Starting and Managing a Nonprofit Organization

A Legal Guide

Bruce R. Hopkins

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118520628
• Edition: 6
• Topic: Betriebswirtschaft
• Subtopic: Non-Profit- & gemeinnützige Organisationen

Nuts-and-bolts guidance on the laws, rules, and regulations governing the nonprofit sector—from leading nonprofit law expert, Bruce R. Hopkins

Nonprofits must comply with stringent federal and state laws due to their special tax-exempt status; the government's ultimate threat is revocation of a nonprofit's tax-exempt status, which usually means the nonprofit's demise. Written in plain English, not "legalese, " Starting and Managing a Nonprofit Organization: A Legal Guide, Sixth Edition, provides essential guidance for those interested in starting nonprofits, as well as valuable advice for leaders of established organizations.

• Revised and expanded to include updated information on changes in laws, rules, and regulations governing the nonprofit sector
• Covers federal tax law, nonprofit, governance, the annual information return (Form 990), charitable giving rules, and current IRS ruling policy
• Presents essential, practical legal information in easy-to-understand English
• Explains the applications and implications of corporate, tax, and fundraising laws for nonprofits

This easy-to-read resource contains essential information on virtually every legal aspect of starting and operating a nonprofit organization from receiving and maintaining tax-exempt status to tips for successful management practices.

Part One

Starting a Nonprofit Organization

Chapter One

What is a Nonprofit Organization?

One of the most striking features of life as we settle into the third millennium is the awesome sweep of societal reform around the globe. Freedom of thought and action is now permitted in societies that previously knew only totalitarianism and suppression. Frequently, a country earns the label emerging democracy by introducing startling economic and political changes. Sometimes, this is accomplished by elections; sometimes, a revolution is necessary. Struggles for individual freedom are today commonplace throughout the world, whether in Eastern Europe, on the African continent, or in the roiling Middle East.

Countries that are planning transitions to a democratic state are discovering a fact that some Western countries learned a long time ago: In order to create and maintain economic and political freedom, which is the essence of a true democracy, the power to influence and cause changes cannot be concentrated in one sector of that state or society. There must be a pluralization of institutions in society, which is a fancy way of saying that the ability to bring about changes and the accumulation of power cannot belong to just one sector—namely, the government. A society that has achieved this type of pluralization is sometimes known as a civil society.

A strong democratic state has three sectors: a government sector, a private business sector, and a nonprofit sector. Each sector must function effectively and must cooperate with the others, to some degree, if the democracy is to persist for the good of the individuals in the society. A democratic society must be able to make and implement policy decisions with the participation of all three sectors. Ideally, a democratic society can solve some of its problems with minimal involvement of government if there is a well-developed and active nonprofit sector—charitable, educational, scientific, and religious organizations; associations and other membership organizations; advocacy groups; and similar private agencies.

Of all countries, the United States has the most highly developed sector of nonprofit organizations. The reach of the U.S. government is often curbed by the activities of nonprofit organizations, but that is a prime mark of a free and otherwise democratic society. The federal, state, and local governments acknowledge this fact (sometimes grudgingly) by exempting most nonprofit organizations from income and other taxes and, in some instances, allowing tax-deductible gifts to them. These tax enhancements are crucial for the survival of many nonprofit organizations.

When an individual in the United States perceives either a personal problem or one involving society, he or she does not always have to turn to a government for the problem's resolution. The individual, acting individually or with a group, can attempt to remedy the problem by turning to a nongovernmental body. There are obvious exceptions to this sweeping statement: Governments provide a wide range of services that individuals cannot, such as national defense and foreign policy implementations. Still, in U.S. culture, more so than in any other, an individual is often likely to use nongovernmental means to remedy, or at least address, personal and social problems.

