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Nonprofit Legal Structures: The Basics

Adapted from Starting and Building a Nonprofit

The term "nonprofit" describes all kinds of groups that are bound together by a desire to achieve a mission, rather than to make a profit. By itself, the term "nonprofit" does not indicate any specific type of legal structure. If a nonprofit group incorporates, it is a nonprofit corporation; if not, it is an unincorporated nonprofit association.

Nonprofit Corporations

A nonprofit corporation is an organization that has a mission to serve the public interest and has filed incorporation papers with the state. In exchange for working for the public good and governing themselves according to certain rules designed to ensure accountability, nonprofit corporations receive exemptions from state and federal taxes they would otherwise be required to pay.

State laws require nonprofit corporations to establish certain organizational structures. A nonprofit corporation must have a board of directors (sometimes called a board of trustees), which is responsible for keeping the organization on track, working toward its stated mission. Other state rules impose legal duties on the board -- for example, the duty to act with care and the duty to be loyal to the organization -- and ensure that the board does not stand to gain personally from the nonprofit's activities.

Corporations in General

To create any type of corporation, nonprofit or for-profit, you must file paperwork with the state government, usually the secretary of state's office. Once you file the required document -- typically called "articles of incorporation" -- you have "incorporated" and created a separate legal entity: your corporation.

In the simplest terms, a corporation -- whether nonprofit or for-profit -- is a type of business structure. Other types of business structures include sole proprietorships, partnerships and limited liability companies (LLCs). Some states also recognize associations: groups of individuals who work together for some common goal but haven't taken steps to create a specific legal entity.

The main differences between the various business structures lie in how they handle two important issues: personal liability and taxation.

  • Personal Liability. Some business structures (such as corporations) protect their owners from personal liability, while others (such as sole proprietorships) do not. Many nonprofits choose to incorporate primarily to receive liability protection for their board members and staff.
  • Taxation. In some business structures (such as partnerships), business profits are taxed as if they are simply the personal income of the business owners. Other business entities (such as corporations) pay and report their own taxes, separate from the owners' personal incomes. Nonprofit corporations are separate tax entities but have different -- and more favorable -- tax rules than for-profit corporations.
Forming a Nonprofit

The steps you must take to form a nonprofit corporation are similar to the procedures for starting a regular corporation, but a bit more involved. You must apply to the same agency and follow a similar process, but satisfy a few extra rules. 

Tax-Exempt Status

Whether or not you choose to incorporate, you may be eligible for tax-exempt status from the federal government. There are several types of federal tax-exempt status, but the most favorable is known as 501(c)(3) status. This moniker refers to the specific section of the IRS tax code that not only exempts certain nonprofits from having to pay federal income taxes, but also makes contributions to these organizations tax-deductible to the donor. Other sections of the federal tax code (such as 501(c)(4) or 501(c)(6)) also offer exemptions from income taxes for nonprofits, but do not allow donors to deduct their contributions. In this way, 501(c)(3) status confers especially favorable tax treatment to organizations that qualify.

Only groups created for specific exempt purposes -- religious, charitable, scientific, educational or literary purposes that benefit the public -- are eligible for 501(c)(3) tax treatment. Groups that haven't incorporated (often called "unincorporated associations") can still be eligible for 501(c)(3) status as long as they meet all other requirements. Groups that don't qualify for 501(c)(3) status might be eligible for other types of tax-exempt status -- for example, section 501(c)(7) for social clubs, and section 501(c)(6) for trade associations.

To obtain 501(c)(3) status, an organization must file an application with the IRS and be approved. The organization must submit additional documents with the application, such as its articles of incorporation and bylaws, to show that the entity is, in fact, dedicated to one or more of the specific nonprofit purposes outlined above.

In most states, a nonprofit that obtains an exemption from federal taxes automatically obtains an exemption from state taxes as well, so "tax-exempt" generally means exempt from both federal and state taxes.

Corporation Rules Vary by State
All corporations -- nonprofit and for-profit alike -- are creatures of state law. Although state laws that govern corporations are, for the most part, similar throughout the nation, there are important differences. For example, states vary on the minimum number of directors required for nonprofit boards, as well as on eligibility rules for directors. And corporate tax laws can vary significantly from state to state. In addition, corporations created in one state are not automatically qualified to do business in others. If you create your nonprofit corporation in Wisconsin, for example, it is technically a "Wisconsin corporation." Other states will view it as a "foreign corporation" and will generally require you to file paperwork and pay a fee before allowing you to do business within their borders. If you do not plan to engage in nonprofit activities in other states, then incorporating in your home state alone is probably sufficient, at least in your early days. If, on the other hand, you expect the scope of your activities or services to extend into other states, you should investigate the requirements for operating as a nonprofit corporation in those other states.