Nonprofits Flashcards
What is a nonprofit?
A nonprofit organization is a group organized for purposes other than generating profit that does not distribute its income to its members, directors, or officers (except paying wages).
What is a 501(c)(3) nonprofit organization?
501(c)(3) is just one category of 501(c) nonprofit organizations – the Internal Revenue Service recognizes about 30 types of nonprofits, including 501(c)(4) nonprofits – but 501(c)(3) is the primary tax status that allows donors to deduct their donations to the organization.
A 501(c)(3) nonprofit – which is what most people think of when they hear “nonprofit” – is an organization that is organized and operated to benefit a certain segment of people or a community for one or more of the exempt purposes laid out in Section 501(c)(3) of the Internal Revenue Code (charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals). It must not be created or operated for the benefit of private interests, and no earnings can inure to the benefit of any shareholder or individual (this means, in part, that no one can receive stock or stock options in the entity). If your organization meets these criteria, it can apply to the Internal Revenue Service for an exemption from federal income tax.
A 501(c)(3) cannot engage in a substantial amount of lobbying activity (i.e., influencing legislation) and is strictly prohibited from participating in any political campaign activities that support or oppose political candidates. A limited amount of lobbying, both direct and grassroots, is permitted for 501(c)(3) public charities, but exactly how much of such activity is unclear under the law.
Organizations that wish to engage in these behaviors with fewer restrictions can pursue other tax-exempt structures (such as a 501(c)(4)).
What are the types of 501(c)(3)s?
In addition to religious organizations, there are two categories of 501(c)(3)s: public charities and private foundations. The biggest difference between a public charity and a private foundation is how they raise funds. A public charity must meet the “public support” test, which means the IRS looks at whether a nonprofit’s income comes from a diverse set of donors or payors for charitable services, rather than from a single source. While it is slightly more complicated, the simplest rule of thumb is that at least one-third (33.3%) of donations must be given by donors who give less than 2% of the nonprofit’s overall receipts.
A private foundation, by contrast, is generally created by a single benefactor, usually an individual or a business, through an endowment of funds. All of the requirements of a public charity apply to private foundations (i.e., no private inurement, no operation for private interests, etc.) plus additional rules specific to private foundations, including:
Restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons (self-dealing is where an insider benefits (financially) from the activities of the private foundation);
Requirements that the foundation annually distribute 5% of its assets for charitable purposes (without the annual distribution requirement, the private foundation would never be under an obligation to fund charitable activities even though the donor would get a tax deduction, see more here); and
Limits on holdings in private businesses.
Should I form a nonprofit?
When determining whether a for-profit, a for-profit social enterprise structure (e.g., a Delaware Public Benefit Corporation), or a nonprofit legal structure is best, founders should consider:
How important is the mission relative to profit?
How well are revenue and purpose aligned?
Are revenue and impact derived from the same activities?
Will resources needed to generate impact take away from resources needed to grow profit?
Is an increase in profit positively and linearly correlated with an increase in impact?
Revenue and growth
Do you plan to scale significantly? How?
Will you generate enough revenue to produce market rate financial returns to attract future institutional investment capital? Will you be self-sustaining?
Or will you need to rely on donations to fund the work you do?
Who are the investors/donors and do they have any limitations on the types of entities they can engage with?
Employee and founder goals and expectations
Will employees be expecting market salary and the possibility of a lump sum payout on acquisition or initial public offering?
What are the advantages of forming a 501(c)(3) nonprofit compared to a for-profit entity?
In addition to not paying federal income tax, the organization may also be exempt from state income tax and certain other state and local taxes;
Donations made to your organization will also be tax deductible to the donor;
Your entity may be eligible for public and private grants that are often exclusively available to 501(c)(3) organizations;
Your organization will have a clearly delineated public purpose, with all of the attendant social benefits; and
Like for-profits, your organization – if incorporated as a legal entity – will benefit from limited protection from personal liability:
Like for-profit entities, members, directors, and staff cannot be held responsible for debts incurred by the organization, meaning that your personal assets cannot be taken away to pay for debts. Directors can, however, be held responsible if they breach their fiduciary duties to the organization.
What are the disadvantages of forming a 501(c)(3) nonprofit compared to a for-profit entity?
Applying for 501(c)(3) status is a long and somewhat expensive process;
There are significant annual reporting requirements related to taxes and fundraising that must be filed with the IRS and all states in which the entity operates.
In California, for example, three state agencies require the following reports from most public charities organized as corporations:
Form SI-100, Statement of Information for Domestic Nonprofit Corporation and is filed with the Secretary of State every other year. It asks for the names and addresses of the corporation’s officers and other similar information. (Filing fee: $20 as of 2023)
Form RRF-1, Registration/Renewal Fee, is filed with the Attorney General’s Registry of Charitable Trusts along with the IRS Form 990. (Filing fee: based on the organization’s gross annual revenue for the prior fiscal year.)
