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An Overview of Nonprofit Organizations

Advantages and Disadvantages | How to Set Up a Nonprofit Entity

Nonprofit OrganizationsAs an incentive for individuals to create organizations that seek to improve the quality of life for others, federal and state governments have enacted laws that provide certain benefits to nonprofit entities. What are those benefits? How do you qualify for nonprofit status? Are there disadvantages to operating your entity as a nonprofit organization?

What Is a Nonprofit Organization?

A nonprofit organization is set up and operated to create a social benefit, rather than to maximize shareholder value. A nonprofit may pay salaries to its employees, but it does not have owners and accordingly cannot distribute income to members. Instead, all income that exceeds expenses must be used to further the organization’s stated objectives. As a general rule, nonprofits enjoy tax-exempt status, provided they are set up to promote a religious, scientific, charitable, educational, literary, public safety, or cruelty-prevention purpose.

How Does a Nonprofit Entity Differ from a For-Profit Business?

Legally, the distinction between a nonprofit and a for-profit entity is that the former is granted tax-exempt status by the Internal Revenue Service and typically by the revenue agency in the state of incorporation.

Another distinction between a nonprofit and a for-profit entity is the concept of ownership. A nonprofit organization has no owners, only directors and employees. A for-profit business–whether a sole proprietorship, partnership, limited liability company (LLC), or corporation–has owners who may have legal rights to any company profits. A nonprofit exists to further a social or public objective, whereas the primary objective of a for-profit entity is to maximize owner value. Though a nonprofit may seek to generate or maximize income, it does so only to further its stated mission.

What Is a “Not-for-Profit” Organization and How Does It Differ from a “Nonprofit”?

Often, the terms “nonprofit organization” (NPO) and “not-for-profit organizations” (NFPO) are used interchangeably, but there is a technical difference. The fundamental difference is that a nonprofit organization is formed to serve the public good, whereas a not-for-profit organization serves only its members. NPOs include hospitals, universities, and national charities. An example of an NFPO would be a sports club, which exists for the enjoyment of its members.

While nonprofit organizations are run like businesses and seek to generate income, which must be used to further the organization’s stated goals, not-for-profit organizations are typically recreational organizations that don’t operate with the intent of generating revenue. NFPOs operate on donations. Nonprofit organizations are exempt from income tax under Section 501(c)(3) of the Internal Revenue Code. Not-for-profit organizations may or may not be exempt from paying income tax. However, NFPOs are generally exempt from sales and property tax.

How Do You Form a Nonprofit Entity?

The initial steps for establishing a nonprofit organization are the same as those for a corporation:

  • You must choose a business name that is not already in use.
  • You must file Articles of Incorporation with the relevant state agency.

Once incorporated, you must file for tax exemptions from both the Internal Revenue Service and the relevant state revenue agency. Once those exemptions are approved, you can draft and implement bylaws, appoint a board of directors, hold an initial meeting of the board of directors, and seek all necessary permits and licenses.

What Are the Benefits of a Nonprofit Organization?

Though the most commonly perceived benefit of an NPO is its tax-exempt status, there are other advantages to seeking treatment as a nonprofit organization:

  • An NPO enjoys the same limitations on liability as corporations and limited liability companies. Individuals cannot be personally liable for the debts or obligations of the organization.
  • An NPO may have easier access to funding; it may qualify for public aid or may be eligible for grants from charitable organizations.
  • Once established, a nonprofit organization continues to exist until action is taken to dissolve it, regardless of any changes in leadership.
  • As a separate legal entity, an NPO can enter into agreements without imposing potential liability on any employee, officer, or other representative of the NPO. It can also appoint a person to act as its registered agent, so that all communication is properly directed to the NPO.
  • An NPO may be eligible for postal discounts.

What Are Disadvantages or Potential Problems Associated with Nonprofit Entities?

Because of the tax-exempt status granted to nonprofit organizations, there are typically significant annual reporting and disclosure requirements. You may be required to make the financial aspects of your entity available for public inspection.

Setting up and running a nonprofit can include both initial filing fees and annual fees as well.

The laws of your state will determine the extent of management oversight that must be applied to the NPO. You may need to appoint a board of directors, hold regular and periodic board meetings, maintain minutes of those meetings, or comply with other statutory requirements.

Because of its tax-exempt status, an NPO may not engage in political campaigning or lobbying and cannot make contributions for those purposes.

Summary

Obtaining nonprofit status allows an organization to avoid taxation on any income; however, all profits generated by the nonprofit organization must be used to further its stated objectives.

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