Fact checked for accuracy by Billie Anne Grigg, a bookkeeper and Mastery Level Certified Profit First Professional.
Do you have a cause you believe in and are considering forming a nonprofit organization?
If so, you might feel confused about the differences between nonprofit and for-profit businesses.
This article will help you understand everything you need to know about nonprofit corporations so you don’t form an entity that isn’t set up to do what you want it to do.
What Is a Nonprofit Corporation?
A nonprofit corporation is a legal entity formed to help its officers carry out charitable causes. It can also help further scientific, religious, literary, or educational purposes.
Although it doesn’t distribute its net earnings to private individuals or shareholders, it can carry out profitable business activities.
All profits are directly applied toward achieving the goals and mission of the organization. A nonprofit corporation cannot organize itself for the benefit of private interests.
Nonprofit Taxation
A nonprofit corporation is a business that doesn’t have to pay regular taxes. Nonprofit corporations can apply for tax-exempt status under section 501(c)(3) of the Internal Revenue Code.
A nonprofit granted this special designation is exempt from federal income tax and isn’t obligated to pay any income taxes on money received. That exemption includes donations or grants.
However, to attain tax-exempt status, a nonprofit must meet three criteria:
- It must have an exempt purpose
- Its net earnings cannot benefit any private shareholder or individual
- It can’t engage in attempts to influence legislation
There are several misconceptions about the tax status of nonprofit corporations that people get wrong. Nonprofits are not exempt from all taxes. They still have payroll taxes and city/state taxes they must pay. They just don’t have to pay federal income tax.
Financial Requirements
All nonprofits must file an annual return, called Form 990, with the Internal Revenue Service.
This form gives them a chance to explain how they use their money and what kinds of projects they are working on.
Additionally, each state has its own requirements for nonprofit financial reporting and taxation (if the nonprofit makes a certain amount of revenue, for example).
Another thing to consider regarding nonprofit taxation is that state and federal governments can revoke a nonprofit’s tax-exempt status if the company doesn’t follow the necessary rules.
This often happens when a nonprofit purposefully violate any of the three criteria for tax exemption.
Types of Nonprofit Designations and Tax-Exempt Status
Here’s what you need to know about the types of nonprofit designations:
There are 501(c)(3) nonprofit corporations, and there are also 501(c) (4), (6),(29) nonprofits, and other nonprofits under 501(c).
Nonprofit corporations cannot make political contributions, but they can engage in some lobbying activities.
All nonprofits fall under the 501(c) section of the tax code. The other types like (4), (6), and (29) relate to similar tax-exempt organizations under different parts of the tax code.
Nonprofit corporations can apply for one of three designations:
- Charitable nonprofits, which benefit the public interest or advance religion
- Public nonprofits, which serve a government unit
- Mutual benefit nonprofits, which promote a particular cause or interest
Tax-Exempt Status Details
Here’s what you need to know about the tax-exempt status.
Applicants must apply for tax-exempt status through the IRS. The application must include photos of your board members and complete information on the corporation’s purpose and activities. It’s a good idea to hire an attorney or accountant during this process because some applications are more complex than others.
A nonprofit must apply for special recognition in each state where it becomes registered or incorporated.
The application process can take many months. The IRS gives applicants a tax code number after they receive approval.
Advantages and Disadvantages of Forming a Nonprofit Corporation
The nonprofit designation isn’t for everyone. Before deciding to form a nonprofit corporation, consider these advantages and disadvantages. Read our full article on the drawbacks and benefits of non-profit corporations for more information.
Advantages of Forming a Nonprofit Corporation
Below are essential benefits to forming your nonprofit corporation.
- A nonprofit corporation is an excellent way to manage wealth because it can allow for expansion and growth.
- Your nonprofit can receive donations and grants. This is advantageous because you can receive funds for projects and other business expenses.
- Nonprofits can invest funds to meet their financial obligations.
- Nonprofits can remain flexible about their organizational structure and can allow for innovative ideas to take root.
- Nonprofits exist in perpetuity, offering the ability to further your cause for generations.
- They are exempt from income tax, so all money donated is essentially tax-exempt.
- New nonprofits receive free services, such as credit score checks and bank account setup procedures.
- Your nonprofit establishes additional credibility that you might not enjoy as a single individual working toward your cause.
