All sorts of groups, from artists and musicians to people active in education, health, and community services wish to operate as nonprofit (or not-for-profit) corporations. Often the reason for doing this is simple — nonprofit status is usually a requirement for obtaining funds from government agencies and private foundations. Obtaining grants, however, is not the only reason to incorporate. Here, we discuss two additional important benefits of forming a nonprofit — tax-exempt status and personal liability protection. We then introduce you to some of the basic rules for setting up and running your nonprofit corporation.
In addition to qualifying for public and private grant money, most nonprofit groups seek nonprofit corporate status to obtain exemptions from federal and state income taxes. The most common federal tax exemption for nonprofits comes from Section 501(c)(3) of the Internal Revenue Code, which is why nonprofits are sometimes called 501(c)(3) corporations. (To learn about applying for tax exemptions, read How to Form a Nonprofit Corporation.)
If your group obtains tax-exempt status, not only is it free from paying taxes on all income from activities related to its nonprofit purpose, but people and organizations that donate to the nonprofit can take a tax deduction for their contributions. For more information on which activities are considered related to a nonprofit’s purpose, see Earning Income as a Nonprofit Corporation.
Protection From Personal Liability
Forming a nonprofit corporation normally protects the directors, officers and members of the nonprofit from personal liability for the corporation’s debts and other obligations. Called “limited liability,” this shield ensures that anyone who obtains a judgment against the nonprofit can reach only the assets of the corporation, not the bank accounts, houses or other property owned by the individuals who manage, work for or participate in the business.
As an example, consider a nonprofit symphony that is sued by a visitor who falls through a poorly maintained railing on a staircase. The court finds in favor of the visitor and issues a judgment against the nonprofit for an amount greater than the nonprofit’s insurance coverage. The amount of the judgment is a debt of the corporation, but the directors, officers and members are not personally responsible for paying it. By contrast, if an unincorporated association of musicians owned the premises, the principals of the unincorporated group could be required to pay the judgment amount out of their own pockets.
Exceptions to the Limited Liability Rule
In a few situations, people involved with a nonprofit corporation can be held personally liable for its debts. A director or officer of a nonprofit corporation can be held personally liable if she:
- personally and directly injures someone
- personally guarantees a bank loan or a business debt on which the corporation defaults
- fails to deposit taxes or file any necessary tax returns
- does something intentionally fraudulent, illegal or clearly wrong-headed that causes harm, or
- co-mingles nonprofit and personal funds.
To cover some of these exceptions, reasonably priced insurance is available to protect volunteer directors, who may be reluctant to serve without it.
Additional Benefits for Your Nonprofit Corporation
Tax-exempt grants and personal liability protection are the most important reasons to incorporate your nonprofit group, but there are still more benefits to be had. To learn about them, read Five Reasons to Incorporate Your Nonprofit Association.
Who Should Consider Becoming a Nonprofit
The types of groups that typically seek nonprofit status vary widely. Here’s a partial list of associations that may be eligible:
- child care centers
- shelters for the homeless
- community healthcare clinics
- churches, synagogues, mosques and other places of worship
- performing arts groups, and
- conservation groups.
If your group isn’t on this list, it doesn’t necessarily mean you won’t qualify for tax-exempt status. As long as your group’s activity is charitable, educational, literary, religious or scientific, you should be able to get a tax exemption.
Forming a Nonprofit Corporation
Forming a nonprofit corporation is very similar to forming a regular corporation: You must file “articles of incorporation” with the corporations division (usually part of the Secretary of State’s office) of your state government. But unlike regular corporations, you must also complete federal and state applications for tax exemptions.
After filing this initial paperwork, you will create “corporate bylaws,” which lay out the operating rules for your nonprofit. Finally, you elect the initial directors of your nonprofit and hold an organizational meeting of the board. (To learn more about forming a nonprofit corporation, see How to Form a Nonprofit Corporation
Running a Nonprofit Corporation
Most nonprofit corporations are run by a board of directors — called “trustees” in some states. The directors set policy for the nonprofit and are usually actively involved in the work of the corporation. Officers (who may also serve on the board) carry out the day-to-day business of the corporation and sometimes receive salaries. Depending on its structure, a nonprofit may or may not have formal members with voting rights. If the nonprofit does not create a formal membership structure, the only people who participate in the management of the nonprofit are the directors and officers.
Nonprofit corporations must observe most of the same formalities as regular corporations. These include keeping good corporate records, holding and preparing minutes of directors’ (and possibly members’) meetings and maintaining a separate bank account.
Unlike regular corporations, a nonprofit corporation cannot distribute any profits to its members, contribute money to political campaigns or engage in lobbying activity, except in very limited circumstances. (For more information about recordkeeping and further details about what nonprofits can and cannot do, see Running Your Nonprofit Corporation.)
Ending a Nonprofit Corporation
Nonprofits are not actually owned by anyone and therefore cannot be sold. If the directors of a nonprofit corporation decide to dissolve it, they must pay off all debts and obligations of the nonprofit and distribute all of its assets to another tax-exempt nonprofit corporation.