Starting a business is a daunting task, and nonprofits are no different. While on the surface the decision between a for-profit and nonprofit may look simple, it’s critical to spend time considering your current situation and future goals before deciding which direction to take your organization. While you may have an ultimate goal of serving the public interest or helping a specific group of people in need, there are several practical considerations to make before selecting nonprofit status.
Perhaps the most important question to ask is how you will raise capital. One of the major differences between for-profit and nonprofit corporations is how they are funded. For-profit corporations are primarily funded by investors who are given shares in the company. Their primary motivation is the potential for making a return on their investments as the company becomes profitable.
Nonprofits, however, do not have shareholders and cannot issue stock or other financial incentives to their investors. These corporations may only be funded through donations. Donors contribute capital to the corporation based on the fact that they will see a social return on their investment rather than a monetary one. While plenty of people are willing to make donations to help nonprofit corporations get off the ground, funding a new and unproven organization entirely on donations can be a challenge.
Beyond considering how your organization will raise capital, the following questions can help you determine if starting a nonprofit corporation is the best way to accomplish your goals.
- How, specifically, do you hope to fulfill the mission of your organization?
- What are the costs of starting and running your organization?
- Will your organization qualify for tax-exempt status?
- How will your organization handle financial difficulties?
- Will you hire employees, volunteers, or both?
When answering these questions, it can be helpful to look at other nonprofits addressing the same or similar issues as your organization.
As with any business structure, there are pros and cons of starting a nonprofit. It is important to take these into account before beginning this type of venture.
Advantages of Forming a Nonprofit Organization
- Tax exemption. One of the biggest advantages of running a nonprofit is tax-exempt status. Many nonprofits are eligible for exemptions from paying state and federal taxes. Moreover, once an organization is tax-exempt, any donations made by individuals or other corporations are tax deductible, creating an incentive for people to give to your cause.
- Legal protection. Just like for-profit corporations, nonprofits offer their founders, directors, and employees limited liability protection, shielding their assets in the event of lawsuits or financial problems.
- Eligibility for grants. Nonprofits may be funded through both public and private grants.
- Perpetual existence. Nonprofit corporations also enjoy the corporate benefit of perpetual existence. This means that a nonprofit corporation will continue to exist even after founders leave, as long as the purpose of the nonprofit remains and it continues to generate revenue.
- Highly motivated employees. Nonprofit corporations have the advantage of attracting highly motivated individuals who believe in their cause. This makes for hard working, effective employees.
- Volunteer and Versatile Board Members. Since nonprofit board members are generally volunteers, it’s possible to bring on people with a range of skills and backgrounds to give a well rounded voice to your organization.
Disadvantages of Forming a Nonprofit Organization
- Cost. In addition to filing fees for forming the nonprofit and applying for for tax-exempt status, there are costs related to hiring an attorney, accountant, and consultant if needed.
- Paperwork. Running a nonprofit and maintaining your status with the IRS comes with a great deal of ongoing record keeping and paperwork beyond the standard requirements of a for-profit corporation.
- Shared control. Because a nonprofit has no shareholders, determining control of the organization can be more difficult. Some organizations, like public charities, are required by law to operate under a shared governance model through which a diverse board of directors runs the corporation.
- Public scrutiny. Since nonprofits are dedicated to public interest, their finances are open to public inspection. This can make them more susceptible to scrutiny and criticism than other organizations.
- Limited purpose. Nonprofits are restricted by law to only perform specific functions. They must refrain from certain activities such as contributing to political campaigns.
- Assets. Should a nonprofit decide to close its doors, its profits must go to another nonprofit.
- Funding can be difficult. Aside from the typical challenges of raising funds for an organization, nonprofits face the additional challenge of being funded solely by donations. Additionally, with 1.5 million nonprofits in the United States, competition for donors is high.
- Choose a name. You must choose a unique name that hasn’t already been registered by another corporation in your state. The name must also include the word “corporation,” “incorporated,” “limited,” or an abbreviation of one of these indicators.
