Wednesday, February 22, 2006

Should You Buy a Franchise?

This episode features an excerpt from the Nolo book “How to Run a Thriving Business: Strategies for Success and Satisfaction,” by Attorney Ralph Warner.

Should You Buy a Franchise?

Almost every franchise presentation emphasizes that nation-wide franchise businesses take in about 50% of the retail sales dollar. What isn’t said is that the great majority of these dollars come from just a few categories: automobiles, gasoline, lodging, and fast food. Beyond these mega-buck fields, only a small percent of the money retailers take in goes to franchised operations.

Some Exceptions to the Rule:

Although I’ve become convinced that sinking money in a franchise is generally a bad investment, and no way to get your start in business, let me start with a couple of exceptions to my own rule. The first exception involves franchises built around continent-spanning communications networks, such as national hotel and motel groups, which maintain 800 phone numbers, and web sites allowing travelers to easily book reservations. This is not to say, of course, that any particular hotel, motel, or auto rental franchise is a good deal, only that, unlike many other franchises, they do sell something of real value. Second, franchises with brands that really are famous and highly regarded can sometimes be worth the high cost. Franchisees, especially those who bought in years ago at good locations, have made big profits in McDonald’s, Pizza Hut, Motel 6, and other world-famous franchises. But it’s been decades since an ordinary person could afford to purchase and build out one of the relatively few guilt-edged franchises.

The High Cost of Franchising

The biggest problem with many, if not most, franchises is depressingly simple: they charge too much for a business that doesn’t have enough value to justify the high upfront and ongoing costs. To help understand why this is true, answer these three simple questions: how hard is it to make a sandwich? How hard is it to clean a house? How hard is it to put grout in tile? If your answer is “not very,” then I have another question for you: why pay a franchise operator a large sum to teach you how to do one of these or other simple tasks, when you could learn to do it on your own for far less?

How Much Will You Have to Pay?

First, you’ll pay an upfront franchise fee, which might be $30,000 to $70,000 or more, for a little known housecleaning service. Typically, you’ll also be required to pay the franchise 3-6% of your monthly gross revenue. Big name fast food operators such as Wendy’s, McDonald’s, Burger King, and Subway, typically charge between 8% and 11%, plus a few cents on the dollar for a franchiser’s marketing effort. Put these fees together and it means that in addition to paying the upfront fee for the franchise, you’ll usually have to pay the franchiser six to ten cents or more of every dollar of revenue, and if the franchiser requires that you buy goods or services either directly from it, or from an approved supplier, your costs will probably be higher, because franchisers commonly charge substantially more than do suppliers on the open market. Let’s assume that the extra cost would amount to two cents out of every dollar of revenue. Add it all up, and you’ll likely pay the franchiser ten cents of every dollar you take in. This is a huge burden to your long-term profitability.

But Won’t a High Volume of Sales Compensate for These Costs?

Consider that the entire profit margin of many small businesses is less than ten cents on the dollar, and few businesses do much better. And, of course, your franchise fees don’t get your business open. If you want to open a business that has a high startup cost, such as a restaurant, you’ll need to build or remodel a physical space, purchase equipment, and train employees, things that are usually more expensive when you must conform to a franchiser’s many specifications. But if you don’t get a leg up from a franchiser, how will you get the knowledge and skills you need to open a successful business? Chances are, you can learn on your own for free. For example, if you’re interested in opening a lock shop, nail salon, or coffee shop, get a job in one for a few months, instead of buying a franchise. Not only will you learn much about how the business works, but you’ll be paid to do it.

But What About All the Benefits of the Franchiser’s Marketing Efforts?

National franchise outfits rarely do a good job of promoting their local franchises, in part because they typically rely on broadcast and print media campaigns, which for small businesses are usually an inefficient way to use precious marketing resources. Even worse, because franchisers are usually headquartered outside a franchisee’s area, they’re not equipped to implement the many types of low-cost local marketing that can be extremely effective.

But Won’t the Franchiser teach me How to Run My Business?

