Just what is a tax-exempt nonprofit corporation?

I love posing and discussing big picture questions that we, as busy human beings, never stop to think about. This is one of my favorites because exploring it illuminates so many helpful concepts for nonprofit professionals and directors. Let’s dig in: what is a tax-exempt nonprofit corporation? I’ll break it down to its three components: tax-exemption, nonprofit designation, and corporate status.

A “corporation” is a legal entity formed under state law.  Understanding their purposes, benefits, and governance within their original for-profit context is critical to understanding how they function within the nonprofit context.

The law treats a corporation like a person in that it can enter contracts, can sue and be sued, borrow money, own assets, and be taxed and pay taxes.  Each state has a statute that authorizes the creation of a corporation by filing a “charter” (also knowns as “articles of incorporation”) with the state’s secretary of state and – presto! – you got yourself a corporation.  The charter sets out the essential terms that the law requires for a corporation to exist – like the purpose, its address, and who is authorized to receive official mail and notices. 

Corporations were invented by clever lawyers as far back as the 1600s for three reasons:  (1) to allow people (called “shareholders”) to buy pieces of a business (called “shares”) as a passive investment (i.e., they aren’t involved in the day-to-day running of the business), (2) to limit the potential loss of shareholders’ investments to the amount they invest as opposed to being liable for the corporation’s losses (called “limited liability”) and (3) to provide a legal force field around the people involved in the corporation – the shareholders, officers, directors, and employees – so they cannot be sued and risk losing their personal assets (called “the corporate shield”).

Regarding the first two reasons, the corporate model resulted in a new source of funding for a corporation’s business operations (called “capital”); for the shareholders, it provided a new means for generating wealth through distributions of excess cash (called “dividends”) and when shareholders sell shares to other investors for more than they paid for them (called “return on investment” or “ROI”).  The limited liability aspect also allowed risk averse investors to know exactly what their potential losses were in case the business went belly up. 

Lawmakers realized early on that this new model of passive investment presented an opportunity for abuse by unscrupulous businesspeople, so the law requires a group of people (called “directors,” who collectively form a “board”) for each corporation to oversee its operations and protect against mismanagement and fraud (called “governance” or “to govern”) under a legal duty (called “fiduciary duty”) to make all decisions related to the corporation solely in the best interests of the shareholders.  Fiduciary duty is no joke – it is the highest level of duty that exists under the law.  Shareholders can hold the directors accountable by either voting to replace them at regular shareholder meetings or by suing them for damages they cause by breaching their duty (called a “derivative lawsuit”).

An essential element of governance is for directors to build an infrastructure for the corporation that informs and communicates to the people responsible for the day-to-day operations (called “officers”) how they should run things in accordance to the wishes of the board, in compliance with applicable with laws, and within limits of authority set by the board.  This infrastructure consists of written directives and statements (called “policies”) that share the directors’ vision of what they want the corporation to achieve (called the “mission”) and how they want to achieve it (the “strategy” or “strategic plan).  It is then the officers’ sole responsibility to execute (“execute” > “executive,” get it?) the strategy within the policies adopted by the board to achieve the mission.

Regular corporations (called “C corporations” and “for-profits”) have one goal:  to make as much money as possible for the shareholders.  Fairly recently, states have added new designations for corporations that allow directors to consider factors relevant to social impact and good when making decisions (called “B corporations” or “benefit corporations”).  This status allows directors to take into consideration the social impact of their decisions instead of just profit maximization (e.g., environmental impact) and insulates them from liability for doing so.

The third reason corporations exist – the corporate shield – ensures that the shareholders, officers, directors, and employees they cannot be sued personally and lose their personal assets.  Prior to corporations, if you owned a business, you were a “sole proprietorship” or “partnership” and if the business harmed a customer or stiffed another business they could sue you personally and collect a judgment by taking your stuff – house, money, crossbow, armor, favorite horse and buggy.  To maintain the corporate shield, the directors must do all the things the law requires to keep it legit, e.g., have regular meetings, have written rules about how it will run the corporation (called “bylaws”) and follow them, and keep a written record of the decisions is makes and how it made those decisions in the best interests of the shareholders (called “minutes”).  If the government’s legal watchdogs (called “regulators”) or shareholders ever think that the directors did not do their job and fulfill their duties, these minutes will be the first thing examined in an investigation, or a derivative lawsuit brought by the shareholders.

So, in sum, corporations exist to promote people investing in businesses, increasing their wealth and providing operating capital to businesses, and to protect the people who are running the businesses so they can run them without risking their personal assets. Understanding their purpose, benefits, and governance is critical to understanding how they apply within the nonprofit context.

