In a previous post, I provided a very broad overview of nonprofit organizations. In this post, I will expand on the basic rules I previously described. In particular, I will began discussing the process and considerations that go into founding a nonprofit organization.
Choice of Legal Forms When Founding a Nonprofit
One of the first decisions that you must make when founding a nonprofit organization is the legal form in which you would like the organization to exist. There are generally three such types of forms: the unincorporated association, the charitable trust, and the nonprofit corporation.
The Unincorporated Association
This is the easiest form to create, and it is somewhat similar to the general partnership of the business world. (Like a partnership, an unincorporated association can be formed accidentally.)
An unincorporated association consists simply of two or more persons associated for a common purpose. This is a good form for a new organization with uncertain prospects, as it lacks most of the legal formalities and filings that the other organizations require.
Note, however, that banks are generally more reluctant to lend money to an unincorporated association, so, if you will require a loan, you should probably choose a different form.
This form also makes it more difficult to obtain 501(c)(3) status (discussed below). While the IRS is willing to recognize an unincorporated association as a 501(c)(3) organization, the hoops the organization must jump through to receive that recognition, including the adoption of written bylaws and/or a constitution, often makes it easier just to form a nonprofit corporation.
In addition, as with general partnerships, an unincorporated association offers little to no personal limited liability to its members. So, it is generally advantageous for the nonprofit to exist in a different form, just as it is generally advantageous for a partnership to set itself up as an LLP or LLC.
It is important to note that an individual cannot create a nonprofit unincorporated association. So, if you are looking to found a nonprofit organization on your own, this form will probably not work for you.
A charitable trust is, just as it sounds, a trust that exists for charitable purposes. Under this form, a trustee will manage the property, will be restricted by his fiduciary duty, and will be accountable to the beneficiaries of the trust.
Unlike a private trust, which has defined beneficiaries, however, a charitable trust exists for the benefit of the community as a whole. Consequently, it will often be the state’s attorney general who will enforce the terms of a charitable trust.
Also, unlike private trusts, charitable trusts can exist for unlimited durations. Charitable trusts do not have to worry about the rule against perpetuities (or similar state laws adopted to replace that extraordinarily confusing rule). They can exist forever.
Some advantages of the charitable trust include the ease with which they can be formed, the fact that they require little to no regular filings with the Secretary of State, and their low maintenance requirements. A trust generally must only state its basic purpose, name the successor trustee and method by which the trustee will be chosen, state the duration of the trust, and state how the assets will be distributed upon the trust’s dissolution.
Charitable trusts also provide significant flexibility when utilized for estate planning purposes, particularly for larger estates.
If founding a nonprofit is attractive to you, you should consider the nonprofit corporation. This is the most common form in which nonprofit organizations appear. In addition to following all the state requirements to form a nonprofit corporation, the organization must file with the IRS a 1023 application and a governing instrument that meets various requirements–such as providing that, upon its dissolution, the organization’s assets will be distributed to another tax-exempt organization.
As with for-profit businesses, corporation status grants the organization’s members limited liability and gives the corporation the ability to sue and be sued in its own name. The IRS may, however, view applications for incorporation with more scrutiny if the organization previously existed as an unincorporated association. It is often therefore a good idea to incorporate from the beginning.
Considerations When Making the Choice
Generally, when founding a nonprofit, there are several factors to consider when choosing a form, including
- Do the parties founding the nonprofit have the time to set up a corporation or does the organization need to get started right away?
- Are the parties concerned about personal liability?
- How well are the parties able to keep records? Corporations—and to a lesser extent, trusts—require more record keeping than unincorporated associations.
- What type of tax exemption does the organization want? Does it want to be merely tax exempt, or does it want to offer its donors a tax deduction for their donations?
- Does it desire public or private foundation status? That is, will support come from a broad range of individuals or from a few individuals in particular?
A lot of thought and consideration should go into founding a nonprofit. Below are some general issues to consider.
Regardless of the form chosen, any type of organization that is contrary to public policy will be denied nonprofit status. This rule, however, has generally only been consistently enforced in the area of racial discrimination. Bob Jones University, for example, lost its tax exempt status in the 1970s over its racially discriminatory admissions policies.