Of course, to many prospective purchasers, the big appeal of buying a franchise is that someone else has figured out how to run the business. Just pay your money, and the franchiser will explain in great detail exactly how to make a donut, or wash a car, or sell sneakers. Often overlooked is the fact that operating a business by following an instruction manual can also be a big negative. Instead of having a chance to exercise your creativity and imagination to improve and change your products and services, you’ll be sentenced to endlessly repeating someone else’s recipe. Some people think they won’t mind running a boring, uncreative business, as long as it’s solidly profitable. Well, maybe. But the truth is that you are limited from actively using your intelligence and creativity to adjust the business to fit local circumstances, or take advantage of what you learn, which is almost sure to make the business less likely to succeed.

Watch Out for Franchise Contracts

Another reason to avoid a franchise is that franchise contracts are stacked against you. These contracts, which typically run fifty pages or more, are written and rewritten by skilled lawyers, to be sure the franchiser remains firmly in control of the relationship. Like buying a car or an insurance policy, you have no chance to negotiate a change to even one word of these agreements, which by itself should tell you all you need to know about the one-sided nature of your future relationship. Here are just a few of the ways the fine print of these contracts benefit the franchiser:

You Can’t Compete.

Should you wish to close a franchise and open a similar independent business, you’re typically prohibited from doing so for at least three to five years.

You’ll Need Approval to Sell the Franchise

To sell your franchise sometime in the future, you’ll probably have to get the franchiser’s approval. Not only can this make the sales process more difficult -- the franchiser might reject a purchaser you consider well-qualified -- but it means the prospective purchaser will have to agree to the terms in the then-current franchise contract.

You’ll Have to Travel to the Franchiser’s Home State for Legal Disputes

If you get into a legal dispute with a franchiser, the franchiser may require that you file your lawsuit on the opposite side of the country, and be subject to the law of the state whose courts are most favorable to the franchiser.

You Must Buy Goods and Services From the Franchiser

And, of course, the contract may require that you buy supplies, goods, and even services, such as marketing and advertising services, from the franchiser. Although this sometimes make sense – all chicken sold at Big Ben’s Bird House should look and taste the same – often it’s just another way that franchisers take money away from franchisees.

How do you evaluate a Franchise?

Well, despite my anti-franchise arguments, you may remain convinced that a particular franchise really does have such a valuable name and reputation that buying in might be a good deal. If that’s so, I recommend you go through the following steps:

Step 1: Get the Franchise Circular

Before you do anything else, ask the franchiser for a copy of its Uniform Franchise Offering Circular (UFOC), a federally mandated document that contains loads of information about the franchise company’s history, operations, franchise network, rules, and costs.

Step 2: Talk to Franchisees

If you talk to a number of people who already own a franchise in the outfit you’re attracted to, I can virtually guarantee you’ll learn many interesting things the salespeople somehow never told you. Check out the list of franchisees who have left the system in the last year, and call some of these people. If the franchiser suggests that you talk to particular franchisees, don’t bother. One way or another, these people are part of the franchiser’s sales team, and are unlikely to give you fully objective information.

Step 3: Look at All the Costs

Carefully study sections five and six of the UFOC for answers to these questions: how much is the upfront franchise fee? How much money do you have to pay the franchiser by way of a monthly fee, often called a royalty? Is there an additional marketing or advertising fee? Are there other fees, for such things as travel, training, audits, and attorneys? How much will it cost you to actually get into business – that is, to construct a building or buy equipment?

Step 4: Find Out About Recent Lawsuits Against the Franchiser

You’ll want to know whether any unhappy franchisees have sued the company recently. Any such lawsuits should be listed near the beginning of the UFOC. If you find a history of litigation, contact the people involved to get their side of the story.

Step 5: Check Out the Competition

Open the phone book, and count the competitors in the particular market niche. In any popular field, chances are there will be a number of other competing franchise operations, as well as many independents. Do the franchise operators really have an advantage over the well-run independents?

Step 6: Analyze Your Options.

Finally, compare the cost of a franchise to the cost of opening and operating a similar independent business for a year. If, for example, you’d save $50,000 by operating independently, pretend you invest this money in United States bonds, and leave it there until you retire. Obviously, it makes sense to invest in the franchise only if you are pretty sure you would earn more than you would take in running an independent business plus your annual investment income.

The material you have just heard is excerpted from the Nolo book, “How to Run a Thriving Business: Strategies for Success and Satisfaction,” by Attorney Ralph Warner.

Copyright by Nolo. For over thirty years, Nolo has published reliable plain English books, software, and forms. Check it out at

Do Good Companies Make for Good Stocks?

