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To Start or Not to Start a Nonprofit — That is the Question

by Linda Alexander

Linda_Alexander_2According to GuideStar, there are 164,315 nonprofit organizations in California. 1,839 nonprofits are registered in Long Beach and 999 of those have an income under $100K. Every week, someone is thinking about starting a nonprofit organization. There is a lot to consider before making the decision to start your own nonprofit: from assessing community need to having the ability to invest the time and resources necessary to be successful.

            To this end, our partners at The Legal Aid Foundation of Los Angeles have provided the following information from their publication, “Forming a Tax Exempt California Nonprofit Organization”.

There are two decisions your organization must initially make. First, do you want to become a nonprofit corporation? The incorporation process is governed by the California Corporations Code. Therefore, all the forms and processes will be governed by California law.

Next, does your organization wish to seek tax exempt status? Tax exempt status provides many advantages for an organization. Some of these advantages include no state or federal income tax liabilities, assisting your organization with qualifying for certain grants and/or funding and, in some instances, providing your donors with a charitable contribution tax deduction. Tax-exempt status is governed by both state and federal regulations. Under state law, the Franchise Tax Board establishes filing and reporting requirements; under federal law, the Internal Revenue Service establishes such requirements.

Consider the following before beginning:

Nonprofit versus For-Profit

A nonprofit organization is defined by the American Bar Association as a corporation “no part of the income or profit of which is distributed to its members, directors or officers”. All nonprofit organizations have three basic characteristics:

  1. They are designed from the outset to be nonprofit.
  2. None of the income or assets may be divided among members, officers, or directors.
  3. They may only pursue legally defined purposes.

A for-profit corporation, on the other hand, would allow for income and asset distribution and serve very different purposes.

Types of Nonprofits

Under California Corporations Code, there are four basic types of legal organizations that can be used for nonprofit purposes, outlined below.

An unincorporated association is formed for some purpose other than for profit and is generally the organizational structure selected by small local clubs, labor unions and fraternal organizations. Often the association structure is selected if the organization will only operate for a short time period. Advantages include: easy to organize; informal; no incorporation costs; may enter into contracts; may sue or be sued; limited record keeping. Disadvantages include: Somewhat vague state regulations; potential individual director and member liability for acts and omissions within the scope of their authority; difficulty in doing business in association’s name; difficulty in raising funds; net income potentially taxable.

The corporation is the most common and probably the best form of organizational structure for most nonprofit organizations.  It is a legal entity, organized according to prescribed legal requirements and having a specific name and specific powers granted by law. Advantages include: recognized legal entity; clear statutory requirements; no individual director or officer liability for good faith acts and omissions that are within the scope of their duties and in the best interest of the corporation and within the exercise of their policy making judgment; prerequisite from some funding sources to receiving monies. Disadvantages include: costs of formation; need to fulfill corporate formalities; formalized structure, reporting and record keeping requirements.

Charitable trusts are generally developed by one person, the trustee, for the purpose of holding legal title to certain property, the trust, for the benefit of another, the beneficiary.  This organizational structure is used for very specific and very limited purposes, for example, a Family Foundation. Advantages include: can be established and operated relatively quickly and inexpensively; does not have to comply with any statutorily required formalities; founder has the authority to name the trustee. Disadvantages include: must register with the Attorney General and is subject to the Attorney General’s continuing supervision.

Limited Liability Companies…are a hybrid between corporations and partnerships. Although they offer the limited liability of corporations, they have greater flexibility of structure and can be structured so that the entity is not subject to corporate income tax. Advantages include: members, managers and officers are not personally liable for obligations or liabilities of the LLC, with the same narrow exceptions as corporate shareholders; flexible structure allowing members to actively participate in management and control of company; can be structured so that the entity is not subject to corporate income tax but has pass-through tax status similar to a partnership. Disadvantages include: costs of formation and annual tax; law is unclear as to whether LLCs can be formed for charitable purposes; very limited circumstances under which LLCs can obtain 501(c)(3) tax exemption.

An alternative to independent 501(c)(3) status may be operating as an informal organization under the legal umbrella of an existing charity.

Advantages of fiscal sponsorship:

  • Can raise grants, contributions, and other funds based on the sponsor’s track record and experience
  • The sponsor has fiscal, accounting, personnel, management and other systems in place
  • Can operate informally, no incorporation costs
  • The sponsor assumes the risk of liability

Disadvantages of fiscal sponsorship:

  • Loss of control over activities, since ultimate authority lies with the board of directors of the sponsor
  • Community perception that its activities are those of the sponsor. The sponsor may receive credit for a successful project. A sponsor with a bad reputation may tarnish the project
  • As a small part of a larger organization, the project may not receive timely and adequate support. Also, the sponsor might retain a significant portion of the funds for its administrative expenses.
  • May be difficult to disengage from the sponsor and continue the project as a separate corporation.

 

The Legal Aid Foundation of Los Angeles is the front line law firm for poor and low-income people in greater Los Angeles.

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