The Importance of Legal Audits

Date: December 20, 2011

Legal audits provide a good opportunity for nonprofit organizations and associations to prevent unexpected liability by addressing and resolving problematic issues before they escalate.  Risks of liability are a serious concern for nonprofit organizations and associations.  A legal audit is particularly important if the association or nonprofit organization has recently undergone a change in management, so that preexisting problems are not attributed to the new leadership.

Most organizations conduct financial audits, but many neglect ensuring their legal house is in order  by doing a legal audit.  In a legal audit, your lawyer will review broadly the legal “health” of your organization by looking at legal documents, filings, and policies.  Described below are some of the issues to be examined during a legal audit.


  • It is usually advisable for nonprofit organizations and associations to incorporate in order to protect officers, directors, and members from personal liability.  Tax-exempt organizations usually are nonprofit (or nonstock) corporations, which are formed by filing Articles (or Certificate) of Incorporation with governmental authorities in a state or the District of Columbia. 
  • State nonprofit corporation law provides the rules for such corporations, and the Articles must be consistent with the law.
  • If a corporation incorporated in one state “does business” in another state, the other state law will likely require the corporation also to “register” or “qualify” to do business in that other state as a “foreign” corporation.  If an organization opens an office or has employees in another state, that will usually trigger registration requirements; just having a bank account or holding a meeting in another state does not give rise to registration, and there are a number of activities that are in the middle of the spectrum.  
  • Corporations typically have to file periodic reports listing officers and directors with the states, usually every year or two.  
  • Just as Articles can be viewed as a “contract” with the state, Bylaws are like a contract with the members (or stockholders in a stock corporation).  The Articles and Bylaws both must be consistent with state law and with one another.  Bylaws govern the Board and member activities and governance, and should also reflect current practices, policies, and procedures.

Tax issues should clearly be a part of any audit. 

  • It should be confirmed that all annual reports filed with the Internal Revenue Service (“IRS”) are completed carefully and filed in a timely manner. 
  • The IRS determination letter granting Section 501(c)(3) or Section 501(c)(6) status should be part of the organization's permanent record, and its activities should be conducted in strict compliance with its tax-exempt purposes described under the Internal Revenue Code.  Should its activities run afoul of such purposes, the organization may be subject to substantial penalties and taxes.  Even worse, the organization's tax-exempt status may be in jeopardy. 
  • Revenues that are not related to the exempt purpose, constitute a trade or business, and are regularly carried on are Unrelated Business Income subject to Tax (“UBIT”); these revenues include advertising, commissions, referral fees, and management or administrative fees.  An organization pays the tax on net taxable revenues over expenses, but if the amount of taxable revenue reaches 30 or 40 percent of the organization's gross revenue, tax-exempt status can be jeopardized. 
  • The IRS permits tax-exempt organizations to set up other affiliated entities to conduct activities that may not be appropriate, such as a 501(c)(3) organization establishing a Section 501(c)(6) to lobby or a for-profit subsidiary to engage in marketing, but it is important to ensure appropriate structures are in place.  
  • If a tax-exempt organization changes its mission or other aspects of its governing documents, the new or amended documents must be sent to the IRS. 

It is crucial that the process for managing the organization's money be designed and implemented to ensure proper spending and reporting. 

  • The Board has ultimate responsibility and should have general oversight of the organization's budget and finances. 
  • Policies and procedures are vital for these purposes, such as those dealing with conflicts of interest, check cashing, financing, handling funds, and investments. 

A legal audit should also include a review of the organization's contracts and its procedures on entering into contracts. 

  • It is advisable to have a policy in place requiring legal counsel to review and approve all contracts and stipulating that only authorized officers have the authority to execute contracts. 
  • Examples of provisions that should normally be included in contracts are warranties regarding the contracted-for goods or services, payment terms, indemnification, cancellation clauses, and licenses for the use of intellectual property.  
  • To ensure that provisions like these are never left out, corporations often make use of standard-form contracts designed for their dealings with hotels and other vendors, and then tailor them to meet their particular needs.

Again, policies and procedures are important.

