Entity Selection for Nonprofits

nonprofit entity selection

Nonprofit entity selection is one of the first important decisions a nonprofit founder makes.  

The Four Types of Entities that can Generally Qualify for 501(c)(3) Status

I. Charitable Trusts

A trust is formed when a donor, (trustor) transfers assets to someone, (trustee), with the express instruction that the trustee will use the donated assets to benefit a specific charitable purpose. Greater privacy is one benefit of forming a charitable trust because a charitable trust can be formed without obtaining permission from, or filing anything with, any governmental body.

Other advantages include the ability to permanently fix the terms of the trust and deny future trustees the power to amend the trust. A key disadvantage is that trustees do not have the protection of the business judgment rule applicable to corporate directors and are, therefore, at greater risk of being held personally liable for trust liabilities.

Even so, the trust can indemnify the trustees. Indemnification can provide significant protection to the trustees so long as the trust has sufficient assets to cover potential liabilities.

Another disadvantage to forming a charitable trust is the trust agreement must be drafted with significantly more care because charitable trusts are governed by both case and statutory law, and are therefore trickier to draft and more difficult to amend.

2. Nonprofit Corporations

The most common form of nonprofit today is a nonprofit corporation. One reason for the nonprofit corporation’s popularity is due to it being relatively easy to form. To form the nonprofit corporation, a person (the incorporator) files Articles of Incorporation with the home state.

Corporations are creatures of state law, so following state rules regarding incorporation is key. A nonprofit corporation operates pursuant to statutes that provide default governance rules.

Once incorporation is complete, directors and officers are elected to manage the nonprofit corporation. The nonprofit corporation then adopts bylaws which are a more specific expression of the corporation’s governance rules but must still comply with state statutes governing nonprofit corporations.

A major advantage nonprofit corporations have over other forms of charitable entities is if a nonprofit corporation is properly managed and operated, it can provide a greater degree of personal liability protection to its directors and officers. This protection is known as the corporate veil and serves to insulate directors and officers from the debts and liabilities of the nonprofit corporation so long as they are fulfilling their fiduciary duties of good faith, due care, and loyalty.

Take note, this protection from liability is not absolute, which is why most nonprofit corporations also purchase directors’ and officers’ insurance.

Finally, those forming Arizona nonprofit corporations that will apply for tax-exempt status should avoid using the state forms as they do not include any of the required tax languages.

3. Unincorporated Associations

An unincorporated association consists of at least two or more people who wish to join together to accomplish a common purpose. To recognize an unincorporated association, the IRS will also require some written document evidencing this intention.

However, no governmental permission or registration is required. An unincorporated association is unlikely to be able to protect its directors or leaders from personal liability, as there is a legal question about whether the unincorporated association is a legal entity separate from its members.

Some states have passed laws providing liability protection to members of unincorporated associations; however, many states, including Arizona, provide no protection for members of unincorporated associations. Therefore, association members in those states risk being held personally liable for association debts.

Further, in the states providing liability protection for unincorporated associations, one member’s actions could theoretically impose liability on the other members. If you are considering operating as an unincorporated association,

It is critical to understand the risk of personal liability. Unincorporated associations are usually chosen by extremely small groups and groups wanting minimal government reporting obligations.

4. Limited Liability Companies

An LLC is formed by filing articles of organization with the state. Internal governance rules are typically expressed in an operating agreement.  Every state has different laws regarding LLCs, so it is important to review the law in the state where the nonprofit is located, as some states specifically allow nonprofit LLCs, and some states require that the LLC have a business purpose.

One downside to choosing an LLC as an organizational structure is that the I.R.S. has thus far made very few rulings as to nonprofit LLCs. For example, until recently, a question remained as to whether a charitable contribution is tax-deductible if it is made directly to a tax-exempt LLC rather than to its 501(c)(3) parent. The IRS answered this question favorably in 2012.

Limited Liability Companies (LLCs) can be recognized as tax-exempt but there is a trap for the unwary. Specifically, an LLC with units and private party members will not qualify for tax-exempt status. Tax-exempt organizations cannot be privately owned; therefore, only an LLC whose member or members are other 501(c)(3) organizations can qualify as tax-exempt.

Although nonprofit entity selection is one of the most important decisions the founder must make. In this author’s opinion,  a nonprofit corporation is the most straightforward and protective option for a stand-alone nonprofit to choose.

On the other hand, 501(c)(3) organizations looking to form subsidiaries may find forming a limited liability company to be a more attractive solution. Donors looking to ensure their intent is followed after their death may prefer a charitable trust. Whichever form your new nonprofit takes, be sure to research your state’s laws regarding nonprofit formation before selecting an entity.

Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations.  Ellis is licensed to practice in Washington and Arizona and advises nonprofits on federal tax and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.

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