Many business and community leaders graciously decide to give their time and effort to causes they believe in by becoming a director of a charity. The board of directors of a nonprofit is responsible for setting its strategy and ultimate management, through the executives they appoint, of all activities of the charity.

Oftentimes, because of the very business or other activities that led to an individual being appointed to a board, there is a meeting of an individual’s private or business interest and their role as a fiduciary of the nonprofit. These situations give rise to the potential for a conflict of interest, which it is important for the charity to avoid. An example of a conflict of interests would be the director of a mosque who also owns a piece of land the mosque wants to build a school on.

The director is willing to sell the property to the mosque at a reduced rate, and the Islamic Center has the funds available and wants to buy the property. Even though the director would be effectively making a donation to the mosque by selling the property at a below market price, special legal considerations must be taken because the director has the theoretical potential to make a profit on the transaction. In California, any business transaction with a director of a nonprofit or a close family member needs to be approved by all the uninterested directors, those without any business or personal connection to the agreement. If a nonprofit fails to do this, the contract could be voided and the charity may risk losing its state tax-exemption. The exact requirements vary state to state, and might cover executives and past directors as well. Additionally, IRS regulations prohibit “excess benefit transaction," an unfair business deal between an insider and the nonprofit.

If the IRS determines that an excise benefit transaction took place, it can penalize the individual involved with a 200 percent tax on all profits made and revoke the charity’s ability to take tax-deductible donations. In order to avoid these problems, the directors of a nonprofit must take special care when entering into a business deal with a director, executive, any of their family members or any business that they have an interest in.

The directors must investigate the financials of the deal to make sure that it is fair for the charity. The directors may be required to take an independent vote to approve the contract, without the interested director present. It is also highly recommended that the directors approve a board resolution documenting their inquiry into the transaction and the steps they took to approve it. The exact legal compliance issues facing any nonprofit vary state-to-state and can be highly technical.