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A. What Is a Corporation? 1/2
B. Types of Corporations 1/2 1. Profit and Nonprofit Corporations 1/2 2. Domestic and Foreign Corporations 1/4
C. Valid Nonprofit Purposes 1/6
D. Advantages of the 501(c)(3) Nonprofit Corporation 1/6 1. Tax Exemptions 1/6 2. Receiving Public and Private Funds 1/7 3. Limited Liability 1/7 4. Separate and Perpetual Legal Existence 1/9 5. Employee Benefits 1/9 6. Formality and Structure 1/9 7. Other Advantages 1/9
E. Disadvantages of a Nonprofit Corporation 1/10 1. Paperwork 1/10 2. Incorporation Costs and Fees 1/11 3. Time and Energy 1/11
F. Summing Up 1/13
This chapter provides a general overview of nonprofit corporations and their advantages and disadvantages, with a special emphasis on nonprofit corporations exempt from federal corporate income taxation under Section 501(c)(3) of the Internal Revenue Code. We also discuss basic corporate concepts and classifications to help you understand where nonprofits fit into the larger legal and corporate world.
If You Want to Know More. Some important points are very briefly treated in this overview. Don't worry-important corporate concepts (such as limited liability, requirements for 501(c)(3) tax-exempt status, deductibility of charitable contributions, etc.) are explained in more detail in later chapters.
A. What Is a Corporation?
A corporation is a legal entity that enables a group of people to pool energy, time and money for profit or nonprofit activities. It acquires legal existence after complying with a particular state's incorporation procedures and formalities. The law treats a corporation as a separate "person," distinct from the people who own, manage or operate it. It may enter into contracts, incur debts and pay taxes. The fact that the corporation exists as a separate entity gives directors, employees and members the benefits of limited liability. That is, business claims and lawsuits arising from corporate debts, transactions and activities may normally be made only against the corporation and corporate assets, not against any of the individuals associated with it or their own personal assets. We discuss the concept of limited liability and other unique advantages of the corporate form in later sections below.
B. Types of Corporations
State corporate statutes classify corporations in several ways. Let's look at two of the most basic divisions found in the corporation laws of the various states.
1. Profit and Nonprofit Corporations
State laws distinguish between profit (stock or business) corporations and nonprofit (nonstock) corporations. Profit corporations are authorized to issue shares of stock to shareholders in return for capital investments of money, property or past services to the corporation. Shareholders receive a return on their investment only if dividends are declared and paid or if corporate assets remain to be divided among the shareholders (after payment of creditors) upon the dissolution of the corporation. (For more information on small profit corporations, see Incorporate Your Business, by Anthony Mancuso (Nolo)-order information is at the back of this book.)
Except for some hybrids such as consumer or producer co-ops, nonprofit corporations generally can neither issue shares nor pay dividends under state law. The federal tax code also prohibits 501(c)(3) tax-exempt nonprofit corporations from paying dividends or profits, as such, to members or other individuals. When such a corporation dissolves, it must distribute its remaining assets to a similarly tax-exempt nonprofit group.
Nonprofit corporations do share some common attributes with profit corporations-for example, limited liability is available to founders and directors of profit and nonprofit corporations alike. More surprising, perhaps, is the fact that nonprofits may, like their for-profit counterparts, make a profit from nonprofit as well as commercial activities.
2. Domestic and Foreign Corporations
Corporations are also classified according to the state in which they are formed. For example, if a nonprofit corporation files Articles of Incorporation with the Oregon Secretary of State, it is considered a "domestic" nonprofit corporation in Oregon (or, more colloquially, an "Oregon corporation") and is subject to the corporate rules and procedures contained in Oregon's nonprofit corporation law. This Oregon corporation will be treated as a "foreign" (out-of-state) corporation under the laws of other states. Generally, each state requires foreign corporations that transact business in the state to file qualification papers as a "foreign" corporation and pay a qualification fee.
Should You Incorporate Out-of-State? The distinction between domestic and foreign corporations leads to the following often-asked question: Why not incorporate in the state where incorporation fees or corporate taxes are lowest, state corporate taxes are minimal or nonexistent, or nonprofit statutes are more flexible-then qualify to do business in your home state as a foreign corporation? Our answer is that although this is theoretically possible, in practice it's too much trouble and too expensive to incorporate out-of-state. Here are a few reasons why:
• The process of qualifying a foreign corporation to operate in most states takes about as much time and expense as incorporating a domestic corporation. Paperwork must be filed with the secretary of state and qualification fees must also be paid (which are at least as high as, and often higher than, regular incorporation fees). In short, you end up meeting the requirements and paying the fees in two states, not one.
• Your corporation will still be subject to taxation in each state in which it earns or derives income or funds. If both states (the state of incorporation and the home state where the corporation will be active) impose a corporate income tax, the nonprofit corporation will need to file for and obtain two state corporate tax exemptions-one for each state. Similarly, double sales, property and other state tax exemptions may often be necessary or appropriate.
• Your out-of-state corporation will still be subject to many, if not most, of the laws that affect corporations in your home state. Many corporate statutes that apply to domestic corporations also apply to foreign corporations with a specified percentage of payroll, property or sales within the state.
