Managing Finances: Understanding Nonprofit Status and Tax Exemption
Learn what it means to be nonprofit and tax-exempt, exploring the advantages and disadvantages of both, and when it makes sense to apply for status.
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WHAT DOES IT MEAN TO BE NONPROFIT AND TAX-EXEMPT?
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WHAT ARE THE ADVANTAGES OF NONPROFIT AND TAX-EXEMPT STATUS?
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WHAT ARE THE DISADVANTAGES OF NONPROFIT AND TAX-EXEMPT STATUS?
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WHEN SHOULD YOU CONSIDER APPLYING FOR NONPROFIT AND TAX-EXEMPT STATUS?
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WHEN YOU MIGHT NOT WANT TO APPLY FOR NONPROFIT AND TAX-EXEMPT STATUS
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HOW DO YOU APPLY FOR NONPROFIT STATUS?
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HOW DO YOU APPLY FOR FEDERAL TAX-EXEMPT STATUS?
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A LAST WORD ON GETTING HELP
In any society, there are rules citizens need to follow. In a good society, these rules have been created to help things run smoothly, for the benefit of individuals and for the community as a whole.
As individuals, others help us learn these rules as we grow. Our parents are quick to point out that we must pay for the candy bar at the grocery store; we take courses in government in school; we register to vote when we turn 18; and as we agonize over our tax forms each April, we know where we can go for help, especially the first time we fill out the paperwork and agonize over foreign terms such as "earned income credit" and "total taxable income."
Organizations are part of the community as well. They don't exist in a vacuum, and therefore, they're bound by laws and regulations, just as private citizens are. And so, like individuals, community groups will go through a "coming of age" when they will decide what their place in society is, what laws affect how they do business, and how they can use those laws to run most effectively.
Unfortunately, help sometimes seems a bit harder to come by than it did when we grew up and learned the laws we needed to follow (whether we liked it or not!). Eventually, a community organization will need to consider its legal position. And this brings up a myriad of difficult questions that make us wish all we had to deal with was a 1040-EZ form.
Some of the questions that most community groups will face are:
- What different types of organizations exist? Just what type of organization are we? What kind of organization should we be?
- We're nonprofit, right? What does that mean? Can we make a profit?
- If we are a nonprofit group, are we tax-exempt? What does tax-exempt mean? Should we apply for it? How? Does it exempt the organization from federal, state, and local taxes?
In this section of the Tool Box, we'll walk you through the answers to these questions, and give you an idea of what it means to be nonprofit and tax-exempt. We'll explore the advantages and disadvantages of both, and talk about when it makes the most sense for an organization to apply for such status. In the end, we'll give a brief overview of the nuts and bolts of the application processes.
Will you be able to fill out these applications on your own at the end of this section? Probably not. In fact, we strongly suggest you get professional help - either from a lawyer or an accountant who is well-versed in nonprofit and corporate law - as you decide what form your organization will take, and to help complete and file the papers. This section is not meant to take the place of an attorney or other legal counsel.
What we do hope this section will give you is an understanding of what's out there and what might be useful to your organization. We'd like to demystify some of the "legalese" that's so hard to understand, so you'll be able to make the best choices for your organization. If that makes sense to you, then let's begin.
WHAT DOES IT MEAN TO BE NONPROFIT AND TAX-EXEMPT?
ARE NONPROFIT AND TAX-EXEMPT STATUSES THE SAME?
No, but they are closely related. Nearly all organizations that are nonprofit wish to be tax-exempt as well, so the terms are often confused. Many charitable organizations, for example, are nonprofit organizations and are recognized by the federal government as being tax-exempt. But becoming nonprofit and becoming tax-exempt are different processes, done at different times (usually), and by different government agencies.
A first important distinction to make is that granting nonprofit status is done by the state, while applying for tax-exempt designation (such as 501(c)(3), the charitable tax-exemption) is granted by the federal government in the form of the IRS.
To apply for federal tax-exemption, you need to have been granted nonprofit status first. Further, not all nonprofits are eligible to be tax-exempt. Let's look at each term individually.
NONPROFIT STATUS
A nonprofit organization in its simplest variation is any organization for which those who control or support it do not earn a profit. This doesn't mean that a nonprofit can't make a profit--quite the contrary is true. A nonprofit organization can produce goods and services, and it can earn a profit while doing so. It can even invest those profits (in the stock market, for example) in hopes of earning more money. However, all of the money made must go back into the organization - there is no "profit sharing" among members. Generally speaking, these organizations don't have any owners.
This is one reason that nonprofits are known more and more commonly as "not-for-profits." They may make a profit to help them stay in business, but making money is not their reason for being.
Individual states, and not the federal government, grant official nonprofit status. They may do so in slightly different ways, and give slightly different advantages for obtaining it. However, the federal government can recognize your nonprofit status. If you want to apply for tax-exemption, for example, you must be recognized as a nonprofit by the federal government.
There are three types of nonprofit organizations that are recognized for this purpose by the federal government:
- A corporation
- An unincorporated organization
- A trust
Becoming a corporation is perhaps the most common choice for community organizations. For incorporation, the organization must be structured according to specific state laws. These laws include having a "creating document" commonly known as the articles of incorporation, and rules of operation which are commonly known as bylaws. Usually, there is a board of directors and officers, and state laws (usually) limit the liability of members in varying degrees.
Often, incorporation is the best choice for a community organization. Part of this is simply a matter of perception, or of comfort, of the people with whom you work. People are familiar with corporations; they're used to working with them and often perceive corporations as serious and dependable. Also, the limitations on personal liability mentioned above can be quite helpful.
Basically, the personal liability protection means that if someone feels the organization or one of its members has harmed him, only the organization may be sued, and not individual members if you have this protection. For example, if a potential employee feels she has not been hired because she is hearing-impaired, she can sue the organization as a whole, but not the person who interviewed her. Likewise, if the organization's director gets in an accident and hurts a passerby on the way to a coalition meeting, the organization, but not the director, may be sued.
It's important to note, however, that the limits of this liability do vary from state to state, and you should be aware of the laws that govern what you do. There may be circumstances in which directors or members of corporations may face personal liability. Some insurance companies offer additional insurance for directors and officers of nonprofit corporations.
An unincorporated organization is a group much like a corporation and often has similar bylaws and purposes. Although the name seems to suggest otherwise, it is still a formal structure with an official structure. However, a constitution or other policies may take the place of the articles of incorporation, and there is no protection against personal liability. Additionally, much less reporting to the state occurs.
A trust generally has more narrow interests than a corporation or an unincorporated group. Many laws which govern trusts are created with charitable trusts (i.e, groups that give away money) in mind. Because of this, becoming a trust is rarely appropriate for a community group.
Going into depth on each of these types of organizations is beyond the scope of the section; for detailed information on each of them, you might speak with an attorney, or read B.R. Hopkins' Starting and managing a nonprofit organization: A legal guide.
And of course, you can certainly be a nonprofit organization in the loose sense of the word without ever filing papers, having a board, or any of those things. For example, a neighborhood group could be very effective without ever incorporating, or having a board, or even elected officers. It's still a nonprofit in practice, though, even if the law does not recognize it. We'll discuss the advantages and disadvantages of becoming officially recognized later in the section.
FEDERAL TAX-EXEMPT STATUS
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