Recently, a business client dropped by to talk about a few challenges he faced in establishing his business. As the discussion wore on, it became apparent that, while his true vocation was in the field of education, his passion was to offer disadvantaged adolescents opportunities they simply could not find in the environment in which they lived. This he could not do in the for-profit world because his target audience couldn’t pay him. We decided he needed to look into the possibility of establishing a nonprofit corporation.

So, how does one go about establishing a nonprofit entity? Is it as easy as calling up the guy who advertises he can setup a corporation for $99 in Nevada? Are there any differences in the legal requirements for a nonprofit versus a for-profit business? How do you register with the IRS? For that matter, how do you make sure donors get a tax break?

First of all, the guy in Nevada can’t setup your nonprofit organization in Florida. Just about every state has its own rules governing the establishment of nonprofit organizations. The best advice is to get a good lawyer in your state to make sure the legal requirements are met. One of the most important aspects of establishing your corporation will be the provisions for the distribution of assets should the company ever cease to exist. In order for an entity to qualify as a 501(c)(3) organization (i.e. one to which donors can make deductible contributions), it must be certain to avoid benefiting a private interest. To do this, the articles of incorporation must provide that, in the event of liquidation, any assets must be distributed to another 501(c)(3) entity.

Let’s talk about the 501(c)(3) designation. A 501(c)(3) organization is one that is established to carry out a qualified educational, religious or other charitable purpose. Once you have formed the organization and established a board of directors, you will need to file a Form 1023 with the Internal Revenue Service. This form will ask a series of questions regarding the purpose for your organization and its projected funding sources. The board of directors must be composed of individuals representative of the community served.

Form 1023 does not automatically give the company its 501(c)(3) designation. Rather, the IRS will allow donors to take a deduction for contributions to your venture, but there is a five year testing period that requires the entity to prove it meets the requirements of a publicly-supported charity. For further information, you can refer to IRS Publication 557.

Why is it important to have a 501(c)(3) designation? Simply put, the 501(c)(3) designation opens the doors of major funding sources. According to the Foundation Center, in 2005, there were 71,095 funding entities with an aggregate of approximately $551 Billion in assets available to support charitable causes. This represents a massive amount of resources to assist nonprofit organizations in carrying out their missions. Additionally, many donors have more than just altruistic reasons for giving – they want a tax advantage along with their gift. Even if a donor would give in the absence of a tax deduction, the ability to deduct a contribution is an added incentive and can even convince a donor to give more.

Operating a nonprofit organization can be far more difficult than running a for-profit company. In the first place, your organization will rely on the goodwill of the public. You will have to get out into the community you serve and seek financial support. One of your most important assets will be an effective grant writer. If you receive significant amounts from foundations or governmental entities, you might as well expect to have an independent audit conducted annually. You must also be careful to avoid expending any funds on political activities. Penalties for a nonprofit engaging in political activities can be severe and the IRS is constantly revising policies and procedures to ensure nonprofits adhere to the law.

Not only does a nonprofit manager have to operate in a minefield of regulatory scrutiny, but he or she needs to ensure the organization is meeting its mission goals. One often hears of organizations that spend too much money on general and administrative or fundraising expenses and too little on program related expenses. Put yourself in the shoes of a donor. Wouldn’t you rather give $1,000 to an organization that will use 85% of that for its designated purpose than one that uses only 50%. Funding agencies are very cognizant of these statistics. When you are using other people’s money, you must ensure you operate at peak efficiency.

This is just a high level overview of the challenges facing nonprofit organizations. Next month, we will go deeper into the management of a nonprofit corporation. In the meantime, if you are considering establishing a nonprofit entity, give us a call. We are more than happy to discuss options with you.

Have a terrific month!