- Articles of Incorporation. Once you have chosen a name, you must file your articles of incorporation with your state’s corporate filing office. It’s important to pay close attention to any specific information or paperwork required to designate nonprofit status.
- Apply for IRS tax exemption. One you’ve filed your articles of incorporation, you must file a separate application for tax exemption with the IRS. The most common tax exempt nonprofit is the 501(c)(3). To apply, you will need to complete the IRS 1023 package or IRS 1023-EZ.
- Apply for state tax exemption. Some states require a separate application for state tax exemption. Be sure to check with your state’s tax agency to determine what is required.
- Draft bylaws. Bylaws are a corporation’s internal governing rules. They are designed to lay out procedures for holding meetings, voting, and electing directors and officers. These bylaws are usually approved at the first board meeting.
- Appoint directors. Some states allow for just one director, while others require a minimum of three. Directors will make major policy and financial decisions for your corporation.
- Hold a board of directors meeting. Once you have appointed your directors, you will need to organize an initial meeting to approve your bylaws, appoint officers, and recording the receipt of federal and state tax exemptions. Minutes must be recorded and filed for your corporation’s records.
- Obtain licenses and permits. Ensure your corporation obtains all necessary licenses and permits required to operate in your state of formation.
As a nonprofit corporation that cannot issue equity in return for investments, raising funds can be a challenge. To bring in enough capital to get your organization up and running, you’ll need to tap into a variety of resources. These include:
- Fundraising & Donations. One of the most common ways to raise money for a nonprofit is through direct personal donations. This can be accomplished in several ways, but having a strong, diverse fundraising strategy that complies with all state and federal regulations is essential to the success of your nonprofit.
- Grants. Nonprofit organizations are eligible for both public and private grants. Finding a qualified grant writer can make a big difference in how much capital you’re able to raise in this way.
- Corporate Sponsorship. Another way to raise money for your organization is to find a corporate sponsor. This is essentially a company that agrees to fund your organization’s programs or events. The payoff for the sponsor is recognition of their association with your organization, while you earn a sold source of capital. Some consideration should be given to what corporations you would and would not like your organization to be associated with before seeking out sponsorships.
- Cause related marketing. Similar to corporate sponsorship, cause related marketing is another mutually beneficial partnership between a business and a nonprofit. In cause marketing, rather than simply funding your organization, the business will link its products directly to your cause for the purpose of both bringing in a profit and gathering funds for your organization. Contributing a certain percentage of profits from the sale of a product is a common method of cause related marketing.
- Community fundraiser. Even if you’re unable to find larger corporate partners, your community can be an excellent resource for fundraising. Local businesses are often willing to sponsor events, include a donation box and information in their establishment, or run one-time specials to donate a portion of their daily profits to your organization.
- Product or service sales. Some nonprofit corporations offer a product or service for sale to fund their organizations. Others sell merchandise to bring in extra funds. Both can be effective methods of bringing in capital to your nonprofit.
- Pro bono work. Finally, you may be able to find local businesses and consultants willing to offer pro-bono services to your organization to help save funds.
Obtaining tax-exempt status is a critical step in forming your nonprofit that begins when you file your articles of incorporation. Once formed, your nonprofit will then file form 1023 with the IRS requesting this designation. Some organizations bring on an attorney to help with this process and ensure compliance, but this is not required. Below are some tips to help you through the process.
- Don’t forget key clauses. When you file your articles of incorporation to become a nonprofit corporation, there are a few things you’ll need to include to ensure you meet the qualifications for tax-exemption. Most importantly, your articles of incorporation must:
- State the tax-exempt purpose your corporation is being formed to advance (i.e. education, charity, health).
- Make clear that any assets remaining after dissolution will be distributed to another tax-exempt nonprofit or to a federal, state, or local government for public purposes.
