A nonprofit corporation is a separate legal entity distinct from that of its directors, officers and employees. As such, liabilities and obligations incurred by the corporation, in the absence of unusual circumstances, must be satisfied out of the assets of the corporation and do not “pass-through” to its directors, officers or employees. Put another way, a corporation’s directors, officers and employees generally have “limited liability” with regard to the liabilities and obligations incurred by the corporation.
In certain circumstances, however, a corporation’s officers, directors or members may become personally liable for the corporation’s liabilities and obligations. This “pass through” of liability occurs when a corporation’s officers, directors or members fail to maintain the corporation’s separate legal identity by confusing their individual identity with that of the corporation. This confusion of identities generally occurs when the directors, officers or members of the corporation mix their personal, individual business with the corporation’s business. In such cases, a court may choose to disregard the corporate entity created and hold the individuals acting on behalf of the corporation (i.e. the directors, officers or members) personally responsible for the corporation’s liabilities and obligations.
A court may choose to impose personal liability in this manner even though articles of incorporation creating a corporation have been filed, which, as stated above, generally limits an individual’s liability. Courts and the Internal Revenue Service (“IRS”) tend to give particular scrutiny to cases involving a small number of individuals who fill multiple roles within the corporation. In deciding whether to hold the individuals personally liable for the corporation’s obligations, courts and the IRS scrutinize the corporation and its operation to decide if the corporation meets certain minimum standards to be considered a separate entity. For instance, courts examine whether the corporation has adequate funds to pay its creditors, whether the individuals commingled corporate and personal funds on a regular basis, whether the individuals failed to keep proper corporate records and whether the corporation generally failed to act like a corporation.
The IRS may assess taxes and penalties personally against the corporation’s principals if it concludes the corporation is not a valid, separate entity. Therefore, nonprofit corporations should fastidiously hold regular meetings for both the board of directors and members (if it is a membership organization). It should also prepare and place written minutes of these meetings in the corporate record book. Nonprofit corporations should also be especially diligent in maintaining sufficient funds to pay their debts and in segregating corporate funds from the personal funds of the corporation’s principals.
A failure to segregate funds could also result in loss of tax-exempt status. See the discussion in the next chapter on private inurement. A principal of a corporation (usually is an officer or director) may also become personally liable for the liabilities of the corporation if the principal fails to make clear to persons with whom the principal is dealing that he or she is in fact acting as an agent of the corporation and not individually. All business transactions of a corporation should clearly indicate that they are corporate, not individual, transactions and the representative capacity of the officers or directors acting on behalf of the corporation should always be disclosed.