Why a Nonprofit Corporation?

A nonprofit corporation is a time-tested structure, particularly for public charities. The many benefits include:

  • A history of case law supporting the limited liability protection provided to directors.
  • An IRS familiarity with reviewing and approving tax exempt applications for nonprofit corporations that carries over to evaluating your organization for ongoing compliance with the exempt section of the federal tax code.
  • State tax exemptions written based on the traditional nonprofit corporation structure.
  • Grant reviewers evaluating proposals based on their understanding of the nonprofit corporation model.
  • Donors knowing and feeling comfortable contributing to nonprofit corporations.

Keep in mind that options may vary state by state and you should consider whether or not you intend to pursue federal tax exemption.

Nonprofit vs. For-Profit Options

Before you file any government documents, it’s critical to have a clear end goal in mind of how you want your organization classified in state and federal records.

Why is this so important? We speak from experience. We provide “rescue services” to more organizations than we would like to - those who get all the way to applying for 501(c) exemption before they realize they’re on the wrong path. After discovering an error, getting back on the right track may require an amendment, a conversion to a different entity, or a full dissolution and starting over from scratch. All of this results in additional expense, delay, and most of all, distraction from the mission of your organization.

Take time to decide your legal structure and tax classification before you start filing government documents.

Nonprofit vs. For-Profit vs. Blended Structures

Once upon a time, a nonprofit corporation was the obvious legal structure for those who wanted to change the world by giving back. More and more, modern social entrepreneurs are mixing traditionally for-profit and nonprofit missions. In response to organizations like these, lawmakers have introduced new legal structures like B-Corporations, L3Cs, and Flexible Benefit Corporations. If you are struggling with the very fundamental question of whether your organization is nonprofit or for-profit, then this is the first decision you need to make.

How to Decide

The first step is to determine whether the organization is a nonprofit or a for-profit. If the organization will not obtain 501(c) federal income tax exemption, don’t start a nonprofit. A nonprofit that does not obtain exemption simply doesn’t make sense because there are no owners to whom you can distribute profits.

To take it one step further, if your organization can obtain 501(c) tax exemption it probably should. The benefit of 501(c) tax exemption is simple - all of the money saved on taxes can go back to further your cause. If your organization qualifies for exemption, use it to the advantage of your mission.

Use the following five tests to help you decide.

  • Primary purpose “smell test”
    Does the primary purpose of your organization align with a traditional 501(c) exemption - such as a charitable, religious, or educational purpose?
  • Unrelated Business Income (UBI)
    Technically, 501(c)s are limited to conducting the exempt purpose stated in their formation documents. In practice, 501(c)s sometimes collect business income and pay taxes on this portion. If you start collecting too much UBI, you are at risk of losing your 501(c) status and owing back-taxes. The IRS decides this by conducting an “operational test” to consider if the nonprofit is being run in line with it’s exempt mission.
  • Will you seek private funding and reward investors?
    Nonprofit 501(c)s primarily obtain funding from donations, grants, membership dues, and other tax exempt income sources. For-profits attract shareholder-like investors and can obtain SBA-backed loans. Nonprofits never disburse profits to owners and investors; they are prohibited from private inurement.
  • How much control do you want of the organization?
    Control in for-profit corporations is clearly in the hands of shareholders who vote their shares. A founder can keep control by holding 51% or more of outstanding shares. The founder of a nonprofit should expect community-based decision-making by the Board of Directors.
  • Personal pay-out
    As a social entrepreneur, how will you personally be compensated? A nonprofit permits a “reasonable” salary. Along the same lines, what is your exit strategy? You cannot one day “sell” a nonprofit for a pay-out.

Still undecided? Some organizations create for-profit and nonprofit entities in tandem that can be structured in a parent-child or brother-sister arrangement.

Legal Structures Used by Nonprofits and Social Entrepreneurs

The following legal structures are used by traditional nonprofits and by social entrepreneurs blending nonprofit and for-profit missions. Remember - available legal structures vary by state so your state may not offer all of these options.

  • Nonprofit corporations protect your directors and members from personal liability from any financial debts and legal liability of the nonprofit. This is called limited liability. Needing your limited liability protection is an unlikely and worst case scenario for your nonprofit; nevertheless, this protection is the most important feature of a corporation. Nonprofit corporations may or may not have members. The members elect the Board of Directors to oversee the corporation; otherwise the Board of Directors self-perpetuates. Your state may further classify nonprofit corporations into a:
    • Public benefit corporation, those that serve the community at large such as volunteer firefighter departments, grantmaking foundations, and homeless shelters.
    • Mutual benefit corporation, those that serve a limited number of members with common interest such as homeowners’ associations, snowmobile clubs, or trade associations. These corporations typically do not apply for tax exemption under 501(c)(3) but may apply for other tax exemptions.
    • Nonprofit professional corporation, those that are formed to provide the services of licensed professionals such as accountants, lawyers, or doctors.
    • Religious corporation, used primarily for religious purposes.
    • Cooperative corporation, that places more control of the corporation in the hands of the employees or patrons. This model is appropriate for local food cooperatives and others with a community-based mindset.
  • B-Corporations, or benefit corporations, are a newer type of corporation. A B-corporation is a for-profit corporation that meets rigorous standards of social and environmental performance, accountability, and transparency. B-Corps are appropriate for organizations that attract significant investment and reward investors while at the same time giving directors additional license to make decisions in line with nonprofit goals as opposed to shareholder profits. B-Corps often obtain third-party certification, such as “B Corp” certification from B Lab.
  • Flexible Purpose Corporations (FPC) are a new corporation form available in California. FPCs must specify at least one “social purpose” in their charter and protect boards and management from shareholder liability when they weigh pursuit of the social purpose against shareholder value. It is different than a B-Corp in that this structure is meant for for-profit companies seeking traditional investment.
  • Low-profit limited liability companies (L3Cs) are for-profit social enterprise ventures. This structure was created to help bridge the gap between for-profit and nonprofit investing by mirroring federal tax standards for program-related investing (PRI). It preserves the tax flexibility of a traditional LLC.
  • Unincorporated nonprofit associations, or nonprofits that chooses not to incorporate, are still subject to certain legal and taxation requirements. The members of an unincorporated nonprofit association do not have limited liability protection. This structure can be appropriate when you wish to perform short-term community service or fundraising.
  • Charitable Trusts are most commonly seen when an estate is left for charitable purposes. A trustee holds the assets that pass to the beneficiaries.

Our Nonprofit Startup Guide is written for nonprofit corporations that file for 501(c)(3) tax exemption. Please contact us for more information on less popular structures.

Key Takeaways:

  1. There are many benefits to pursuing the time-tested, nonprofit corporation structure.
  2. Donors know and feel comfortable contributing to nonprofit corporations.
  3. The nonprofit corporation is your best choice if you intend to pursue federal tax exemption.
Continue reading “What are Your 501c Options?”
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