According to government statistics, the rate at which new charities are being formed is increasing each year. Not surprisingly, founders of these fledgling charities often look to individuals they know in the community to help them get started. As a result, an important question is often presented: Can a person or business that is related to one or more of the directors of a charity perform services for the charity for compensation? Mythology and common assumptions aside, the general answer is "yes." This answer, however, is not without limits and the issues that it presents can be complex.

In addition to certain tax rules discussed below, state law generally governs when a charity legally may engage in a transaction with an interested party. Most states have enacted "conflict of interest laws" which govern the relationships between a charity (or any nonprofit organization for that matter) and certain individuals who have a close relationship to the charity (e.g., board members, officers, spouses and children of board members and officers) — generally referred to as "interested parties". Conflict of interest laws are designed to ensure that an interested party does not use his or her position to gain an economic advantage to the detriment of the charity. In most states, an interested party may enter into agreements with a charity for compensation so long as the nature of the relationship and the financial interest of the interested party is disclosed and disinterested individuals approve the transaction. Significantly, in many states, such as Illinois and New York, even if no disclosure is made the agreement is valid if its terms are fair to the charity and reasonable at the time the agreement is made. In these cases, however, the interested party bears the burden of proving fairness and reasonableness.

If a charity is exempt from federal income tax (i.e., as a charity described in Section 501(c)(3) of the Internal Revenue Code), federal law will also apply to an agreement for compensation with an interested party. Whether the agreement is permitted will depend on whether the charity is a "public charity" (e.g., a school, hospital, church, synagogue or publicly supported organization) or a "private foundation." If the organization is a public charity, then, with a few exceptions, parties to the transaction usually need only to establish that the transaction was fair and reasonable. However, if the charity is a private foundation, only those services that qualify as "personal services" that are reasonable and necessary to the performance of the foundation's exempt purpose may be compensated. Virtually all other agreements requiring a payment by a private foundation to an interested party will be strictly prohibited.

One may ask why the law would permit such transactions in the first place. Many new charities have very limited funding, but at the same time require products and services from a wide array of sources. Founders are often required to rely on individuals they know in order to obtain the assistance they need. For many individuals and businesses, it may be easier to provide assistance to a new charity by providing its own products or services to the charity as opposed to providing monetary contributions. In many cases, a provider of products or services may not be prepared to provide such products or services for free, but may do so at a reduced cost to the charity, or under terms that require payment on a deferred basis (i.e., once the charity has begun to raise funds). If the law did not allow such transactions many new charities would be frustrated in their efforts to obtain the products and services they need.

New charities are not the only ones with this problem. Many established charities seek individuals to serve on their boards who bring special knowledge and expertise. Consider the hospital whose board includes physicians who work at the hospital, the university that includes faculty members among its board members, the church that has its minister on its board, the local food bank that purchases food at a discount from a local market whose owner sits on the food bank's board and the family foundation that utilizes the services of an accountant who is also on the board. Although such individuals may provide services to the charity for free, for countless reasons not all individuals will be able to do so all of the time. Consider for a moment the choice a charity would be required to make if it were absolutely prohibited from entering into an agreement with a related party. In that case, each time the charity considered who should be extended an invitation to join its board, the charity would be required to determine whether the charity will need to retain the services of that person, whether the person will be willing and able to provide those services for free and whether the charity would be better served by not having this person on the board so that the charity could retain the person's services.

Entering into agreements with interested parties should be approached with great caution. Failing to comply with all the technical requirements can cause both legal and public relations problems for any charity. If you are considering such an agreement, whether as a board member or as the related party, you should ask, at a minimum, the following questions:

This is an important example of why operating a charity can be a tricky business. The laws impacting charitable organizations (including a family foundation) and the use of foundation funds is complicated. If you are involved with a charity or are thinking of becoming involved with one, make sure you seek experienced skilled professionals to work with you and your organization. The consequences of missteps in starting or administering the organization can extend far beyond the income tax ramifications. 

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