WHAT IS A NONPROFIT ORGANIZATION?
The basic definition of a nonprofit organization is that it is one which does not pass its income to its members or shareholders, but rather, it uses the income in the furtherance of a goal which benefits the community or some part of the community.
This doesn't mean that the operations of a nonprofit cannot be profitable. Many nonprofits make large profits on their operations, but those profits must not benefit private parties. They must be used to further the organization's stated goal. If a nonprofit disbands, no one except another qualified nonprofit organization (with as similar goals as possible) can take over its assets.
ADVANTAGES OF NONPROFIT STATUS
There are four main advantages of being a nonprofit organization rather than an ordinary business: the tax exemptions, the ability to receive tax deductible donations, the ability to qualify for grants, and lower costs for such things as postage, advertising, and filing fees.
TAX EXEMPTION
For many nonprofits, the tax exemptions are the most important benefits. Several exemptions from taxes are available depending on the type of organization and the state in which it is located.
Income received by most nonprofits is not subject to income tax at either the state or federal level if you successfully apply for and are granted an exemption. In most states, you can get an exemption from paying sales and use taxes on items that the organization purchases. Also, many nonprofits do not have to pay property taxes on the real estate they own. Again, you must apply for, and be granted, the exemption.
DEDUCTIBILITY OF CONTRIBUTIONS
Perhaps more important than being tax exempt, contributions made by taxpayers to certain types of nonprofits are deductible on the taxpayer's income tax return. This is a big incentive to give and without this deduction, many nonprofits would not survive.
GRANTS
Being a nonprofit organization makes your group eligible for both private and government grants. There are many large foundations which are required by law to give away a percentage of their assets each year, but they can only do so to qualified nonprofit organizations.
LOWER COSTS
The postal service offers special rates to nonprofit organizations, and these rates are much lower than the normal rates. Some newspapers, magazines, radio stations, and other media give discounted advertising rates to nonprofits. It is even possible in some cases for nonprofit organizations to get free advertising, also known as public service announcements.
TAX EXEMPT BONDS
Some types of nonprofit organizations are able to raise money by issuing tax-exempt bonds which are similar to municipal bonds. This is usually done by organizations like hospitals which need to finance multimillion dollar facilities.
DISADVANTAGES OF NONPROFIT STATUS
The benefits of nonprofit status would be useful to nearly all types of businesses and organizations, and many businesses could successfully operate as nonprofits. But there are disadvantages that go with them which make them unworkable to many types of organizations. In recent years, some for-profit businesses have complained that nonprofits were competing against them unfairly. So, the laws have been changed to make it more difficult for nonprofits to engage in activities which compete with for-profit businesses.
LOSS OF CONTROL
One of the most important things to know about a nonprofit organization is that it is not "owned" by its founders. Unlike a private business that can be sold after it has grown big and profitable, a nonprofit organization "belongs" to the public at large. If it dissolves, its assets must be given to another nonprofit organization with a purpose as close as possible to its purpose. If its assets are misapplied or used for private benefit by the officers, the state attorney general (or similar official) can seize them.
If you are planning to put a lot of money and years of your life into an organization, you should consider whether the advantages are worth the loss of control. But there are ways to set up a nonprofit to give yourself de facto control, and you are allowed to pay yourself a reasonable salary and set up a pension plan.
LIMITED PURPOSES
In order to be exempt under the tax laws, a nonprofit organization can only perform certain functions listed in those laws. If it goes outside those limits, it may have to pay taxes on some of its income, pay penalties, or lose its exemption entirely.
LIMITED LOBBYING
Most types of tax exempt nonprofit organizations are forbidden from contributing to political campaigns and may only do a limited amount of lobbying.
PUBLIC SCRUTINY
Another disadvantage is public scrutiny. Because a nonprofit organization is dedicated to the public, your finances are open to public inspection. This means that the public can obtain copies of your tax returns and find out your salaries and other expenditures.
FEDERAL TAX LAWS
The federal tax law controls what a nonprofit may or may not do if it wishes to take advantage of the tax exemptions.
State laws are usually very broad and allow nonprofits wide leeway in their purposes. Nearly any small group which doesn't intend to distribute its profit to its members could easily come under the nonprofit law of most states. However, the federal tax law applicable to nonprofits is very strict. It is also contradictory and confusing. This is because every few years Congress gets upset about some perceived abuse and tightens the laws. Consider the following:
- Because rich donors were setting up nonprofits to hire their family members and avoid estate taxes, a law was passed saying that nonprofits were forbidden to benefit private parties (the private inurement doctrine). But what about nonprofit social clubs whose sole purpose is to benefit their members? Well, they can only benefit their members and not serve the public.
