Illuminating the way for nonprofits

You save the world, we’ll do the paperwork™

What is a Nonprofit?

There are over 1.5 million nonprofit organizations in the United States. However, not everyone understands what a nonprofit really is.

First, many people think that nonprofits don’t make money, or don’t have any money. This is just not true. A nonprofit corporation should recoup its costs and may even make a profit, and some private foundations have more assets than the governments of small nations. These organizations are termed “nonprofits” because they are not organized primarily for profit.

Next, a nonprofit is not the same as a “501(c)(3)” organization. Charities that are exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code are indeed nonprofits, but the term nonprofit is much broader than just 501(c)(3) charities. The term “nonprofit” refers to

how the entity is organized under state law, and section 501 of the Internal Revenue Code is a federal law. Also, section 501(c) encompasses 29 categories of organizations that are tax-exempt under federal law. For example, social welfare organizations are exempt from income tax under 501(c)(4) and have greater flexibility to engage in lobbying and political activities, but donations to these entities are not tax-deductible. Other nonprofits that are not 501(c)(3) charities include chambers of commerce and other civic or business leagues, fraternal organizations, and state-chartered credit unions. These nonprofit organizations are exempt from certain taxes because of the contributions they make in the community.

Section 501(c)(3) nonprofits make up the majority of nonprofits, and are the most favorable from a tax perspective, as they are the only organization to which donations are tax-deductible to the donor. Within this grouping, there are two main types of entities: public charities and private foundations. Want more information?

Public charities are what most people think of when they think of nonprofits – these are entities like the United Way, UNICEF, Red Cross, and Teach for America. Hospitals, churches, schools, and museums are also public charities.

Private foundations are also 501(c)(3) organizations but they’re not “in the trenches” like public charities. Instead, these are foundations that provide grants and funds to the charities doing the work. Private foundations are subject to more stringent regulations by the IRS, and the limits on deductibility of contributions are less favorable than for public charities. The best-known example of a private foundation is probably the Bill & Melinda Gates Foundation, which has an endowment worth close to $50 billion, and which makes grants to public charities of about $3 billion per year.

How Do I Form a Nonprofit?

You have a passion for something and you’re ready to change the world for the better. What next?

First, decide if your venture should be formed as a nonprofit. Do you want to make money at it? If so, you should rethink what structure you want to use. Instead of a nonprofit, you might choose a for-profit or a “social enterprise” instead of a nonprofit. The downside to nonprofits is increased IRS oversight, and prohibitions on individuals making too much money (what’s deemed “private inurement”). If your idea has the potential to make a lot of money and you want the option to keep some of it for yourself, you should rethink the vehicle. As an alternative, you may want to form a for-profit entity and start a separate nonprofit to do good with a portion of the profits.

Next, decide if there’s already someone out there doing what you want to do. Don’t reinvent the wheel. If you want to improve the lives of homeless dogs by providing free veterinarian care and there’s already a nonprofit in your area doing just that, consider contributing to and volunteering with them. Unless your activities and funding are going to be significant, forming a 501(c)(3) on your own is expensive, time-consuming, and requires long-term commitment.

If all you want to do is contribute money to a cause, but you don’t want to operate as a charity, then consider contributing to a donor-advised fund (DAF). In this way, you can contribute funds to an already established 501(c)(3) foundation, receive an immediate tax deduction, and then recommend grants from the fund to the charities you choose over time.

Ready to Form?

Once you’ve decided your cause and your commitment are big enough and you need to do this on your own, the next step is to form a nonprofit entity in the state of your choice. An attorney can help you evaluate the pros and cons of the different entities available and the various state laws governing them so that you can decide which state and which entity to form in that state. Most people starting charities choose to form nonprofit corporations.

Establishing a nonprofit corporation involves several steps:

• File a Certificate of Formation (sometimes called Articles of Incorporation) in the state you select.
• Get an EIN from the IRS.
• Open a bank account for the entity.
  

