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What is a non-profit?
A non-profit is a business with a mission that qualifies for special tax treatment under the IRC and state revenue codes. The mission must be to undertake a task that the government deems a public necessity or good. A non-profit is generally a corporation, but the corporate entity status is not mandatory.
• Note: State statutes often distinguish between non-profits and not-for-profit entities. While these classifications are largely the same, there are some minor differences. Generally, the differences regard membership status and who benefits from the operations of the entity (employees, third-parties or internal members).
What types of activities qualify for non-profit status?
To qualify for Federal, non-profit status, a business’ mission must a public purpose, such as charitable, educational, religious, literary purposes, or scientific in nature. There is a lot of room for interpretation within the general categories.
• Example: The NCAA college football bowl games are non-profits, but they bring in millions of dollars for the NCAA and the schools involved.
• Note: States also recognize business entities as non-profits. State recognition generally depends upon federal recognition of the entity as having a tax-exempt (non-profit) purpose. There are many types of activities that qualify for non-profit tax treatment under Section 501(c) of the IRC.
How is a non-profit formed?
Most non-profits are corporations. Unlike a for-profit corporation, non-profit corporations do not issue shares of stock. The corporation chooses to either designate members who vote to elect directors to the corporate board or the incorporate simply appoints the initial board of directors. These directors then govern the business in accordance with the bylaws. This includes the addition or removal of new directors. Some states recognize a specific entity form dedicated to non-profit status. The rules governing these entities facilitate the non-profit mission and add certainty to the maintenance and governance requirements. These are known as non-profit corporations.
To form the non-profit entity, the organizer must undertake the necessary filing requirements with the Secretary of State’s office. After receiving an entity charter, the initial board of directors will adopt the organization’s bylaws, appoint officers, and complete other organizational requirements. The business must then file for tax exemption with the IRS. The business must complete a Form 1023 packet, which requires specific information about the business’ mission, articles, bylaws (or other governance document), capitalization (or expected revenue), the founders (directors), the officers and their compensation, etc. If the business qualifies under IRC Section 501(c), then the IRS will issue a tax-exempt certification letter. The business will then follow the required application steps of the State’s Department of Revenue (DOR). The DOR will generally require similar information to that required by the IRS in Form 1023, including the IRS exemption letter. Upon approval, the DOR will issue a state income tax exemption letter.
What are the maintenance requirements for non-profits?
The maintenance requirements for a non-profit are similar to those of a corporation. Non-profits must still hold meetings, keep minutes, and maintain other records. One notable difference is that non-profit corporations do not have shareholder meetings. If the corporation has members, these members may meet in a fashion similar to that of shareholders to take actions within their authority (e.g., vote for directors, approve major corporate actions, etc.). The non-profit must also file annual financial disclosures with the IRS on some variation of Form 990 and with the DOR on the applicable state forms. All records must be available for inspection at its business office or principal place of business.
• Note: Failure to file the annual IRS disclosures will result in a revocation of the tax-exempt status. States may also require an annual filing with the State’s Department of Revenue in order to maintain tax-exempt status in that state.
Who owns and controls a non-profit?
Unlike regular corporations, non-profit corporations do not have traditional shareholders or owners. The organizer elects the initial directors, who adopt the bylaws. Since the non-profit is often organized as a corporation, the role of the shareholder becomes synonymous with membership. The original members may be noted in the corporate charter or they may be designated during a board of directors meeting. The board will immediately adopt the bylaws of the corporation. The bylaws determine the procedures for managing and governing the non-profit. The non-profit may have a membership structure where the appointed members vote on the board of directors and on major decisions for the non-profit. In contrast, the non-profit may choose a structure where the board of directors makes all decisions for the non-profit. The members (or the board of directors, depending upon the structure) will vote to elect new directors or to make any major changes to the non-profit. The board will be in charge of hiring officers and establishing compensation structures. The officers will run the daily affairs of the non-profit.
• Note: The primary characteristic of a non-profit’s control structure is that the directors often taken on the roles assumed by shareholders and directors in a typical corporation.
What is the non-profit continuity?
The non-profit exists independently of its members or directors. If any member or director leaves, the non-profit continues to exist. Since a non-profit does not have owners, there is no need for continuity measures, such as buy-sell agreements. If a non-profit dissolves, it must distribute all of its assets to another non-profit.
• Note: Non-profits often have a fixed life. This is common when the non-profit is expected to exhaust a finite endowment of funds. In such a case, once the non-profit has fulfilled its useful purpose then it will dissolve unless the directors take action to extend the life of the entity.
What profit is a non-profit allowed to make?
