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Not-for-Profit vs For-Profit Entities

Why Create a Not-for-Profit 501(c)(3) Organization?

Non-Profits as Businesses
Have you been considering whether to start a non-profit versus a for-profit company? Operating as a non-profit does not mean that the principals in the organization must submit to a life of poverty. On the contrary, many directors of non-profit organizations are very well paid. The IRS requires “reasonable compensation,” a mushy standard that is often best met by looking to the salaries of directors and employees in similar organizations. Non-profits may even earn a profit, or surplus, but that surplus must be retained by the organization for its preservation, expansion and future plans. Many business principles derived from for-profit entities can benefit non-profits, and many non-profits invest resources in developing effective internal management, monitoring performance, and ensuring accountability in the organization.

The Basics on Non-Profits

Non-profit organizations are often referred to as charitable organizations, but in fact a number of organizations that are not obviously “charitable” also qualify for non-profit status. A non-profit entity is one that is organized and operated exclusively for an exempt purpose, as recognized by the Internal Revenue Service (IRS) in Section 501(c) of the Internal Revenue Code (Code). Most non-profits derive their status under Section 501(c)(3) of the Code, which lists charitable, religious, educational, scientific, or literary purposes; testing for public safety, fostering national or international amateur sports competition, promoting the arts, and preventing cruelty to children or animals. Charitable purposes include relief of the poor or underprivileged, eliminating prejudice and discrimination, defending human and civil rights, erecting and maintaining public works and buildings, and lessening the burdens of government.

Twenty-eight types of organizations qualify for tax-exempt status under Section 501(c) of the Code, including:

  • Civic or Business Leagues
  • Employee Benefit Associations or Funds
  • Fraternal Societies
  • Labor and Agricultural Organizations
  • Social Clubs
  • Social Welfare Organizations
  • Veterans Organizations
  • Credit Unions
  • Private Foundations
  • Political Organizations (under Section 527 of the Code)

None of an organization’s earnings may inure to the benefit of any private shareholder or individual, and therefore any budget surplus at the end of the fiscal year must remain within the organization.

Benefits of Organizing as a Non-Profit

Qualifying non-profit organizations are exempt from federal taxation on income tax and often property tax as well. State and local tax exemptions from income, sales and property taxes are also available in accordance with state and local law.
Contributors to the organization are permitted an income tax deduction for donations of both money and property.

Limitations of Organizing as a Non-Profit

Non-profits organized under Section 501(c)(3) are prohibited from engaging in certain political activities. Specifically, a 501(c)(3) cannot participate either directly or indirectly in a political campaign on behalf of any candidate for elected office. Charities may conduct lobbying so long as the lobbying does not amount to a “substantial part” of the organization’s activities.

An otherwise exempt organization may be subject to the unrelated business income tax (UBIT) on certain activities if an activity: is a trade or business, regularly carried on, and not substantially related to the organization’s exempt purpose. For example, a museum that publishes a quarterly magazine containing advertisements would be subject to the UBIT on the profits generated by the advertisements. The museum would not be subject to the UBIT for offering art appreciation classes for a fee.

What to Consider When Establishing a Non-Profit?

Have you analyzed your primary objective and formulated a mission statement? Your primary objective must be for a charitable purpose that meets the requirements of the IRS. Your mission statement should address the question of why your organization exists, and it might identify your clients, describe your services and primary benefits to clients, and include the values that will guide your organization.

How will you organize? Setting up a non-profit starts with creating the corporation at the state level. The process can get very complicated and there is usually a lot of correspondence with the IRS Examiner once the application has been submitted. It is always suggested to seek a competent professional to assist with this process.

A non-profit entity may organize as a corporation, partnership, individual enterprise, unincorporated organization, or foundation, among a few others. Filing for exempt status follows incorporation and the development of a budget, since the amount of the filing fee depends upon your budget. An organization with (expected) gross annual receipts under $10,000 pays a $400 annual fee; the fee for organizations with gross annuals receipts equal to or greater than $10,000 is $850 on an annual basis. Your organization may also need an Employer Identification Number (EIN) from the IRS, which can be obtained through the IRS web site.

Will you have employees? If you have employees, the organization is responsible for Federal Income Tax Withholding and Social Security and Medicare taxes. In addition, some organizations are responsible for Federal Unemployment Tax.

Will some of your activities be subjected to the UBIT? With a few exceptions, any business activities conducted by your organization will be subject to the UBIT if they are not substantially related to the purpose of the organization. Consider whether a good portion of your organization’s intended activities will be subject to taxation.

Are you sure you want to start a non-profit? Consider whether you want your organization to focus on meeting an unmet need in the community, rather than on maximizing profits. The idea of forming a non-profit can seem more desirable in a tough economic climate, but the work required for starting a non-profit is not any different from starting a for-profit business. Instead of courting investors, you will be courting donors. While the tax deduction is an incentive for attracting donors, fundraising may be difficult if the services your organization will provide are not unique. You must do your research before starting your organization to ensure that your idea is original and that there is a need in the market for your services.

Although you can start a non-profit on your own, an attorney knowledgeable in non-profit law can help to ensure that you do not make mistakes as you establish your organization, which will expedite your application for exempt status and get your organization off to a good start.

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