The Decision to Incorporate--Chapter 1 of The Nonprofit Handbook

A corporation is a legal entity formed for business activities. Under state and federal laws, a corporation is treated as a separate “person” for purposes of making contracts, paying taxes, and being liable for the consequences of business activity. A nonprofit corporation, also called a “not-for-profit” corporation in some states, generally is not permitted to issue shares of stock, and does not provide shareholders with dividends from the profits that are received from operating the business. While nonprofit corporations can and do make profits, these profits may not inure to the benefit of the “owners” of the corporation―the board of directors or trustees. Rather, these profits must be used to operate and maintain the organization. Some states place limitations on the types of activities that are the primary purpose of the nonprofit corporation.

Generally, there are three classes of nonprofit corporations:

1. Funding agency (e.g., United Way, Jewish Federation, private foundations)

The primary purpose of these organizations is to allocate funds, either those solicited as private donations or those already accumulated in an endowment or private fortune, for other agencies that provide actual services. Many of these organizations restrict their grants of funds to groups that provide a narrow range of services of interest to the funding organization. A Jewish federation is likely to make contributions solely to Jewish-affiliated organizations or others that principally serve the Jewish community. The United Way generally provides funding to social service agencies. Some foundations restrict their contributions to organizations promoting services for women, health-care related studies, or arts and humanities organizations.

2. Membership organizations (e.g., Common Cause, the Sierra Club, League of Women Voters)

These organizations exist primarily to provide services (such as advocacy, information sharing, and networking) for their members, usually with a specialty of expertise.

3. Service agencies (e.g., hospitals, schools, day-care centers, family services)

These organizations exist to provide specific services to the public. They often charge fees on a sliding scale for their services to fund the bulk of their budgets.

Each type of organization operates differently in many significant ways.

The decision to incorporate is a mere formality for most leaders who envision a large organization with employees, contracts, offices, property, and equipment. Corporate status in general, and nonprofit corporate status in particular, provides many advantages. Maintaining an unincorporated organization with annual revenue and expenditures comfortably in five figures is cumbersome at best, if not impossible. It is at the low end of the scale where the decision to incorporate is most important.

It would be ludicrous to consider incorporation for the Saturday morning running group get-together, which collects two dollars from each of its eight members to pay for the refreshments after the run. Yet, when the group expands to three hundred members, dues are collected to finance a race, the municipality demands that the club purchase insurance to indemnify against accidents, and the club wants a grant from an area foundation to purchase a bus to transport its members to area races, then incorporation is clearly the option of choice.

The advantages of incorporation are the following:

1. Limited Liability. Of all the reasons to seek corporate status, this is perhaps the most compelling. Under all state laws, the officers, directors, employees, and members of a corporation, except under very limited and unusual circumstances, are not personally liable for lawsuit judgments and debts related to the organization. Thus, the personal assets of the organization’s executive director or board members are not at risk in the event of a successful suit brought against the corporation, or in the event the organization goes out of business while owing money to its creditors. The assets of an organization may be minimal, while the individuals running it may have substantial assets. Corporate status protects those personal assets. Many people won’t even consider participating in the leadership of an organization unless their personal assets are shielded by incorporation.     

The Congress and many state legislatures have enacted laws that are designed to expand the liability protection afforded to nonprofit boards of directors and volunteers (see Chapter 9).

2. Tax Advantages. In the absence of incorporation, income accruing to an individual running an organization is subject to federal, state, and local taxes at the individual rate, which is likely to be substantially more than the corporate rate. In the case of nonprofit incorporation, an organization can be exempt from many taxes, depending upon its type.

For organizations that are charitable, educational, religious, literary, or scientific, 501(c)(3) tax-exempt status is particularly attractive (see Chapter 8). Most states exempt corporations that have federal tax-exempt status from state corporate income tax. Certain types of charities may be exempt from state sales and use tax and local property taxes, as well. Many types of charitable institutions, such as colleges and hospitals, which have substantial property holdings, would be taxed beyond their abilities to operate if they were denied tax exemptions. Many funding sources, such as government, foundations, and the public, will not make contributions to an organization that is not exempt under Section 501(c)(3), since this status provides a tax exemption to the contributor and assures that there is at least some minimal level of accountability on the part of the organization.

3. Structure, Accountability, Perpetuity, and Legally Recognized Authority. When people and organizations interact with a bona fide corporation, they have confidence that there is some order and authority behind the decision-making of that entity. A reasonable expectation exists that the corporation will continue to honor agreements even if the principal actor for the organization dies, resigns, or is otherwise disassociated from the organization. They know that there is a legal document governing decision-making (as detailed in the bylaws), succession of officers, clear purposes (as detailed in the Articles of Incorporation), a system for paying bills, accounting for income and expenses, and a forum for the sharing of ideas on policy and direction from the corporation’s board members. So long as the necessary papers are filed, the organization will continue in perpetuity regardless of changes in leadership. This gives such organizations an aura of immortality, which is seen as an advantage in planning beyond the likely tenure of an individual board chairperson or executive director.

4. Ancillary Benefits. Nonprofit incorporation can provide lower postage rates (see chapter 24); access to media (through free public service announcements); volunteers, who would be more hesitant volunteering for a comparable for-profit entity; and the so-called “halo effect,” in which the public is more willing to do business with a nonprofit because of a real or perceived view that such an organization is founded and operated in the public interest.

