Columbus Free Press: Tips & Tools #2: Building an Organization? Tax Exempt or Plain Nonprofit

From Columbus Free Press May 28th, 2018

Written by Wade Rathke

In building an organization for social change it is clear to everyone that the group should be nonprofit, but what does that really mean?  Talking to other people there seems to be an automatic assumption that nonprofit means the same as tax exempt.  Asking for advice from colleagues and lawyers, there is often a kneejerk presumption that if the organization is going to be nonprofit then by definition it should become a tax exempt under the rules of the Internal Revenue Service.

What is the real deal?  Is this an automatic and default option or is this something that an emerging group of leaders and organizers really needs to spend time thinking about when they begin building this new organization?

Structure matters!  Every minute spent on the front end of these decisions may determine the long-term future of the organization, so the time to debate these questions and make the hard decisions is at the very beginning before it prejudices the ends.

A nonprofit organization quite simply is an organization that cannot distribute “profits” or surpluses to its board members.  There are no investors or “owners.”   Certainly, there can be profits or surpluses, and if they are not reinvested in building the organization or spent as quickly as they are earned, then the organization might have to pay taxes.  In many states there are even “stock-based” nonprofits.  Such a structure is common for example in nonprofit building corporations and other asset-holding nonprofits where the governance structure might be created by issuing shares to various other nonprofit or even for-profit organizations to direct the affairs of the organization.   The shares indicate voting strength within the board, but such a share does not mean ownership or trigger any division of income or surpluses.  The shares in a stock-based nonprofit are analogous to a cooperative.  The membership definition in the bylaws of a nonprofit can as easily define members as individuals or families as they can other entities and organizations.

The important thing to remember about a “plain vanilla” nonprofit is that other than not distributing “profits” if there were any, there are NO other restrictions on the activity of a nonprofit, including for political action.  Furthermore, there is no minimum tax liability.  If a nonprofit spends or reinvests and dedicates its financial resources, including membership dues, it pays no taxes.

Tax-exempt in the United States means what it says at a very basic level.  A tax-exempt organization pays no federal taxes.  Depending on the state, county or city, such an organization may enjoy other tax exemptions for purchases or land holdings, especially those that are religious or educational institutions.  The most favorable exemption is as a public charity under section 501c3 of the Internal Revenue Service codes.  Unions, cooperatives, and trade associations enjoy some tax-exempt benefits under other 501c sections as well.

In exchange for the exemption from federal taxation, the organization agrees to limit its political activity and right to public expression in “grassroots lobbying.”  Many organizations and funders insist that the ban on such activity is total or only allowable at a small percentage of the total expenditures of the organization.  Any such assignment is speculative.  There has never been a regulation issued by the IRS or a legal case based on prohibited or allowable activity by a tax-exempt organization that has established a number or guideline, so it is all guess work, unfortunately rooted in the appetite for risk by the leaders or lawyers of such a nonprofit.

Many funding organizations, foundations, and rich individuals insist on funding only tax-exempt organizations.  There is no good reason for them doing so.  In the case of religious organizations, like the Catholic Campaign for Human Development for example, since their contributions come from the public, there are no requirements that would restrict their grants.  For foundations and others, their demand for tax-exempt status from their grantees is implicitly the way that they subcontract the responsibility for oversight for their own tax benefits from themselves to their grantees.  A foundation exercising its own expenditure responsibility for its grant could simply monitor how its grantee of whatever shape and stripe was spending its monies to make sure they qualify as educational and charitable.  Instead most of them protect their own tax benefits by claiming their donations to be tax exempt by forcing the grantee to accept the liability and police their grant.  Granting to a 501c4 organization rather than a “plain vanilla” nonprofit gives no benefits to the grantee, it simply shields the donor from public scrutiny.

An organization may want to create a separate tax-exempt organization as a partner, while maintaining its nonprofit status to allow maximum flexibility of action to its members or mission.  If not, an organization may want to partner with an independent tax-exempt organization whether intermediary, church, or other 501c3, to act as fiscal agent to meet a funder’s requirements.

Under no circumstances in creating an organization should the decision on whether to be tax-exempt or a regular nonprofit be allowed to be dictated by a funder or a lawyer.  In a democratic, membership organization the path forward will almost always dictate being a simple nonprofit, so the future is open to all prospects and possibilities going forward.  Any decision to create a tax-exempt organization is a decision that should be carefully made after full deliberations since the organization’s future will be narrowed severely by the requirements of the Internal Revenue codes in all of their specificity and ambiguity.