A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary or scientific purpose. In order to become a nonprofit, the entity must first be organized in its home state as a not-for-profit corporation.
The formation of the nonprofit corporation in itself does not mean that the corporation is a tax-exempt entity under either federal or state law. In order to become tax-exempt, the corporation must thereafter file for tax exempt status with the IRS under Internal Revenue Code Section 501(c). Concurrently, the entity may also apply for tax exemption from state taxation by filing the necessary application with the state’s franchise tax board, or equivalent, and exemption from certain county, city or other local taxes.
Since the tax-exempt nonprofit is the most popular, the majority of the information provided herein will related to tax exempt organizations.
One of the biggest attractions for filing for tax-exempt status, besides the exemption from federal and state income tax, is the individual tax deduction for contributions. This tax deduction makes the job of fundraising for the nonprofit easier in that donations may be tax deductible by the donor. For example, for nonprofit food banks and sports programs, this would allow local merchants to donate food supplies or athletic equipment and uniforms to the organization and be able to take a tax deduction for the value of the goods donated. Without this tax deduction, many nonprofit organizations would not be able to sustain viability.
A common misconception about nonprofit corporations is that they cannot make a profit. This is not true. Unlike for-profit corporations who make money and then redistribute the profits in the form of dividends to their owners and shareholders, a nonprofit corporation has no shareholders and is owned by the public. And unlike a for-profit corporation whose primary purpose is to make profits and distribute them to its shareholders, the nonprofit’s primary purpose is to pursue public benefit purposes that are recognized under federal and state law. Accordingly, all profits must be retained by the nonprofit corporation as working capital or used for expansion or other use consistent with the nonprofit’s public benefit mission and activities.
Profits and property owned by the nonprofit are never distributed to any owners or shareholders. Most states require that the nonprofit, within its organizational documents, irrevocably dedicate its assets to the public upon dissolution, which usually means that assets will go to another nonprofit corporation whose mission and purpose are similar. These unique characteristics are what distinguish a nonprofit from other types of corporations.
The management of a nonprofit is exercised by a board of directors or trustees. The board or the trustees make important policy decisions, while the corporation’s officers oversee and manage the day-to-day business of the nonprofit. The board’s primary purpose is to make sure that the nonprofit fulfills its purpose. At no time are any board members or its officers permitted to benefit financially from the activities of the nonprofit. The IRS looks very closely at the nonprofit’s conflict of interest provisions to ensure that there are procedures in place to eliminate the possibility of such disallowed enrichment. Additionally, many states have rules governing the pay of nonprofit directors.
Directors, officers and members of a nonprofit are generally protected from personal liability for the debts and obligations of the organization. In certain circumstances personal liability can be attached where there is conduct injurious to the nonprofit, fraud, inappropriate handling of finances, unpaid taxes and personal guarantees.
If a nonprofit has received tax-exempt status under both federal and state law, the entity does not pay any federal or state income taxes. An exception to this rule is unrelated income generated by an otherwise tax-exempt organization. Many times a nonprofit will generate income from activities not directly related to the organization’s mission and purpose. The most common example is the sale of products (food, clothing, accessories) by a nonprofit organization as a source of raising funds for the organization’s use. All other nonprofits without tax-exempt status must file tax returns and pay tax on all profits. Despite the fact that the tax-exempt nonprofit will not be paying taxes, it still must file year-end documents with all applicable taxing authorities.
Advantages of a Nonprofit Corporation
- Profits are exempt from corporate taxation at both the federal and state levels.
- Contributions by donors are tax-deductible.
- Limited personal liability protection from the debts and obligations of the organization is afforded to its directors, officers and members.
- Some state and local municipalities offer property tax and sales tax exemptions (requires the filing of additional application or forms).
Disadvantages of a Nonprofit Corporation
- A non-profit organization is not owned by its shareholders, and its assets can never be transferred to a private person or an entity unless it's also a nonprofit.
- No dividends or profits can be distributed.
- Increased scrutiny of its operations by both federal and state authorities (typically the IRS and the U.S. and State Attorney Generals’ Office).
A nonprofit corporation, by law, is unable to hold or distribute profits like a "for-profit" business. It is formed to carry out charitable, educational, religious, literary or scientific purposes that are recognized under federal and state law. Contrary to its name, a nonprofit corporation may earn profits, but rather than disburse them to its shareholders, all profits must be retained by the organization as working capital or used for expansion or other use consistent with the nonprofit’s public benefit mission and activities.
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