The following is an excerpt from an audio presentation given by Bob Clyatt, author of, Work Less, Live More: The New Way to Retire Early, (Nolo) in which the best-selling author details six common stock market myths.

Myth #1. Find a Hot Fund Manager

Have you heard this Myth before? “Sure, you and I may be investment amateurs, but this fund manager I heard about is a genius. He has outperformed the market now for eight years, through up markets and down. Your best move would be to just invest with him, beat the market, and grow rich.”

Now here’s the Reality: While there is nothing wrong with looking for fund managers with good track records—assuming their fees are reasonable, which they usually are not—expecting to actually find ones who will outperform in the future is nearly impossible. On average, only about a quarter of fund managers outperform their relevant index, after fees, in any year; and only one in 10 outperforms for three years running. One study shows the average mutual fund underperforms the market by 1% and Vanguard’s John Bogle recently calculated that the average stock mutual fund achieved just 9.9% in annual returns from 1984 to 2004, falling 3.1% short of the S&P500 Index, which returned 13%. He argues that fees and trading costs make up the difference in this zero-sum game. With thousands of funds out there, a few can always be found that outperform for several years running. But you can never be sure if this year will be its last. Far better to invest to match the market, with low fee index-style mutual funds, than to try to bounce around trying to find a manager who will beat the market over the long run.

Myth #2. Bonds Are for Wimps

This Myth can be summed up like this: “If the average rate of return on stocks is 12% per year and the average long-run rate of return on bonds is 6%, then why would I ever want to own bonds? I am a long-run investor, so I’m going to load up 100% on stocks and trounce the balanced investors over the long run.”

Here’s the Reality: Sure, you can load up on stocks if you don’t need to withdraw money for a very long time. And if you have a stomach made of cast iron. But as an early retiree, you will likely need to make annual withdrawals for decades, so you’ll be selling some assets every year. That means you’ll need to sell some of the stocks in your portfolio even if the market has dropped like a rock. In short, this myth ignores volatility: An asset class that has a high expected rate of return over time is almost invariably riskier. That is fine as a small portion of a balanced portfolio, but if the volatile asset is your only asset and you need to sell some of it for living expenses every year, you can be wiped out.

Myth #3. All-Bond Portfolios Are All-Safe

The Myth: “I know how to retire early and be really safe. I’ll buy a portfolio of 20-year AAA municipal bonds with enough tax-free interest every year to support me in fine style. Who needs to think about asset allocation or risk? All bonds means no worries.”

The Reality is that this myth neglects to factor in inflation. Enticing as this approach is on the surface, this strategy will safely and securely decimate the real value of a portfolio and its withdrawals. Whether the bonds are municipal bonds, long-term CDs, or regular taxable bonds, the dilemma for the investor is the same. First, what the bondholders receive each year from this portfolio is a fixed coupon that diminishes in spending power every year. Second, what the investor gets back at the end of 20 years is the original principal, which, at 3% inflation rates, will be worth about half of its original value in real terms. The investor now has just half of the spending power he or she had at the beginning of retirement, permanently eaten away by inflation. And note that the popular strategy of building a bond ladder—an array of bonds with varying maturities—won’t solve this problem.

There is nothing inherently wrong with bonds or tax-free municipal bonds, though most early retirees will be taxed in such low brackets that the tax advantages of munis will be wasted. The problem is not properly setting aside the first 3% or so of yield each year for inflation. After you have done that, you can withdraw safely and know the real value of your portfolio will remain intact, though there may be little left to withdraw. In order to set aside 3% for inflation and withdraw the desired 4%, Safe Withdrawal Rate, you’d need a high quality bond yielding at least 7%, something as scarce now as snowballs in July.

Myth #4. Good Companies Make Good Stocks

This Myth runs like this: “This stock-picking business isn’t so hard. I can just buy the shares of good, profitable growing companies whose products I really like and hold on. I’m bound to do well.”

The Reality? Of course, quality companies with strong growing revenues, steadily rising profits, well-known brands, and solid managements can provide investors with good stock returns. But it happens much less frequently than you might assume. That’s because these firms, their successes touted throughout the business press, are well-known and attractive to investors—and their stock prices are almost always already high. While you might want to buy their products, you’ll generally want to avoid their stocks. Because they start out expensive, growth stocks’ returns tend to lag behind those of value stocks, which are on the other end of the spectrum.