- Because the government doesn't want to give tax benefits to groups that discriminate, nonprofits are forbidden from discriminating on the basis of race, religion, etc. But what about religious nonprofit organizations? Well, they can discriminate on the basis of religion if they have a good reason.
- To be sure the government doesn't subsidize groups that support those who hold office, nonprofits aren't allowed to contribute to political campaigns.
Every year the IRS issues new Revenue Rulings, the courts issue new opinions, and usually Congress tinkers with the law. How can you ever hope to comply with such a system? Keep in mind that the people enforcing the law are no more intelligent than you and in many cases they are as confused as you. A large percentage of the answers given on the IRS phone lines are wrong. Money magazine sends out sample income information to fifty accounting firms each year and every one of them comes up with a different tax amount, usually differing by thousands of dollars. There is no one alive who understands the entire tax code!
So here is your best strategy:
- Learn as much about the laws as you can and make a good faith effort to follow them carefully. If you are planning something that might be questionable, ask a tax specialist for an opinion.
- Keep good records.
- If your tax return or activities are questioned, make it clear that you are doing your best to comply and cooperate fully. (But get the best professional consulting you can afford to be sure of your rights.)
PROHIBITED PRACTICES
There are certain things which nonprofit organizations are prohibited from doing. Violation of those rules can cause loss of tax-exempt status or even penalties and fines.
Many of these rules were enacted when nonprofit organizations were seen to be abusing their status. When one nonprofit opposed the reelection of a certain United States Senator, he got a law passed to prohibit them from political activities. When some rich families began using nonprofit organizations to employ their family members, laws were passed to prohibit such arrangements. Every few years, someone does an expose of abuses at nonprofits and new laws are proposed to control them. As a nonprofit organization, your group will want to keep abreast of proposals for changes in the law.
There are big differences in what charitable 501(c)(3) groups can do (those that can collect tax deductible contributions) and what other nonprofits can do. The limits are much more strict for charitable groups because the deductibility of their income is considered a government subsidy which should go to the good of the community rather than a few individuals.
The following are the major prohibitions for nonprofit organizations.
NO SPECIFIC BENEFIT
For nonprofit organizations to qualify as charitable, the focus of their mission must be the community at large, not any individual or small group of individuals. For example, you can get an exemption for a group that wants to aid tornado victims, but not for a group formed to help one specific victim. Similarly, you can get an exemption to clean up an entire community, but not just one subdivision.
Groups that do benefit limited numbers of people, such as social clubs, trade groups, and homeowners associations, can be nonprofit and tax exempt, but the members' dues are not deductible and their outside income must be limited.
NO PRIVATE INUREMENT
Similar to the requirement that the purpose of the nonprofit be to aid the community, the private inurement doctrine mandates that private parties not get undue profits from a nonprofit organization.
This means that the organizer and directors cannot get inflated salaries or other unusual financial arrangements. Business dealings between a nonprofit and persons related to it are put under careful scrutiny and can result in penalties or loss of tax exemption if found to be unreasonable.
Business dealings are allowed between nonprofits and their members and directors, but they should be at commercially reasonable terms. For example, if an organization rents an office from one if its directors, the rent should be documented as fair and reasonable. If it is inflated, the organization's tax status is in jeopardy.
LIMITED LOBBYING
Because of perceived abuses, Congress has put strict restraints on the type of lobbying that can be done by charitable organizations.
Charitable nonprofit organizations (those whose contributions are deductible) are prohibited from contributing to political campaigns and their lobbying cannot be substantial. Private foundations cannot lobby at all, and other charitable organizations must stick to certain limits. The exact limits are determined by applying either the expenditure test or the substantial part test.
LIMITED COMMERCIAL ACTIVITIES
Because of complaints by businesses that they cannot compete with tax exempt organizations that are in the same business, nonprofit organizations are limited in the types of commercial activities in which they can engage. If a nonprofit does engage in a business venture that is unrelated to its purpose, the profits from that venture are taxable. But if a nontaxable organization has too much taxable income, it may lose its status as tax exempt. For this reason, successful nonprofit groups, such as the National Geographic Society, have had to spin off operations which became too profitable.
Fortunately, there are some loopholes which nonprofits can use to make money and still avoid paying tax. These include selling donated items, performing services provided by volunteers, and giving away small items.
|