- A nonprofit corporation offers limited liability protection. It helps protect your personal assets from the company’s liabilities.
- Nonprofits enjoy separate entity status. They’re responsible for their own contractual obligations, banking, and other such business activities.
Disadvantages of Forming a Nonprofit Corporation
You should consider a few disadvantages that exist when forming a nonprofit corporation.
- It can’t participate in most political activities. Nonprofits aren’t allowed to endorse or contribute to a candidate running for public office.
- Any profits raised by the nonprofit corporation must get distributed to other organizations. There is no way for you as an individual owner to use any of that money (and it must remain accounted for).
- It may require more paperwork than other types of organizations. For example, you will need to file an annual return with the secretary of state and a yearly report with the IRS.
- Nonprofits must spend the majority of donated funds on their projects or programs rather than distributing dividends. This point is a disadvantage because the money gets spread out among more people than if you had formed a for-profit corporation and used those profits to distribute dividends.
How to Form a Nonprofit Corporation
First, select the nonprofit name. Verify with your state government or county clerk office that the title you’ve chosen isn’t already in use.
Form a nonprofit corporation by filing articles of incorporation with the secretary of state in the state where you will operate. Your articles of incorporation include information about your business, its name and address, and its purpose.
You’ll also need to include the names and addresses of each trustee or director on your board. Add an explanation about how you decided on the number of trustees.
The next step is filing for the IRS tax exemption. You can do this by filling out the IRS Form 1023-EZ or IRS Form 1023 package. The IRS will review your application to determine whether you qualify for tax-exempt status.
You’ll then get a letter with the nonprofit’s new tax exemption status, which you can then bring to the state or county official office to get the necessary business licenses and permits.
Lastly, draft the bylaws, set up a board of directors, and establish financial accounts.
You can draft your bylaws or find examples of them online through the National Center for Nonprofit Board. This site is a good place to start if you want to learn about the expectations in this area.
Read our complete guide on how to form a nonprofit corporation for all the detailed steps.
Understanding Nonprofit Governance
A significant difference between nonprofits and other kinds of companies is their governance. For-profit corporations have a board of directors that makes the company’s major decisions. In contrast, a group called “trustees” or “governing members” run nonprofits.
Trustees are agents of the nonprofit and can be held personally liable for any debts or losses the business incurs due to their actions.
In addition to its board of directors, a for-profit corporation can have non-voting members whose opinions the board considers when making significant decisions. For example, these individuals might include spouses or partners of shareholders or investors.
Nonprofits don’t have this option because they must represent everyone in their community equally and can’t favor particular people.
Trustees must also remain careful to follow official rules and procedures for their organization’s management and operations (called “bylaws”). They must submit yearly reports that include financial documents.
Trustees of a nonprofit corporation typically serve without pay. However, they’re entitled to reimbursement if they perform work that benefits the corporation. Keep in mind, though, that this doesn’t mean they can deduct travel or entertainment expenses from their taxes. Those types of expenditures are personal and not reimbursable business costs.
Public vs. Private Nonprofit Corporations: Which Is Right for You?
A public nonprofit corporation operates in the interest of the public good. For example, one goal might include assisting veterans by offering homes, medical care, and job training.
A private nonprofit corporation operates in the interest of a particular group. An example of this is your local running club. It may have nonprofit status to help with expenses like storage for registration materials and getting maps printed every season.
The Private Nonprofit Corporation Structure
You can structure a private nonprofit corporation in several ways. Typically, the board of directors manages the company and has full power to carry out day-to-day operations.
The board of directors is responsible for all activities. These activities include the hiring and firing of employees, fundraising efforts, and events involving the public.
Nonprofit organizations can have one member on their board of directors, or they can have a management team made up of more than one person.
The Public Nonprofit Corporation Structure
A board of directors governs a public nonprofit corporation. The board of directors may have more than one member, but it must be made up of individuals representing the public that the nonprofit serves.
For example, if your nonprofit provides services to veterans, you should have veterans, family members of veterans, and people who care about the well-being of veterans on your board.
The Last Word
There you have it, the basics about nonprofit corporations. If you think a nonprofit corporation is the right legal entity for you, gather your paperwork and get your nonprofit started. You can check out our recommendations for the best nonprofit formation services to help you get started.
Filed under: Advice Columns
