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, NGOsare 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?

Definition: What’s a non-profit corporation?

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.

Definition: non-profit corporation

A non-profit corporation is a legal entity which has been legally incorporated and serves a purpose other than making profits.

When is a corporation considered non-profit?

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)

Note

Non-profits are often confused with not-for-profit companies, but they are not the same. Not-for-profits are smaller and easier to set-up and are usually run by volunteers. Non-profits, on the other hand, may have paid employees.

Non-profit tax considerations

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

How are non-profit corporations structured?

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.

Hybrid non-profits?

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.

The advantages and disadvantages of a non-profit corporation

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?

Advantages Disadvantages
Internal reward: Starting a non-profit enables you to work for a greater good and fulfill your personal ambition to help others or make a change in the world. Potential criticism of your purpose: Depending on the nature of your purpose, you may attract criticism from opponents or people who do not share a similar goal.
Commitment: Volunteers and staff of non-profits are often considerably more committed to work hard because of the internal reward. They are usually not driven by monetary, but personal gain. Difficulty finding volunteers: It can be challenging to entice people to give up their time when they’re not getting paid.
Tax benefits: Non-profits are tax-exempt and because donations are tax-deductible, donors may more readily sponsor a non-profit. Ongoing compliance: You must keep up with annual filing requirements to keep your tax status. Failure to do so could result in your non-profit losing its tax-exempt status.
Limited liability: When you incorporate as a non-profit corporation, you and your staff are protected from personal liability in case of lawsuits and debt. Cost and effort: Setting up a non-profit corporation takes considerable effort and paperwork. Both incorporation and application with the IRS do incur fees. You may also want to hire a lawyer or accountant to help you traverse the legal landscape.

Click here for important legal disclaimers.

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