Considering a Nonprofit Approach to your Business?

December 14, 2012

Does being exempt from business income tax, helping others and tapping into grants sound attractive?

But what about relinquishing control to a board of directors and giving up ownership and profits?

All of the above are true if you decide to form a nonprofit. That said, perhaps you feel your present business model would function better as a nonprofit or the addition of a charitable arm would allow you to meet altruistic goals.

Necessary steps include identifying your mission, creating and filing organizational documents on the state level, and obtaining tax-exempt status from the Internal Revenue Service. You will also choose a name and form a board of directors.

Most commonly, nonprofits apply for 501(c)(3) status, named for the relevant section of income tax code. The 501(c)(3) status not only exempts your organization from income tax, it allows contributions to be tax deductible for donors, an important benefit.

The intrinsic difference between for-profit and nonprofit resides in the mission and purpose of the enterprise. Businesses are created to provide a service or product with the ultimate aim of generating profits and wealth for the owners. Owners make the investment, take the risk and absorb the losses.

If the business is sold or liquidated, any proceeds of cash or assets go to the owners. The owners and their designated managers make all business decisions, including money management and distribution of wages and profits.

For-profit companies often have a mission of making the world a better place. Some even donate a percentage of profits or make contributions to charity. But in essence, the business exists to serve the owners.

In contrast, nonprofits exist to serve their constituents and the public’s “greater good.” The mission may encompass assisting the poor, education, community development, social welfare, medical services or religious purposes.

All money received is regarded as being in trust to the purpose the nonprofit was created to serve. Although many directors have great latitude in making management decisions, the final responsibility resides with a board of directors. The board also can hire or fire an executive director. Any surplus of revenues over expenses must go back into the organization, and upon dissolution, assets are distributed to other nonprofits.

A solid mission statement is core to your success as a nonprofit and essential to obtain approval from the IRS for nonprofit status, a critical step. Your nonprofit mission should include who you serve, what you do, where and how. For example, Kiva.org’s mission is “To connect people through lending to alleviate poverty. Leveraging the Internet and a worldwide network of microfinance institutions, Kiva lets individuals lend as little as $25 to help create opportunity around the world.”

The IRS allows nonprofits to be corporations, limited liability companies (LLCs), trusts and unincorporated associations. You must register with your state first. Each state’s laws vary regarding converting tax status for corporations and LLCs.

Some states will require the existing organization to be dissolved and a new one incorporated. Others allow simple conversion. All will require you to create bylaws and identify your board of directors. If you are a sole proprietor, you will need to form an LLC or corporation. To form a charitable division, you will set up a separate company.

Bylaws vary according to the organization’s purpose but generally include your purpose, corporate structure, how the board operates, officers, voting, financial management and dissolution.

Setting up a board of directors is another critical piece. You need to find people who share your passion for your mission as well as your vision for the organization. Having the wrong board members can lead to internal conflict and opposition to your plans.

Flexibility, appropriate expertise, commitment and good social skills are all essential qualities for a good board member. In today’s difficult fundraising environment, board members are being called upon to help with raising money as well as make personal donations.

If your board members are uncomfortable with that, the full responsibility will rest on you, and it may hamper you from receiving significant gifts and donations. It’s essential to have constituent representation as well as slots for well-connected professionals or philanthropists. Funders often require documentation of direct board donations and constituent governance.

It is highly recommended to engage an attorney to obtain IRS tax-exempt status. This can be a lengthy and difficult process and, if not done correctly, can result in your being denied.

The IRS understands the attractiveness of being tax exempt and allowed to receive donations from individuals as well as government grants. The concern is to ensure the organization will truly serve the public good.

Publication 557 and Form 1023 cover the requirements for filing and operating a 501(c)(3) nonprofit. Publication 4220 gives a brief overview of the process. While approval is pending, you may operate as a tax-exempt organization, and you must file required annual returns and other paperwork on time.