What is a nonprofit organization?

1070609_65995437Because my practice focuses on nonprofit and tax exempt entities, when clients call me to seek help in starting a new organization typically they’ve already made the decision to take the nonprofit form. However, the decision as to whether to take the nonprofit form as opposed to the for-profit form is a critical first choice. And that choice can’t be made without first understanding just what is a nonprofit? Stated another way, what makes a nonprofit unique?

Many people consider nonprofit as synonymous with tax exempt or even charitable. Neither is the case though tax exempt and charitable organizations do take the nonprofit form. The vast majority of nonprofits are tax exempt and recognized as charitable organizations described under Section 501(c)(3) of the Internal Revenue Code; however, there are many others that do not fit that classification. Organizations are not charitable such as social welfare organizations, business leagues, professional associations, labor unions, political organizations, and title holding companies to name a few are tax exempt but not charitable. There are also nonprofits that are not tax exempt at all. For example, in Texas, statutory law prohibits the corporate practice of medicine. An exception is a practice in the form of a nonprofit known as an accountable care organization. Such an organization takes the nonprofit form for corporate state law purposes but is not required to be tax exempt (though under certain circumstances it can be!).

Many mistakenly believe the core characteristic of nonprofit organizations is a prohibition from either making or retaining profits, in other words, their revenues must be less than their expenses. This is incorrect and would cause most nonprofits to Close their doors. However, it does have a tinge of accuracy. Profits do lie at the center of nonprofits though the prohibition is not on the organization making or retaining a profit but on profits at the ownership/control level.

At its core a nonprofit is unique because of something referred to as the non-distribution constraint — that is, absent of paying reasonable compensation, nonprofits are prohibited form passing on profits to their owners/controlling parties. In most states, nonprofits do not have owners at all but are rather controlled by a governing board typically referred to as its board of directors.

Understanding the inability to pass profits on to owners other than as reasonable compensation, what are some of the factors to consider in making the decision whether to take the nonprofit form? Most often the decision is made because the organizational founders desire to seek tax exempt status. Nevertheless, care should be taken to understand that, as referenced above, nonprofit form does not equal tax exempt status. To qualify for exempt treatment under the Internal Revenue Code (as well as for state law purposes), an organization but be organized and operated for exempt purposes.

For organizations that can demonstrate they are organized and operated for exempt purposes, the founders must consider whether they are satisfied leaving profits at the organizational level and receiving only reasonable compensation. Founders that desire to grow a business and reap the profits either through dividends, bonuses, or upon sale, the nonprofit form would be inappropriate.

A second reason for choosing the nonprofit form is licensing or statutory requirement. The accountable care organization referenced above is an example.

Some founders will choose to take the nonprofit form for the perceived “halo effect.” That is, some view nonprofits as more trustworthy and founders seek to tap into this trust. This could apply in the context of a hospital, daycare or camp. Each could take the for-profit or nonprofit form.

Other factors that could play into the decision (though much more ancillary) are nonprofit postage rates, the number of governing persons (in Texas there must be three members of the board of a nonprofit corporation and must be at least three people involved to form a nonprofit unincorporated association), opportunity for certain types of government assistance, and liability protection under certain circumstances.

Once the decision has been made to take the nonprofit form, the decision moves to what form is the appropriate form. And that will be the topic of the next post.

Treasury Issues New Examples of Program-Related Investments

Last month the Treasury Department and IRS issues an Advanced Notice of Proposed Rulemaking which would modify the Treasury Regulations to provide new examples of program-related investments (PRIs) for private foundations.  This is a welcome development as these examples provide further clarity with respect to the breadth of PRIs.

While foundations generally accomplish their charitable purposes (and satisfy their payout requirement) by making grants to public charities, the rules are actually much broader and include (among other qualifying distributions), the making of PRIs.  PRIs are an alternative form of financing to flow capital to charitable programs, a form that allows for (and anticipates) repayment thereby enabling reinvestment of that same capital and other charitable programs.  A program-related investment is an investment that has a primary purpose of accomplishing one or more charitable purposes, no significant purpose of producing income or appreciation of property, and no purpose to accomplish prohibited political purposes.  The Treasury Regulations have for the past 40 years provided ten examples of program-related investments.  Because these examples have not necessarily kept pace with the changes in forms of financing and opportunities for the making of PRIs, the new examples were needed.  These additional examples demonstrate the use of PRI’s in other contexts (including international contexts) and with other forms of financing (loans, equity investments, credit enhancement, etc.).  The flexibility of PRIs and their allowance for reinvestment and recirculation of capital make PRIs an attractive complement to a foundation’s standard grantmaking activities.

The new examples (which can be relied upon now) can be found at this link.  For a more detailed discussion on the rules related to program-related investments see the my paper on PRI’s presented in August 2011 at the State Bar of Texas’s Governance of Nonprofit Organizations Course.


Recognizing and Avoiding Self-Dealing: Both Direct and Indirect

moore-slider3In recognition of the societal benefits achieved as a result of the work of the independent sector, the laws of the United States provide various benefits to specific types of philanthropic organizations.  Chief among those benefits is exemption from federal income tax for organizations that meet specific requirements as set out in the Internal Revenue Code. For organizations formed for more narrowly defined purposes (including religious, charitable, scientific, and educational purposes among others) federal tax law provides what amounts to a double subsidy—exemption from federal income tax along with the ability to receive donations that are deductible from the personal income tax obligations of the donors.

The Internal Revenue Code further categorizes charitable organizations as public charities and private foundations.  Public charities are those charitable organizations that have a traditional public purpose (churches, schools, and hospitals) or are publicly supported.  Private non-operating foundations generally do not directly perform charitable programs or services, but rather pursue their charitable purposes through their grantmaking activities (in 2010, foundations gave approximately $45.78 billion for charitable purposes).  Because private foundations do not attract broad public support and thus allow donors (at least in theory) to retain more control over assets owned by the private foundation, Congress has imposed certain prohibitions that apply specifically to private foundations including prohibitions on self-dealing, failing to distribute income, maintaining excess business holdings, investing in ways that jeopardize the charitable purposes of the organization, and making taxable expenditures.

Perhaps the most onerous of these prohibitions is that prohibiting self-dealing between a private foundation and its disqualified persons.  This prohibition forbids specific transactions regardless of the fairness of the transaction – even where the transaction is a sweetheart deal to the foundation.  Because of the broad nature of this prohibition and the excise tax penalties resulting from violation, it is critical for private foundations (and their donors, board members, and other related parties) to be familiar with the relevant definitions, concepts, and exceptions.