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Nonprofit organizations exist in the United States for a number of reasons. Many of these organizations are formed for the purpose of fulfilling needs in society by providing an organization that handles what the government would handle otherwise. Nonprofit organizations exist along with two other types of entities: for-profit businesses and government agencies. Each of these serves different purposes in society.
Many people associate nonprofit organizations and tax exemption, though not all nonprofit entities are exempt from taxation. Moreover, a nonprofit organization is not prohibited from earning a profit, for many of these organizations generate profits. To the contrary, the law governing nonprofit entities sets forth requirements as to what each entity must do with the profits it earns. More specifically, the law expects nonprofit organizations to devote any profits to the goal of furthering the purposes and activities of the organization.
Additionally, not all nonprofit organizations are charitable in nature. Although contributions to charitable organizations generally qualify for a charitable contribution deduction, some nonprofit entities that are not charitable in nature are also tax exempt.
One of the first steps in forming a nonprofit entity is to define the purpose of the entity. This statement of purpose, which must be made in writing, will define the type of tax exemption for which that organization is qualified. The following list provides examples of the types of tax-exempt nonprofit organizations:
The purpose driving a for-profit business is to benefit the owners of the business. By comparison, the activities of a nonprofit entity must be conducted for the benefit of the organization and not the owners. In order to qualify for tax exempt status, the organization must benefit the public.
Once a person or group decides to form a nonprofit organization, one of the first issues that must be addressed is where this entity will be formed. Some states may be more attractive than others due to several factors. For instance, states such as New York and California are more intense in terms of regulating nonprofit entities than other states. Moreover, state laws may differ about the requirements the entity must satisfy in order to qualify for taxexempt status.
A nonprofit organization may form under the laws in one state but operate in a different state. This option may be advantageous when the laws of one state allow those who form the nonprofit entity to fulfill the purpose of the entity better than the laws of another state. On the other hand, this option is usually more costly because both the state in which the entity is formed and the state where the entity operates will charge fees.
Another complicated decision that those who form nonprofit entities must make is what organization form the entity will take. In general, nonprofit entities appear in four organizational forms, including the following: corporations, charitable trusts, limited liability companies, and unincorporated associations. Each of these forms has some benefits and some disadvantages that must be considered when the organization is formed.
The most common form of nonprofit organization is the corporation. A corporation is a creation of the law. Those who create a corporation must file a document known as articles of incorporation, which sets forth important information about the corporation itself. Once a corporation is formed, it becomes its own "person" under the law, separate from its directors, officers, or owners. The corporation itself may sue others or be sued.
A nonprofit entity benefits from forming as a corporation for two primary reasons. First, the laws governing corporations provides considerable protection to officers, directors, members, employees, and volunteers against personal liability. This means that if the corporation itself incurs liability (e.g., a third person successfully sues the corporation), those who act on the corporations behalf usually do not incur liability. Second, the law governing corporations is generally well-settled, meaning that the rules that govern the operation of the corporation are more clearly defined.
Several states have adopted the Model Nonprofit Corporation Act, which was first drafted by the Business Law Section of the American Bar Association in 1964. It was subsequently revised in 1987.
Unlike a corporation, which must be created and structured according to the directives of state law, two or more people may form an unincorporated association without following those formalities. Those who form an unincorporated association may choose how the association should be governed, which is one of the benefits of this form of entity. Such an entity may be formed as a nonprofit entity.
However, whether those associated with the entity are liable for the entity's debts is not clear. In several states, including those that have adopted the Uniform Nonprofit Unincorporated Association Act, an unincorporated association is treated as an entity separate from its members. Where a state recognizes the association as a separate entity, then the members of the entity are probably shielded from personal liability for the association debts. On the other hand, some states may not recognize the association as separate, meaning that the members could incur personal liability.
