Surprisingly, there is no legal definition of a nonprofit organization. In general, a nonprofit organization is one that is organized to achieve a purpose other than generating profit. Despite this, a nonprofit organization is not precluded from making a profit or engaging in profit-making activities. It is prohibited from passing along any profits to those individuals who control it, like founders, directors, officers, employees, and members. Nothing, however, prevents a nonprofit from paying reasonable salaries to officers, employees, and others who perform a service for it.
This section is aimed at those seeking to start and operate a nonprofit corporation that is a public charity under section 501(c)(3) of the U.S. Internal Revenue Code (the "tax code"). A corporation is the most common and generally most appropriate structure used to create a nonprofit organization. You should seek the advice of an experienced nonprofit lawyer if you wish to establish a nonprofit organization using some other business structure.
Section 501(c)(3) of the tax code exempts certain nonprofit organizations from federal corporate income taxes. Gaining tax-exempt status gives a nonprofit corporation credibility with potential donors because it shows that the organization has a legitimate charitable purpose, a formal structure for accomplishing its goals, and is publicly accountable. Section 501(c)(3) tax exemptions are denied to any nonprofit organization engaging in certain political or legislative activities, which will be discussed below.
Section 501(c)(3) classifies nonprofit organizations into private foundations and public charities. In all likelihood, you want your nonprofit organization to avoid being classified as a private foundation because a number of complex additional regulations and restrictions apply to them. When you fill out your application for 501(c)(3) tax-exempt status, you should request to be classified as a public charity in Part X of Form 1023, usually by checking the box in Line 5g, 5h, or 5i (depending on the nature of your funding).
In order to qualify as a public charity, a nonprofit
corporation must be formed and operated for a charitable purpose.
"Charitable" is a narrow descriptor given the many types of
organizations covered under section 501(c)(3). The section
also applies to organizations with religious, educational, scientific,
or literary purposes, among others. These purposes must be for the
benefit of some significant section of society, whether it be the
general public or a specific community.
Additionally, a public charity must be publicly supported. This means that the nonprofit corporation must normally receive funds from governmental entities or multiple private donors. Contrast this with a private foundation, which typically gets its funds from a single source. The calculations behind what "public support" means are complicated, see the Nonprofit Law Blog's Public Support Tests for details.
Keep in mind the following factors as you consider whether to operate as a nonprofit public charity corporation:
Liability
Like other corporate entities, nonprofit organizations can be sued for any number of reasons, including:
- publishing defamatory statements
- neglecting to pay taxes (tax exemptions under 501(c)(3) only cover federal corporate income tax; the nonprofit is still responsible for other taxes)
- violating state charitable solicitation laws, antitrust laws, or the tax code by engaging in prohibited political activity or substantial lobbying
- lawsuits common to any business: wrongful termination, employment discrimination, personal injury, and breach of contract
Like shareholders in a for-profit corporation, directors of a nonprofit corporation, and other individuals who participate in the founding and/or operating of the nonprofit organization, enjoy limited liability for the debts and obligations of the organization, including for the unlawful acts of other directors, officers, and employees.
- For example, assume you are a director of a nonprofit corporation for which you and others operate a blog about the environmental impacts of deep-sea fishing. If a fellow director or employee publishes a defamatory blog post or posts copyright infringing material on the nonprofit organization's website, you are not personally liable by virtue of your status as a director of the organization, and your liability ordinarily is limited to the amount you contributed to the nonprofit organization (if any).
However, directors, officers, and employees may be personally liable for their own wrongful conduct, regardless of whether they are paid for their work or are volunteers.
- For example, assume that you make defamatory statements about one of the larger fishing companies. The fishing company can sue you personally and satisfy the judgment out of your personal assets.
Note that if you apply for a small business loan to help fund your nonprofit corporation, the lender probably will require you to give a personal guarantee. In that case, you are personally responsible for the paying back the debt, even if your business is a nonprofit corporation and even if there is no basis for piercing the corporate veil.
