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Fundamentals of Nonprofit Corporations

The term "nonprofit" broadly refers to any organization in which income and revenues are not shared on the basis of ownership as there are no shareholders or official earnings to distribute. Corporate status for nonprofit entities provides a shield against potentially unlimited liability for directors, officers, employees, volunteers and other agents of the organization. Although many nonprofit corporations are tax exempt, other reasons exist for a business that never expects to have tax-exempt status to set up as a nonprofit corporation.
 
Advantages of Nonprofit Incorporation
 
  • Protection of personal assets if the organization is sued
  • Avoidance or minimization state and federal taxes
  • Donations to organization are tax deductible
  • Eligibility for government and private foundation grants and other funds
  • Property tax exemptions
  • Special mailing rates at the post office
  • Good marketing, as people like to do business with a nonprofit  
Disadvantages of Nonprofit Incorporation
 
  • Taxes may be owed on profits from activities that are not related to the nonprofit corporate purpose
  • Inability to disburse earnings to organization members
  • Difficulty in raising capital
  • Participation in political fundraising or lobbying is forbidden
  • When the corporation is dissolved, all corporate assets will need to be transferred to another nonprofit corporation  
Incorporating a Nonprofit Organization
 
The incorporation process, which varies by state, generally includes the following:
 
  • Filing Articles of Incorporation with the corporate division of the state, with information about the name of the organization, the identities of the members of the initial board of directors, and the identity of the registered agent who will accept legal service on behalf of the corporation
  • Drafting Corporate By-Laws, which dictates how the corporation will operate and who will have voting status to make decisions. Most states have laws that specify exactly what language should be used to protect board members and other active participants from personal liability.  
Applying for Tax-Exempt Status
Being nonprofit is not the same thing as having tax-exempt status. Usually, nonprofit corporations are still subject to taxation until they file separate applications under both federal and state law to be granted tax-exempt status.
 
Section 501(c)(3) of the federal tax code gives tax-exempt status to qualified nonprofit organizations. Generally, the operations of such organizations must be for nonprofit purposes falling within one of the following categories:
 
  • Charitable
  • Religious
  • Educational
  • Scientific
  • Civic leagues and social welfare organizations
  • Testing for public safety
  • Literary
  • Fostering national or international amateur sports competition
  • Prevention of cruelty to children or animals
  • Labor, agricultural and horticultural organizations
  • Business leagues
  • Social and recreational clubs
  • Fraternal societies
  • Employee associations
  • Credit unions
  • Veterans' organizations
  • High-risk health coverage organizations
  • Workers' compensation reinsurance organizations
 
The IRS will look at substance over form and will require a tax-exempt applicant to structure the organization along well-defined guidelines so that the activities of the organization do not benefit any particular individual. After receiving 501(c)(3) status, donations to the charitable organization are generally tax deductible for the donor.
 
Receiving tax-exempt status does not give a nonprofit corporation the authority to do whatever it wants, however. Activities outside of its tax-exempt purpose can result in taxation on "unrelated business income." In a worst case scenario, the organization's tax-exempt status can be revoked.
 
Guarding Nonprofit Tax Status
 
The board of directors of a nonprofit corporation should be directed to take the following steps to protect the nonprofit tax status:
 
  • Keep detailed records on the sources of any income
  • Carefully segregate out and pay taxes on any income that comes from non-related business activities
  • Keep careful records of corporate meetings
  • Make sure minutes, resolutions and any correspondence with the IRS are carefully documented and stored
  • Refrain from distributing any of the corporate income to board members or any one else connected with the organization. The exception to this rule is salaries and benefits for employees, as long as they are reasonably equal to salaries and benefits of similarly situated employees of for-profit organizations.