• Create bylaws to govern the entity.
• Choose a board of directors that will govern the entity. Some states, including Texas, require a minimum of three directors for a nonprofit corporation. The IRS prefers that a majority of your Board be independent, which basically means uncompensated by the entity.
  
• Hold the organizational meeting of the Board of Directors, where you will take care of formalities such as adopting the bylaws, electing officers, recording the receipt of federal and state tax exemptions, setting a budget, and adopting programs. After the meeting is completed, minutes of the meeting should be created and filed in the nonprofit's records binder.
  
• Draft the appropriate resolutions to take Board actions.
  
• File for federal tax exemption with the Internal Revenue Service (Form 1023). This is the most complicated step, and could take months of preparation. You will need to explain to the IRS all of your proposed activities, your budget, and the systems you have in place for governance of the entity, among many other things. [hyperlink to article on Form 1023 preparation]. You may have to wait several months for the IRS to approve your application. The more time and thought goes into the application, the more likely the IRS will streamline the decision. In the meantime, you can conduct activities as a nonprofit, and if your exemption is granted, the effective date will be retroactive to the date of formation, assuming you file the exemption application within 27 months of formation.
  
• Obtain your state tax exemption, based on your federal tax exemption.
  
• Obtain necessary licenses and permits to operate in your jurisdiction, such as sales tax licenses, etc. Continue to file necessary information returns and filings with the appropriate state and federal agencies on an annual basis. If you don’t, your entity’s tax-exempt status could be forfeited.
  

This process can take time, often up to a year or more. The advice of experts can be invaluable, saving you time and effort down the road. We are happy to help with setting up your nonprofit, and offer affordable hourly rates and even some fixed fee arrangements.

What are Social Enterprises?

A new model of business is gaining momentum, one that allows enterprises to focus on their social mission rather than profits first. Modern social entrepreneurs are no longer satisfied with just profits. Increasingly, people want to use the power of business to solve social and environmental problems.

Social enterprise is a term that describes this new paradigm. The Social Enterprise Alliance defines it as an organization or initiative that marries the social mission of a nonprofit or government program with the market-driven approach of a business.

Think of a social enterprise as a hybrid between a nonprofit and a traditional, profits-focused business. Traditional business managers are required to focus on profits; doing good comes second (if at all). In fact, if managers of publicly traded companies make decisions that are not profit-driven, shareholders can sue them over it.

A social enterprise model allows decision makers to focus instead on their mission of providing social or environmental benefits, with profits a secondary consideration.

What are B Corps? Are they the same thing as social enterprises?

Social enterprises, B Corps and benefit corporations are not the same thing, although B Corps and public benefit corporations may both be described as social enterprises.

B Corps are for-profit companies certified by the nonprofit B Lab to meet certain standards of social and environmental performance, accountability, and transparency. The B Corp certification is a distinction for social responsibility, similar to certifications for fair trade and organic. There are currently 2,014 B Corps in 50 different countries. Some notable examples are Patagonia, Method Products, Ben & Jerry’s, and Numi Organic Teas.

Why should I consider B Corp certification?

Here are just a few of the many benefits of B Corp status:

• Protect the Mission: B Corps are legally obligated to maintain a focus on their mission, even in hard times. This commitment must be sustained regardless of changes in management. According to B Lab: “The value of meeting the legal requirement for B Corp certification is that it bakes sustainability into the DNA of your company as it grows, brings in outside capital, or plans succession, ensuring that your mission can better survive new management, new investors, or even new ownership.”
  

• Marketing: B Corp certification proclaims to the public who you are, what’s meaningful to your company, and what you stand for. It may lead consumers to choose your company over non-certified competitors.
  
• Investment: B Corp certification can allow you to command higher valuations and achieve greater impact. The B Corp legal and performance standards help ensure that B Corps and their investors meet these objectives.
  
• Hiring: B Corp status allows companies to attract young, talented, socially-conscious employees.
  
• Networking: B Corp certification puts your company in a network of likeminded businesses, providing support and community.
  
