My First Question for Clients Forming a Nonprofit: Do You Want a Baby?
Often a client comes to me with an idea for a business and is deciding whether to go the nonprofit or for-profit route. Most commonly, the client is weighing exemption from taxes, eligibility for grant-funding, or the "halo effect" of nonprofit status with the downside of complying with all the rules and regulations that constrict nonprofits. They are, therefore, often surprised by the first question I ask: Do you want a baby?
Bear with me.
A distinction between nonprofit and for-profit corporations is the issue of control. Both state and federal law prohibit one person from controlling or benefiting from a nonprofit, while it is perfectly acceptable in the for-profit context. For instance, a Tennessee for-profit may have only one shareholder and she can function as the sole director of the board; nonprofits must have at least three directors. Why the difference? Because for-profit corporations benefit individuals while nonprofits must benefit the public. The three-person requirement for a nonprofit board protects against the corporation being exploited by one director for his or her personal benefit.
Addressing the same concern, the IRS strictly prohibits a tax-exempt organization from benefiting any one individual -- what is known as the "private inurement" prohibition. The directors are bound by law to act only in the best interests of the organization, its mission, and its shareholders -- the taxpaying public.
So what does this have to do with a baby?
Founders of companies often refer to their businesses as their "baby." Indeed, growing a business from an idea to a full-fledged company is in many ways (excluding, of course, physical pain) like giving birth to and raising a child. While treating a business as one's "baby" is appropriate in the for-profit context, it is a precarious mindset in the nonprofit context.
The founder of a nonprofit business needs to understand from the outset that the nonprofit is not, cannot, and never will be his baby.
Control is and will always be with the majority of directors who, at any moment, can cut the founder out by terminating him as an employee and/or expelling him as a director. The history of nonprofits in America is replete with dramatic stories of just that -- much to the dismay of the founders who watched "their nonprofit" move on without them.
So the baby question is meant to focus my clients on this reality and contingency. Apart from any issue of exemption from taxes, eligibility for grant-funding, or the halo effect of nonprofit status, the threshold question is: "Do you want this business to be your baby?" If the answer is "yes", then going the nonprofit route is not only ill-advised, but might be very painful in the long run.
T McKee Law has helped hundreds of clients select and form entities for nonprofit and social enterprise purposes. We’d love to help you if you have any questions.
