Exceptions to the limited liability clause

One of the most important benefit of Incorporation is that, its protects the individual members from being held personally liable for the the liabilities of the corporation.

However in a few situations, Individuals involved with an incorporated nonprofit organization may be held personally liable for the liabilities of the organization. It is therefore imperative for you to know these exceptions before you start a non profit.

The situations in which Individuals may be held personally liable include –

1) Non payment of taxes/ Non filing of tax return – An organization that has obtained 501 (c) (3)tax exemption  from the IRS does not have to pay taxes. However the organization is still required to file periodical tax returns. A non profit organization that has not obtained 501(c)(3) exemption mus t file returns as well as pay taxes to the federal and the state authorities.

A board member or any other individual who has been entrusted with the responsibly to pay taxes by the organization is supposed to act diligently in this situation. However if  the individual fails to report or pay taxes, he is held personally liable for any unpaid taxes, penalty there upon or interests payable for delay in payment or delay in filing of returns.

2) Non compliance of other statutory requirements – An individual may also be held personally liable, if he is duly authorized by the organization to act on its behalf  and still fails to comply on issues like –

  • Filing of Annual report with the Secretary of state
  • Filing of Annual report with the State Attorney general
  • Paying of employee withholding tax
  • Paying of unrelated business Income tax

This is just an indicative list. If a director, officer, employee or other member is found guilty of willful negligence on any statutory or compulsory matter he/she may be held personally responsible. However, this should not be a cause of  undue worry for the members.  This is an exception and not a rule. If an individual exercises due diligence while carrying on his responsibilities, he/she is eligible for the limited liability shield.

3) Membership fees – An individual is always personally liable to pay his membership fee or subscription fee  dues on time. Most of the non profit organizations keep a very small amount as the membership fees and hence the extent of liability is negligible in most of the cases.

4)Piercing the Corporate veil– If a individual is found to be misusing the corporate veil to misappropriate funds, he/she may be held  personally liable. In legal parlance, this is called – ‘Piercing the corporate veil’. The corporate veil may be pierced if the personal funds and corporate funds are so intermingled so as to deliberately misuse the limited liability clause for personal gains.

For e.g – If an Individual uses organization as a tool for raising undue debt and then willingly defaults, the court may decide to pierce the corporate veil and hold the individual personally liable to repay the debt.

5) Private foundations – If an organization is classified as a private foundation (as per its IRS classification), its members can be held personally liable for failing to file federal or state tax returns or for failure to pay  excise tax on certain specifically prohibited transaction.  (Please refer to IRS manual on Private foundations)

6) In case of explicit personal guarantee – If an individual explicitly agrees and enters into a contract to provide his personal guarantee for the liabilities of the organization, he/she is bound by the terms of the guarantee contract. This kind of situation is generally observed when banks or lenders who agree to give loan to the organization, insist for personal guarantee of some key members. If a member offers his personal guarantee in such case, he cannot claim protection under the limited liability clause.