The Advantages and Disadvantages of Establishing a Nonprofit Organization

By Kristen A. Campbell

Nonprofit organizations play an increasingly critical role in our society. They help reach millions of people every year throughout the country through charitable work and giving.   If you're involved in a fledgling charitable cause, you have probably wondered whether or not you should form a nonprofit organization. Becoming a nonprofit requires paperwork and ongoing compliance requirements, but for many groups, the benefits of nonprofit status outweigh the complications. Each group should weigh the pros and cons of applying for nonprofit status in the context of its own unique goals. 

Advantages

• Tax exemption/deduction

Organizations that qualify as public charities under Internal Revenue Code 501(c)(3) are eligible for federal exemption from payment of corporate income tax. Once exempt from this tax, the nonprofit will usually be exempt from similar state and local taxes. If an organization has obtained 501(c)(3) tax exempt status, an individual's or company's charitable contributions to this entity are tax-deductible.  Consequently, a nonprofit can devote a larger proportion of its resources to achieving their particular goals.

• Eligibility for public and private grants

Many agencies limit their grants to public charities.  A nonprofit status can qualify groups for special grants or government funding, as well as special rates for services such as postage. Donors prefer contributing to tax exempt nonprofit entities because they can deduct the payments from their own taxes.

• Limited Liability

One of the primary advantages of forming a nonprofit entity is protection from personal liability for business debts or judgments in the event of a lawsuit. If a lawsuit was to occur or the entity was to default on its debts, the liability will lie with the nonprofit and its assets. While directors and members of nonprofits will enjoy limited liability from debts, they are not protected from illegal or intentional actions. Directors/members are required to perform their job functions to maintain the nonprofit's best interest and can be held liable if they don't.

In order to gain tax-exempt status, an entity will need to comply with the United States Tax Code and Internal Revenue Service. Illustratively, in order to qualify for tax-exempt status under 501 (c)(3), a nonprofit's key purpose has to fall into one of the categories reserved for charitable organizations. These include an organization that has a "Charitable Purpose," is a "Religious Group," is a "Scientific Organization," serves a "Literary Purpose," or qualifies as an "Educational Organization.

Disadvantages

Despite numerous advantages, nonprofit and tax-exempt status should not be an automatic goal. Drawbacks to the status include:

• Cost

Creating a nonprofit organization takes time, effort, and money. Filing fees are required to apply for incorporation and tax exemption. The use of an attorney, accountant, or other consultant may also be necessary.

• Paperwork

As an exempt corporation, a nonprofit must keep detailed records and submit annual filings to the state and IRS by stated deadlines in order to keep its active and exempt status.

• Shared Control

Personal control is limited. A nonprofit organization is subject to laws and regulations, including its own articles of incorporation and bylaws. Further, many forgo nonprofit status on account of: 1) the inability to divide profits among members beyond payment of reasonable salaries; 2) limitations on the sources of the group's incomes; 3) restrictions on the use of assets to purposes justifying tax exemption; and 4) if one decides to move on to other pursuits down the road, he or she can’t take any assets accumulated by the organization.

• Scrutiny by the Public

A nonprofit is dedicated to the public interest; therefore, its finances are open to public inspection. The public may obtain copies of a nonprofit organization's state and Federal filings to learn about salaries and other expenditures.

Some organizations prefer the flexibility and potential for personal gain implicated by for profit status. Other organizations eschew incorporation entirely. Many smaller organizations will not realize substantial advantages from nonprofit tax-exempt status after going through the intensive application process. Each group should weight the advantages and disadvantages based on its goals.  Also, even after you settle on a structure, remember that the circumstances that make one type of structure favorable are always subject to changes in the laws. It is important to reassess your form of business from time to time to make sure you're using the entity that provides the most benefits.