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The Key Elements to Forming a 501(c)(3) Charitable Organization

This post represents the unedited version of an answer I recently posted on Linkedin®: 

Hotep.  I believe far too many entrepreneurs overlook forming a nonprofit organization when determining the best legal structure for their new concern.  Having said that, the best way of selecting the right type of entity, i.e. how to operate, comes from examining the issues of Control, Liability and Taxes against the proposed business model.  But since we are already talking 501(c)(3) organizations, I will do my best to set forth what I believe to the be the key elements to starting one, which include:  1) Understanding section 501 of the Internal Revenue Code; 2) Incorporation; and 3) Fundraising.

Understanding IRC § 501:

Section 501 of the Internal Revenue Code [IRC] provides the rules for establishing and operating a federally tax exempt organization.  An entity applying for exemption under § 501(c)(3) must file IRS Form 1023.  The US Internal Revenue Service [IRS] will make a determination as to whether or not the entity meets the organizational test for receiving the 501(c)(3) status.  The primary factor involved in this determination becomes the entity’s purpose.  In order for an organization to receive 501(c)(3) status, it must be “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals … .” 26 USC § 501(c)(3).  If an organization does not pass muster with regard to the IRS organizational test, its organizers may elect to seek exemption under another category of § 501(c) like 501(c)(4) or (c)(6).  Keep in mind, however, that it may take the IRS up to one (1) year or more to render a 501(c)(3) determination.

Additionally, because of the tax exempt status, many people believe that nonprofits are otherwise barred from making money.  Nonprofit organizations can engage in commercial ventures but not for the sole purpose of turning a profit; furthermore, nonprofit organizations can also own for-profit subsidiaries; however, the income derived wherefrom may fall outside of the parent’s tax exemption but not always.  Notwithstanding, certain absolutes do exist under § 501 and other applicable provisions of the tax code.  Only a 501(c)(3) organization that is not a private foundation under § 509(a) can offer contributors—i.e. donors—a tax deduction.  Furthermore, a 501(c)(3) organization can engage in neither lobbying activities nor endorsing candidates for political office.

Incorporation:

Nonprofit organizations, also known as not-for-profit corporations, can take the form of a non-stock corporation or an unincorporated association.  Nonprofits generally take the form of non-stock corporations for two reasons: 1) Under the provisions of IRC § 501, while a nonprofit may provide salaries for employees, no part of the net earnings of a nonprofit organization may inure to the benefit of any organizer, board member or supporter; and 2) Incorporation provides limited liability protection to the employees, board members and other agents of the company.  Please note that for the purposes of IRC § 501, an unincorporated association does not pertain to a partnership or a limited liability company.  An unincorporated association under this statue takes the common law definition, being a group of individuals who operate a venture as a collective of sole proprietors; therefore, in this instance, the association itself does not take on any separate legal status.  In order to establish the legal entity, the organizer(s) must file Articles of Incorporation with the proper state agency charged with overseeing corporate registration in the jurisdiction wherein they wish to operate.  Additionally, unlike other corporations, most jurisdictions—i.e. a state or US territory—require a nonprofit be governed by a board of directors comprised of not less than three (3) individuals.

Fundraising:

Capitalizing a nonprofit organization can be somewhat easier than raising capital for a for-profit entity.  Funding a nonprofit involves attracting the right combination of money and in-kind contributions which take the form of expertise—i.e. pro bono services—or property.  For the most part, nonprofits rely on public contributions—i.e. government or private grants and donations—and large gifts from private foundations or wealthy individuals.  In fact, the most reliable source of fundraising in this country is contributions received via direct mail campaigns.  Most grant-making agencies will require that the nonprofit be recognized by the IRS as a 501(c)(3) organization or use another, more mature nonprofit as its fiduciary agent.  At the end of the day, people and corporations alike give more readily to those organizations bearing a mission with which they can identify or promotes an interest they support.

The better part of my professional life has been spent in various social entrepreneurial endeavors.  Not only do I find the work to be rewarding, the business aspects of growing a social enterprise can present challenges myriad enough to hold the interest of the most prolific of entrepreneurs.  I other words, I really dig what I do J  I apologize for the lengthy answer, but I hope this helps.  Take Care!

Disclaimer:  The foregoing information is intended to be used for educational purposes only and cannot be used as or construed to be legal advice.  Please consult an attorney licensed in the jurisdiction in which your concern is located for specific advice on the legality of statements made above. 

The Benefits of Organizing a Limited Liability Company

A few days ago, a person in my Linkedin® network asked the question: “What are the benefits of having a LLC?” Since I get asked this question a lot, I thought I would share my answer—the unedited version, that is—on BlogIED™:

Hotep. Most entrepreneurs organize LLCs for one primary reason: FLEXIBILITY. LLCs offer flexibility with respect to the three major considerations involved in selecting a legal structure for your business: 1) Control; 2) Liability; and 3) Taxes. LLCs combine the limited liability of a corporation with the tax benefits of a partnership or S-Corp. What follows represents what I consider to be the benefits of organizing a LLC.