Form 199, the annual information return for nonprofits registered in California, is filed with the California Franchise Tax Board. (Filing fee: $10 as of 2023.)
Restrictions on political activities and lobbying;
No engagement in any campaign activities to support or oppose any political candidate;
Lobbying must stay below a limited threshold, which varies based on a 501(c)(3)’s expenditures but can never exceed $1 million.
Limited financial upside to the founders and employees – including guardrails on how and how much directors and officers are paid – because nonprofits do not have owners or shareholders;
501(c)(3) employees must be paid “reasonable” compensation, which is based on fair market value wages. Compensation is reported publicly.
Close tracking of revenue, spending, fundraising, etc. in case of an audit (while the historical audit rate is extremely low, AI is now being used to scan 990s for certain reg flag issues); and
Activities can be scrutinized by the public, since Form 990 annual tax filings are publicly available.
What are mission-aligned alternatives to non-profits?
Mission-focused alternatives to creating a new nonprofit include obtaining a fiscal sponsorship from an existing nonprofit or forming a for-profit social enterprise, such as a Delaware public benefit corporation.
What are tandem/hybrid structures (and should I consider them)?
A tandem or hybrid structure is a close relationship between a nonprofit and for-profit entity, typically via contract, funding, or equity ownership. Common examples include a nonprofit establishing a wholly-owned for-profit subsidiary or a for-profit creating a separate but affiliated nonprofit (often in the form of a private foundation).
Note that a for-profit entity may not “own” a nonprofit (nonprofits cannot be owned), and there are strict rules regarding overlapping board members, managers, and economic interests that must be observed in order to preserve the nonprofit’s tax-exempt status. A nonprofit may own a for-profit subsidiary, but likewise there are strict rules governing the relationship in order to preserve the nonprofit’s tax-exempt status.
These structures and relationships are complicated to set up and maintain correctly from a governance and operational perspective, so they are generally not advisable for a new startup. One other key issue is that intellectual property that is developed by a nonprofit cannot be easily transferred to a for-profit, e.g., in the case where the intellectual property turns out to be commercially valuable. A for-profit entity will need to purchase or license the intellectual property from the nonprofit at fair market value. If you are considering this structure, you should seek the advice of experienced counsel.
What is fiscal sponsorship?
Under a fiscal sponsorship, a tax-exempt nonprofit sponsors a charitable project – which may or may not be incorporated as its own entity – enabling the charitable project to receive deductible gifts and grants. Fiscal sponsorship can be especially helpful for charitable projects to get started without waiting for independent tax-exempt status approval from the IRS, which typically takes many months. Managers of those charitable projects can incorporate their own nonprofits and pursue tax-exempt status in parallel with a fiscal sponsorship.
Typically, the sponsoring organization confers their tax-exempt status on the project and provides administrative services in support of the project. In exchange, the sponsor keeps a certain portion of the funds donated to the project. This fee, along with the precise contours of the support provided by the sponsor and the rights of the project’s initiators, are spelled out in the contractual agreement between the parties and may vary widely depending on the type of fiscal sponsorship. Fees typically range from 5-10%, though fees for government funding can be higher.
The fiscal sponsor has full fiduciary control over the funds it receives.
Types of fiscal sponsorships
The most common type of fiscal sponsorship is the direct model – also know as a “comprehensive” or “Model A” – fiscal sponsorship. In this model, the charitable project is housed within the sponsoring tax-exempt organization (“sponsor”) and has no separate legal existence (note: a nonprofit can separately incorporate while it is part of a Model A sponsorship, but the separate legal entity will typically not be involved in the sponsorship.) Because the sponsored project is not an established nonprofit, it cannot solicit funds or directly receive charitable donations. Instead, the sponsor receives donations and grants for the project. The assets and liabilities of the charitable project are seen as that of the sponsor, and the project’s staff are employees of the sponsor. The project typically pays the sponsor a fiscal sponsorship fee of between 5-10% of all funds held on behalf of the project, though this fee is sometimes waived. The sponsor exercises significant control over the project’s actions and funding to safeguard itself from legal liability and losing its tax-exempt status.
A grant model fiscal sponsorship – also known as “Model C” – is more of a financial partnership wherein the sponsored entity still owns and operates its own projects. It is generally best for larger organizations, either for-profit or nonprofit, that have administrative capacity, but that need a nonprofit entity to manage and collect charitable funds because the sponsored entity lacks tax-exempt status. In this model, the sponsor receives funds and generally re-grants them to the sponsored entity. The sponsored entity receives a 1099 for revenue funneled through the fiscal sponsor and is responsible for filing its own tax returns and typically for paying expenses directly to vendors, employees, etc.
There are also other models of fiscal sponsorship, but those are seldomly used. Credit to Adler & Colvin for classifying the different types of fiscal sponsorships into different “models.” For more details on fiscal sponsorship, see Adler & Colvins’s book here.).
