Have you considered starting a nonprofit but don’t know precisely what that means or where to start? The following is a brief overview of what constitutes a nonprofit organization and how to start one. This is a basic overview and is not intended to cover every matter of concern if you’re considering starting a nonprofit.
What Is a Nonprofit, exactly?
A nonprofit doesn’t necessarily refer to a company that earns no profits from its operations.
In fact, some nonprofits earn substantial profits. For this discussion, consider a nonprofit to be a corporation organized for purposes other than generating profit and in which no part of the organization’s income is distributed to its members, directors, or officers. So, any profits that the nonprofit does generate from its operation must be used for charitable, educational or other specified purposes for which the nonprofit was established or donated to other charitable or educational causes.
Who Owns a Nonprofit?
Unlike a regular for-profit corporation, profits earned by a nonprofit cannot be distributed to the corporation’s shareholders because there are no shareholders in a nonprofit. Nobody owns a nonprofit.
A nonprofit cannot be bought or sold like a regular corporation. It can merge into another nonprofit, or it can be dissolved. In the case of a merger, the assets (including cash) of the nonprofit are transferred to the surviving nonprofit. If a nonprofit is dissolved, the assets that are left after all debts are paid are either donated to another nonprofit or go to the state or federal government.
What Are the Different Types of Nonprofit Organizations?
There are many forms of nonprofit business entities. These include trade associations representing an industry, interest group or its members such as:
- Industry-specific organizations such as American Petroleum Institute
- Labor unions like the Teamsters
- Social clubs such as the Moose Lodge
- Social welfare organizations like AARP
In fact, there are 27 different types of nonprofits recognized by the IRS, all of which are described in section 501(c) (26 U.S. Code § 501(c)) of the Internal Revenue Code (IRC).
For this discussion, however, the focus is on those nonprofit entities covered by section 501(c)(3) of the IRC. These are the organizations that many people think of when referring to nonprofits. Organizations like:
- The United Way
- The American Red Cross
- The Salvation Army
These organizations are among large, well-known 501(c)(3) businesses. The vast majority of 501(c)(3)s are much smaller.
What Is a 501(c)(3)?
According to the Legal Information Institute, a section 501(c)(3) organization includes corporations, and any community chest, fund, or foundation organized and operated exclusively for:
- Religious
- Charitable
- Scientific
- Testing
That can be used for public safety, literary, or educational purposes, to foster national or international amateur sports competition (but only if no part of its activities involves the provision of athletic facilities or equipment), or to prevent cruelty to children or animals.”
Private vs. Public Foundation
501(c)(3) organizations are mostly organized as either a public charity or a private foundation. The critical difference is in the way the organizations are funded. A private foundation is funded by the contributions of a single donor or group, such as a wealthy individual or a corporation or a family. On the other hand, a public charity is funded by donations from the public, including from private foundations in some cases.
Unlike most other nonprofit types, donations to 501(c)(3) organizations are deductible to the donor. Net income earned by a 501(c)(3) is not subject to taxation, except to the extent it includes “unrelated business income” (UBI). UBI is income earned from operations that are not substantially related to the charitable, educational, or other stated purposes of the organization. UBI is subject to the same taxes paid by any for-profit corporation.
How Is a Nonprofit Formed?
The vast majority of 501(c)(3) organizations are first formed as not-for-profit corporations under state law. However, forming a nonprofit corporation in Florida (or any state) does not mean the organization is a tax-exempt 501(c)(3) organization.
A nonprofit corporation is formed in Florida by filing articles of incorporation with the Florida Department of State, in much the same manner as any for-profit corporation is formed. As with a regular for-profit corporation, the nonprofit corporation must have bylaws and initial incorporating resolutions, which are the product of the initial meeting of the nonprofit’s board of directors. Bylaws and initial resolutions are not filed with the state but must be established and maintained by state law.