The limited liability company (LLC) is a newer form of business entity. The organizational structure of an LLC borrows from the structures of both unincorporated entities and corporations. The benefit in forming an LLC is its flexibility, since someone who
Although the LLC form of organizational structure may provide some benefits, the use of the LLC for nonprofit entities is not well settled. Questions about the taxation of a nonprofit LLC have yet to be answered, and in some states, state law is not clear whether an LLC may be formed for nonprofit purposes. On the other hand, this form of entity provides flexibility in terms of structure and may be preferable to some nonprofit entities.
A person who wishes to set aside property for the benefit of another may form a trust. Unlike a corporation or LLC, a person may form a trust without filing anything with the government. Instead, the trust is formed when a person transfers property to a person or an entity, known as a trustee, and directs the trustee to use the transferred assets for the benefit of a third person, known as a beneficiary. State law dictates how a trustee must handle the property that is being used for the benefit of the beneficiary.
Some nonprofit entities are formed as charitable trusts, where the beneficiaries are not specific individuals. Instead, the trustee of a charitable trust uses the property for the benefit of a specified purpose, such as education of disadvantaged youth. The laws that apply to trusts in general also apply to charitable trusts. Because modern corporations are generally easy to form, those who wish to form a charitable nonprofit entity are more likely to form a corporation than they are to create a charitable trust.
Although some people associate nonprofit organizations with tax-exempt organizations, certainly not all nonprofit entities are exempted from taxes. Moreover, even though a tax-exempt organization may be free from paying federal income taxes, such an organization may still be liable for other types of taxes. For instance, a tax-exempt organization may be liable for taxes on net investment income as well as income derived from business activities that do not relate to the organization's exempt functions (known as unrelated business activities, discussed below).
Statutory law generally determines whether an organization is exempt from taxes. Section 501 of the Internal Revenue Code (IRC) provides the basic rules for tax-exempt status at the federal level. The Internal Revenue Service (IRS) is the federal body responsible for recognizing that an organization qualifies for tax-exempt status. An entity that wants to seek recognition for this status must file a form entitled "Application for Recognition of Exemption."
State laws regarding tax exemptions vary. Those who form nonprofit entities should consult the laws of relevant states to determine which organizations are eligible for tax-exempt status and which steps, if any, the organization must take in order for the state to recognize that status.
The IRC contains a laundry list of organizations that qualify as tax-exempt organizations. The most common of these are charitable organizations, though the IRC also includes educational, scientific, and religious organizations. Moreover, the Code includes several other types of entities, such as labor organizations, social clubs, credit unions, employee benefit trusts, and farmers' cooperatives.
Federal law recognizes several different forms of charitable organizations. Charitable organizations are often referred to as Section 501(c)(3) organizations, named after the section of the IRC section under which these organizations are formed. The definition of charitable has been developed through the promulgation of tax regulations and tax rulings, as well as through federal and state judicial cases. The following list includes the purposes that are generally recognized as charitable:
Federal tax law distinguishes between activities that relate to the exempt functions of a nonprofit and those activities that are unrelated. Gross revenues that are gained on unrelated business activities are subject to taxation. Because most nonprofit organizations conduct some sort of business, most of these organizations must determine whether any aspect of their businesses may be characterized as an unrelated business activity.
In order for income of a tax-exempt organization to be taxable, the income must be produced from a trade or business that the organization carries on regularly. An organization carries on a trade or business regularly if it does so frequently and continually, as opposed to sporadically or infrequently. The income must also be unrelated to the purpose for which the organization has been formed and which forms the basis for the tax exemption. Income from activities that bear a substantial relationship to the purpose of the nonprofit entity are not subject to tax, while income from activities that do not bear a substantial relationship to the purpose of the entity are subject to taxation.
Revenue that a tax-exempt organization gains on an unrelated business activity is subject to the federal corporate income tax that applies to non-exempt entities. An exempt organization is entitled to certain deductions related to the business that earned this income, much like a for-profit entity may be entitled to deductions for certain activities.
The Internal Revenue Code distinguishes between nonprofit entities that are public charities and those that are private foundations. A public charity is one that has involvement from the public in general, earns financial support from the public in general, or has an operating relationship with a public organization. By comparison, a private foundation usually derives its financial support from one source; earns money through investment assets, rather than through contributions from the public; and makes grants to other charitable organizations instead of operating its own activities.