Unloved, unknown, or temporarily embarrassed, the riskier value stocks should be an investor’s friend, as they outperform the broad market averages over the long term by as much as 3%. Of course, these are averages and trends. There are some growth stocks that start out expensive and just keep going up. And no one wants to get caught in the “value trap” in which they buy a depressed stock—after all, it is cheap for a reason—and then have it go bankrupt. These frightening emotional totems are what produce the value-stock premium, which is created anew each day as investors flinch at the thought of owning a value stock or smile at the thought of owning a growth stock, and adjust their prices accordingly. When the growth stock slips, it is mercilessly hammered down. Investors have long since given up on the value stock, so when the company finally turns around, the stock is brought up smartly due to the upside surprise. That is when the value fund sells it. And the cycle starts again.

Myth #5. The S&P 500 Index is the Stock Market

This Myth isn’t so dangerous, but it is still worth noting here. It runs like this: “I shouldn’t try to time the market, pick stocks, or even pick a fund manager. I’m just going to load up the equity portion of my portfolio in a low-cost S&P 500 index fund and be done with it.”

The Reality: Actually, this approach does get us closer to long-term investment sanity than many of the other myths, but the S&P 500 is only a part of the world’s stock market—and not the most important piece at that. For example, it is among the most heavily skewed of the major indices, with just the top 22 stocks comprising a third of the overall weight or movement of the index and the bottom 150 stocks in the index comprising just 5% of the index weight. So tying your fortunes to the S&P 500 essentially ties you to the fortunes of a tiny fraction of America’s firms. The S&P 500 is a convenient way to track some megacap firms, but to get real diversification into less-correlated asset classes—such as small stocks, international stocks, and value stocks—you will need to go beyond the S&P 500.

Myth #6. Foreign Assets Are Un-American and Unnecessary

“Why should I bother with foreign stocks? After all, U.S. firms are bigger, safer, and better understood than all those other companies out there. And besides, American companies are so global in their operations that good times overseas will surely be reflected in my U.S. company stocks.”

In Reality, while most people are drawn to invest more heavily in their local markets, there is little economic rationale for it any more. American stocks and bonds do represent about 40% of the world’s financial assets, but now that investing overseas has become safe, inexpensive, and convenient, it is time for Americans to look further a field. The goal is to find low-correlation asset classes with liquid markets, quality securities, and reasonable transaction costs. While emerging markets and the chances for shenanigans still put those securities at the furthest limit of acceptable risk, well-documented scandals in major American companies don’t exactly measure up to a gold standard of corporate probity, either. In any case, the global marketplace is fast growing up and foreign companies offer great potential for returns at reasonable prices.

The idea that strong overseas operations for American firms will capture that growth in their stocks is not supported by historical data. Global American companies’ stocks tend to rise and fall with other American companies; their international operations do not provide meaningful diversification. An investor gets far better diversification, both through non-dollar currencies and the actual foreign companies themselves, by owning pools of foreign stocks.

Thursday, February 16, 2006

Should You Create a Living Trust?

We’re speaking with Attorney Denis Clifford, an expert on estate planning and the author of several books on wills, estates, and trusts, including the best-selling “Make Your Own Living Trust,” from Nolo.

QUESTION: Denis, I wanted to talk about one of the main reasons which a lot of people want to create a living trust, is to avoid probate. So maybe you can start by explaining for people what probate is, and why people want to avoid it so much.

DENIS CLIFFORD: Well, I’d say yes, it’s definitely the major reason people want to create and do create living trusts, is to avoid probate. Probate is a court process required of almost all wills. Someone dies, and they get the will, and then you have to hire a lawyer and the lawyer files the will with the court, and there’s a bunch of legal falderal that goes on, and forms are filed, and fees are generated, and finally a judge says, “Okay, the will’s valid, and okay, I order the property transferred to who the beneficiaries are in the will.” This process takes a minimum of several months, and often longer. It’s really an absurd process and in almost all cases has no benefit for anyone except the lawyers involved, and the court system, for making money. One of the things I’ve pointed out for years is that unlike almost all other court proceedings, in a probate proceeding, it’s almost never contested; it’s basically a clerical proceeding in which the rubber stamps are applied, and the actual proceeding isn’t too different than something at the DMV office, and it’s really no reason at all except historical accident that this goes through a court system. But it’s so lucrative, and generates billions of dollars a year for lawyers, that the system continues and goes on.

