Choosing the Right Legal Entity for Company - Exploring Nonprofits
- Choosing the Right Legal Entity for Company - Exploring Nonprofits
- What is a Nonprofit?
- What Are the Best Types of Businesses to Operate as Nonprofits?
- Who Is Eligible to Operate as a Nonprofit in the US?
- How to Register a Nonprofit
- What are the Key Advantages of a Nonprofit?
- What Are the Key Disadvantages of a Nonprofit?
- Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
- How is a Nonprofit Taxed?
- How to Convert a Nonprofit
Choosing to start a nonprofit can be rewarding and make a difference. Being a nonprofit impacts every aspect of the business, and you must consider all the parameters before deciding to go that route. Although a nonprofit has some significant benefits it may also have some drawbacks.
According to the Bureau of Labor Statistics, more than 10% of U.S. companies (1.8 million companies) are registered as nonprofits (501(c)(3)). This large percentage is due to the vast benefits of a nonprofit. When choosing to register your company as a nonprofit, you have three types available to you, and they are as follows:
Meeting the requirements of becoming a nonprofit is more complicated than other types of entities. You must take some time to evaluate if you want nonprofit status and, if so, what type you will become. There are pros and cons to having a nonprofit. Further down this page, you can learn about what a nonprofit is, the different types, how it works, how they are taxed, and the unique features and benefits of a nonprofit.
What is a Nonprofit?
What is a Nonprofit?
Nonprofits are companies founded to serve the public or a cause. They are sometimes called nonprofit organizations (NPOs) or not-for-profit organizations (NFPOs). When these companies make money, they reinvest the surplus funds back into the company rather than distribute them to shareholders. Many nonprofits are tax-exempt and may operate as special types of entities, like foundations, associations, or corporations.
There are a few varieties of nonprofits; they are as follows:
Numerous other types of nonprofits exist, including those focused on veterans' organizations, social clubs, business leagues, and more. Organizations designed to better the lives of others are typically nonprofits.
Key Features of Nonprofit
Nonprofits have some distinct features that set them apart from other business entities. The key features of a nonprofit organization are as follows:
What Are the Best Types of Businesses to Operate as Nonprofits?
The type of business entity you choose to operate depends on many factors, including the types of services you intend to provide and to whom. Some of the most common types of businesses that operate as nonprofits are as follows:
Beyond the list above, other types of companies that work best as nonprofits include agricultural organizations, labor unions, and social or recreational clubs. However, these nonprofits operate with their own unique goals and models.
Some factors to consider when choosing a business type for nonprofit status are as follows:
Who Is Eligible to Operate as a Nonprofit in the US?
Who Is Eligible to Operate as a Nonprofit in the US?
To qualify as a tax-exempt nonprofit, the organization must be organized and operated exclusively for a specific purpose, such as religious, charitable, scientific, literary, educational, or another purpose as outlined in the IRS code. Additionally, the organization's activities must serve the purpose, not private interests or persons. As such, nonprofits do not have "owners." Instead, they are governed by a board of directors or trustees. These individuals oversee the organization's activities and ensure compliance. To qualify, a nonprofit must serve the public good.
Although all 501(c)(3) organizations are nonprofits, not all nonprofits are 501(c)(3) or tax-exempt. The types of entities that are eligible to become a nonprofit include:
How to Register a Nonprofit
To register a nonprofit, you need to complete a few steps. They are as follows:
1. Incorporate Your Organization
First, you must incorporate your organization through the Secretary of State or another agency responsible for business filings. Follow each of the steps below to do that.
The first step is to choose your nonprofit's name. Keep the name simple, impactful, and related to your business purpose. Don't choose a name that is too long or hard to remember or spell. The goal is to make it easy for your patrons to find you and remember your name.
Check with your Secretary of State to ensure the name is available. You cannot use an existing name or one close to your chosen business name. Also, check the U.S. trademarks database to see if your proposed company name is already in there. You do not want to infringe on anyone's trademark.
You can incorporate your company in any state within the U.S. Take some time to learn about the corporate laws, taxes, and fees to find a state that works best for you. Consider how easy or hard it is to incorporate in that state and how much it will cost. Some states offer a more business-friendly environment.