Private foundations are subject to certain restrictive rules and taxes for which public charities are not subject. Thus, those who form nonprofit organizations often would like to avoid the status of a private foundation. Several types of institutions are exempted from the rules governing private foundations. These institutions include certain churches, educational institutions, health care providers, and govern-mental units.
Those organizations that are exempt from federal taxes must file what is known as an information return with the IRS. Most organizations that are entitled to tax exemptions must file a Form 990 with the IRS. This form, which is about 20 pages long including schedules, requires an exempt entity to report on items of revenue, including a balance sheet. The form also asks the organization questions about the organization's operation, mostly relating to issues dealing with the organizations tax-exempt status. The public is entitled to inspect this form.
In addition to annual information returns, nonprofit organizations are required to disclose information about their operations. The reason behind these requirements is to ensure that each nonprofit organization is acting in a transparent manner. Those items that are subject to disclosure requirements include the following:
State laws generally provide some protection for directors, employees, and volunteers against liability.
Other state laws limit liability for directors and officers of nonprofit organizations. These laws restrict the amount that someone can recover for damages stemming from the activities of an officer or director of a nonprofit entity. Much like volunteer protection acts, however, commentators often note that these statutes that limit liability are fairly weak.
Several states have modeled their state laws after the Model Nonprofit Corporation Act, which was approved by the Business Law Section of the American Bar Association in 1964 and revised in 1987. Other states have not explicitly adopted either version of the model act but may borrow provisions from the model legislation. Another source of law governing nonprofit entities appears in the form of the Uniform Unincorporated Nonprofit Association Act, which was approved by the National Conference of Commissioners on Uniform State Laws in 1996. Eleven states have adopted this uniform law, which serves as a complement to the model act.
ALABAMA: Alabama has adopted both the Model Nonprofit Corporation Act and the Uniform Unincorporated Nonprofit Association Act.
ARKANSAS: Arkansas has adopted both the Model Nonprofit Corporation Act and the Uniform Unincorporated Nonprofit Association Act.
COLORADO: Colorado has adopted the Uniform Unincorporated Nonprofit Association Act.
DELAWARE: Delaware has adopted the Uniform Unincorporated Nonprofit Association Act.
DISTRICT OF COLUMBIA: The District of Columbia has adopted the Uniform Unincorporated Nonprofit Association Act.
HAWAII: Hawaii has adopted the Uniform Unincorporated Nonprofit Association Act.
IDAHO: Idaho has adopted the Uniform Unincorporated Nonprofit Association Act.
INDIANA: Indiana has adopted the Model Nonprofit Corporation Act.
MISSISSIPPI: Mississippi has adopted the Model Nonprofit Corporation Act.
MONTANA: Montana has adopted the Model Nonprofit Corporation Act.
NORTH CAROLINA: North Carolina has adopted the Model Nonprofit Corporation Act.
SOUTH CAROLINA: South Carolina has adopted the Model Nonprofit Corporation Act.
TEXAS: Texas has adopted the Uniform Unincorporated Nonprofit Association Act.
WASHINGTON: Washington has adopted the Model Nonprofit Corporation Act.
WEST VIRGINIA: West Virginia has adopted the Uniform Unincorporated Nonprofit Association Act.
WISCONSIN: Wisconsin has adopted the Uniform Unincorporated Nonprofit Association Act.
WYOMING: Wyoming has adopted both the Model Nonprofit Corporation Act and the Uniform Unincorporated Nonprofit Association Act.
The ABCs of Nonprofits. Runquist, Lisa A., American Bar Association, 2005.
Nonprofit Law Made Easy. Hopkins, Bruce R., John Wiley & Sons, Inc., 2005.
Starting and Managing a Nonprofit Organization: A Legal Guide, 4th Edition. Hopkins, Bruce R., John Wiley & Sons, Inc., 2005.
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