Start-up businesses that register with the government with the intent of making a profit are required to pay federal, state and local taxes, just as any other business does. Certain types of organizations offer valuable services to communities. In exchange for their services, governments offer them the benefit of being tax-exempt, as long as they agree to adhere to the strict requirements of the 501(c)(3) statute. Governments intend that nonprofit corporations will use the money that they save in taxes to advance their missions. In that way, they also benefit their communities.
Certain types of businesses that are also classified as social enterprises have the option of registering their businesses either as a regular business or as a nonprofit corporation. The organization’s mission may be the best indicator of how best to register the business.
Some businesses have found that a hybrid approach of registering one business as a for-profit and a separate, but related, business as a nonprofit is the best arrangement for their purpose.
What Is a 501(c)(3)?
It’s common for people to refer to a nonprofit business as a 501(c)(3); however, 501(c)(3) refers to a section of the IRS code that describes the requirements needed for organizations to qualify as tax-exempt.
Organizations that qualify for 501(c)(3) status are required to operate exclusively for the purpose they state to the IRS.
While nonprofit organizations aren’t allowed to net and distribute profits, they are allowed to retain money in a budget. Any money that nonprofits receive must be recycled back into the organization to fund its programs and operations.
Donors that make contributions to corporations that fall under the 501(c)(3) code may deduct their contributions at the annual tax filing date.
One of the most notable differences between for-profit and nonprofit entities is how they obtain capital to run their businesses. For-profit corporations can use their own money or earned profits, or seek investment funds from private investors. Investors expect a return on their investment, which motivates for-profit corporations to succeed. Business owners repay the capital they borrowed in the form of equity or dividends.
By contrast, nonprofit corporations seek donations, rather than asking individuals or corporations to invest in their businesses. Rather than expecting equity or financial gains from nonprofit businesses, donors expect a “social return” on the money they invest. In fact, the 501(c)(3) statute specifically states that no private or individual shareholder may benefit from the organization’s earnings.
There Are Three Main Types of Charitable Organizations
The IRS designates eight categories of organizations that may be allowed to operate as 501(c)(3) entities. Most organizations are eligible to become one of the three main categories, including public charities, private foundations and private operating foundations.
Public charities are the most common type of 501(c)(3). This type of nonprofit may accept donations, which are tax-deductible. Individuals may donate up to 50% of their income and corporations may donate up to 10% of the organization’s revenue before being taxed on donations.
Public charities are governed by a board of directors, and no more than 50% of the board directors may be related to each other. Nonprofit boards are often heavily scrutinized to make sure that they are strictly following the rules for nonprofits. The government also expects that public charities will obtain most of their funding through fundraisers and donations. Examples of public charities include churches, religious institutions, animal welfare agencies and educational organizations.
Private foundations are sometimes called non-operating foundations. This type of 501(c)(3) doesn’t have any active programs. An individual, a family or small groups of donors usually fund the foundation with their own money. Private foundations sometimes grant money to other nonprofit organizations or to individuals who are working on the same tax-exempt purpose. Family foundations are a common type of private foundation. Donors for private foundations may donate up to 30% of their income without paying taxes on it.
Private Operating Foundations
The least common of the three main types of 501(c)(3) corporations is the private operating foundation. They’re similar to private foundations, but they also offer active programs, much like a public charity. Some people consider private operating foundations as a sort of hybrid between a public charity and a private foundation. They are regulated somewhat like private foundations. Both private foundations and private operating foundations aren’t as heavily scrutinized as other charitable foundations because donors have close ties to the charity.
There are five other types of 501(c)(3) organizations that have specific purposes for their organizations, including:
- Testing for public safety
- To foster national or international amateur sports competitions
- Prevention of cruelty to children or animals
Businesses in these categories are heavily regulated and monitored by the IRS for compliance, particularly with respect to the donations they use for political advocacy.
What Else Can’t 501(c)(3) Corporations Do?
The IRS 501(c)(3) code has strict rules for nonprofits related to political advocacy and lobbying. Nonprofit organizations are prohibited from donating directly to any political candidate’s campaign fund. This is because the political candidate would benefit from the nonprofit’s efforts, which is illegal. In addition, nonprofit organizations can’t campaign actively for any political candidates.
The law does allow nonprofits to be somewhat involved in political efforts that help to advance their causes. Nonprofit organizations may support specific legislation, participate in lobbying and advocate for their cause, as long as it’s not a major part of the nonprofit’s programs and activities.
Board Directors and Members of Nonprofits Must Abide by All Laws
Board directors and others connected with nonprofit organizations must be aware of all laws that they encounter when working in or with a nonprofit organization. For example, donors can designate how they want nonprofits to use their funds, which are called restricted funds. Nonprofits may only use restricted funds for the express purpose outlined by the donors. Nonprofits may not borrow from restricted funds for other activities, even if they’re borrowing from them for the short term.
In seeking donors and funds, nonprofit boards also need to be aware of marketing laws aimed at getting rid of spammers. Nonprofits need to make sure that their donors want to be contacted and have the ability to unsubscribe from mailing lists.