Co-working has exploded in the last five years. Essentially, co-working spaces are places where workers – typically freelancers, self-employed individuals and start-up ventures – can go to work while being surrounded by like-minded, creative entrepreneurs without having to rent their own offices. Many co-working spaces have a mission to create social change and spur community rejuvenation, making them of great interest to the social impact sector.
Table of contents
- Key Considerations When Deciding Whether to Form a For-profit or Tax-exempt Entity
- A. Does the Founder Want to Remain in Control?
- B. Where Will Funding Come From?
- C. Will the 501(c)(3) Restrictions Limit Activities?
- D. How Much Taxable Income is Generated?
- E. Will the Co-working Organization Qualify for 501(c)(3) Tax Exemption?
One of the first decisions a founder of a co-working space must grapple with is whether to form the organization as a for-profit or tax-exempt entity. This decision is critical to the organization’s success as it will drive (or potentially limit) the activities the organization can pursue.
For co-working organizations, competing goals and incentives can complicate the decision whether to structure the organization as a for-profit or tax-exempt entity. Below we have distilled the most common decision points faced by co-working founders and leaders. We do not attempt to advise one-way or the other, but instead attempt to illustrate the factors the founders of a co-working organization should take into account when making this critical decision.
Key Considerations When Deciding Whether to Form a For-profit or Tax-exempt Entity
Accordingly, the factors discussed below address the key considerations founders should take into account when deciding whether to form as a for-profit or tax-exempt entity.
A. Does the Founder Want to Remain in Control?
The fact that no one owns a nonprofit is a concern for many founders, but should not be prohibitive when choosing to form as a for-profit or a nonprofit. Most nonprofits are governed by a board of directors. The board’s role is to set policy and strategy and oversee the organization’s performance.
It is common for nonprofit founders to serve as the chief executives of the organizations they found. In practice, the collaborative approach many co-working spaces voluntarily adopt is similar to a board’s decision-making process. Another advantage of the nonprofit model is that the board can help steer the organization once the founder leaves, enhancing the organization’s sustainability over the long term.
B. Where Will Funding Come From?
When deciding whether a for-profit or nonprofit structure is the best fit for a new venture, the most likely source of funding is one of the first questions to consider. Will the fees the co-working space is able to charge fully offset its expenses? If not, contribution revenue may need to be part of the funding picture. In that case, most contributors prefer to contribute to 501(c)(3) organizations to take advantage of the charitable income tax deduction.
C. Will the 501(c)(3) Restrictions Limit Activities?
The tax advantages bestowed upon tax-exempt entities come at the cost of greater tax regulation. Understandably, many co-working organizations worry that the limits on a 501(c)(3)’s activities will overly constrain their activities. In practice, it is likely that many co-working organizations would not be greatly impacted.
The Key Limits for Public Charities
- A 501(c)(3) may not distribute earnings to private shareholders or individuals through dividends, distributions or other means.
- Transactions with insiders must be at fair market value and on arm’s length terms;
- Lobbying efforts are limited;
- No campaign activity is allowed;
- Business activities unrelated to the organization’s tax-exempt purposes will be taxable at corporate income tax rates; and
- A publicly available information return must be filed each year with the IRS in lieu of a tax return.
Many co-working organizations may find that these restrictions are in line with how they currently operate or plan to operate. Others may find the changes required to make their plans fit within these parameters to be overly burdensome.
D. How Much Taxable Income is Generated?
As the organization’s taxable revenue increases, so does the incentive to form as an exempt nonprofit. Three misconceptions drive this issue:
- Nonprofit ‰ Tax-exempt. Being a nonprofit does not mean the organization is tax-exempt. The organization must apply to the IRS for tax-exempt status.
- Tax-exempt Nonprofits Can Make Money. Contrary to what some believe, a tax-exempt organization can have revenue in excess of expenses. They are simply required to (a) hold revenues in excess of expenses in reserve or (b) invest them back into programs. That is, they cannot distribute profits to private interests.
- Tax-exempt Nonprofits Can Pay Reasonable Compensation. Tax-exempt co-working organizations can charge patrons reasonable fees and can pay their employees reasonable salaries at market rates. However, if the fee schedule is designed to maximize fee revenue in a manner that is similar to a for-profit office suite, the organization is unlikely to qualify for tax-exempt status.
E. Will the Co-working Organization Qualify for 501(c)(3) Tax Exemption?
While creating a low-cost high-energy space for entrepreneurs and community members may be a beneficial thing to do, it does not necessarily qualify for tax exemption under 501(c)(3). However, many co-working organizations, both for-profit and non-profit, share a social mission “ putting on community events, hosting educational programming for community members, etc. Accordingly, the tax-exempt purposes co-working organizations are most likely to qualify for include the following:
1. Economic Development
It can be tricky to get the IRS to recognize economic development entities as 501(c)(3) organizations. To obtain a 501(c)(3) determination, the organization must demonstrate that it is not just promoting economic development but developing an economically depressed area.
There are many considerations such as crime statistics, blight, high unemployment rates, etc. that can be used to prove to the IRS that an area is economically depressed. Alternatively, the government often designates certain geographic areas as economically depressed. Often, these designations include gentrifying sections of a city’s urban core that are desirable to co-working organizations.
Education is another common basis for 501(c)(3) status. Many co-working organizations regularly host skills training seminars for members. The Treasury Regulations define education as:
- “the instruction or training of the individual for the purpose of improving or developing his capabilities”
- “the instruction of the public on subjects useful to the individual and beneficial to the community.”
Based on this definition of education, both in-house seminars and events open to the public qualify as educational so long as they instruct people on useful subjects that improve their skills or are beneficial to the community.
3. Lessening of Government Burdens
It is possible that a co-working space could qualify for 501(c)(3) status because it lessens the burdens of government; however, this is the most difficult test to meet and the least likely to be successful. The IRS includes “lessening of the burdens of government” in the definition of the term “charitable.” As stated in Rev. Rul. 85“2, 1985“2 C.B. 178, an organization is lessening the burdens of government if:
- its activities are activities that a governmental unit considers to be its burdens; and
- the activities actually lessen such governmental burden.
The organization must demonstrate that a governmental unit considers the organization to be acting on the government’s behalf, thereby actually freeing up government assets ” human, material, and fiscal ” that would otherwise have to be devoted to the particular activity. This determination is based on facts and circumstances.
If 501(c)(3) does not seem like a good fit for a co-working organization, a 501(c)(4), also known as a Social Welfare Organization, could be a better fit. A Social Welfare Organization is exempt from federal income tax and can both lobby and engage in some political activity; however, gifts to it are not tax deductible. Organizations that merely want to avoid income tax may want to consider applying for recognition as a Social Welfare Organization.
Co-working organizations must be strategic when making formation decisions. Our hope is by weighing the issues discussed above, potential founders will better sort through the pros and cons of forming as an exempt nonprofit.