Bankruptcy for Social Welfare Organizations

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When debts begin to spiral out of control, bankruptcy offers an avenue for an organization to take a degree of control over how it resolves the problem. Like churches, 501(c)(4) social welfare organizations can run into unsustainable financial difficulties. Under the U.S. Bankruptcy Code, a nonprofit corporation can’t be forced to declare bankruptcy by its creditors. But the leadership of a social welfare organization may need to turn to bankruptcy as a way to meet their obligations to the organization and its constituents.

Bear in mind that when talking about bankruptcy of a nonprofit, there are several distinct legal regimes one must consider. A social welfare organization is defined as such by the federal tax code. Its status as a legal entity, meanwhile, is determined by state law. And bankruptcy itself is governed again by another complex federal statute. A short blog is not the right place to look for detailed explanations of all of these topics, but instead, we’re going to try to address a few of the most important preliminary questions.

  1. What are the potential advantages of bankruptcy for a 501(c)(4) organization?

Bankruptcy can accomplish a number of important things for a nonprofit organization. At the outset, it can stop creditors from continuously making demands for payments, giving managers some breathing space. It can also provide the organization with leverage to begin court-mediated negotiations with creditors.

  • What are the potential outcomes of bankruptcy?

The ultimate outcome of bankruptcy likely will depend on a range of variables, such as whether the organization has a reliable long-term plan for returning to financial health, whether the organization has assets that might still be useful for pursuing the nonprofit’s mission, and so on. Bankruptcy can, and often does, result in the bankrupt organization being liquidated and dissolved, but in some cases the organization can survive the process to carry on operations.

  • When is bankruptcy the right course of action?

There is no easy answer to this question. When debts outpace revenue and leadership sees no path toward solvency on the horizon, the conversation about bankruptcy might need to begin. As with any major management decision, a nonprofit’s board needs to consider its fiduciary obligations toward the organization, each other, and the organization’s constituents in the course of evaluating how to manage significant amounts of debt.

  • Is there an alternative to bankruptcy?

The short answer is yes. California nonprofit corporations, for example, may have the option of pursuing dissolution under state law. Dissolution is a process with bankruptcy-like features, but it follows different rules and may be preferable in some circumstances. Another option may simply be to negotiate directly with major creditors, who may prefer to work out a deal rather than get tied up in a court-driven process.

The Church Law Center of California counsels nonprofits

The Church Law Center of California advises nonprofits in a wide range of fields on matters of governance and risk. With a recession looming we expect to see some nonprofits come under financial pressure. If your organization is facing serious challenges and you would like to better understand your options, we’re here to help. To schedule an appointment call us at (949) 892-1221 or reach out through our contact page.

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