QUESTION: The will is easy for us to understand; the person dies, there’s a piece of paper telling who gets the money. A trust seems a little more complicated, so could you just walk us through an example of what happens when someone creates a living trust and what happens after they’re dead?

DENIS CLIFFORD: Well, first of all, they’re not that different. They’re a little different, but basically, a living trust is another piece of paper, or pieces of paper, that says who gets the property that the living trust “owns” when the person who set it up dies. So, to that extent, it’s really no different than a will. The difference in a living trust is you officially, legally transfer property that you own into ownership of your name as trustee of your living trust. So, instead of let’s say, a house being owned by Denis Clifford, it would now be owned by Denis Clifford as trustee of the Denis Clifford living trust, and it would actually file a deed transferring that house from me personally to me as trustee of the trust. So, there is a little bit of extra paperwork involved, but it’s not particularly burdensome. One, there’s no requirements that you file any tax returns for a living trust where you’re the trustee of the property. The IRS long ago realized, “Hey, this is just a paper thing to avoid probate; we don’t want a whole bunch of extra forms.” So you report all living trust transaction as part of your regular income tax; there’s no property tax reappraisal for the transfer, because it’s not really a transfer. So, basically you’re setting up really what’s a fictitious legal animal, but real when you die. Then when you die, that living trust actually is the legal owner of your property, and then you’re the trustee of this trust while you live, so you manage all the property. In the trust document, you name a successor trustee who functions the same as your executor in your will. He or she is the person responsible for carrying out the terms of your living trust, as they are with your will. When you die, your successor trustee reads the living trust, or presumably knows about it beforehand, and says, “Okay, here’s the property, and here’s who it’s to go to,” and then arranges for the mechanisms of the transfer, exactly as would happen under a will.

QUESTION: You put your property in the trust and then you manage it. What can’t you do with the property?

DENIS CLIFFORD: You can do anything with the property; it’s absolutely indistinguishable from property you own yourself. I mean, theoretically, you could draft a living trust that says, “Now that it’s in the trust, you can’t do this, or you can’t do that,” but no one ever does that. Certainly in the living trusts we give people, why would people want less authority over their own property in a trust then they have themselves? So in fact, it’s utterly indistinguishable. You can sell it, mortgage it, loan it, whatever you want to do with it, destroy it, or anything you want to.

QUESTION: The successor trustee then, after you’re gone, will have to distribute that to the beneficiaries. How does that person know what to do? How do they get paid?

DENIS CLIFFORD: Well, first of all, they don’t have to get paid, and they often don’t. When my mother died, and my father, I was the successor trustee for them, and there’s seven kids in our family, and all the property was divided equally, and I certainly wasn’t going to charge my brothers and sisters a fee for preparing some paperwork for them. And basically, the successor trustee himself or herself determines what’s a reasonable fee, but I would say in the vast majority of cases, there’s no fee involved. Presumably, the person who set up the trust talks with the successor trustee; it’s not a good idea to have them all of a sudden find out, “Hey, I’m a successor trustee,” I mean, maybe they don’t want to be, or maybe they’re not here. So, they talk with them and say, “Here’s my property, and here’s what’s going to happen when I die,” just as a person should with a will with their executor. Whether you want to talk to anyone else is different, but you certainly need to talk to the person who’s going to responsible for handling your property when you die, and tell them how it’s going to work. Then, the successor trustee actually needs to take some steps when you die. So, the trustee has to transfer that property. As successor trustee, he files the documents, “As a successor trustee, I transfer this property to whoever the beneficiary is.” Nolo has a couple of very good books including The Executor’s Guide that also includes, as well as executors duties, successor trustee’s duties, after the person who set up the trust dies, and it’s all clearly spelled out there what you have to do and exactly how you go about doing that.

QUESTION: Okay, two magic words that lawyers like to use but we may not understand as laypeople would be, revocable and irrevocable, as they apply to a living trust.

