Non-profit cor­po­ra­tion: What is a non-profit?

Over the last few years, a growing number of social en­tre­pre­neurs have emerged, driven by the desire to make a change in their com­mu­ni­ties or address social or en­vi­ron­men­tal issues through their work. Non-profit start-ups can take on many forms. In the US, anyone can tech­ni­cal­ly launch a non-profit, but to qualify for tax exemption with the Internal Revenue Service (IRS), you must apply for non-profit tax status. Most char­i­ta­ble companies will choose to launch as a non-profit cor­po­ra­tion or a non-gov­ern­men­tal or­ga­ni­za­tion (NGO). But what exactly are the dif­fer­ences between the two?

Both are types of non-profit companies that serve a social or char­i­ta­ble purpose, but as the name suggests, NGOs are non-gov­ern­men­tal companies. As such, they often work on an in­ter­na­tion­al scale, for example, hu­man­i­tar­i­an or en­vi­ron­men­tal NGOs working overseas include the American Red Cross or Green­peace. Meanwhile, non-profit cor­po­ra­tions are more concerned with community and national issues, for example, ed­u­ca­tion­al programs or animal charities.

Non-profit cor­po­ra­tions are typically smaller than NGOs. Any profits that are generated go toward the cause and company directors do not receive any benefits. They typically rely on vol­un­teers, grants and donations to support their cause.

NGOs usually work on larger projects or de­vel­op­men­tal efforts. They are funded through private donations, grants, loans and sales of products. However, over recent years, more cor­po­ra­tions have extended their social re­spon­si­bil­i­ty efforts and launched NGOs or begun to col­lab­o­rate with NGOs.

But how are non-profit companies treated legally?

A non-profit is largely defined by its tax status in the US. In 1969, the tax reform resulted in the addition of Section 501(c)(3) in the IRS code which allows companies to apply for tax-exempt status if they meet certain re­quire­ments. Whether a non-profit is exempt from taxation is down to federal law, while state law will usually determine which legal entity you can choose for your non-profit. For example, according to Cal­i­for­nia state law, non-profits can be non-profit cor­po­ra­tions, trusts, un­in­cor­po­rat­ed non-profits and limited liability companies. Legally speaking, NGOs can be in­cor­po­rat­ed or un­in­cor­po­rat­ed whereas non-profit cor­po­ra­tions are always in­cor­po­rat­ed. You may be able to consult an attorney general’s guide for charities provided by your state (in this case Cal­i­for­nia) to find out more about how to operate a non-profit at the state level.

It may also be worth con­sult­ing the Cor­po­ra­tions Code of the state you are looking to register your non-profit in.

As mentioned, the decision whether a legal form can be con­sid­ered non-profit is down to the state, while its tax exemption ap­pli­ca­tion is reviewed by the IRS. To be con­sid­ered by the IRS for tax relief, non-profits must fulfill certain criteria. The purpose of a company that the IRS deems worthy of tax exemption include:

• Char­i­ta­ble
• Religious
• Ed­u­ca­tion­al/literary
• Sci­en­tif­ic
• Public safety
• Sports
• Animal cruelty pre­ven­tion
• Children’s cruelty pre­ven­tion

Since char­i­ta­ble is a broad term, the IRS has provided further guidance on what it deems char­i­ta­ble, including: “relief of the poor, the dis­tressed, or the un­der­priv­i­leged; ad­vance­ment of religion; ad­vance­ment of education or science; erecting or main­tain­ing public buildings, monuments, or works; lessening the burdens of gov­ern­ment; lessening neigh­bor­hood tensions; elim­i­nat­ing prejudice and dis­crim­i­na­tion; defending human and civil rights secured by law; and combating community de­te­ri­o­ra­tion and juvenile delin­quen­cy” according to Exempt Purposes - Internal Revenue Code Section 501(c)(3)

Non-profit cor­po­ra­tions are exempt from income tax under IRS code 501(c)(3). However, to suc­cess­ful­ly apply for tax-exemption status, non-profits must meet certain criteria. Their lawful purpose must be among the criteria specified in the previous paragraph. They must be organized and operated to support their cause, and in­di­vid­u­als or members should not have financial ad­van­tages. Ad­di­tion­al­ly, NGOs and non-profit cor­po­ra­tions are usually re­strict­ed in their political ac­tiv­i­ties and cannot be involved in lobbying. Their income must be used to support their char­i­ta­ble purpose. If a non-profit stops operating, it must dis­trib­ute all remaining assets to charity.

When making the 501(c)(3) ap­pli­ca­tion, the IRS will examine your company’s structure, purpose and your planned ac­tiv­i­ties. For tax purposes, federal law dis­tin­guish­es between public charities and private foun­da­tions. The latter tend to be heavily regulated and different tax rules may apply. You must apply for char­i­ta­ble tax status within 27 months after in­cor­po­ra­tion. If you miss that deadline, your tax status will only change from the date you applied. It can take up to 6 months for the ap­pli­ca­tion to be approved or denied. Consult our practical guide on how to form a non-profit cor­po­ra­tion for more in­for­ma­tion.

