Most regulators (including the IRS) and watchdog organizations consider an independent board to be a fundamental component of a nonprofit’s good governance and a key protection against oversight failures. While federal and state laws generally do not mandate the minimum number of independent directors that must serve on a nonprofit board, it is recommended that a majority of the board consist of independent directors (if not feasible for the entire board to be independent, as may be the case with small and family-run nonprofits). A nonprofit with an independent board can:
- Ensure that the board represents a broad public interest.
- Minimize the risk of conflict of interest transactions, including insider transactions that could result in a misuse or perceived misuse of charitable assets.
Nonprofits that apply for federal tax-exempt status and are required to annually file IRS Form 990 must provide information about their board composition, include the number of independent directors. This helps the IRS determine whether the organization is a legitimate tax-exempt entity formed for public purposes.
In the instructions for Form 990, a director is independent only if, at all times during the nonprofit’s tax year:
- The director is neither a compensated officer nor an employee.
- The director is not an independent contractor who received more than $10,000.
- Neither the director nor the director’s family was involved in a transaction with:
- the nonprofit, either directly or indirectly, that must be reported on Schedule L of the Form 990 or 990-EZ; or
- a related organization, either directly or indirectly, of a type and amount that the related organization would have to report on Schedule L.
Transactions that must be reported on Schedule L include:
- Excess benefit transactions.
- Loans to or from interested persons.
- Grants benefiting interested persons.
- Business transactions involving interested persons.
It may be difficult for many small and start-up nonprofits to recruit directors and maintain a predominance of independent directors. The directors of these types of nonprofits are typically the founder and the founder’s family and business associates. When a nonprofit is small, directors also often wear many hats in the organization, including as employees of the non-profit. However, as the nonprofit grows, it should seek independent directors, both for better corporate governance and to avoid IRS scrutiny. In the meantime, these nonprofits should use extra care to keep accurate meeting minutes and document any conflicts of interest and how they are handled.