Formation
Nonprofit organizations usually incorporate in the state where they expect to do business. Forming a nonprofit 501(c)(3) corporation is burdensome. The section on Forming a Nonprofit Corporation provides the steps necessary to get established in general; the section on State Law: Forming a Nonprofit Corporation outlines what is required by the fifteen most populous U.S. states and the District of Columbia.
There are two main steps involved in forming a nonprofit corporation:
1. Incorporating as a nonprofit corporation at the state level
If you want to incorporate, you must file articles of incorporation with a state office, usually the Secretary of State. Creating articles of incorporation for a nonprofit corporation can be more involved than creating one for a for-profit corporation because you will need to include language about the purpose of your nonprofit corporation in order to be eligible for 501(c)(3) tax exemptions. Drafting the articles of incorporation generally does not require the assistance of a lawyer, and usually the filing fees are significantly less than the filing fees for incorporating as a for-profit corporation.
You will also need to create corporate bylaws which are the internal rules and procedures of the nonprofit corporation. Drafting bylaws that are highly customized to your business may involve some complexity. Additionally, you must keep a records book at the nonprofit's place of business.
The incorporators and/or directors of a newly formed nonprofit corporation should hold an initial organizational meeting to adopt bylaws and elect initial directors (if not named in the articles of incorporation), among other things. Minutes of this meeting must be recorded.
2. Applying for 501(c)(3) corporate income tax exemptions at the federal level
You need to file Form 1023 in order to apply for tax-exempt status under 501(c)(3). The application process is complicated, but can be done without the assistance of a lawyer if you are willing to devote the requisite time and energy in to the process. IRS resources (both the website and the call centers) are of immense help as is Anthony Mancuso's book "How to Form a Nonprofit Corporation," which provides line-by-line guidance on how to complete the application form. For detailed information on how the IRS evaluates journalism non-profits to see whether they qualify for a tax exemption, see the Citizen Media Law Project's Guide to the Internal Revenue Service Decision-Making Process under Section 501(c)(3) for Journalism and Publishing Non-Profit Organizations.
The filing fee for the application is high: $300 if your gross receipts have not exceeded or will not exceed $10,000 annually over a 4-year period, and $750 otherwise. You do not have to apply for tax-exempt status if you anticipate bringing in gross receipts of less than $5,000 per year. If you actually bring in more than $5,000 in any particular year, however, you will need to file Form 1023 within 90 days of the end of the year. See Application for 501(c)(3) Tax Exemption for details.
Note that if the IRS classifies you as a private foundation and not a public charity, you should contact an experienced nonprofit lawyer immediately to understand the implications of such a classification.
Management Structure
Like other corporations, a nonprofit corporation consists of the following classes of people:
- Incorporators: Incorporators form the nonprofit corporation.
- Board of Directors: The board of directors makes major strategic and financial decisions for the organization and ensures compliance with relevant legal and accounting requirements.
- Officers: Officers oversee day-to-day affairs; usually officers consist of the president, vice-president, secretary, and treasurer.
- Employees: Employees execute the decisions made by the directors and officers.
Another category unique to nonprofits is members. Members are a special class of individuals and/or organizations that have rights to participate in the current and future affairs of the nonprofit organization. Nonprofit organizations are not required to have members. You should consult with an experienced nonprofit lawyer if you wish to become a membership organization.
State corporate laws and the nonprofit organization's corporate bylaws govern such things as:
- the required number of directors, or minimum and maximum sizes of the board
- voting requirements for valid board action, such as how many directors are needed to constitute a quorum
- whether action in writing without a formal meeting is permitted
The full array of issues surrounding nonprofit governance is beyond the scope of this Guide. For example, there are reasons to both limit a board's numbers (concentrate control) and broaden a board's numbers (live up to the ideals of representation). A good legal professional or legal resource should be able to help you find the best structure for your nonprofit. For the board example above, in "Starting and Managing a Nonprofit Organization," Bruce R. Hopkins suggests creating an additional advisory committee, thus satisfying concerns of representation and control. You should seek out resources such as Hopkins' book, or consult with a lawyer experienced in nonprofit matters.