A non-profit can make a profit on its operations. The limitation is that it cannot return those profits to members or directors of the non-profit. The non-profit must retain any profits and employ those funds in pursuit of its non-profit mission. The profits will be used to pay for the operations and in general support of the non-profit mission. The non-profit may also transfer those funds to other eligible non-profits. The officers in charge of running the non-profit, along with all other employees, may be compensated for their services as in a regular corporation.
• Example: Alex founds a non-profit and serves as a board member and president (an officer). The non-profit brings in revenue of $1 million in the year. Alex receives a salary of $200,000 per year for his service as president to the non-profit. Alex, however, cannot receive any portion of the profits outside of his salary. All of the business profits must be reinvested in the business’s operations or transferred to another non-profit.
• Note: There are general limitations on the amount of compensation that non-profits can pay to individual employees. There are, however, cases where non-profit CEOs earn over $1 million in annual compensation. As with for-profit corporations, it often depends on whether the regulators find the salary reasonable.
What are the limitations of non-profits?
A non-profit cannot become involved in political campaigns, is limited in its lobbying activity, and cannot distribute profits to any member, director, etc. If the non-profit earns income unrelated to its non-profit purpose, then it must pay income taxes on those profits. Further, the non-profit is limited in the amount of profits that it can receive from the unrelated activities. Unrelated activities are generally subject to normal income tax, as the earnings are not sufficiently related to the non-profit mission.
• Note: Excessive unrelated profits can jeopardize the non-profit’s tax-exempt status with state or federal authorities. Further, a non-profit must benefit a defined class of people and cannot use its funds to benefit one or a small group of people. This is known as the “private benefit” prohibition.
What type of unrelated activities are exempt from taxation?
Several non-profit activities that are not related to the non-profit purpose, but still receive tax-exempt treatment are:
• Sales of merchandise that has largely been donated to the non-profit,
• Distributions of items worth less than $5 in return for donations,
• Some activities that primarily benefit members, patients, students, officers or employees of the non-profit,
• Activities where nearly all of the work is done by volunteers, and
• Sales, rentals or exchanges of donor mailing lists.
• Note: Engaging in unrelated activities is extremely risky for the non-profit. This generally becomes a concern as the non-profit grows.
What limited liability protection does a non-profit offer?
A non-profit business entity generally has limited personal liability in accordance with its underlying entity status (e.g., a corporation). The directors, officers, and members of a non-profit corporation all receive protection from personal liability for the legal obligations of the non-profit. In certain circumstances, however, limited liability will not provide protection when a director or officer:
• Personally commits a tort,
• Personally guarantees a loan or business debt that is defaulted on by the non-profit,
• Co-mingles personal funds with non-profit funds, or
• Engages in fraudulent or reckless behavior that causes harm.
How does a non-profit raise money?
A primary benefit for a non-profit is that it is eligible for public and private grants and can receive contributions from individuals. If the non-profit is classed for tax purposes as a 501(c)(3), the donation is generally tax deductible for the individual or organization that made the contribution.
• Example: GoodGuys, Inc., a local IRC Section 501(c)(3) organization, asks Daniel for a contribution to support the organization. Daniel makes a contribution of $500 to the non-profit. The non-profit can raise money through this type of solicitation. Daniel, in turn, may be able to deduct $500 from his taxable income.
• Note: State rules regarding fraud apply when soliciting funds from potential donors to the non-profit. States also often have special rules that non-profits must follow when soliciting its citizens.
What are the main benefits of organizing as a non-profit?
Qualifying organizations pay no tax on federal, state, and local taxes, and therefore can devote a larger proportion of their resources to achieving their particular goals. The status can also qualify groups for special grants or government funding, as well as special rates for services or even postage. Donors prefer making contributions to these groups because they can generally deduct the payments from their own taxes. Non-profits are exempt from local property tax. The form of the organization offers advantages in itself. Since non-profits may exist as corporations, they may also possess all the benefits of corporate status. As previously discussed, the corporate form shields owners and managers of the organization from personal liability for the group’s actions, subject to certain legal exceptions. Non-profit incorporation also serves a strategic goal by formalizing the group’s goals and helps maintain organizational focus as the effort grows.
• Note: The benefits of non-profit status should accrue to the business and its operations. These benefits should generally not accrue to individual members of the non-profit.
What are the disadvantages of organizing as a non-profit?
Despite the advantages noted above, non-profit status has numerous disadvantages. Drawbacks to the status include:
• Inability to divide profits among members;
• Limitations on the sources of the group’s income; and
• Restrictions on the use of assets to tax exempt purposes expressed in the governing documents.