The defining factor between a nonprofit and for-profit organization boils down to IRS code 501(c), which excuses nonprofits from federal tax liability. These qualified charitable organizations face a tradeoff since they must distribute surplus earnings to a social cause.
The individuals in a nonprofit possess limited liability about the incorporated legal entity, which provides both an upside and downside.
Key Takeaways
- Organizations and companies must evaluate the tradeoffs of becoming a tax-exempt nonprofit or a for-profit business.
- Nonprofits represent a wide range of entities, including houses of worship, campus societies, public school foundation boards, chambers of commerce, and non-governmental organizations.
- A hybrid business model used successfully by large companies like Tesla has both nonprofit and for-profit arms.
- An alternative route, rather than incorporate an entire leg of a business as a nonprofit, is when nonprofits and for-profits choose to work with one another.
- The affiliation of a brand and a nonprofit cause can be a mutually beneficial relationship.
What Is a Nonprofit?
Nonprofits refer to organizations like public charities, foundations, churches, fraternal groups, and chambers of commerce, which are built to address a social purpose. They encompass a broad range of structures such as non-governmental organizations also called NGOs.
Non-governmental organizations tend to tackle larger causes, often on an international scale. In the U.S. an estimated 1.9 million nonprofits exist, according to the latest tax-filing records.
Whether or not a cause will find success in raising funds and serving the public good will rely primarily on the decision to become a nonprofit or for-profit entity.
The Benefits of Nonprofit Status
Nonprofits can qualify under the 501(c) federal corporate income tax exemption. After establishing this exemption, most nonprofits are exempt under state and local tax law.
This status also increases the chance of investments to a nonprofit, as individuals are more willing to donate to organizations that will help reduce their tax liability. One can claim a deduction on their taxes regarding a gift or donation to a 501(c) qualified organization. Nonprofits may also solicit money from both private and public grants.
When incorporating a nonprofit, the individual founders are completely separated from the nonprofit. This takes the burden off any individual founders in the case of debts, lawsuits, fines, and other legal matters.
Important
Employees and board members of a nonprofit entity possess limited liability.
Legal Status
The private assets of the founders of a nonprofit are shielded from creditors and courts. However, if a person acts illegally or unethically behind the shield of the nonprofit, they will be held accountable if the nonprofit is harmed.
The nonprofit organization holds a legal status and identity that transcends the founders. This aspect is attractive to those looking to start a mission-driven organization that will endure for generations.
Donors are more willing to give to organizations with legacies that they foresee surviving in the long term.
Starting a Nonprofit
The elimination of tax and legal liabilities sounds like an excellent way to mitigate risk when starting a new organization. However, when businesses try to take off the ground, they need to raise capital from investors and attract talent with competitive wages.
The public’s reluctance to give nonprofits the same leeway as for-profits severely thwart their ability to succeed. Therefore, many nonprofits need large sums of money upfront from well-established families and foundations.
Related Tasks
Starting a nonprofit requires considerable funds to pay lawyers, accountants, and consultants. Costly administrative tasks face nonprofits, including applying for federal tax exemptions and public reporting requirements. They are required to maintain specialized accounts for reporting.
Applying for the federal tax exemption alone will cost $275-$600, in addition to varying state fees for incorporation. To grow a nonprofit takes time and money, similar to starting up a company.
Important Deadlines
There’s a lot of paperwork weighing down the nonprofit operation. Strict deadlines for annual reporting are put in place by the government for a nonprofit to continue to qualify for tax exemption status. Documents include financial statements and reports that must meet particular requirements.
Since the nonprofit is in the public domain, these statements are subject to the public’s criticism and the scrutiny of a possible independent or governmental audit. The public is often hypercritical of nonprofit decisions regarding employee pay and the use of funding.
Controlling a Nonprofit
The diminished role of founders and individuals of nonprofits also affects management’s decision to start a nonprofit.
For leaders who desire a large degree of control over the direction of the nonprofit, they may not enjoy the shared control structure, which delegates decisions to several directors and follows relatively stringent procedures.
Hybrid Business Models
Nonprofits receive better treatment by the federal government and charitable view from the general public. Holding for-profit status gives business leaders autonomy and empowers companies with an entrepreneurial spirit. Therefore, some organizations have taken a hybrid approach by maintaining a for-profit leg and incorporating a nonprofit into the business, or vice versa.
Many traditional for-profit companies and entire industries have taken on corporate social responsibility standards and initiatives. These companies work to optimize social good works and profits side by side.
Examples of Successful For-Profit and Nonprofit Hybrids
Organizations such as Life Is Good, Chipotle, The Body Shop, and Tesla have found that the two goals actually work to enhance one another. Instead of viewing the decision as a zero-sum game, innovators experiment with balancing the proper dose of nonprofit and for-profit roles.
Embrace and Embrace Innovations are examples of a nonprofit that spun off a for-profit leg. Jane Chen founded Embrace to save babies through innovative, cheap technology in impoverished communities around the world. In a Harvard Business Review article, Chen stated that after setting up as a nonprofit, she felt it was essential to raise money from venture capitalists to scale social impact.
Nonprofit Side
The nonprofit arm of Chen’s company maintains the responsibility for owning intellectual property, receiving donations, distributing the technology in poor communities, and serving as the face for education and promotion of the cause.
For-Profit Arm
The for-profit spin-off at Embrace takes on the role of managing capital-intensive work and building up business infrastructure to enable the sale of the technology to those who could afford it.
Choose Your Business Model
The hybrid business model works very well for large corporations, like Embrace, with a great ability to influence the social good. For different stages of growth and variable long-term growth potentials, considering whether to be a profit or nonprofit will change.
Changing from a nonprofit to a for-profit is doable but requires much administrative work. Among the necessary steps required to do so includes:
- The board must first approve the plan.
- A statement of nonprofit conversion, liquidation plan, valuation, and other information must be provided to authorities.
- Founders will need to reorganize and plan from scratch.
In short, when you switch from a nonprofit to a for-profit (or vice versa), you will have to restart your company.
The Bottom Line
The choice of whether to become a for-profit or nonprofit entity may not be as clear-cut. The obvious tax benefits of becoming a nonprofit weigh against the flexibility granted to for-profit organizations that have the leverage to raise money and attract the best talent. Moreover, nonprofits face public scrutiny and strict legislation.
Perhaps if there is a change in how society views charity, nonprofits would have a better chance up against bigger and more powerful corporate rivals.
On the other hand, the nonprofit world seems to have taken innovation upon itself, as social entrepreneurs take up hybrid organizations that demand the public’s respect while strategizing like a for-profit business.
Read the original article on Investopedia.