Operation
Operating a nonprofit organization is often burdensome and costly. There are reporting requirements and operating restrictions that you need to keep in mind in order to to comply with the law and maintain 501(c)(3) exempt status. Expect increased paperwork and red tape in order to comply with:
- state corporate laws' formalities for corporate governance
- state laws on charitable organizations' record-keeping requirements
- IRS regulations on tax exemptions (do not underestimate the time and energy that you will need to spend organizing the fundraising arm of your nonprofit corporation in order to solicit and accept donations and remain a publicly supported public charity)
- the public's right to inspect your nonprofit organization's corporate records book
Note that the operating restrictions and requirements are even more stringent if your organization qualifies as a private foundation and not as a public charity.
Additionally, you will also be responsible for the tax and other regulatory obligations imposed on all small businesses. For more on the tax obligations of small businesses, see the Tax Obligations of Small Businesses section and the IRS's informational guide, Publication 583 (1/2007), Starting a Business and Keeping Records.
Ownership of Assets/Distribution of Profits
Once incorporated, the newly created nonprofit organization is a separate legal entity from its incorporators, directors, and employees. In fact, a nonprofit has no owners, at least not in any ordinary sense. The nonprofit corporation owns all assets of the business and is entitled to receive all profits from its operation. Among the most important assets of any nonprofit corporation that operates a website or blog are its articles, posts, videos, and other content. For details on who owns what from a copyright perspective, see the Copyright Ownership of Articles and Posts section.
Despite its name, a nonprofit organization is not precluded from making a profit or engaging in profit-making activities. However, a nonprofit is prohibited from passing along any profits to those individuals who control them, like founders, directors, officers, key employees, and members. (A handful of states allow a nonprofit corporation to issue stock as a mechanism of control, but no dividend rights accompany the issued stock.) Instead, a nonprofit organization must use any profits to further its program activities or "exempt functions." It may also invest profits in another tax-exempt organization.
Although a nonprofit organization may not distribute profits to its directors, officers, key employees, or members, a nonprofit organization may pay its employees a salary and give them benefits. A nonprofit organization may also pay directors for their expenses and time spent attending director meetings. The key is that the salaries and payments must be reasonable. Excessive payments or exorbitant amounts posturing as salaries or compensation violate the tax code and may lead to penalties and a loss of tax-exempt status.
Note: If you dissolve your nonprofit organization, you must invest all profits into another nonprofit organization.
Tax Treatment
If you obtain 501(c)(3) tax-exempt status, your nonprofit corporation will be exempt from paying federal corporate income tax. However, the 501(c)(3) tax exemption does not apply to unrelated business taxable income or "UBTI," which refers to income generated from regular trade or business activity that is not substantially related to the nonprofit organization's exempt purpose.
Note that your nonprofit corporation may engage in unrelated trade or business activity, but will be liable for the taxes on the gross income exceeding $1,000 generated by it. In this situation, you will need to file Form 990T, the UBTI return, with the IRS.
For example, the sale of advertising in a periodical constitutes UBTI, according to the IRS. Therefore, if your nonprofit organization sells advertising space on a website, in a print periodical, or for a broadcast, you must report the income generated from advertising as taxable. However, you might be able to deduct the cost of selling advertising space as an ordinary and necessary trade or business expense.
For more information on advertising sales as UBTI, or UBTI in general, consult the IRS publication, Tax on Unrelated Business Income of Exempt Organizations.
If you achieve 501(c)(3) tax-exempt status, you will still need to file an annual tax return with the IRS, unless your organization's gross receipts are normally $25,000 or less. Organizations beyond the $25,000 threshold with gross receipts below $100,000 and total assets at the end of the year less than $250,000 can file the return on Form 990EZ. Organizations with gross receipts above $100,000 and assets above $250,000 must file the return on Form 990. For details, including how to calculate gross receipts, see the Instructions for Form 990 and Form 990-EZ.
Beyond exemption for federal income tax, qualifying under 501(c)(3) provides another important benefit: donations to the organization will be tax deductible by donor, making fundraising easier. Moreover, some donors, like foundations and the federal government, are barred from funding projects that don't have 501(c)(3) status.