DENIS CLIFFORD: Yeah, that’s a good question. Living trusts are always revocable until you die, and the reason for that is one, why would you want to give up control over your property? If for any reason you decide, “You know, I want to sell it, or I want to do this, or get it out of the trust,” you could always transfer it directly out of the trust, but you can always just end the trust if you want to. The other reason it’s important to be revocable is that if you set up an irrevocable trust, that constitutes a whole different animal than a revocable trust. An irrevocable trust is a gift to a new legal entity called the trust, and if I set up the Denis Clifford irrevocable trust, that is a separate legal entity that has to file annual income tax returns, it has to have its own accounting, its own financial operations… that kind of trust is set up, for instance, if somebody wants to give a lot of money for their own charity and set up the Denis Clifford Foundation to Help Starving Artists, or whatever it would be. It’s a totally different thing than a living trust, which is revocable, which means you can change it, and you don’t have any tax consequences.

QUESTION: Let’s talk about this thing called an AB trust, and how that saves on taxes. It seems like it applies primarily to married couples, is that correct?

DENIS CLIFFORD: Well, not necessarily; it can apply to any couple who have a substantial amount of money and want to leave it to each other. Generally, it’s used by married couples, but you can be an unmarried couple. Let’s say you have, for example, four million dollars between you, and you own it equally. You can use an AB trust to try and save on estate taxes. It’s sort of complicated to explain in a short answer, but first of all, it’s an estate tax saving device, and the simple answer is, if I’m going to leave my two million dollars to my spouse when I die, she now has an estate of four million dollars. If she dies this year, her exemption will be two million dollars, and two million dollars of our property will be subject to estate tax because our property has now been lumped together. The idea of an AB trust is to split the two estates, so the property is left for the use and benefit of the surviving spouse, but it never becomes legally owned by her, so each estate is kept separate, and in this case, you would use the two million dollar exemption twice, first when I die, and then when my spouse dies, and that would mean no estate tax would be made. So, first of all, like I said, it’s only for people who are likely to be subject to estate tax. You need to read about it, and understand it, and see if you think it works, and see if you want to set it up, because it does impose some restrictions on the surviving spouse’s ability to invade the trust principle: the money and property in the trust.

QUESTION: There’s a trust you talk about in your book called “a child’s trust,” which is for the benefit of surviving children?

DENIS CLIFFORD: Yeah. A child’s trust is a trust, in this case set up through a living trust, although it can also be set up through a will, for property you leave to children. Children under eighteen cannot own any significant amount of property outright. If you want to leave property for the benefit of children or, say, young grandchildren, you need to find a way to impose legal adult supervision over that property, if they’re still under eighteen when you die. A child’s trust is one of the principle ways to create this supervision. A child’s trust, when it becomes operational, is irrevocable. In other words, you set one up in your living trust, but since you’re still alive and the whole living trust is revocable, so is the child’s trust. Once you die, then your living trust becomes irrevocable, and it can’t be changed, because you’re dead. Then, if you have a child’s trust, that child’s trust is established and becomes irrevocable, and whatever property you left that child goes into that trust and is managed by whoever you named to be trustee of that trust, and that person hands out money to the child, including principle, as that person sees fit, until the child becomes whatever age you selected as the age when that trust property, or what remains of it, will be turned over outright to the child.

QUESTION: How hard is it to amend the living trust?

DENIS CLIFFORD: It’s very easy; you amend the living trust simply by preparing any form amendment. Living trusts always need to be notarized, and you would have the amendment notarized, but you don’t even have to have witnesses; you just have it notarized. And you can amend it any way you want; there are amendment forms in our Make Your Own Living Trust and other Nolo software programs. And you simply say, “I insert this paragraph into my trust, paragraph X section 2 is now this, here’s what’s deleted,” and that’s it. So, it’s a very simple process to amend it.

QUESTION: One of the things I thought that was really interesting in your living trust book is that you suggest that people create a backup will, so maybe you could just explain your thinking on that.

DENIS CLIFFORD: Yeah, I think people always need a will. I call it a backup will; even if you’re trying to transfer all your property by living trust, you’re not always sure that you have. You know, you may win the lottery the day before you die, or you may get an inheritance, or some property you may not think about, a small bank account or some personal stuff, may not get transferred into your trust. So, it’s always a good idea to prepare a will, just in case this property exists when you die. If it doesn’t, then nothing happens; if it does, then you’ve got a document in place that says, “All property that isn’t in my living trust for whatever reasons goes to…” whoever you name it to. And given that creating a simple will like this is very easy, I can’t see any reason not to do it. It’s a kind of insurance.

Wednesday, February 1, 2006

What Are the Rules for Nonprofit Fundraising?

