The Benefits and Disadvantages of Becoming a 501(c)(3) Nonprofit Corporation

Becoming a 501(c)(3) nonprofit organization requires considerable time and energy, but tax-exempt status can provide important financial, legal, and structural advantages to charitable groups. In many cases, obtaining tax-exempt status under state and federal tax statutes allows groups to expand their impact and to increase their sustainability. However, it is important to recognize that many groups are able to operate smoothly and to provide significant public benefit without becoming a tax-exempt organization. Instead of applying for 501(c)(3) status of their own, many smaller and/or newer nonprofits operate under a fiscal sponsor, which is a 501(c)(3) corporation that serves as an umbrella organization for other not-for-profit groups. Even without a fiscal sponsor, groups with limited staffs and small operating budgets may not need to obtain tax-exempt status in order to fulfill their organizational objectives. Before applying for their 501(c)(3), groups should first consider whether they are applicable for tax-exempt status, and if so, whether incorporating will truly serve their best interests.

501(c)(3) Eligibility

A wide-range of groups that benefit either the public at large or particular segments of the population are eligible for state and federal tax exemptions. In order to qualify under the Section 501(c)(3) of the Internal Revenue Code, an organization must be formed for charitable, religious, scientific, literary, and/or educational purposes. A detailed description of requirements are available on the IRS website.

The Benefits of Incorporating

If your organization does, in fact, meet the IRS requirements for 501(c)(3) organizations, incorporating could provide your group with a wide-range of advantages.

– Public and Private Donations: For groups with large-scale fundraising goals, obtaining either a fiscal sponsor or 501(c)(3) status is essential. Many public and private funding sources, such as community or family foundations, require organizations to have a 501(c)(3) in order to be eligible for funding. Although many funders accept proposals from groups operating under fiscal sponsors, some are required by their own operating guidelines to only donate directly to groups with 501(c)(3) status. Individual donors will also be incentivized to donate to groups with either fiscal sponsors or 501(c)(3) status, as donors can claim personal income tax deductions for charitable contributions.

– Protection from Personal Liability: Once an organization is incorporated, employees, board members, and members of the corporation are not personally liable for lawsuits against the nonprofit or organizational debts. There are a few exceptions to this rule: for example, the individual responsible for managing the nonprofit’s reporting and corporate taxes may be held personally liable if he or she fails to pay the organization’s taxes or to file necessary returns, and employees can also be held personally liable if corporate funds are unlawfully intermingled with employees’ personal funds. However, generally creditors may only go after the organization’s assets and may not pursue the personal wealth of the individuals involved in an organization. Although unincorporated groups can also protect themselves through insurance, 501(c)(3) status provides important legal protection by making the organization a distinct entity.

– Independent and Perpetual Legal Existence: In a sense, obtaining 501(c)(3) status for your group makes your organization legally immortal. Organizations might fail due to leadership or funding issues, but 501(c)(3) nonprofit status ensures that an organization is not contingent on the involvement of any particular individual. Regardless of the resignation, termination, or death of the founding member, a nonprofit will continue to exist as a legal entity unless it is dissolved. A 501(c)(3) organization can be dissolved at any time, so long as the remaining organizational assets are paid to another incorporated nonprofit.

– Legitimacy and Recognition: Being a 501(c)(3) exempt organization makes a group more legitimate in the eyes of donors, partners, and the community at large. This legitimacy is often accompanied by benefits such as lower advertising rates, reduced prices/membership rates, or inexpensive training programs for nonprofit leaders. The federal government also recognizes 501(c)(3) organizations as eligible for reduced postage rates and free radio and television public service announcements, as well as a variety of other opportunities.

– Clear Organizational Framework: Preparing articles, bylaws, and board resolutions will be a useful process for your organization. The 501(c)(3) application involves outlining your group’s purpose and concretely delegating authority. Although the paperwork involved in the application might seem tedious, it presents a valuable opportunity for your team to come together to reinvigorate your organization’s mission.

The Disadvantages of Incorporating

Although there are many benefits associated with incorporating, it is important for organizations to thoroughly consider the time and effort involved in running a 501(c)(3) organization before launching into the application process.

– Bureaucratic Requirements: Redtape is an inevitable component of running a nonprofit organization. Both the application process and ongoing operations will require a considerable amount of official paperwork. The application process will likely take several months, as organizations need to apply for both state and federal exemption and there are several rounds of paperwork involved. Additionally, 501(c)(3) organizations must file annual tax and reporting returns with their state and the IRS, and they are required to maintain a precise bookkeeping system. Most organizations require the help of an experienced nonprofit tax advisor to handle the required annual 501(c)(3) reporting forms.

– Incorporation Costs and Fees: The application fees for 501(c)(3) exemption generally range from $450 to $850 depending on the size of an organization’s budget. In many cases, however, groups rely on outside counsel for assistance with the application, and legal fees can make this process far more expensive.

– Necessary Organizational Changes: Obtaining 501(c)(3) status involves much more than simply filling out paperwork. Most organizations must make significant changes to their internal structure in order to operate in accordance with 501(c)(3) requirements. These changes might include setting up and maintaining a detailed bookkeeping system, depositing and reporting payroll taxes, meeting with an accountant each year to report year-end figures, developing a board of directors, and operating under clear bylaws and articles. In many cases these changes can be beneficial to an organization’s health, but for smaller or newer groups, these requirements may be overwhelming.

If your organization decides the benefits of incorporating outweigh the challenges, your next step is to decide whether your group will seek incorporation independently or work with an attorney. In the best-case scenario, your group may be able to find free or reduced-cost legal services. However, many groups go through the application process on their own, and there a variety of useful online resources and books available to guide you through this process. Applying for 501(c)(3) status may seem a bit daunting at first, but it can also serve as a valuable opportunity to re-energize and improve your organization.

If you have more questions about whether or not you should incorporate your organization, feel free to contact SOURCE at SOURCE@cmc.edu. Our nonprofit consultants can further advise your organization throughout the process, if needed.

by jess davis