You may also be eligible for other special benefits, such as:
- discounted postal rates
- state tax exemptions (such as sales tax), and limited tort liability
- local tax exemptions, including property tax
Taxation is a very technical subject and you should consider having the nonprofit corporation's tax returns and reports handled by an experienced tax accountant.
Prohibition on Political and Legislative Activities
An important issue is the federal tax code's rule against 501(c)(3) organizations engaging in political and legislative activities. Because the proscribed activities violate the tax code (and may result in the revocation of the organization's tax-exempt status, the imposition of an excise tax, and liability for back taxes), you must understand how 501(c)(3) defines each type of activity. See the section on Prohibitions on Political and Legislative Activities in this guide for more information.
Other Considerations
As discussed above, forming and maintaining a 501(c)(3) nonprofit corporation can take a lot of time, energy, and money, especially if you are beyond the gross receipts threshold requiring you to formally apply for 501(c)(3) exempt status. You may worry that the work needed to incorporate will distract you from your online publishing activities, but also believe that the benefits of tax-exempt status are too important to pass up.
One option to explore is whether a relationship with a "fiscal sponsor" is right for you. Fiscal sponsorship is the mechanism by which a nonprofit organization with 501(c)(3) status lends its legal and nonprofit status to persons, groups, or businesses that engage in activities related to the sponsor's mission. Through fiscal sponsorship, you may be able to function as a nonprofit organization (including receiving tax-deductible donations) without going through the hassle of forming your own independent organization. Fiscal sponsorship also offers the possibility of benefiting from the sponsor's established administrative infrastructure, financial liquidity, and expertise. In exchange for these services, the fiscal sponsor generally keeps a percentage of each financial transaction or charges a monthly or yearly membership fee. Note that fiscal sponsors that work on a percentage basis or provide services beyond simply acting as an umbrella organization often have a minimum fundraising requirement for eligibility.
Seeking a fiscal sponsor may be best if you are:
- working on a short-term project
- initiating a project that has yet to show long-term viability (in some cases fiscal sponsors may help a new project spin off as an independent nonprofit organization)
- waiting for IRS approval on your application for the 501(c)(3) tax exemption
- performing work effectively, but without access to support staff
When evaluating potential fiscal sponsors, you may want to consider several factors, including:
- the mission and vision of the sponsoring group
- the sponsoring group's administrative and management policies
- whether the sponsoring group has sufficient financial resources to support you
- whether the sponsoring group has human resource capacities
- the transparency with which the sponsoring group operates
- the accountability and financial integrity of the sponsoring group
When determining if fiscal sponsorship is right for you, you should weigh the benefits of gaining immediate tax-exempt status and administrative support (if selected) against the time and effort it takes to research fiscal sponsors and apply for sponsorship, the control relinquished in the relationship, and the fees charged by a sponsor.
Some examples of fiscal sponsors include:
- Fractured Atlas is an organization that offers fiscal sponsorship as well as other services (such as event liability insurance and even health insurance) to individuals or groups involved in the arts (including publishing). In order to apply, you must become a member. While rates for membership start at $7.50/month, there is no fee to apply for fiscal sponsorship. Once you are sponsored, Fractured Atlas will accept donations for you and act as a bank from which you can withdraw funds at any time. When you withdraw from your account, you are charged an administrative fee of the greater of $10 or 6% of the funds withdrawn. All sponsored groups can begin fundraising immediately once they are approved by the Fractured Atlas board.
- The Tides Center is a large fiscal sponsor supporting programs that seek to accelerate social change. In addition to sponsorship, the Tides Center offers other office-related services such as human resources management and payroll management. Tides offers more comprehensive services and greater availability of experts than most fiscal sponsors and charges a fee equal to 9% of gross annual revenue. The Tides Center does not offer sponsorship to projects with less than $30,000 in annual funding and does not offer sponsorship to individuals.
- Los Angeles-based Community Partners provides sponsorship services to southern California organizations. They do not have a minimum fund-raising requirement, but they analyze your business structure to determine the community's need for your project and the likelihood that your project will raise sufficient funding.
