Are you passionate about promoting responsible recycling in your community? Perhaps you want to encourage responsible gun ownership or reduce homelessness. Maybe your side hustle turned into something much, much more. If you have an idea on how to translate your passion into potentially effective action, perhaps you should consider forming a nonprofit corporation.
The information below represents a general description of the process of forming nonprofit corporations. It is not intended to provide legal advice. Each state has specific regulations associated with forming a nonprofit corporation. You should consult with an attorney in your state that specializes in nonprofit corporations with specific questions.
In this article
What Are Nonprofit Corporations?
Many people associate the word “corporation” with a commercial conglomerate intent on maximizing profit above all else. But “corporation” is merely a legal term that defines a company that has obtained legal status separate from its officers or directors. There are four main differences between nonprofit corporations and their for-profit siblings.
Purpose: For-profit corporations are commercial enterprises designed to provide goods and services while generating revenues in the form of profit. In plain English, commercial corporations are designed to make money by providing things that people are willing to pay money for. By contrast, nonprofit corporations are designed to provide a service or a product intended to improve the lives of their clients or the general public.
Shareholders: For-profit corporations are owned by their shareholders, who share in any profits the corporation generates. By contrast, nonprofit corporations are not allowed to have shareholders. Any revenue generated by a nonprofit corporation must be redistributed back into the enterprise – to promote its stated mission, to provide reasonable salaries to employees and to cover operating costs. Nonprofit corporations that generate large excesses frequently use their surplus funds to expand their operations.
Dissolution and Winding Up: A for-profit company that ends its operations in the black can liquidate its assets and distribute the proceeds among its officers and shareholders. Nonprofit corporations that end their operations must distribute any assets either to other nonprofit organizations, not to individuals.
Taxes: For-profit corporations must pay taxes on the earnings of the corporation (which gives rise to the term “double taxation,” because shareholders must also declare their dividends on their individual tax returns). Nonprofit corporations are eligible for exemption from federal and state taxes, although their employees and officers must still declare their salaries on their federal and state income tax returns. Nonprofit corporations that have obtained federal tax-exempt status can also solicit grants from organizations and tax-deductible donations from individuals.
What Is a Social Entrepreneur?
A nonprofit corporation is often the brainchild of a social entrepreneur – an individual who has adapted an entrepreneurial approach to promote the public good. Nonprofit corporations allow social entrepreneurs to apply sound business principles to social problems. While many social entrepreneurial projects generate large revenues, making money for its own sake is not the ultimate goal.
One of the most famous social entrepreneurs is Muhammad Yunus, an economist from Bangladesh who won the Nobel Peace Prize in 2006 for inventing and instituting the concept of microloans through his institution, the Grameen Bank, which he founded in 1976. The Grameen Bank provides small loans, often less than $100 US, to poor individuals, overwhelmingly female, with no collateral and who would otherwise have no way of qualifying for credit. With their loans, recipients are able to purchase equipment such as sewing machines or ovens that allow them to create goods for sale. They repay their loans with proceeds from sales of their products, which also frequently allow them to lift ether families out of poverty.
The Incorporation Process
It is not necessary to be a social entrepreneur to form a nonprofit corporation. In fact, many social service agencies are formed as nonprofit corporations specifically to qualify for tax-exempt status along with providing their services. Aside from the process associated with obtaining tax-exempt status, the process required to form a nonprofit corporation is much like the process associated with forming any corporation.
To obtain legal status as a nonprofit corporation, each organization must execute the following steps with their secretary of state or similar office:
- Choose a name that is available and that adheres to state regulations
- File proper paperwork, often called articles of incorporation plus a filing fee
- Create corporate bylaws, which are the operating rules of the corporation
- Appoint initial directors (some states require this step before filing the articles of incorporation because directors’’ names must be included with the paperwork)
- Hold initial board of directors meeting
- Obtain necessary licenses and permits
Applying for Tax-Exempt Status
Along with organizing as a nonprofit corporation, you will almost certainly wish to pursue tax-exempt status as well. Tax-exempt organizations must meet three tests set by the IRS: the organizational test, the political test and the asset test. The political test requires tax-exempt organizations to refrain from involvement in political campaigns; the asset test requires charitable organizations to reinvest proceeds back into the organization in the form of salaries, operational costs or expansion. The organizational test specifies allowed categories for types of tax-exempt organizations – which are listed below.
Tax code / Type of organization
·501(c)4 Social Welfare Organization
·501(c)6 Business membership
·501(c)8 Fraternal beneficiary
·501(c)10 Domestic fraternal
As the list above illustrates, there are several types of tax-exempt organizations. Nonetheless, the overwhelming majority of tax-exempt organizations hold 501(c)(3) status. To apply for tax-exempt status, nonprofit organizations must apply for an Employer Identification Number (EIN), available for no charge through the IRS website. Form 1023, along with copies of the articles of incorporation and a fee of $400 for organizations with gross receipts during the previous four years that averaged less than $10,000 annually and a fee of $850 for organizations with gross receipts that averaged more than $10,000 annually for the previous four years. The application process for obtaining tax-exempt status is lengthy and can be complicated. It is advisable to seek the services of a professional specializing in tax exempt organizations if you take on the task.
Is Obtaining Tax-Exempt Status Worth the Hassle?
Contrary to common perception, it is not necessary to obtain tax-exempt status in order to operate as a nonprofit organization. Many nonprofit organizations lose their tax-exempt status each year, largely due to failure to file the proper paperwork to maintain the organization’s tax-exempt status. Unincorporated Nonprofit Organizations with revenues less than $5,000 annually are not required to apply for tax-exempt status In addition, political and lobbying organizations are largely ineligible for tax-exempt status.
But obtaining and maintaining tax-exempt status provides two major advantages: 1) wider eligibility for grants and 2) the ability to solicit tax-deductible donations from individuals. Unincorporated Nonprofit Organizations may also provide individuals with tax-deductible status for donations, but may still face difficulties in soliciting donations and especially in applying for grants. In addition, the personal assets of individuals associated with an Unincorporated Nonprofit Organization are not shielded from legal action taken against the organization, which has no separate legal status.
If your cause resonates with large numbers of people, you may find yourself inundated with offers of assistance – and request for help. Forming a nonprofit corporation provides your organization with the opportunity to expand beyond your personal resources and to continue past your lifetime. It could very well be your “pay-it-forward” legacy to society.