In addition, it is important to note that, if the primary purpose of the organization is not a tax exempt purpose as provided by the tax code, then the IRS will not confer nonprofit status. It does not matter if the proceeds of the organization will go to a charitable purposes.
So, for example, if a group of people open an electronics store with the intention of giving all the profits to charity, they may think that are founding a nonprofit. They cannot qualify for nonprofit status because the primary purpose of the organization is to sell electronics.
On reflection, this makes sense. Were a business able to qualify as a nonprofit organization, it would have an unfair advantage over its competition that has to pay taxes on its profits. This has too much effect on the business world for the IRS to consider such activities as not-for-profit. In fact, they are for profit. The profit just happens to go to charity.
Categories of Nonprofit Organizations
There are two major types of non-religious nonprofit organizations: the public benefits organization and the mutual benefits organization. (Religious organizations have their own quirks under the tax code, which I will discuss in a future post.) Founding a nonprofit requires you to determine which type of organization you want to found from the beginning.
Public Benefit Organization
Public benefit organizations exist to benefit the public at large and are what we generally think of when we think of nonprofits. These types of organization must use their assets for public or charitable purposes. Membership cannot be sold or transferred, and the members’ right to vote is generally limited.
Public benefit organizations must also have an independent board of directors, which have more rigorous standards than mutual benefit organizations. Public benefit organizations are generally policed by the states attorneys general, rather than the members or donors themselves.
Mutual Benefit Organizations
Mutual benefit organizations generally exist for the benefit of a select group of individuals and entities and encompass such groups as trade organizations, social clubs, and fraternal groups. These organizations generally have their own rules carved out for them within the tax code. They may be considered not-for-profit but not charitable. They do not qualify for 501(c)(3) status.
Such organizations generally have broader voting rights for their members. In addition, unlike public benefit organizations, mutual benefit organizations may sometimes distribute their assets to their members upon dissolution, assuming the issuing state law so allows.
I will discuss these organizations and the special rules applicable to them in a future post.
What is a Charitable Purpose?
One critical issue to address when founding a nonprofit organization is whether it in fact exists for a charitable purpose, particularly where the organization hopes to qualify as a 501(c)(3) organization.
Such a designation is extremely important because donations to 501(c)(3) organizations are tax deductible. It is obviously much easier for an organization to raise money when the donors know that they will be able to deduct their donation on their taxes.
In addition, some states provide property tax exemptions to charitable organizations. Such states often provide such exemptions only to 501(c)(3) organizations, deferring to federal law. Other states, however, make their own determination as to what qualifies as a charitable organization.
So, what has Congress determined to be a charitable purpose?
First, a 501(c)(3) organization cannot benefit only a finite number of easily identifiable individuals. So, a 501(c)(3) organization could exist to feed the hungry of Chicago, but it could not exist to feed the “my hungry relatives,” or “the poor of Apartment 9F.”
If it is easy to identify all the specific individuals that would benefit from the organization’s purpose, even if that purpose is charitable, it will likely not qualify as a 501(c)(3) organization because it is not helping the public at large.
There are many purposes that are traditionally recognized as charitable. Religious organizations, universities, and hospitals are some examples—though universities and hospitals can exist in for-profit forms.
The rules are not black and white when it comes to determining if an organization’s purpose is charitable. Religious organizations and organizations that lessen the burden of government will usually receive recognition as charitable organizations, but other organizations may as well.
If a rational person might reasonably believe that public advantages might accrue as a result of the organization’s activities, even if the organization falls outside the traditional guidelines, it still might be considered charitable.
Special Quirks of Educational Organizations
As a side note, an organization may qualify as a 501(c)(3) organization solely by virtue of existing for an educational purpose. That being said, such organizations should have an additional purpose, as many states do not recognize purely educational organizations as charitable.
Finally, while a charitable organization cannot exist for the sole benefit of its members, that does not mean it cannot provide some special benefits to the organization’s members. An organization’s nonprofit status will not be threatened, for example, if the organization gives discounts on assets it owns or services it provides to its members. So, a church offering its members discounted tuition to its school is generally not a problem.