Control:

Control refers to the ability / authority of an agent—people within the entity be they owners, employees, board members, etc.—or group of agents to direct the affairs of the organization or bind the company with respect to agreements and contracts. A LLC can be controlled by the Members—i.e. the owners—or by Managers. Managers do not have to be Members. In fact, a group of Managers can be treated as the board of directors. How the company shall deal with the issue of control would be articulated either in your Articles of Organization or in your LLC Operating Agreement.

What truly makes a limited liability company different in this regard becomes the access to control. While most jurisdictions allow single shareholder / single board member corporations, the control of a LLC defaults to the Members just as it would in a partnership; notwithstanding, the shareholders may elect to control the corporation through a formal shareholder agreement. The Members of a LLC may elect to manage the organization themselves or through one or more Managers without entering into any formal agreement to do so.

So, what is the difference between membership interests and shares? Each share (of capital stock) equals the basic unit of ownership in a corporation. A share conveys certain rights and privileges to the holder under law and equity, as granted by the jurisdiction in which the company is incorporated. A corporation need not issues all of the shares it is authorized to issue by its Articles of Incorporation. In a simple corporation, the percentage of control and profits to which a shareholder is entitled is based upon the percentage of shares owned in relation to the number of shares issued; therefore, if a corporation authorized to issue 1,000 shares of stock issues 255 shares to Shareholder A and another 245 to Shareholder B—the two of whom represent the sole shareholders of the company—Shareholder A owns 51% of the company, as 255 equals 51% of 500—the total number of shares outstanding. Ownership (control) in a LLC is calculated by taking the value of the total capital initially invested by the owners and assigning a percentage—1% – 100%—based upon the amount of each owner’s investment. This percentage becomes the owner’s membership interest in the LLC. Membership interests cannot be sold on the open market as easily as shares. Unless otherwise agreed by the other Members, ownership, i.e. the rights and privileges thereof, cannot be conveyed by selling membership interests. So, generally, investors who wish to enter a limited liability company purchase an assignment of rights to the percentage of profits / losses to which the selling member is entitled.

Additionally, along with incorporation come administrative formalities such as board meetings and issuing stock certificates. While both LLCs and corporations are required to keep minutes or records of their meetings, LLCs are not generally required to hold regular meetings by law; nonetheless, meetings may be called by the Members or Managers or both.

Liability:

Although in some jurisdictions—i.e. US states and territories—Members of a LLC receive an absolute bar from personal liability with respect to the debts of the company, plaintiffs may yet pierce the so-called corporate veil of a LLC. This usually involves proving that the company merely represents the alter ego of the owner(s). Furthermore, either Members or Managers can be exposed to personal liability for reckless or wanton business decisions that cause harm to another or even the entity itself.

Taxes:

LLCs can be taxed as a corporation, sole proprietorship—i.e. disregarded entity—or a partnership. While true that IRS Form 8832 defines the type of entity classification a limited liability company elects for tax purposes, it becomes redundant to suggest that a LLC can be taxed as S-Corp simply due to the fact that both are treated as advanced pass-through entities—i.e. profit / losses of the business recognized by the individual owners—for tax purposes. Besides, organizing a LLC then electing to be taxed as an S-Corp would defeat the point in forming a LLC in the first place. Why? S-Corps receive pass-through status due to the shareholders agreeing to certain restrictions not required of LLC Members:

1) S-Corps cannot have more than 100 shareholders;

2) S-Corps cannot have more than one (1) class of stock;

3) S-Corp shareholders must be US residents; and

4) All S-Corp shareholders must be either an individual, an estate or an exempt organization under the section 401(a) or 501(c)(3) of the US Tax Code (the IRC).

S-Corps were not intended to be flexible. The biggest difference between a LLC and S-Corp lies in who may be an owner. Entities eligible to hold membership interest in a LLC include corporations, individuals other business entities and even other LLCs.

Further, double taxation is not always a bad thing. Consider two points: 1) Corporations pay less in taxes than individuals do; and 2) If your business projects to make a bunch of money from year to year, you actually save money by allowing the company to pay its taxes first. Just as corporations may pay dividends, LLCs may make distributions to their Members. Since nothing said here can be used as legal advice, ask your lawyer what this means.

