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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.