Can 501(c)(4)s be fiscal sponsors?
Yes, but 501(c)(4)s cannot provide tax deductibility to project donors. And since the vast majority of those seeking fiscal sponsorship will want the benefit of tax-deductible donations and grants for their donors provided by a 501(c)(3), 501(c)(4)s are not a popular choice for fiscal sponsors. But for politically active groups that want to do more lobbying or even electioneering – and who do not want the hassle of forming and operating their own corporations – pursuing a fiscal sponsorship with a 501(c)(4) could make sense.
How do I find a fiscal sponsor?
There are many nonprofit organizations that are dedicated to fiscal sponsorship, for example, Tides.org, which has offices in San Francisco and New York. Fiscalsponsordirectory.org maintains a directory of potential fiscal sponsors.
Choose a fiscal sponsor carefully; consider the sponsor’s mission, reputation, services, oversight, fees, experience, and legal sophistication, and financial viability.
What are the pros and cons of fiscal sponsorship?
Fiscal sponsorships allow you to focus on your charitable project’s activities and fundraising without many of the burdens of creating your own nonprofit. Under fiscal sponsorship, you get the benefits of immediate tax-exempt status, the advantageous treatment of a public charity without having to meet the IRS’s public support test, better fundraising opportunities using the fiscal sponsor’s network, and administrative and governance support from an existing nonprofit. It can be particularly beneficial where the charitable project is time limited (i.e., short term), is time sensitive, or is waiting to obtain tax-exempt nonprofit status.
On the other hand, you lose some control over the project, many fiscal sponsors charge administrative fees, and the sponsor may receive credit for the project’s impact. It may also be difficult to separate from the fiscal sponsor at a future date unless separation is provided for in the fiscal sponsorship agreement.
Where should I incorporate my nonprofit?
When forming a new nonprofit in the United States, one of the first steps is to create a corporate entity – generally a corporation – under state law. A soon-to-be nonprofit organization can choose any state as its state of incorporation.
While Delaware is often a good option, Delaware does not have quite the same dominance for nonprofit incorporations as for-profits because many of the benefits for incorporating in Delaware do not apply to most nonprofits. Instead, the default for nonprofits is often “home state” formation, because regardless of where you incorporate, you will be subject to your home state’s charitable regulations. For example, if a nonprofit incorporates in Delaware and operates in California, then the nonprofit will need to comply with applicable regulations and reporting requirements in both states.
That said, unless an organization is formed to conduct activities solely in its home state, many attorneys opt to form their nonprofits in Delaware, in part because the Delaware General Corporation Law (which attorneys and entrepreneurs are familiar with) applies to Delaware nonprofits and is more flexible than many states’ laws when it comes to significant corporate structure changes or transactions.
Ultimately, when choosing the best state, consider
Whether the nonprofit will have locations in multiple states;
Whether its mission is connected to a particular geographic area;
Whether long-term sources of funding prefer nonprofits from a certain state;
If a nonprofit has a close affiliation with another nonprofit (e.g., if the nonprofit will serve as the charitable arm of an existing 501(c)(4), the nonprofit can streamline its governance by incorporating in the same state as the existing 501(c)(4)); and
How fast the nonprofit needs to be formed (most states can form a nonprofit entity within a few days, but some states, like New York and California, may require certain preapprovals if the nonprofit is operating in regulated spaces like health or education, which can take additional time.).
Do I need to register my nonprofit in other states where I operate?
Regardless of where you choose to incorporate, a nonprofit must register to do business in any other states in which it operates (just like for-profit entities). This requirement is generally triggered by hiring an employee in that state, entering into a significant contract in that state, etc, but is defined by state law.
Most states also require that nonprofits register for authorization to solicit charitable contributions if the nonprofit seeks to collect charitable funds in that state. This means that if you have a “Donate Now” button on your website or solicit donations on social media, you may need to register in most other states because your donations may come from outside of the state in which you are incorporated. In most states, there are thresholds below which you do not need to register. Generally, organizations should look into the rules of registration for a given state if they get an influx of donations from a state, are actively soliciting in a state, or know a big contribution will be coming from a state. There are consultants who can help with this process, which can add up to around $2000 dollars. See here for some general information. A nonprofit may want to wait until they have received their IRS determination letter and are assured of tax-exempt status before it solicits donations from outside of its home state and begins this charitable solicitation registration process.
What types of nonprofit corporations exist in California?
There are three types of nonprofit corporations in California:
Public benefit corporation. This is the appropriate choice for a nonprofit formed for charitable or public purposes. It is not to be confused with a Delaware public benefit corporation or public benefit corporations in other states, which are for-profit entities! The California-specific nonprofit references in these FAQs are to public benefit corporations.
Mutual benefit corporation. Mutual benefit corporations are formed to benefit their members. These organizations typically include trade associations, automobile clubs and social groups
Religious corporation. Both formal religious groups and religious purpose organizations qualify.