Appoint a company or person to be your registered agent. This entity will receive legal and other official notifications on the company's behalf. The person or business you choose must have a legal address in the state of incorporation. Some nonprofits use their lawyer as their registered agent.
Have an attorney draft your Articles of Incorporation, including the company name, purpose, and structure. File the completed and signed Articles of Incorporation with your state agency, which is most often the Secretary of State.
Along with your Articles of Incorporation, have your lawyer draft your corporate bylaws detailing the internal operations and procedures you intend to base the company upon. Some things to include are shareholder meetings and when they occur, board of directors elections and how they work, and officers of the nonprofits and their duties, responsibilities, and roles.
File Form 1023 or 1023-EZ with the IRS to file for tax-exempt status. You should also obtain an EIN to file wage reports and other tax documents required by the IRS.
This crucial step is easy to accomplish. Log onto the IRS.gov website, register your nonprofit, and get an EIN within a few days. You will need this EIN when you apply to open a business bank account.
Find a corporate business insurance agent and purchase policies that protect you against catastrophic financial loss in case of legal issues or other problems. You will also need commercial auto insurance if you use vehicles in your business.
Apply for as many business bank accounts as you need to keep all business activities in one place. According to corporate laws, you must keep the nonprofit's money separate from any board member's or director's.
2. Form a Board of Directors
Find individuals willing to sit on your board and help govern the nonprofit, make decisions about the purpose, and direct operations.
Once your nonprofit is fully formed, you can hold your first board meeting. During the meeting, you can discuss the business plan and other topics of interest.
3. Register for State Filings
Your business may be required to file regular reports to a state agency. You may also be required to register with the state Attorney General's office. Follow all state-level guidelines and file reports when necessary. Check with your state tax office to learn more about this step.
What are the Key Advantages of a Nonprofit?
Nonprofits have several key advantages that are not available to other types of entities. Not only do the nonprofits benefit from tax-exempt status, but those who donate can often deduct those funds from their income tax. The key advantages of a nonprofit include:
Tax Benefits
Nonprofits can request tax-exempt status under Internal Revenue Code 501(c)(3). Many nonprofits also don't have to pay property taxes, saving them even more money to reinvest in the business to serve their purpose.
Donations to these companies are also tax-deductible, providing an incentive for contributors to give more. Donations are often a major source of funding for nonprofits.
Nonprofits are eligible to file for government grants. Their tax-exempt status makes winning grants and receiving funding from private foundations, corporations, and government agencies easier.
Limited Personal Liability
Another significant benefit of a nonprofit is limited personal liability. Directors, officers, and nonprofit members are protected from debts or lawsuits and are typically not held liable for the company's actions. Generally, nonprofits are structured as corporations or LLCs, which offer further protection for personal assets.
Ease of Fundraising
Fundraising is easier for nonprofits because the public sees charitable work as good. Societal goodwill makes attracting volunteers, donations, and grants easier. Donor incentives like unique experiences, branded merchandise, public acknowledgments, and tax breaks can encourage more giving.
Other Benefits
Other considerable benefits include employee benefits such as health insurance, paid time off, and retirement plans.
Nonprofits can exist in perpetuity, meaning they can operate even if there are leadership, membership, or death changes.
Nonprofits allow people to make a difference in their lives, pursue their passions, and build a stronger sense of community.
What Are the Key Disadvantages of a Nonprofit?
Along with the plethora of advantages, nonprofits do come with a few drawbacks that you should know about. They are as follows:
Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
Nonprofits can be structured as a corporation, trust, or LLC. Review the chart below to learn about the different types of entities and how they compare to see which structure makes the most sense for your nonprofit.