Applying for Tax Exemption with the IRS
Forming a nonprofit corporation in the state of Florida (or another state) does not mean the corporation is immediately exempt from federal income taxes, or that donations to the corporation are tax deductible by the donors. A Florida nonprofit corporation that intends to become exempt from taxes under the IRC must file an application for tax exemption with the IRS. For those nonprofits seeking to become 501(c)(3) organizations, that application is filed using Form 1023, or 1023-EZ, both of which are filed online. The organization is immediately exempt from income tax, and donations to it are deductible as of the date the completed Form 1023 or 1023-EZ is filed with the IRS. If the IRS later finds an application deficient it will reject the application but, in most cases, will give the filer additional time to correct any errors and resubmit the application. However, it’s important to note that if the IRS ultimately rejects a Form 1023 or 1023-EZ, all income earned by the organization prior to the rejection will be taxable and any applicable penalties and interest will be due. Plus, tax deductions taken by any donors to the organization must be reversed by the donor.
How Long Does It Take to Complete Form 1023?
The IRS estimates that completing a Form 1023 will take the average applicant more than 100 man-hours, including time spent by the organization, its attorneys, and accountants. The form is 12 pages long, not including its schedules, some but not all of which will need to be completed by the applicant—requiring the submittal of numerous attachments. A typical Form 1023 submittal is between 50 and 100 pages long.
Form 1023-EZ: Small Organizations
If the applicant is a relatively small organization and plans to remain that way, they may be able to file Form 1023-EZ, which is considerably less burdensome. Form 1023-EZ is three pages long. It requires no narrative responses and consists mostly of checkboxes.
To qualify to use Form 1023-EZ, among other matters, the applicant must:
- Forecast that its annual gross receipts will not exceed $50,000 in the next three years.
- It must also attest that its actual annual gross receipts did not exceed $50,000 in any of the past three years
- The value of the organization’s assets does not exceed $250,000
Even if the applicant qualifies to use Form 1023-EZ, there are potential reasons to avoid its use that are beyond the scope of this article but should be discussed with your attorney before you decide if Form 1023-EZ is the right choice.
Alternatives to Forming a Nonprofit Corporation
After considering all the challenges of forming a nonprofit and obtaining tax-exempt status, you decide it’s too complicated, too expensive, or just too much of a hassle, you might consider alternatives.
One such option is to find an existing 501(c)(3) organization with a mission that fits your project and agree on a joint undertaking. You may be able to obtain grant funding using the nonprofit’s tax-exempt status or solicit donations to the organization to cover any costs that might be incurred. The advantage is you won’t have to form a nonprofit or deal with the IRS and you’ll also have no ongoing compliance concerns because everything will be run in the name of the existing 501(c)(3). The disadvantage is you won’t necessarily have control over your project.
Fiscal sponsorship is a further alternative. This is a formal contractual arrangement between an existing 501(c)(3) and an individual or group for a specific project that fits the mission of the 501(c)(3), and that would be run by the individual or group who would pay the nonprofit for administrative services. The project operators would be permitted to solicit donations or grant funding using the 501(c)(3) ‘s name and exempt status and will be able to focus all efforts on the project instead of administrative issues.
A further alternative to a nonprofit is a benefit corporation (or “B-corporation”). B-corporations are for-profit corporations that are not tax-exempt, and that must be established and operate in furtherance of some public benefit. B-corporations can be publicly traded and can distribute profits to shareholders as a normal for-profit corporation would. As such, B-corporations have appeal to socially conscious investors and to entrepreneurs who might chafe at the profit and ownership restrictions placed on 501(c)(3) organizations and their operators. Patagonia, Ben & Jerry’s, Bombas, and Leesa Mattress are some well-known examples of B-corporations.
Forming a nonprofit corporation under state law is a relatively simple undertaking. However, becoming tax exempt under federal law and complying with the laws governing nonprofits, especially tax laws, is not so simple. Before you decide to operate as a 501(c)(3), you should understand all of the steps you’ll need to take, the costs and time involved and the resources you’ll need. You should also understand what exactly a nonprofit is, and what it isn’t and consider what alternatives are available that might better suit your immediate and future purposes.
If you do decide to proceed or if you want to discuss how you might do so, we’d be happy to schedule a consultation with attorney Ralph Dyer. Ralph practices primarily in corporate and business law, including corporate formation, mergers and acquisitions, contracts and corporate transactions, and employment law.
You can Contact Ralph to discuss your situation at rdyer@uslegalteam.com or by calling (407) 566-0001.
