What’s Up Wednesday 9/18/19

Non-Profit 501(c)(3) Corporations

You have many options when deciding what type of legal entity your startup will be. StartupSmack explains the for-profit forms in separate articles:

You may be considering forming a non-profit organization. If so, you have two decisions to make: whether to start a for-profit or non-profit organization, and whether or not to incorporate if you do form a non-profit organization. This article presents the pros and cons of both choices.

The law firm Perkins Coie explains that, “The legal structure under which you choose to operate should merit careful consideration,” so that it “aligns with your short and long-term business goals and provides you optimal legal protection.” You will be subject to federal and state laws, regulations, and requirements that are based on the type of legal entity you have formed. Your attorney and accountant should be able to recommend what type of entity would work best for your specific startup, but you will save time and money by understanding the considerations and terminology before you begin those consultations.

For-Profit vs. Non-Profit

As a tech startup, your options for non-profit status are greatly limited. For illustrative purposes, let’s consider a hypothetical startup idea that might work as a for-profit or non-profit organization. You are frustrated by the current consumer antivirus software choices. The commercial programs are bloated, buggy, or both. Their licenses are only valid for a fixed term, usually a year. The programs are buggy and not as effective as they could be because the companies that produce them race to develop a new product every year to have something new to sell. Internet security suites are full of frivolous extras that slow and inhibit computing and Internet use. The free antivirus alternatives all have catches. Many are abridged versions of commercial products. The companies constantly upsell. They require registration. Free programs are frequently less effective than commercial alternatives. You want to create a better product that never expires, is continually updated, and non-invasive. It will require enough software engineers that you can’t do this as a volunteer project. These are the advantages of forming as a nonprofit organization:

  • You are making a contribution to society. Granted, you aren’t saving lives or feeding needy families, but you could be relieving headaches for millions of Your intent is charitable.
  • You are free from demands by private investors or stockholders. You can innovate and experiment without the pressure of providing return on investment for anyone.
  • You may be eligible for exemption from federal, state, and local income taxes. If you form as a 501(c)(3) corporation, you should be eligible for the federal exemption, which will usually qualify you for a state exemption.
  • You can solicit grants from foundations and government agencies, as well as contributions from individuals. As with many freeware and shareware programs, you can solicit contributions at the time of download or with a button in the program interface. Individual contributions are tax deductible for people who can itemize deductions.
  • Your state may grant additional benefits. Some states exempt non-profit organizations from paying for unemployment compensation insurance, grant or give limited immunity from certain types of lawsuits, and don’t charge various fees.

The disadvantages of forming as a nonprofit organization are:

  • You can’t get rich. Personal gain is limited by law. You can’t collect royalties.
  • Startup fundraising may be harder. You can’t get loans or VC funding.
  • The bureaucracy requirements are more demanding. The IRS and states have more rigid reporting requirements. You must keep detailed records.
  • If you form a non-profit corporation, you must file articles of incorporation and establish bylaws. Your state may require that you have a board of directors that determines policies. In contrast, you make all the decisions with a sole proprietorship.
  • Startup costs may be higher. You may need greater help with the legal and financial complexities. You have to pay fees to apply for non-profit status.
  • Your books are open. As a non-profit, your salaries, expenditures, and government filings are subject to inspection by the public.
  • Attracting great employees could be more challenging. Prospective employees take a risk with any startup, but you can’t offset that with high salaries or stock options. They will have to buy into your mission.
  • Your organization may not engage in politics.

You may wish to consider a somewhat in-between alternative form. A public corporation is required to act in the best interest of its stockholders, which many entrepreneurs see as a disadvantage. A benefit corporation (“B Corp,” in short) is a new alternative. As the name implies, a benefit corporation is a for-profit entity that is equally dedicated to making a profit and executing a social mission. In most states, it must publish an annual report that evaluates its benefit to society using an independent yardstick.

For more detail about your options, you may wish to consult the recent book, 51 Questions on Social Entrepreneurship: Social Impact through Business, An Actionable Q&A, by attorney Neetal Parekh.

Types of Non-Profit Organizations

Although many types of non-profit organizations exist (e.g. professional associations, political parties, clubs, labor unions), only a couple are relevant for an organization operating as the equivalent of a business. The most common is a 501(c)(3) corporation, which is named for section 501(c)(3) of the Internal Revenue Service (IRS) code. You can also start a non-profit business without incorporating it. However, with any type of non-profit entity, all income must go into operating expenses.

Advantages and Disadvantages of 501(c)(3) Incorporation

Only certain types of organizations are eligible for 501 (c)(3) status under the IRS code. As a tech startup, you would most likely only be eligible if the only purpose of your operation is charitable or educational, or you are engaging in scientific research in the public interest. The definition of charitable is narrow enough that an organization that gives away software, as in the example above, very possibly would not qualify. If your professional advisors believe that your idea would qualify for 501 (c)(3) status, consider these advantages to incorporation:

  • Exemption from federal income taxes, and generally state and local taxes. That enables you to use all of your income for your objective.
  • You can solicit public and private grants. Some states impose requirements.
  • Corporations have benefits other organizations do not. In particular, your liability is limited in a couple of ways. You and your directors are generally not liable for the corporation’s debts. If you act illegally or irresponsibly, you lose that legal shield. Some states also grant or limit the liability of non-profit corporations if an employee’s negligence results in an injury.
  • Contributions are tax deductible for businesses and people who can itemize deductions.
  • Reduced postage rates.
  • You may be able to get free or discounted advertising rates and free public service announcements.
  • The corporation will persist if you move on to other ventures.

The disadvantages of 501 (c)(3) incorporation are:

  • Your organization’s mission takes precedence over your personal interests. Your ability to make money and make decisions is limited. Directors may not be paid and corporate officers do not share profits. You and your executives can only earn “reasonable” salaries.
  • Although government requirements are not onerous, they do take time and require attention to detail and a willingness to comply. You must initially file articles of incorporation with your state and pay a modest filing fee. The articles of incorporation will establish the name and address of the corporation, its registered agent (the public contact for lawsuits), and (in many states) the names and contact information of your officers and/or board of directors. The next step is filing for 501(c)(3) status with the IRS and then for tax-exempt status with your state. You will nonetheless need to file annual forms with the IRS. The corporation must follow record-keeping requirements established by its state. States also regulate various activities. You are subject to corporate obligations, such as providing mandatory benefits for employees and withholding taxes from their paychecks. Failure to comply with any bureaucratic or financial obligations can result in loss of your 501 (c)(3) status.
  • You need to draft bylaws and elect a board of directors (not required in all states). The board must ratify your bylaws it its first meeting.
  • The activities described above all have costs.
  • Your expenditures must further the objectives of the corporation.
  • If the corporation is dissolved, its remaining assets must be distributed to other non-profit organizations.

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