohibition on private inurement, which is the requirement that none of the organization’s net earnings inure to the benefit of any private individual, applies directly to executive compensation that is excessive relative to the value of the services provided. Legal issues nonprofit organizations create through improper compensation practices include intermediate sanctions, excise taxes on the disqualified person who received excess compensation and on the organization managers who approved it without following the safe harbor procedures that demonstrate the compensation was reasonable.
Nonprofit legal risks in the compensation domain are managed through the rebuttable presumption process, which is a documented procedure for setting executive compensation that, when properly followed, shifts the burden of proof from the organization to the IRS in any dispute about whether the compensation was reasonable. The rebuttable presumption process requires that compensation be approved by an authorized body composed entirely of individuals without a conflict of interest, that the approving body rely on appropriate comparability data showing what similar organizations pay for similar services before approving the compensation, and that the approving body document the basis for its determination in its meeting minutes contemporaneously with the approval decision.
Compliance mistakes charities make in executive compensation include approving compensation without conducting any comparability analysis, setting compensation through informal discussions rather than documented board processes, and failing to document the basis for compensation decisions in a way that would support a defense of reasonableness if the IRS questioned the amount. The investment in following proper compensation approval procedures is modest relative to the financial exposure that improper compensation practices create, and the documentation generated by the proper process also serves as evidence of governance quality in donor due diligence processes.
Unrelated Business Income Tax Compliance
Many nonprofits generate revenue from activities that are not directly related to their exempt purpose, and the failure to recognize when these activities constitute unrelated business taxable income and to report and pay tax on that income is a common source of nonprofit legal risk that can result in significant back taxes, penalties, and interest when discovered in an IRS examination. Unrelated business income is income from a trade or business that is regularly carried on and that is not substantially related to the organization’s exempt purpose, and it is subject to corporate income tax at standard rates rather than exempt from tax like income from the organization’s charitable activities.
Nonprofit penalties for failing to report unrelated business income include the tax itself plus interest from the date it was due plus accuracy-related penalties that can add twenty percent of the tax due for negligent or intentional disregard of the reporting requirement. Legal issues nonprofit organizations face in the UBIT area often arise from activities that the organization has not analyzed carefully enough to determine whether they generate UBIT, including advertising revenue in publications, income from providing services to other organizations, rental income from properties where the organization provides services to tenants, and income from gaming activities.
The analysis of whether a specific revenue-generating activity produces UBIT requires application of the three-part test of whether the activity is a trade or business, whether it is regularly carried on, and whether it is not substantially related to the exempt purpose, and this analysis is complex enough that organizations with significant non-program revenue streams should consult a tax advisor familiar with nonprofit tax law before concluding that specific income is not taxable as UBIT.
Lobbying and Political Activity Violations
Tax-exempt organizations under Section 501(c)(3) are subject to strict limitations on political campaign activity and lobbying, and violations of these limitations represent some of the most serious nonprofit legal risks in the compliance landscape because they can result in both excise taxes and loss of tax-exempt status in the case of the most serious violations. The absolute prohibition on political campaign activity for 501(c)(3) organizations means that the organization cannot endorse or oppose candidates for public office, contribute to political campaigns, or engage in any activity that would be considered intervention in a political campaign, and this prohibition has no de minimis exception.
Compliance mistakes charities make in the political activity area include allowing board members or staff to use organizational resources including email, letterhead, or facilities for political campaign purposes, making statements in organizational communications that endorse or oppose political candidates, and participating in activities at candidate events that could be characterized as organizational endorsement. Lobbying, which is attempts to influence legislation, is not absolutely prohibited for 501(c)(3) organizations but is limited to a substantial portion of the organization’s activities, and the specific definition of the limits depends on whether the organization has elected to be governed by the expenditure test under Section 501(h) or is subject to the more subjective substantial part test.
Organizations that have not made the 501(h) election are subject to the substantial part test, which requires judgment about whether lobbying activities represent a substantial portion of total activities, without clear numerical guidance about what substantial means. Making the 501(h) election, which provides specific numerical safe harbors for lobbying expenditure, is advisable for most organizations that engage in any significant advocacy activity because it replaces an inherently uncertain standard with a clear numerical test.
Employment Law Compliance
Nonprofit organizations with paid employees are subject to the same employment laws as for-profit employers, and the nonprofit character of the organization provides no exemption from requirements around minimum wage and overtime, anti-discrimination law, workplace safety, unemployment insurance, workers compensation, and employment tax reporting and withholding. Legal issues nonprofit organizations create through employment law violations range from wage and hour claims for failure to pay overtime to discrimination claims to penalties for failure to properly classify workers as employees rather than independent contractors.
The worker classification issue is particularly common in nonprofit organizations that rely heavily on the contributions of consultants and independent contractors, because the IRS and the Department of Labor apply specific tests to determine whether a worker’s relationship with an organization meets the legal definition of independent contractor or should be treated as an employee, and misclassification as an independent contractor when the legal standard requires employee status creates liability for back employment taxes, penalties, and employee benefit claims.
Nonprofit penalties for employment law violations can be substantial, and organizations that discover historical misclassification are advised to consult employment law counsel about the Voluntary Classification Settlement Program and other mechanisms for correcting historical classification errors at reduced penalty exposure. Building employment law compliance into the organization’s operational practices through regular consultation with employment law counsel, particularly when hiring practices, compensation structures, or worker relationships are being established or changed, prevents the accumulation of employment law liability that can create significant financial exposure when eventually discovered.
Record Keeping and Document Retention
Legal issues nonprofit organizations face often have their roots in inadequate record-keeping practices that make it impossible to demonstrate compliance with legal requirements when that demonstration is needed. A nonprofit that cannot produce its board meeting minutes from a year when a significant compensation decision was made, that cannot find the contemporaneous documentation of a gift that a donor claims entitles them to a deduction, or that cannot demonstrate the business purpose of a transaction that the IRS is questioning has a compliance problem regardless of whether the underlying conduct was appropriate.
Compliance mistakes charities make in record keeping include the absence of a formal document retention policy that specifies how long different categories of documents must be retained, the failure to follow whatever retention policy exists in practice, the absence of adequate backup systems for electronic records, and the destruction of records that are subject to litigation holds or regulatory investigations.
The IRS requires tax-exempt organizations to retain records sufficient to show that they qualify for exemption and to prepare required information returns, without specifying a particular retention period for all records, though the statute of limitations for assessment of unrelated business income tax provides a practical minimum retention period for financial records. A document retention policy that specifies retention periods for board minutes, financial records, grant files, personnel records, contracts, and other significant document categories, and that is consistently followed, creates both legal protection and organizational clarity about what records should be kept and for how long.
Conclusion
Nonprofit legal risks are manageable when organizations invest in understanding the specific requirements that apply to their situation and build the organizational practices that satisfy those requirements consistently rather than episodically. Compliance mistakes charities make most often are not the result of bad intentions but of insufficient attention to legal requirements in the midst of mission-focused work, which is why building compliance disciplines into organizational routines rather than treating compliance as a separate parallel activity produces better outcomes.
Nonprofit penalties for legal violations are avoidable through the combination of board engagement with governance responsibilities, staff investment in understanding applicable requirements, regular consultation with legal and tax advisors familiar with nonprofit law, and the documentation practices that create the evidence of compliance when it is needed.
Legal issues nonprofit organizations face most often become serious problems when they have been present for years without being identified or addressed, which is why periodic legal and compliance reviews conducted by qualified advisors are among the highest-value investments a nonprofit organization can make in its own institutional health and sustainability.