Nonprofits are Organized Under State Law
Nonprofits are formed under state law. Therefore, it is important to check with your state about specific rules that may apply to forming and governing your nonprofit. Some states have adopted the Revised Model Nonprofit Corporation Act, and for unincorporated nonprofit associations, some have adopted the Uniform Unincorporated Nonprofit Association Act. Along with different rules and regulations, states offer different benefits for nonprofits. Some states exempt nonprofits from state tax and state employment programs, while others offer different levels of protection from tort liability – from complete immunity to a certain damage cap.
Once registered with the state, you may apply for tax-exemption status with the IRS. To meet federal tax-exemption requirements, nonprofits must be organized and operated solely for the purposes of: charity, religion, education, public safety, literature, prevention of cruelty to animals and children, or promotion of international or national amateur sports.
Incorporated vs. Unincorporated Nonprofits
Most of the time when we think of nonprofits, we think of incorporated nonprofits; but many of us have been a part of unincorporated nonprofit associations without even realizing it. Unincorporated nonprofit associations are formed when two or more people come together for the purpose of providing a public good or service. So, if you had a lemonade stand with your best friend when you were five years old, and the proceeds went to the pet adoption center, then you and your friend formed an unincorporated nonprofit association.
Usually, unincorporated nonprofit associations are formed for short-term periods and disband once the goal is met. However, if you have long-term goals for your nonprofit, it is a good idea to incorporate or form another type of suitable legal entity for your nonprofit. Doing so formalizes your nonprofit as a separate legal entity and affords certain benefits, such as limited liability protection, easier access to grants and other funding options, and even discounted rates on stamps and certain marketing and advertising costs.
Overall, the benefits of incorporating a nonprofit tend to make the process worthwhile, but there are still many unincorporated nonprofit associations. Unincorporated nonprofit associations can still claim tax-exempt status if they meet all the requirements, though it is not as easy to do so.
Public Charities vs. Private Foundations
Public charities tend to have service programs, while private foundations tend to raise funds to support public charities. Structurally, public charities have to follow rigid governance rules and are more open to the public and public scrutiny, while private foundations can be more closely held. Private foundations also face more mandatory paperwork to ensure that funds are being properly used.
The National Taxonomy of Exempt Entities (NTEE) has identified 645 different categories of public charities in eight primary groups. The majority of nonprofits fall under “human services” organizations. This type of organization includes groups providing food and shelter, disaster relief, services for children and the elderly, and much more. Other NTEE categories include arts organizations, education groups, health organizations, mental health services, community and civil rights groups, religious organizations, environmental groups, animal organizations, and international and human rights groups.
Private foundations are also diverse. They may include family foundations, private operating foundations, and corporate foundations. As mentioned, private foundations tend not to have their own programs, instead using the funds they raise to support other charitable organizations and their programs. They also tend to require more start-up funds in order to get the foundation going and cover legal fees.
Charitable trusts were actually the first legal form of a nonprofit. Assets in a charitable trust must be irrevocably dedicated to a charitable purpose. There are three types of nonprofit trusts: charitable trusts, charitable remainder trusts, and pooled charitable trusts.
With a charitable trust, the grantor deposits assets such as cash, real property, jewelry, and art into a trust for beneficiaries that are nonprofits or other charitable organizations. The assets remain in the trust while the grantor is alive, and they may manage the assets – for example, buying or selling stocks or real estate. All assets deposited or purchased in the trust remain in the trust, and income is distributed to the beneficiaries. These trusts survive the grantor, and a provision for management should be included in the trust.
A charitable remainder trust is also an irrevocable trust, but instead of income being distributed to the beneficiaries, it is distributed to the grantor or whomever the grantor specifies, and upon the receiver’s death (whether it’s the death of the grantor or of other specified receivers), the assets transfer to the nonprofit beneficiary.
For those who wish to leave a legacy to a school or charity, a pooled charitable trust is a great option. With pooled trusts, it is the charity that sets up the trust and that then accepts donations for the trust from anyone who wishes to contribute. Similar to a mutual fund, the donations are all pooled into one fund, then invested, and income is paid to you.
The easiest way to set up a charitable trust is through a major life insurance company, financial services company, or investment management company. These companies provide services that ensure that you properly set up your trust, and they even offer disbursement, asset management, and charity evaluation services. You can also reach out to a trust attorney to help you set up a charitable trust and advise you on how to manage it.
Nonprofit vs. Not-for-Profit
Nonprofit and not-for-profit are often used interchangeably, but there are distinctions. One key distinction is their purpose. While nonprofits must serve a purpose of social good, not-for-profits do not have the same requirement. Not-for-profits can exist simply to serve their membership. Furthermore, whereas most nonprofits we are familiar with are governed by 501(c)(3), not-for-profits fall under 501(c)(7). 501(c)(7)s are for “recreational organizations.”
EXAMPLE: A sports organization that is jointly owned by its members and exists simply for the enjoyment of its members would be a not-for-profit organization. While both nonprofit and not-for-profit organizations are tax-exempt, only donations to nonprofits are tax-deductible on the donors’ tax returns.
Nonprofits are a great way to make an impact on your community and on the world. As such, there are certain benefits nonprofits gain from their status, such as tax-exemption. However, because of the advantages nonprofits gain, they are also highly scrutinized at both the state and federal level to ensure that they are doing what they set out to do, which is to serve the community and not individuals’ personal pockets.
If you are considering forming a nonprofit, do your research, figure out what type of nonprofit is best suited for your organization's needs, know what it will take to run and grow your nonprofit, and be prepared to take on the great responsibilities that come with running such an organization.