We’re speaking with Attorney Ilona Bray, author of “Effective Fundraising for Nonprofits.

NOLO: Ilona, when people think of nonprofits, they often think of charities or environmental groups, but actually a nonprofit can really be any type of business, such as an arts group, or a radio station, a church, or a publisher. So, maybe we should start out by talking about the difference between a nonprofit and a for-profit corporation.

ILONA BRAY: First actually, let me just affirm that you’re right about the variety of nonprofits. I was thinking about just on a daily basis; when we go out and about, all of us probably interact with a number of non-profits. Whether we’re shopping in a charity thrift store, dropping off kids at little league, visiting a museum, attending church, mosque, or temple services, going to a hospital, and when you’re done with all that, going to the theatre at night. So, what being a nonprofit means, really, is that any income that the organization brings in is not used for private gain. In other words, your staff, your board members, and your other members, even if some of them draw a salary (which is fine), never actually get a cut of the profits. Instead, they all go to serve some public or mutual benefit.

NOLO: Just so we’re clear on one thing, can a nonprofit make a profit?

ILONA BRAY: A nonprofit actually can make a profit. This is a great question because it’s an important misconception to clear up. So, let’s say I’m running a nonprofit clinic, maybe in a neighborhood that other doctors won’t come to. Do I have to charge less than a regular doctor? Actually, no, under the tax and other relevant laws, I can charge market rate and that’s just fine. Of course, I might want to reduce the fees just to make the service accessible to them. But what if some of the people coming in actually have an okay income? I might want to have, say, a sliding scale and charge them market rates, and again, that’s just fine. I would even say it’s a good idea for nonprofits to try and find ways like that of bringing in extra funds and putting it into a savings account for the future, for hard times, which most every nonprofit is going to experience. And some places think that that’s a problem, that that means they’ve got profits. That’s not a problem at all; in fact, it’s a good management idea.

NOLO: Here’s another basic question. You see the term 501C3 Status for nonprofits. What does that mean?

ILONA BRAY: 501C3 is a number from the tax code. Most organizations that fit the definition that I just gave about not operating for private gain are 501C3s, meaning that they applied to the IRS for their status. It’s also called tax-exempt status under section 501C3. And, the reason they would want to do that is that a 501C3 is exempt from paying taxes, and its donors can deduct their contributions from their taxes. Not all nonprofits are 501C3s, and I won’t get into too much detail there, but 501C3 is especially for nonprofits serving charitable, religious, or education purposes. A bunch of other nonprofits like Chambers of Commerce or recreational clubs would get other 501 statuses.

NOLO: If a person wants to donate money to a nonprofit in their will, how do they go about doing it? Do they need to notify the nonprofit of the prospective gift?

ILONA BRAY: It’s actually quite easy to leave money to a nonprofit, say, in your will. Apart from meeting the usual requirements of a will, which I don’t want to get into here, the donor needs to accurately state the legal name of the organization, where it’s located, what the gift is (it might be money or it might be property), and what the donor expects you to do with the gift. And, maybe because it’s so easy, they don’t need to, and sometime they simply don’t, notify the nonprofit. Now, that can be great fun for organizations; I once worked in a place where we walked in one day and $10,000 appeared from a donor’s estate. But it would have been nice to thank that donor during her lifetime, and maybe plan for the gift. Perhaps we could have gotten that donor more involved in the organization if we’d known about her. And that’s why it’s worth nonprofits efforts to encourage donors thinking of leaving this kind of gift to let them know, communicate with them, talk about what the gift is going to be used for in advance, and get involved with the organization in other ways perhaps.

NOLO: Ilona, is it better to make a donation in your will, or to set up a living trust?

ILONA BRAY: That’s more of a question for somebody’s overall estate-planning goals. You certainly wouldn’t want to divide it up and say, “Oh, I’m going to leave my money to charity in a living trust, and my money for the rest of my legatees in a will.” Folks might want to do a little research or talk to their estate-planning lawyer about that. Living trusts are becoming very popular estate-planning devices because they avoid probate by essentially having someone act as trustee and transfer the property after your death out of the trust. And because the trust sort of lived while you were alive and continues to live after you’re dead, you don’t have to do the separate route into court at the same time. And, it’s just as easy to put money toward a charity in a living trust as in a will.

NOLO: Let’s say you’re leaving money in a will or a trust; can a person set rules on how that gift will be used?