Nonprofits can be structured as a corporation, trust, or LLC. Review the chart below to learn about the different types of entities and how they compare to see which structure makes the most sense for your nonprofit.
| Characteristic | Sole Proprietorship | Partnership | LLC | S-Corp | nonprofit (C-Corp) |
|---|---|---|---|---|---|
| Formation | Quick and simple with no filing requirements with any government agency. | Simple to create with no legal filing requirements. | More expensive to create and requires filing with the state. | An S-Corp is more costly to establish, and it requires state filing. | It is more expensive to establish and requires filing with the state. |
| Cost of Formation | None | None | The cost of the state filing fee is usually between $100-$150. | The cost of registering an S-Corp with the state can be anywhere between $20 and $800. | The average cost to register a C-Corp in the United States is $633. |
| Business Name | Can operate under the owner's name, or a fictitious name using a DBA. | Can operate under the owner's name, or a fictitious name using a DBA. | Must register an official company name with the state that is established and secured. | Must register an official company name with the state that is established and secured. | Must register an official company name with the state that is established and secured. |
| Taxation | Pass-through taxation, where all everything is filed under the owner's personal taxes. | Filed under the partners. Each partner claims their income and losses on their personal returns based on their percentage of the business. | Pass-through taxation, where everything is filed under the owner's personal taxes. If there are multiple owners, taxation is treated like a nonprofit. | Each owner declares their share of profits/losses on their personal returns. Income is allocated based on owner percentage. Owners can use corporate losses to offset other types of income. Fringe benefits are limited to owners who own more than 2% of the shares. | The C-Corp is a separate taxable entity that must file returns. Owners split profits and only declare their portion on personal income tax returns. Owners can deduct fringe benefits as business expenses. |
| Liability | The owner is personally liable for all business actions, liabilities, debts, and damages. | Owners are personally liable for all business debts. | Business is its own entity; therefore, the owner(s) are protected against personal liability. | Owners have limited liability for personal debts, and business legal issues. | Owners have limited liability for personal debts and business legal issues. |
| Operational Requirements | No operational requirements are necessary. | No operational requirements are necessary. | More formal requirements than an LLC but not as strict as a C-Corp. | Much easier to maintain than a nonprofit. Annual member meetings and a report are required. | Annual meetings are required, and members must vote on changes. Shares of stock must be sold to raise capital. |
| Management | Full control of all decisions, management, and operations. | Each partner has equal control and decision-making ability unless it's a limited partnership. | An operating agreement outlines how each member can manage the company. | Managed by a group of directors that shareholders vote in. | Managed by a group of directors that shareholders vote in. |
| Raising Capital | Can be challenging and the owner often has to invest his/her own money. | Each partner can invest, and more partners can be added to raise additional capital. | Managers can sell interest in the business to raise capital based on operating agreement restrictions. | Can sell shares of stock to raise capital. | Can sell shares of stock to raise capital. |
| Transferability of Interest | No | No | Possible based on the operating agreement restrictions. | Yes, as long as IRS regulations about who can own stock are honored. | Shares of stock can be easily transferred. |
How is a Nonprofit Taxed?
Although most nonprofits are tax-exempt, that does not mean they pay no taxes. The nonprofit's tax obligation is based on income sources, activities, and state regulations. Tax-exempt nonprofits are not automatically exempt from all taxes. Some of the taxes that nonprofits must deal with include:
Federal Income Tax Exemption
Most nonprofits, especially those designated under Section 501(c)(3) of the Internal Revenue Code, are exempt from federal income tax on revenue directly related to their exempt purpose (e.g., charitable, educational, religious, etc.). To qualify for this exemption, nonprofits must apply to the IRS and demonstrate regularly that they meet the requirements and continue to comply with reporting regulations. Nonprofits must file annual returns to keep their tax-exempt status.
Unrelated Business Income Tax (UBIT)
If a nonprofit performs activities outside its primary area of interest, it may still have to pay taxes on that revenue. Nonprofits will be taxed on any unrelated business income that is not substantially related to their exempt purpose. An example might be a museum (a 501(c)(3) organization) that operates a gift shop selling items unrelated to the museum's exhibits. The income from the gift shop may be subject to UBIT tax.
Other Taxes
Nonprofits are still responsible for paying regular payroll taxes (Social Security, Medicare, and unemployment taxes) for their employees, the same as for-profit companies.
Nonprofit companies are also subject to state and local taxes. Although they may be exempt from income tax, they might still have to pay sales, property, and other taxes. However, the tax laws regarding these local taxes vary from state to state.
Some states allow nonprofits to skip paying sales tax on purchases directly related to their exempt purpose, but these rules vary significantly.