Non-profits are generally not subject to capital gains tax. They may also apply for exemption from property tax. However, whether your non-profit will have to pay property tax or sales tax depends on state law. If a non-profit generates income that has nothing to do with its business purpose, such earnings could be fully or partially taxed.

Besides the obvious benefit of not paying taxes, other ad­van­tages of securing 501(C)(3) status include:

• Access to gov­ern­ment and in­sti­tu­tion­al grants
• Lower taxes on donations from in­di­vid­ual sponsors
• Special business rates, for example, on marketing packages and postal services
• Legal pro­tec­tion and limited liability for members and owners

The or­ga­ni­za­tion­al structure of a non-profit cor­po­ra­tion may differ according to state law, but generally, it consists of a board of directors, executive staff, managers, and ad­min­is­tra­tors. But what are the exact functions of each entity?

• Board of directors: The board of a non-profit usually consists of select in­di­vid­u­als chosen because of their skill and com­mit­ment to a company’s cause. At the very least, a board usually has a chairman, a treasurer, and a secretary. Some states require there to be at least three board members. Larger NGOs may have up to 50 board members. The board meets through­out the year to discuss and implement policies and programs of action.
• Executive staff: The day-to-day business of a non-profit is organized by executive staff members such as a chief officer and president. Ex­ec­u­tives will liaise with the board and oversee members of the man­age­ment team.
• Man­age­ment: Man­age­r­i­al staff usually deal with the op­er­a­tional duties of a non-profit on a daily basis. They are re­spon­si­ble for the de­vel­op­men­tal process, im­ple­ment­ing programs suggested by the board, and sched­ul­ing events and fundrais­ers. Managers are in charge of ad­min­is­tra­tive staff.
• Ad­min­is­tra­tive staff: Common ad­min­is­tra­tive roles in non-profits include sec­re­taries, ad­min­is­tra­tors, planning and fundrais­ing as­sis­tants. They are re­spon­si­ble for many of the hands-on tasks, such as sched­ul­ing meetings and events and setting up ap­point­ments with donors.

Although many non-profit cor­po­ra­tions rely on vol­un­teers, IRS and state laws allow staff to receive rea­son­able wages. The way the IRS de­ter­mines whether salaries are excessive depends on the annual income of an or­ga­ni­za­tion. Where a company is found to have overpaid its staff, it may be required to pay ad­di­tion­al taxes. In the worst-case scenario, the company could lose its tax-exemption status.

When de­ter­min­ing staff wages, it’s best to check out industry averages. Charities should adhere to state minimum wage leg­is­la­tion.

Many other legal business forms in the US can develop social en­ter­prise arms. For example, sole pro­pri­etor­ships, part­ner­ships and limited liability companies can establish social efforts on the side. There are also hybrid legal forms such as the low-profit limited liability company (L3C).

The L3C has been specif­i­cal­ly designed to combine the nature of a social en­ter­prise with the legal structure of a tra­di­tion­al LLC. It’s a fairly new business structure and currently only rec­og­nized in certain states including Illinois, Michigan, North Dakota, Kansas, Louisiana, Maine, Rhode Island, Utah, Vermont, and Wyoming.

Ad­min­is­tra­tion and filing for L3Cs are rel­a­tive­ly straight­for­ward. Owners and members are also protected from personal liability. But if you’re looking to form a L3C, you must meet the same re­quire­ments as program-related in­vest­ments.

An al­ter­na­tive legal form is the Benefit cor­po­ra­tion (or B corp). It is not tech­ni­cal­ly a hybrid, because B corps are for-profit busi­ness­es. These cor­po­ra­tions serve a greater public good, but are not exempt from income tax. In order to qualify as a B corp, companies must fill out an Impact As­sess­ment.

But if B corps aren’t exempt from taxes, why would anyone choose this legal form? Many start-ups and en­tre­pre­neurs care about a social or en­vi­ron­men­tal mission. The tra­di­tion­al cor­po­ra­tion structure, however, requires directors to maximize profits in order to satisfy share­hold­ers. This can be re­stric­tive for company founders who are socially conscious. The B corp requires boards and directors to consider social and en­vi­ron­men­tal factors alongside financial gain.

Whether the L3C or a B corp is the right business structure for you, depends on the purpose of your company and your pref­er­ence of or­ga­ni­za­tion­al structure.

Now that you have a better un­der­stand­ing of the various business struc­tures and oblig­a­tions of non-profit cor­po­ra­tions and NGOs you may wonder: what are the ad­van­tages and dis­ad­van­tages of starting a non-profit?

Click here for important legal dis­claimers.