When Incorporating Out-of-State May Make Sense. If you plan to set up a multi-state non-profit with corporate offices and activities in more than one state (a tri-state environmental fund for example), then it makes sense to consider incorporating in the state that offers the greatest legal, tax and practical advantages. To help you decide where to incorporate, the State Sheets in Appendix A list many basic nonprofit corporation law provisions for each state. For further information on state-by-state differences, you may be able to check a local nonprofit resource center library. An experienced nonprofit lawyer or consultant may also be able to help you determine which state is the most convenient and least costly to use as the legal home of your new nonprofit corporation.
C. Valid Nonprofit Purposes
While for-profit corporations can generally be formed for "any lawful purpose" under state statutes, nonprofit corporations must usually be established to accomplish specific purposes that benefit the public at large, a segment of the community or a particular membership. Indeed, the essential identity of each nonprofit, and its classification and treatment under the tax statutes, is derived from the specific nonprofit purposes stated in the corporation's Articles and Bylaws. Many different groups-labor unions, chambers of commerce, social and recreational clubs, fraternal societies, credit unions, farmers' coops and legal service organizations, to name a few-may be eligible for a federal nonprofit organization tax exemption under various sections of the Internal Revenue Code (see Table 3.1 for a list of special-purpose IRC tax exemptions).
Only those nonprofit corporations formed for religious, charitable, scientific, educational or literary purposes of benefit to the public may claim tax-exempt status under IRC §501(c)(3). As explained in the introductory chapter, this is the all-important classification for, and the primary subject matter of, this book. We show you how to form a 501(c)(3) tax-exempt nonprofit-one which is not only exempt from corporate taxation under federal and state tax statutes, but also eligible to obtain tax deductible contributions from donors and other benefits not available to other tax-exempt nonprofit organizations.
D. Advantages of the 501(c)(3) Nonprofit Corporation
Now let's look at the specific advantages of forming a tax-exempt 501(c)(3) nonprofit corporation. The relative importance of each of the following factors will vary from group to group. If you are thinking about incorporating, however, at least one of the following points should have a direct bearing on, and represent a significant benefit to, your organization. Continue...
Excerpted from How to Form a Nonprofit Corporation by Anthony Mancuso Copyright © 2002 by Anthony Mancuso Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
"Nonprofit" does not mean literally that you cannot make a profit. Under the federal tax law and state corporate statutes, as long as your corporation is organized and operated for a recognized nonprofit purpose, it can take in more money than it expends in conducting its activities. For example, Friends of the Library, Inc., a 501(c)(3) nonprofit organized to encourage literary appreciation in the community and to raise money for the support and improvement of the public library, can make a profit from its sold-out lecture series featuring famous authors and from its annual sale of donated books. It may use its tax-free profits for its own operating expenses (including salaries for officers, directors and employees) or for the benefit of the library. What it cannot do [under IRC Section 501(c)(3)] is distribute any of the profits for the benefit of officers, directors or employees connected with Friends of the Library (as dividends, for example).
Nonprofits can make money in ways unrelated to their nonprofit purposes. This type of income is usually subject to taxation as unrelated business income under state and federal corporate tax rules, but such income is permissible and often essential to the survival of the nonprofit group. As you'll see, though, it's best not to let unrelated business activities reach the point where you start to look more like a for-profit business than a nonprofit one. This can happen if such activities are absorbing a substantial amount of staff time (or requiring additional paid staff or volunteers to run), or are producing more income than your exempt-purpose activities.
For example, many thousands of books are donated to Friends of the Library for its annual book sale, one of its major fundraising events. Although the sale is always highly successful, thousands of books are left over. Friends decides to sell the more valuable ones by advertising in the rare and out-of-print books classified sections in various magazines. The response is overwhelming; soon, there are six employees cataloguing books. In addition, Friends begins a business purchasing books from other dealers and reselling them to the public. Such a situation could attract attention from the IRS and prompt it to reconsider Friends' 501(c)(3) tax-exempt status.
Although it's not typical for the average group, a nonprofit corporation may make money from "passive" sources such as rents, royalties, interest, investments, etc. This income is non-taxable in some cases.
Each state sets a different threshold of activity for triggering its corporate qualification process for out-of-state corporations. Generally, most states say that any foreign corporation that plans to engage in a regular or repeated pattern of activity in the state must qualify to do so (by obtaining a Certificate of Authority from the secretary of state). Of course, many states have enacted specific statutory exceptions to their qualification rule. For example, in some states, out-of-state nonprofit corporations may engage in one or more of the following activities without having to obtain a Certificate of Authority from the secretary of state: maintaining, defending or settling any legal action or administrative proceeding, including securing or collecting debts and enforcing property rights; holding meetings of corporate directors or of the membership; maintaining bank accounts; making grants of funds; distributing information to members; making sales through independent contractors; engaging in interstate or foreign commerce; conducting a so-called "isolated transaction," which is completed within 30 days and is not one of a series of similar transactions; and exercising powers as an executor, administrator or trustee, so long as none of the activities required of the position amounts to transacting business.
For specific information on a state's out-of-state corporation qualification rules, check the state's nonprofit corporation law (look for a section labeled "Qualification of Foreign Corporations"). For information on how to find these laws, see Chapter 11.