  • It is advisable to have an employment manual or handbook in force.  The courts will often look to such manuals or handbooks as stating the terms and conditions of employment, particularly where there is no individual contract.
  • Most state laws provide for “employment-at-will,” but that does not mean employment can be wrongfully terminated (e.g., for discriminatory reasons). 
  • Under the federal Fair Labor Standards Act, employees must be paid overtime (time and one-half) for hours worked over forty per week.  Executive and managerial employees are exempt from this requirement.  
  • Another issue that arises relates to the distinction between employee and independent contractor status.  Employees must have income taxes and social security withholdings made, and contractors do not.  If a person has a contract, pays his own insurance, has his own office, and works for other clients, the person is probably a contractor, but there are many shades of gray, particularly with more telecommuting employees.


  • Nonprofit organizations and associations conduct many meetings and having proper contracts in place with hotels and other service providers is advisable to spell out required duties. 
  • The Americans with Disabilities Act, as well as copyright laws on obtaining permission for music at events, must be followed when holding such meetings. 
  • Also, state law mandates notices, voting, and other requirements for member and Board meetings.  Parliamentary procedure should be followed, and minutes kept of meetings (although tape recordings and draft minutes should not be retained). 


  • It is important to have contracts in place governing the production and distribution of publications, particularly to ensure intellectual property ownership and permission.  Policies should be maintained to ensure that rights of others are not infringed, or other persons defamed. 
  • Editorial and advertising policies should also be in force setting forth terms and conditions for the publication.  Advertising policies should state all terms of insertion and cancellation, for example.  Antitrust risks may arise if advertisements from competitors of members are prohibited.

Intellectual Property
The most valuable property of a nonprofit organization often is its intellectual (or intangible) property, such as trademarks and copyrights. 

  • The name and logo (i.e., trademarks) of the organization may be its most valuable asset and must be properly used to maximize protections.  Trademarks generally should be registered, and the registrations renewed on a timely basis. 
  • If your organization licenses its trademarks to others, such as chapters, it is important to have license agreements in place to maintain the style and quality of the marks and to ensure that all uses of your organization's marks are subject to prior review and approval; the failure to do so may risk abandonment of the marks or diminished value.  
  • Copyrights also must be protected, and the nonprofit organization or association should neither let others use its copyrighted material without permission nor use the copyrighted materials of others without permission.  Your organization must have a process in place to ensure that staff obtains permission from speakers, authors, and others who contribute intellectual property for use or publication by the organization (such as exam test items).  
  • Published notices about the organization's intellectual property are not legally required, but are highly recommended.  These are the ™ symbol or ® symbol for trademarks – the latter only for registered marks – and Copyright or © symbol for copyrights with the year of publication and name of the copyright owner.  
  • It is important to pursue infringers, even if the infringement doesn't seem serious at the time, because the failure to pursue can lead to loss or reduced value and strength of the property.  
  • Member lists and mailing lists are also viewed as intellectual property, both as copyrights or trade secrets.

Appropriate and sufficient insurance is necessary to adequately protect against legal claims.

  • Your organization's insurance should cover most anticipated legal claims, damage awards, and attorneys' fees (usually with a retention or deductible amount). 
  • A Commercial General Liability policy (also called an office policy) prevents against “slip and fall” and similar types of liability.  
  • A Directors and Officers policy is also advisable, but it is important to have a broad form policy that not only protects the officers and directors, but also the organization itself (so called “entity” coverage) and other volunteers, staff, and agents.  
  • If a legal claim or lawsuit is received, or if there is knowledge that such a claim is expected, it should be promptly reported to the insurance company or agent.


  • If your organization has affiliates, such as regional, state, or local chapters, the organization's Bylaws should be clear about the terms and conditions for affiliation.
  • The affiliates' governing documents need to be consistent with those requirements, and there should be clear charter or affiliation agreements in place to carefully describe the relationship.  
  • A group tax-exemption is also available from the IRS for such subordinate organizations and eliminates the need for separate tax-exemption applications for the affiliates. 

A legal audit is like an insurance policy:  you notice the cost right away, but you reap the benefits a hundred fold if you discover and de-fuse a big problem.  A legal audit can be structured so that the review occurs all at once or in phases to meet budget constraints.  Finally, a legal audit does not need to be conducted every year, but should be conducted periodically.