So, you’re planning on starting a new nonprofit sometime soon. Maybe you’ve heard something about incorporating, but you don’t fully understand what that means. Or, someone told you to form an LLC instead. There’s a lot of misinformation and misunderstanding surrounding this topic, so let’s unpack this idea of nonprofit incorporation.
We’ve written a lot of articles about starting a nonprofit over the years, so we won’t rehash everything. Suffice it to say that there are two primary steps to establishing a 501(c)(3) organization:
- Forming the legal entity in one of the 50 states or territories, and
- Getting IRS determination as tax-exempt under Section 501(c)(3) of the Internal Revenue Code
Step 1 is where incorporation comes into play. Before your new nonprofit can seek 501(c)(3) status, you must first create a legal entity.
As alluded to above, incorporation is the act of creating a legal business entity in a US state or territory. There are other forms of business entities, as well, including LLCs, partnerships, and others. We’ll briefly touch on those below, and explain why those other choices usually aren’t good choices for a nonprofit.
Each state has its own nonprofit corporate law or code. There are far more similarities than differences, but no state law is exactly the same as another. What is consistent, however, is that in the eyes of the law, creating a business or nonprofit corporation is the equivalent of creating a “legal person”. This sounds like strange terminology, and for those unfamiliar with corporate law, I can understand why.
To create a legal person simply means that the entity that has been created has its own standing under the law. This means that corporations can buy and sell, or borrow and lend under its own name. It can sue and be sued. It exists wholly apart from the people who start it. This is very different than a sole proprietorship, for example, where the business and the person are not legally distinguishable.
Incorporating a nonprofit happens by filing Articles of Incorporation, sometimes called a Charter, in a particular state. Most often, a startup will incorporate in the state in which it will base its operations… and no, it’s not better to incorporate in Delaware!
While most states have boilerplate (blank) templates available to fill out for Articles submission, we do not recommend using them. The IRS has strict rules governing what must be contained in a nonprofit’s Articles of Incorporation in order for that organization to qualify for 501(c)(3) status. Only one (1!) state includes the necessary clauses in their boilerplate template. So, if you incorporate using a state’s template, it’s a virtual certainty your Articles will require an amendment prior to seeking 501(c)(3) recognition.
This is yet another reason nonprofit formation is not a good DIY project!
I talked above about a big benefit of incorporation, namely being that the organization is legally distinguishable from its founders, directors, and officers. Why does that matter? Personal liability!
As legal persons, corporations are responsible for their actions, same as humans. This distinction (or separation) matters, otherwise your leaders can be held personally liable for the actions of the organization. This is true whether we’re talking about for-profit or nonprofit corporations. The concept of the “corporate veil” shields individuals from most personal liability that could potentially fall on them. While it is possible to “pierce” the corporate veil in matters of gross negligence or criminal behavior, it is still an indispensable benefit.
But, it is a choice. Another of the entity types that the IRS will allow to seek 501(c)(3) status is the unincorporated association. These are created by preparing a document, often called Articles of Organization, that are adopted by the initial board. Most states do not require unincorporated associations to file this with their business or corporations division. We do NOT recommend unincorporated associations ever, primarily because of the associated risk of personal liability. They are not legal persons, and provide no distinction between entity and leaders.
This question comes up a lot:
Why a corporation and not an LLC? I heard the IRS allows LLCs.
It is true that the IRS will allow a nonprofit LLC to apply for 501(c)(3) status, but it’s not what you think. First of all, only a few states recognize a nonprofit LLC as an entity type in their state. Secondly, and most important, to qualify for 501(c)(3) status, the LLC’s members (think shareholders) must be made up entirely of existing 501(c)(3) organizations. That only works if you’re talking about a new LLC that is essentially a joint venture of multiple other charities.
There’s a reason that over 95% of IRS-recognized nonprofits are corporations. It’s really the only entity choice that makes sense for all but the most unusual situations.
As always, if you need help starting a new nonprofit, Foundation Group is your go-to solution!
Originally Published by www.501c3.org