• Publicity: B Corps get a lot of press, spearheaded by B Lab and in places such as The Economist, Inc., The Wall Street Journal and the New York Times.
  

According to B Lab, “Every B Corp has a compelling story, and we help tell it.”

What are benefit corporations?

Public benefit corporation describes a type of entity created by legislation adopted in certain states. Benefit corporation status provides legal protection to balance financial and non-financial interests when making decisions. It provides assurance to investors, employees, customers and the public that the company is committed to its mission and not just profits.

o 31 states have benefit corporation legislation, and 7 have legislation pending. Texas is not one of these states. (Social entrepreneurs located in states without benefit corporation legislation can form such an entity in another state, and then register as a foreign corporation doing business in their state.)

o Benefit corporations are an alternative form of entity; unlike B corps, third-party certification is not required.

Why should I organize as a benefit corporation?

There are many reasons entrepreneurs seek to organize as a benefit corporation:

• Mission-driven: First and foremost, a benefit corporation structure allows social entrepreneurs to focus on their mission. A benefit corporation’s directors operate the business with the same authority as in a traditional corporation, but instead of using profits as the sole measure of corporate performance, shareholders in a benefit corporation also assess whether the enterprise has achieved a material positive impact.
  
• Alternative Funding: Some social entrepreneurs are more comfortable raising capital and selling products and services than holding fundraisers and courting charitable donors (methods that more traditional nonprofits use raise funds). Producing one’s own profit from business is more sustainable than relying on the unpredictability of donations.
  
• Shifting business paradigm: Allows entrepreneurs to change the public’s perception of business, and to profit from good ideas and business acumen while making the world a better place.
  

Politics and Nonprofits: Never the Twain Shall Meet?

With the recent onslaught of polarizing daily headlines, virtually everything has become politicized. This can put charities in a tough position. Can they speak out about issues and candidates that are important to them? Or will the IRS revoke their tax-exempt status?

Prohibition on Campaigning

Under the Internal Revenue Code, “all section 501(c)(3) organizations are absolutely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate for elective public office.”

What does this prohibition mean? Simply put, charities risk their tax-exempt status if they contribute to or speak out for or against political candidates.

Many section 501(c)(3) public charities that want to engage in lobbying without risking loss of tax-exempt status establish a separate 501(c)(4) tax-exempt organization. To prevent implicating the charity in the 501(c)(4)’s activities, formalities between the two organizations must be respected.

What campaign activities can charities do?

The prohibition does not prevent a 501(c)(3) entity from nonpartisan voting-related activities such as:

• Educating voters by presenting public forums and publishing voter education guides
  
• Conducting voter registration and “get out the vote” activities
  
• Inviting candidates from both sides to a forum for discussing the issues
  

But if these activities are biased, or have the effect of favoring or opposing candidates, they are prohibited. Because of this subjectivity, many 501(c)(3) entities choose to avoid participating in campaigns at all.

Note that this prohibition applies only to section 501(c)(3) nonprofits. Others, such as 501(c)(4)s, are subject to different rules regarding their political activities.

Restrictions on Lobbying

A 501(c)(3) organization may engage in some lobbying, but more than insubstantial lobbying activity risks loss of tax-exempt status and the imposition of excise taxes. The IRS applies a “facts and circumstances” test to determine whether a charity’s lobbying activities are substantial. In other words, there is no clear definition of whether lobbying activities are substantial or not. This makes lobbying a risky activity for 501(c)(3)s, and the advice of counsel in this area is highly encouraged.

What is the difference between political activity and lobbying?

Political (campaign) activity involves the support of or opposition to a candidate for elected office.

Lobbying is activity in support of or in opposition to, or a call to action on, specific legislation.

Can other nonprofits engage in political activity?

Entities exempt under section 501(c)(4), often called social welfare organizations, may be involved in certain political activities, and may use lobbying to effect change for their cause. However, 501(c)(4) organizations are still limited in the amount of political campaigning they may do – it can’t be against political candidates.

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