Tax-Exempt Requirements
Most nonprofits must file annual information returns with the IRS to maintain their tax-exempt status, typically Form 990. This form informs the IRS and the public about the organization's activities, finances, and compliance. Depending on the type of nonprofit, they may file a Form 990, Form 990-EZ, or Form 990-N.
Nonprofit organizations, like 501(c)(3) charities, can take several tax deductions to reduce their tax liability related to unrelated business income (UBI) or in years they do not otherwise qualify for tax exemption. The standard tax deductions available to nonprofits include:
Proper documentation is key to using these deductions. Nonprofits must maintain thorough records of all expenses to support tax deductions. Most use a tax professional to prepare tax returns and file records. Most nonprofits file Form 990 annually with the IRS.
Some other deductions allowed in a nonprofit are:
Pros and Cons of Nonprofit Taxation
In most cases, nonprofits enjoy tax-exempt status. However, they could lose that status if they don't follow specific requirements. Even with that status, they may still have to pay sales, property, or other taxes.
Use the table below from the IRS to be sure you are filing the correct forms:
How to Convert a Nonprofit
There may be times when it makes sense to convert your nonprofit to another type of business entity. Your options are sole proprietorship, partnership, LLC, and corporation.
Some of the reasons you may want to convert include:
- Easier Management:
Sole proprietorships, partnerships, and even LLCs are easier to manage than nonprofit corporations.
- Fewer Corporate Requirements:
Nonprofits are legally required to file reports regularly and are subject to strict compliance regulations. Formation is more complex and costly. Another business entity could simplify things.
- Flexible Operations:
Nonprofits have a very rigid management structure. If you want more flexibility in running your business, another entity, like an LLC, could offer you more flexibility.
- Pass-Through Taxation:
If you switch from a nonprofit, you can take advantage of pass-through taxation to avoid double taxation.
- Change in Liability:
If the business operations change to the point that there is minimal risk, you may not require limited liability, and switching to a simpler structure makes sense.
The steps for switching from a nonprofit organization to another entity are the same regardless of the type. The key tasks are board approval, dissolution, asset distribution, and forming a new business entity. The details are as follows:
Steps for Converting a Nonprofit
- Board Approval and Dissolution – The first step is to get the nonprofit board together for a vote. They must unanimously agree to dissolve the nonprofit organization. Additionally, the decision must be well documented in the meeting minutes. The entire board must also discuss and agree upon a plan for dissolution, including the distribution of assets.
- Dissolution and Asset Distribution – The nonprofit organization must file Articles of Dissolution with the state (usually the Secretary of State). All remaining assets within the nonprofit must be donated to another 501(c)(3) organization or, in rare cases, distributed to members. The asset distribution must comply with the organization's Articles of Incorporation and bylaws.
- Form a New Entity – After dissolution, you can form a new company of whatever business entity you want. You may choose sole proprietorship, partnership, LLC, or corporation. Depending on your for-profit entity, you may need to file new Articles of Incorporation or other paperwork with the Secretary of State. You will also need to apply for a new EIN with the IRS. Some entity types require an EIN by law, while for others it may be optional.
- Tax and Legal Considerations – With the new business type, you will be subject to different tax obligations and must plan for federal income, property, and other types of taxes. Research the IRS regulations and requirements for your new entity type. It may make sense to consult with legal and financial professionals to ensure you don't miss any crucial steps. You do not want to get into any trouble with the IRS.
- Transition – Your operations must change considerably to adjust to for-profit strategies, including sales, revenue generation, pricing, and marketing. Changes may include varying business practices, staffing, and overall business structure.
Important Considerations When Converting
When converting from a nonprofit to another business structure, you must consider some essential factors. They are as follows:
Check with your state office to review the specifics of corporate law and how to change your nonprofit into a new business entity.
- Choosing the Right Legal Entity for Company - Exploring Nonprofits
- What is a Nonprofit?
- What Are the Best Types of Businesses to Operate as Nonprofits?
- Who Is Eligible to Operate as a Nonprofit in the US?
- How to Register a Nonprofit
- What are the Key Advantages of a Nonprofit?
- What Are the Key Disadvantages of a Nonprofit?
- Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
- How is a Nonprofit Taxed?
- How to Convert a Nonprofit