5. Strength of Collegial Decision-Making. Decision-making in an autocracy is clearly easier and more efficient than in an organization run as a democracy. Yet, there is a value in making decisions by building a consensus among a majority of members of a diverse, volunteer, community-based board. Members of a board often bring different experiences and talents and provide information that would otherwise not be available in making decisions. Issues are often raised that, if overlooked, could possibly result in disastrous consequences for the organization.

The disadvantages of nonprofit incorporation are the following:

1. Loss of Centralized Control. Many organizations are formed and run by a charismatic leader with a vision of how to accomplish a particular task or mission. Decision-making is enhanced without the distractions of the scores of issues that relate not to the actual mission of the organization but to the internal management of the organization. The very act of forming a nonprofit corporation can be draining―preparing and filing Articles of Incorporation; negotiating bylaws; finding quality colleagues to serve on a board of directors; hiring qualified staff, if necessary; and dealing with the myriad of personnel issues that emanate from hiring staff, preparing budgets, raising money, and preparing minutes of board meetings. Even finding a convenient time and place where the board can meet to ensure that a quorum is present can pose a troublesome and potentially overwhelming problem at times.

Incorporation is a legal framework that trades off the advantages addressed earlier in this section with some serious disadvantages. Decisions can no longer be made in a vacuum by one person without oversight or accountability, but are legally under the purview of a board of directors. Decisions have to withstand scrutiny of all persons on the board, some of whom may be hostile or have personal axes to grind. By definition, boards of directors are committees, and committees often make decisions that are compromises to mollify members with divergent viewpoints and competing interests.

For those used to making quick decisions “on the fly” and who revel in not having their decisions subject to second-guessing, modification, or otherwise being meddled with, incorporation can be a personally shackling experience and can dilute one’s control over the organization.

2. Paperwork, Paperwork, Paperwork. Even in the smallest nonprofit corporation, the paperwork load related to corporate status can at times be overwhelming. There are deadlines for virtually every filing. Keeping ahead of the paperwork wave requires discipline, commitment, and a sense of humor. Forms get misfiled, or otherwise lost in the bureaucracy or mail.

In some cases, failure to handle this paperwork can result in criminal penalties. There are penalties for missed filings (e.g., failure to file a timely 990 federal tax return results in a $20/day penalty, up to a maximum of $10,000, or 5% of the organization’s gross revenues, whichever is smaller―and $100/day up to $50,000 for organizations with annual gross receipts exceeding $1 million). As soon as the first employee is hired, the paperwork wave accompanying that is substantial.

In the first year, the filings can be intimidating, time-consuming, and frustrating. A new corporation must develop a bookkeeping system that is understandable by the accountant who will perform the audit and prepare the financial reports, pass resolutions, file forms to open up corporate savings and checking accounts, order checks, file tax returns, and pay taxes. There are many federal, state, and local taxes, each of which requires its own filing at different times of the year. A new corporation must also reconcile savings and checking accounts, prepare board meeting announcements and minutes, devise a system to pay bills, and establish a process for the reimbursement of expenses. Other tasks it must accomplish are filing forms to protect its corporate name, preparing an annual report, adopting a personnel policy, purchasing office equipment, renting an office, preparing budgets, writing fundraising letters, and finding and retaining board members.

Few of these tasks have a direct impact on the actual work of the organization, but typically they will consume more time during the initial year after incorporation than does the work related to the actual mission of the organization. The only consolation is that after a few years, one becomes familiar with the required filings. Then they become routine and just a minor nuisance.

3. Expenses in Money and Time. Significant resources are required to establish a corporation and run it efficiently. No law prohibits running a corporation from one’s home with a staff of volunteers. Legally, the only monetary requirement is to pay a fee to file Articles of Incorporation. Yet, doing so often sets off a chain of events that dramatically increases the organization’s complexity. Opening up corporate bank accounts, doing expense reports, filing taxes, and doing the paperwork described above are difficult to accomplish solely with volunteer labor. Raising the funds necessary to hire a person to do all of this work―in addition to coordinating the actual work related to carrying out the stated mission of the organization―adds to this burden, and requires even more filing and paperwork.

Many of these tasks would be required even in the absence of a decision to incorporate. One can avoid much of the “wasted” time and energy by keeping “small,” but this places a substantial limit to what one can accomplish. Experiencing the disadvantages of incorporation is the cost one incurs to receive the substantial benefits.

Nonprofit corporation status provides many advantages over comparable for-profits. Yet this status is not conferred without a cost. Generally, nonprofits must operate differently and with different motivations than their for-profit counterparts. There is a general legal doctrine that prohibits nonprofits from acting in a manner that results in “private inurement” to individuals, i.e., the transfer of earnings or profits from the corporation to its “owners.” The basic principle at work here is that a for-profit is intended to benefit its owners, whereas a nonprofit is intended to further a purpose. In the 2001 book Starting & Managing a Nonprofit Organization, author-attorney Bruce R. Hopkins provides a useful chapter on the issue of private inurement in nonprofits.

There is nothing illegal or unethical about nonprofits selling goods and services and generating income. Nonprofits are becoming more sophisticated in finding new revenue sources to supplant the loss of government funds (see Chapters 21 and 22). Yet, nonprofits are distinguished from their for-profit counterparts by the destination of any profit. Chapter 25 includes a list of many of the important differences between nonprofits and for-profits.

a. Accessible, and not spread too thin among many other competing organizations

b. Potential contributors to the organization

c. Experienced fundraisers

d. Knowledgeable about the issues of concern to the organization

e. Respected and well-known in the community

f. Experienced in legal, accounting, and nonprofit management issues.