In previous posts, I have written about various business organizations and factors to consider when picking a business form. Now, however, I would like to discuss a different type of organization entirely: nonprofit organizations.
Whether charities, fraternal organizations, political action groups, or sports leagues, nonprofit organizations come in many forms and serve a variety of purposes. As their name suggests, however, they are united by the fact that, unlike businesses, they do not exist to make a profit.
An Overview of the Nonprofit Sector
Nonprofit organizations cannot distribute their net income as a profit, particularly not to those who control it. Plainly put, nonprofit organizations cannot pay dividends. Any “profit” that a nonprofit organization may make must be used to further the accepted nonprofit purpose of the organization.
So, what are some accepted nonprofit purposes for which such organizations can exist? I will discuss this in much greater detail in a future post, but some common purposes include religious, charitable, and social advocacy. So, the First Baptist Church, the Red Cross, and Citizens United are examples of those respective categories.
There are a lot of nuances to this issue, but for our purposes here, the tax code outlines acceptable nonprofit purposes that generally center around activities beyond serving the members of the organization.
The Law and Nonprofit Organizations
The body of law governing nonprofit organizations is significantly different than that which governs for-profit businesses. While traditional corporate law serves to protect shareholders from the actions of the board of directors and officers and to ensure that the corporation is run for its stated purpose—that is, generally, to maximize value for shareholders—nonprofit law serves to protect the donors of the organization.
So, laws exist to prevent organization insiders from enriching themselves and to ensure that donations are not used for purposes alien to the stated purpose of the organization. So, if one of those save the children organizations began using a significant amount of its donations to serve partisan political purposes, that could pose a potential problem.
(There are also significant issues related to the activity of the organization and the deductibility of the donations, which I will discuss in a future post.)
That does not mean that insiders cannot be paid a “reasonable” salary, or that charities cannot spend money in controversial ways. Indeed, some charities have attracted a lot of attention for how little they actually spend on their stated charitable activity compared to overhead, salaries, and administrative costs. The line between what is acceptable and what is not is often a blurry one.
One item in particular that tends to get media attention is executive salaries. Goodwill received attention, for example, when media outlets reported that its CEO made more than $800,000 per year. So, if nonprofit organizations cannot distribute their profits to insiders, why are executives at these organizations allowed to make so much money?
The law uses a reasonableness test. That is, courts look to see if the salaries earned by nonprofit insiders are reasonable. Unreasonable salaries will be considered distribution of profits, which would undermine the organization’s nonprofit status.
So, what constitutes a reasonable salary? Is $800,000 a reasonable salary for an employee of a nonprofit organization? After all, tax deductible donations are (often) paying that salary.
In determining whether salaries are reasonable, courts will compare the salaries of nonprofit insiders with those at equivalent for-profit organizations. So, a court may look at an executive’s salary at a nonprofit organization and compare it to the salary of an executive with similar responsibilities at a similarly sized for-profit firm.
While the idea that leaders of charities should not make much money seems noble, the federal government does not seek to enforce this ideal through the tax code. Congress wanted to provide nonprofit organizations the flexibility to attract talent from the for-profit world, should they so choose. This often requires offering comparable compensation packages, which, for better or worse, is perfectly legal.
The Role of the Nonprofit Sector
So, what role should the nonprofit sector serve? Why do we afford special protections and tax benefits to nonprofit organizations?
First, nonprofit organizations allow for the pursuit of unmarketable endeavors. There are some endeavors that we as a society have decided have inherent social value despite having no potential pecuniary gain. Feeding hungry children, for example, is not an endeavor that would attract venture capitalists, but which we as a society would like to encourage. So, we provide special protections and incentives for such efforts.
Second, nonprofit organizations are good avenues for non-majoritarian movements. That is, nonprofit organizations allow groups holding to minority positions—such as various political, religious, or social causes—to band together.
While we as a society might not value the individual endeavors themselves, we value the right of individuals to band together and advocate for their positions. Americans have always been wary of complete majority rule, and our system is set up to provide small cohesive groups with the tools necessary to advocate for themselves.
Contract Failure Theory
The third reason we allow for nonprofit organizations is known as the contract failure theory. This theory states that there are gaps in society, such that neither the government nor a free market can provide that which is necessary for the common good of society. This theory states that only nonprofit organizations can effectively fill this gap.
This theory is further subdivided between the market failure theory and the government failure theory.
The Market Failure Theory
The market failure theory states that there are some causes for which there is no incentive for the free market to provide public goods. This may be because of what is known as the free-rider problem. The free-rider problem refers to a situation where it is just as easy for one person to enjoy a benefit as another and impossible to force everyone to pay for it.
Providing clean air is the common example. The market has no direct financial incentive for providing clean air because a for-profit player could not limit the provision of clean air to those who pay for the service. He could therefore not expect any return on his investment.
Market failure can also occur when the consumers are different than the purchasers. Two common examples are nursing homes and disaster relief. In these situations, those paying for the goods and services are different than those receiving them. People in disaster areas are generally not paying the Red Cross for the bottled water and shelter they receive.
Therefore, the market does not have an incentive to meet the needs of the consumer of the goods and services, but rather those of the payors. This, of course, distorts the service provided. Anyone who has ever had to deal with subpar medical care because of what their insurance does and does not cover should understand what I mean here.
Government Failure Theory
Government failure is the other prong of the contract failure theory. Proponents of this theory state that government moves too slowly and cannot respond rapidly to public needs. Furthermore, government can generally only move with majority consent. So, a genuine need for which there is no political support will generally not garner government action.
Given the limited resources of government and the myriad of different interests and ideologies competing for political power, there are a number of worthy—and unworthy, depending on your point of view—causes that do not receive government support. Nonprofits help fill this gap.
So, what are the legal requirements for creating a nonprofit organization? In the United States, a nonprofit organization must state its intention to be a nonprofit organization in its Articles of Incorporation. These articles must also contain a non-distribution constraint forbidding, as described above, the organization from distributing the money it collects to insiders.
Federal law generally controls the government and formation of nonprofit organizations. Nothing stops the states from providing unique rules for the formation of nonprofits, but since the federal tax implications are often the driving motivation in designating an organization as not-for-profit, the federal tax code generally controls. Acknowledging this reality, states usually defer to the Internal Revenue Code in their own rules governing the formation and recognition of nonprofit organizations.
So, what if a nonprofit organization decides that it wants to convert to a for-profit business? This is possible in a sense, but very difficult. Such a move usually requires the termination of the nonprofit organization and the formation of a new for-profit company.
When a nonprofit organization is terminated, however, all the assets must be used to be distributed for public use. They cannot be used by the new organization, so making the transition is extremely difficult.