ILONA BRAY: You can. You couldn’t go so far as to say it had to be used for some illegal purpose, but you can leave your intentions, and nonprofits are obligated to honor those intentions to the extent possible. And let’s not forget that people can leave other things besides money, and are maybe even more likely to leave those with conditions. Like I’ve heard of many cases in which somebody leaves a painting, or even a huge sculpture, to a museum, and says, “I’m leaving this to you on the condition that it be on permanent display.” And then the museum has this headache of trying to figure out, “Do we accept this gift, and have it right there in the middle of the museum for the rest of its life, or do we not?”

NOLO: Can you be personally liable if you’re an individual member of the nonprofit board if there’s mismanagement of a donor gift?

ILONA BRAY: It’s certainly possible, because board members bear personal responsibility for virtually all of a nonprofit’s actions, and gift management is one of the important activities going on within the nonprofit. There can be exceptions, like, depending on state law, if the board member, say, reasonably relies on information from a staff member, they might be protected, which makes sense; if the board member’s being lied to and didn’t have any reason to expect that that was the case, they should get some protection. But that, as I said, depends on state laws. In general, as practical matter, this doesn’t happen that often; board members aren’t often called to compensate for problems within the nonprofit with their personal funds. But this is a good chance to remind anyone serving with a board not to be lax. You know, you don’t want your own sleepiness at a meeting to be the cause of questioning whether you should be liable for some bad action by the nonprofit.

NOLO: A lot of nonprofits raise money by gambling, for example with raffles. Are there legal rules to be followed, and do you ever have to worry if the police will bust the church raffle, for example?

ILONA BRAY: Well, before any nonprofit thinks about having a raffle, they should check their state’s laws. Because there will probably be provisions about that; you can probably find it on your state’s website. A lot of states will allow only nonprofits to hold raffles, but they want to see proof first that the nonprofit is a nonprofit, so they may ask you to get a permit in advance or something like that. There might be other regulations as well, say on how many raffles you can hold, or when, types of prizes, that sort of thing.

NOLO: The Girl Scouts sell cookies to raise money, Green Peace sells calendars… do these organizations have to pay taxes on these sales?

ILONA BRAY: In those particular cases that you mentioned, probably not, because those are irregular sales that are not part of an ongoing business. If the Girl Scouts sold cookies all year, that might be a different story. So, the general rule for federal taxes, and states might be different story, is that nonprofits have to pay tax on income earned from selling things if what they’re doing is getting unrelated business income, and, unrelated means that it has nothing to do with the mission of the profit. A nice way of remembering that is, if you have a museum gift shop, and you sell postcards with the images from the museum, no tax there, because that’s related to your mission; that helps sort of show people the art. But let’s say it’s in New York and it sells little snow globes with the statue of liberty in it, they would have to pay tax on that, because that has nothing to do with the mission of an art museum.

NOLO: I’m sure it rarely happens, but I’m kind of curious… what happens if a nonprofit or a foundation, for whatever reasons, they don’t want to accept money from an individual, is it legal to turn down a gift?

ILONA BRAY: It’s definitely legal to turn it down, or to return it after you get it. Sometimes that will come about because of public pressure. I was reading recently about an organization that had gotten a rather large gift from a man who was widely known as a racist; I guess he was sending inflammatory letters to the local newspapers, and so the question for the group is, “Do we return it, or do we put the money towards some good use and maybe undo some of the damage this guy has done?” It’s a tough question for organizations.

NOLO: I know there are guidelines for nonprofit accountability and efficiency, but how can a nonprofit find them, and, I guess more importantly, why is it so important that the organization abide by these rules?

ILONA BRAY: That’s a question that’s definitely worth every nonprofit looking into. Simply because, we all see in the newspaper these days, accountability is becoming so important; the media are all out looking for the latest scandal, in terms of some nonprofit doing something that wasn’t quite right. So, the starting point is going to be your state’s law, concerning nonprofits; every state has one. Again, that’s probably findable through the state website. Beyond this, nonprofits can look to a group called the Better Business Bureau’s Wise Giving Alliance, and this is a group that’s published detailed standards and guidance that are pretty much accepted as the industry standard these days. For example, they suggest that no more than 35% of a group’s funding be spent on administration and fundraising. There’s a lot more to their standard providing, and so you can access that at