Nonprofit Corporations

The term "nonprofit" broadly refers to any organization where income and revenues aren't shared on the basis of ownership. There are no shareholders or official "earnings" to distribute.

A nonprofit corporation doesn't have to be incorporated, but it's usually a good idea. A nonprofit corporation provides a shield against potentially unlimited liabilitiy for directors, officers, employees, volunteers and other agents of the organization.

Although many nonprofit corporations are tax exempt, there are other reasons for a business that never expects to have tax-exempt status to set up as a nonprofit corporation.

Advantages of Nonprofit Incorporation

• Avoiding or minimizing state and federal taxes
• Eligibility for government and private foundation grants and other funds
• Protecting your personal assets if the organization is sued
• Making donations to your organization tax deductible
• Property tax exemptions
• Special mailing rates at the post office
• Good marketing, as people like to do business with a nonprofit

Disadvantages of Nonprofit Incorporation

• You may have to pay taxes on profits from activities that aren't related to your nonprofit corporate purpose
• You won't be able to disburse earnings to organization members.
• It's harder to raise capital
• You won't be able to participate in any political fundraising or lobbying
• If you have tax-exempt status, when you end the corporation you'll have to transfer all the corporate assets to another nonprofit corporation

Incorporating a Nonprofit Organization

The incorporation process, which varies by state, generally includes:

• Filing Articles of Incorporation with the corporate division of your government, with information about the name of the organization, who will be on the initial board of directors and who will be the "registered agent" (the person who will accept legal service on behalf of the corporation)
• Drafting Corporate By-Laws, which lay out how you'll run the corporation and who will have voting status to make decisions. Most states have laws that specify exactly what language should be used to protect board members and other active participants from personal liability.

Applying for Tax-Exempt Status

Being nonprofit isn't the same thing as having tax-exempt status. Usually, nonprofit corporations are still subject to taxation until they file separate applications under both federal and state law to be granted tax-exempt status.

Section 501(c)(3) of the federal tax code gives tax-exempt status to qualified nonprofit organizations. Generally, the operations of such organizations must be for nonprofit purposes falling within one of the folowing categories:

• Religious
• Charitable
• Scientific
• Testing for public safety
• Literary
• Educational
• Fostering national or international amateur sports competition
• Preventing cruelty to children or animals
• Civic leagues and social welfare organizations
• Labor, agricultural and horticultural organizations
• Business leagues
• Social and recreational clubs
• Fraternal societies
• Employee associations
• Credit unions
• Veterans' organizations
• High-risk health coverage organizations
• Workers' comp reinsurance organizations

The IRS will look at substance over form and require a tax-exempt applicant to structure the organization along well-defined guidelines, so that the activities of the organization don't benefit any particular individual.

After receiving 501(c)(3) status, donations to your charitable organization are generally tax deductible for the donor.

But receiving tax-exempt status doesn't give a nonprofit corporation the authority to do whatever it wants. Activities outside of its tax-exempt purpose can result in taxation on "unrelated business income." In a worst case scenario, the organization's tax-exempt status can be revoked.

Guarding Your Nonprofit Tax Status

You'll want to:

• Keep detailed records on the sources of any income
• Carefully segregate out and pay taxes on any income that comes from non-related business activities
• Keep careful records of corporate meetings
• Make sure minutes, resolutions and any correspondence with the IRS are carefully documented and stored
• Not distribute any of the corporate income to board members or any one else connected with the organization. The exception to this rule is salaries and benefits for employees, as long as they're reasonably equal to salaries and benefits of similarly situated employees of for-profit organizations.

Setting up a nonprofit corporation is one legal project that you should never attempt without a lawyer to guide you.

Sherrie Bennett is the former director and staff attorney at the University of Washington Student Legal Services in Seattle.

Related Web Links:

Internet Nonprofit Center

IRS Forms for 501(c)(3) Status (pdf format)

Business Organizations Message Board for more help