- File within 27 months. To make your tax-exempt status effective on the date you incorporated, the IRS requires you to file form 1023 within 27 months of the date you filed your articles of incorporation. If you file later than that, your tax-exempt status will not be valid until the postmarked date of your application.
- Be prepared. To fill out the form, you’ll need your nonprofit’s name and contact information, a copy of your articles of incorporation, and a copy of your bylaws.
While the 501(c)(3) is the most common nonprofit designation, there are actually 29 types of organizations listed under section 501(c) of the Internal Revenue Code that are recognized as tax-exempt. They include:
- 501(c)(1): Corporations organized under an Act of Congress, such as federal credit unions.
- 501(c)(2): Holding companies for exempt organizations.
- 501(c)(3): Organizations that are educational, religious, charitable, scientific, or literary. These organizations may test for public safety, foster national or international amateur sports competitions, prevent abuse of children or animals, and much more.
- 501(c)(4): Civic leagues, social welfare organizations, and local associations of employees.
- 501(c)(5): Labor, agricultural, and horticultural organizations.
- 501(c)(6): Business leagues, chambers of commerce, real estate boards.
- 501(c)(7): Social and recreational clubs.
- 501(c)(8): Fraternal beneficiaries and associations that provide for the payment of life, sickness, injury, or other benefits to members.
- 501(c)(9):Voluntary employees’ beneficiary association that provide for the payment of life, sickness, injury, or other benefits to members.
- 501(c)(10): Domestic fraternal beneficiaries and associations, such as lodges devoting their net earnings to charitable, fraternal, and other specified causes.
- 501(c)(11): Teachers’ retirement fund associations.
- 501(c)(12): Benevolent life insurance associations, mutual ditch or irrigation companies, mutual or cooperative telephone companies.
- 501(c)(13): Cemetery companies.
- 501(c)(14): State chartered credit unions and mutual funds.
- 501(c)(15): Mutual insurance companies of association.
- 501(c)(16): Finance crop organizations in conjunction with the activities of a marketing or purchasing association.
- 501(c)(17): Supplemental unemployment benefit trusts that provide for supplemental unemployment compensation benefits.
- 501(c)(18): Employee funded pension trusts.
- 501(c)(19): A post or organization of past or present members of the armed forces.
- 501(c)(20): Group legal services plan organizations.
- 501(c)(21): Black Lung Benefit Trusts, funded by coal mine operators to satisfy their liability for disability or death due to black lung diseases.
- 501(c)(22): Withdrawal Liability Payment Fund, which provides funds to met the liability of employers withdrawing from a multi-employer pension fund.
- 501(c)(23): Veterans organizations.
- 501(c)(24): Trusts that fall under the Employee Retirement Income Security Act.
- 501(c)(25):Corporations holding title to property of another exempt organization.
- 501(c)(26): State-sponsored organizations providing health coverage for high risk individuals.
- 501(c)(27): State-sponsored workers’ compensation reinsurance organizations, which reimburse members for loss under workers’ compensation acts.
- 501(c)(28): National Railroad Retirement Investment Trust.
- 501(c)(29): Qualified nonprofit health insurance issuers.
Other common nonprofit organizations that qualify for tax-exemption include:
- 501(d): Religious and apostolic associations.
- 501(e): Cooperative hospital services.
- 501(f): Cooperative service organizations of operating education organizations.
- 501(k): Child care organizations.
- 501(n): Charitable risk pools.
- 521(a):Farmers’ cooperative associations that participate in cooperative marketing and purchasing for agricultural associations.
Nonprofit corporations come in all shapes and sizes, and there are a number of pros and cons when it comes to starting this type of organization. It can be daunting to assume the personal and financial investment needed to launch an organization without a monetary return on that investment. I can be difficult to secure outside funding and keep things going in the face of financial challenges. However, the personal rewards of building a nonprofit corporation can easily outweigh the difficulties, as you watch your hard work pay off within your community and beyond.