“Nonprofit” status also comes from state law, specifically from nonprofit corporation statutes, because it is a designation for a corporation.  A nonprofit differs from a for-profit corporation in only two fundamental ways. First, its charter must reflect a purpose, articulated in the nonprofit corporation statute, that performs some social function benefiting the public at large.  Second, while a for-profit exists to maximize the wealth of its shareholders, a nonprofit cannot enrich any individual – especially, an insider of the nonprofit like an officer or director.  This is why the regulators will not approve a nonprofit if its reach is too narrow (e.g., a nonprofit set up to help one family whose house has burned down or one established by parents of a sick child to pay for treatments of a horrible disease).  No matter how noble a cause, if the focus is too narrow it will not be approved as a nonprofit.

Keep in mind that nonprofits constitute one of three sectors of the American economy – the nonprofit, public/government, and private sectors.  I like to think of nonprofits as the love child of the other two sectors because they serve a broad public function (like the public sector) but are controlled by private individuals utilizing a director and officer governance model (like the private sector).  And just like each of the other two sectors, the regulations that apply to the nonprofit sector are distinct and different from the other two sectors.  Therefore, recognizing its macro status within the national economy is helpful to appreciate why nonprofit attorneys and professionals who function in the public and private sectors are not necessarily equipped to advise and function in the nonprofit sector.  The knowledge base and skills sets are completely different.   

The “tax-exempt” part comes from federal law, specifically IRS Code chapter 501(c).  Most people are familiar with the subchapter 501(c)(3) designation that applies to public charities and private foundations. But there are many other subchapters, like (c)4 for social welfare organizations and political action committees and (c)6 for trade associations.  The tax-exempt designation comes from the fact that, unlike for-profit corporations, IRS does not require an exempt organization (called an “EO”) to pay income tax.  Therefore, all net revenue or profit realized by an EO remains with it.  On the state level, governments exempt EOs from paying sales taxes and/or property taxes.

The unique feature of a (c)3 EO is that its donors can qualify to deduct the value of a donation from their personal income taxes.  This is a very powerful fundraising tool and the reason why most EOs covet the (c)3 and why the IRS scrutinizes application for the status so carefully. 

There are two types of (c)3 EOs:  “public charities” and “private foundations.”  They differ in two ways:  the source of funding and the type of activity.  Regulations require that public charities have a broad base of support from the general public and conduct their own programs (e.g., run a school, operate a hospital, or provide food at a homeless shelter).  A private foundation’s funding comes from one or a few sources (e.g., an individual, a family, or a company) and instead of running its own programs, it grants funds to public charities to fund their programs.   Because private foundations are more heavily regulated, the IRS presumes that an EO applicant is a private foundation unless it convinces it in its application (the “Form 1023”) that it meets the requirements to be a (c)3 EO. 

Conceptually, regulators view the grant of nonprofit and tax-exempt status as a subsidy granted by the tax-paying public because the benefits of the organization flow to the public.  Therefore, they view the American taxpayers as the shareholders of the EO and impose the same fiduciary duties on EO directors and officers as they impose on for-profit directors and offcers.  And the penalties are the same for breaching these duties – personal liability against the offending directors and officers. 

Unlike for-profit shareholders, the American public is far too large to pay attention to each EO, and EOs are easy targets for unscrupulous businesspeople.  Therefore, the regulators have imposed unique and stringent laws and rules to ensure nonprofit directors do their jobs.  This includes a required, very thorough annual tax report (called the “Form 990”) and doctrines that outlaw private benefits to insiders of the EO, specifically, and to any other individual, generally. 

You may be wondering:  So how does that affect paying compensation to employees and executives?  Compensation, of course, is perfectly permissible; the only limitation is that it must be “reasonable.”   To help EOs determine reasonableness for its chief executive, it provide a handy “safe harbor” elegantly dubbed the “The Rebuttable Presumption of Reasonableness.”  This simply provides three things for a board to do when determining compensation and, if done, the IRS will defer to the board’s judgment:  (1) research salaries paid by peer EOs that are comparable in size and scope to its EO; (2) discuss the research amongst the board and, when voting to approve appropriate compensation, reflect the basis for determining the compensation, and (3) contemporaneously with the discussion and vote, create minutes that reflect the rationale and vote for the compensation.

I hope this clarifies the three fundamental principles of tax-exempt nonprofit corporations. If you understand the three elements and how they interrelate, you will be much better equipped as a nonprofit director or officer.

As always, should you have any questions, you can reach me at tmckee@tmckeelaw.com and 615.916.3224.