Costs:

The costs for organizing a LLC vary by jurisdiction. New Mexico, however, may have the lowest fee for filing Articles of Incorporation—required by every jurisdiction to form a LLC—at $50. Illinois, for example, charges $500. Other costs may include business licenses, depending upon your field or trade. Plus, if you elect to file in jurisdiction outside your state, you must find a registered agent within that state. Any body who can receive service of process—i.e. the official papers the company would receive in the event of legal or (state) administration action—can be your registered agent. Lawyers and other companies charge an annual fee for this service. Sorry for the lengthy answer, but this stuff is just that exciting to me. No matter what you decide, enjoy becoming an entrepreneur! Take Care!

Disclaimer: The foregoing information is intended to be used for educational purposes only and cannot be used as or construed to be legal advice. Please consult an attorney licensed in the jurisdiction in which your concern is located for specific advice on the legality of statements made above.

Can Fantasy Football Help Grow Your Business?

Fall happens to be my favorite season, for my wife, however, not so much.  We mutually enjoy some aspects of the onset of autumn.  The gently falling leaves plucked from their branches by a soft breeze blowing off the Potomac spreads myriad and vivid colors along the walking paths that line our neighborhood.  Walking slowly, hand-in-hand, through this wondrously painted canvas, bathed in the glow of the setting sun, stirs nostalgic images of past experiences, the sum of which provided the opportunity for us to fall in love and create a life together.  Then all of a sudden … after these beautiful moments have occupied their due share … and always too soon for my wife, football occupies the rest of my weekend afternoons and evenings.  Though I must admit, I am simply a spectator fan … at the moment, anyway, for during a recent conversation with an executive from Capital Bank at a networking function, a thought hit me like Dwight Freeney putting the smack-down on Tom Brady.  I might be missing out on a significant opportunity to connect with clients and partners.  I began to wonder if I should join a fantasy football league. 

One of my closest friends and business partners operates a thriving fantasy football league every year in the Greater Columbus, Ohio area.  At the beginning of each NFL season, he always suggests that I join the league.  Each year, I politely make up some excuse to decline his invitation.  Now, I am strongly considering accepting that offer next year, even though I live in the DC Metro area.  Why?  Consider the following.  Market research shows that between 13.6 – 36.8 million adults and teenagers in the US and Canada participate in fantasy sports.  Some analysts suggest that as many as 93% of all fantasy sports participants are members of a fantasy football league.  Even more interesting, adults participating in fantasy football earn, on average, an annual income of $76,000.  Studies further reflect the growing number of women participating in fantasy football leagues, currently comprising approximately 7% of all fantasy football team owners.  The enormous appeal of the National Football League, with a team in every major market across the country, even created an environment fertile enough for a new industry in fantasy sports to blossom, an industry represented by the Fantasy Sports Trade Association since 1999.  The Fantasy Sports Trade Association boasts 125 members companies, operating in several different countries around the globe.  Fantasy sports industry experts expect advertising revenue on sports websites to eclipse $1 billion by 2011.  Sports websites owned by US companies already saw ad revenue surge to $727 million, a dramatic 33% increase over last year’s totals.

If those statistics failed to capture your interest, ponder this.  Can you think of a better excuse to reach out to your current clients, potential clients, or other business contacts on an even more regular basis?  Many executives already use fantasy football as a vehicle for connecting to new business contacts across these United States, while building rapport with existing clients.  In fact, the gentleman from Capital Bank told me story about one of his colleagues who flies clients into Arizona each year for their fantasy draft.  Weekend events surrounding fantasy football drafts have become a steadily growing trend.  In fact, the average participant spends about $493 each year on fantasy sports.

As with anything, certain draw-backs do exist.  For example, analysts also estimate that American corporations lose hundreds of thousands of dollars each week due to a drop in productivity over the course of the 17-week NFL season as a result of employees engaging in fantasy football.  On the other hand, studies also show companies that embrace fantasy football, either by organizing a company league or refraining from strict fantasy football policing, increase employee morale.  40% of employees who participate in a company-sponsored fantasy league say that fantasy football boosts camaraderie among co-workers.  Notwithstanding, you may have also noticed that in recent months many policy debates arose as to whether or not fantasy leagues allow the participants to engage in illegal gambling activities.  A resolution as to whether or not fantasy sports present too much of a temptation to gamble, therefore requiring stricter governmental regulation, does not seem likely to be reached in the near future.

Fantasy football as an opportunity to gamble does not interest me in the least, yet fantasy football as a vehicle to expand my professional network excites me greatly.  Since so many fantasy sports companies provide on-line resources for people to manage their fantasy leagues, tech-savvy fantasy league organizers can use fantasy sports to connect with business contacts the entire world over.  As an avid sports fan doubling as a business person—i.e. remaining employed simply as a means to purchase the latest and greatest television services and technologies in order to enhance my sports viewing experience—fantasy football presents some very interesting opportunities, opportunities which most small business owners should definitely not ignore.