A Bit of Philosophy

For most Americans, this mind-set stems from the very essence of our political history—distrust of government. We really do not like governmental controls; we prefer to act freely, as individuals, to the extent it is realistic and practical to do so. As the perceptive political philosopher Alexis de Tocqueville wrote in 1835, “Americans of all ages, all conditions, and all dispositions constantly form associations” (meaning nonprofit organizations) and “[w]henever at the head of some new undertaking you see the government in France, or a man of rank in England, in the United States you will be sure to find an association.” About 150 years later, John W. Gardner, founder of Common Cause, observed: “In the realm of good works this nation boasts a unique blending of private and governmental effort. There is almost no area of educational, scientific, charitable, or religious activity in which we have not built an effective network of private institutions.”

This “effective network of private institutions” (the nation's nonprofit organizations) is called the independent sector, the voluntary sector, or the third sector of U.S. society. For-profit organizations are the business sector; the governmental sector is made up of the branches, departments, agencies, and bureaus of the federal, state, and local governments.

Nonprofit organizations, particularly charitable ones, foster pluralization of institutions and encourage voluntarism. Society benefits not only from the application of private wealth to specific public purposes but also from the variety of programs that individual philanthropists, making gifts of all sizes, make available for support. Program choice–making is decentralized, efficient, and more responsive to public needs than the cumbersome and less flexible government allocation process. As John Stuart Mill observed, “Government operations tend to be everywhere alike. With individuals and voluntary associations, on the contrary, there are varied experiments, and endless diversity of experience.”

Contemporary writing is replete with statements of these fundamental principles. Here are some examples:

... the associative impulse is strong in American life; no other civilization can show as many secret fraternal orders, businessmen's “service clubs,” trade and occupational associations, social clubs, garden clubs, women's clubs, church clubs, theater groups, political and reform associations, veterans' groups, ethnic societies, and other clusterings of trivial or substantial importance.—Max Lerner

... in America, even in modern times, communities existed before governments were here to care for public needs.—Daniel J. Boorstein

... voluntary association with others in common causes has been thought to be strikingly characteristic of American life.—Merle Curti

We have been unique because another sector, clearly distinct from the other two [business and government], has, in the past, borne a heavy load of public responsibility.—Richard C. Cornuelle

The third sector is ... the seedbed for organized efforts to deal with social problems.—John D. Rockefeller

... the ultimate contribution of the Third Sector to our national life—namely, what it does to ensure the continuing responsiveness, creativity and self-renewal of our democratic society.—Waldemar A. Neilsen

... an array of its [the independent sector's] virtues that is by now fairly familiar: its contributions to pluralism and diversity, its tendency to enable individuals to participate in civic life in ways that make sense to them and help to combat that corrosive feeling of powerlessness that is among the dread social diseases of our era, its encouragement of innovation and its capacity to act as a check on the inadequacies of government.—Richard W. Lyman

The problems of contemporary society are more complex, the solutions more involved and the satisfactions more obscure, but the basic ingredients are still the caring and the resolve to make things better.—Brian O'Connell

Nonprofit Organizations and Law

The English language does not serve us well in this context, in that the term nonprofit organization is often misunderstood. This term does not refer to an organization that is prohibited by law from earning a profit (that is, an excess of gross earnings over expenses); nonprofit does not mean no profit. In fact, it is quite common for nonprofit organizations to generate profits. (These make the better clients.) Rather, the definition of nonprofit organization essentially relates to requirements as to what must be done with the profit earned or otherwise received. This fundamental element of the law is found in the doctrine of private inurement (see Chapter 5).

The word nonprofit, by the way, should not be confused with the term not-for-profit (although it often is). (For inexplicable reasons, the accounting profession prefers the phrase not-for-profit.) The former describes a type of organization; the latter describes a type of activity. For example, in the federal income tax setting, expenses associated with a not-for-profit activity (namely, one conducted without the requisite profit motive, as in the nature of a hobby) are not deductible as business expenses.

The concept in law of a nonprofit organization is best understood through a comparison with the concept of a for-profit organization. A fundamental distinction between the two types of entities is that the for-profit organization has owners that hold the equity in the enterprise, such as stockholders of a corporation. The for-profit organization is operated for the economic benefit of its owners; the profits of the business undertaking are passed through to them, such as by the payment of dividends on shares of stock. That is what is meant by the term for-profit organization: It is an entity that is designed to generate a profit for its owners. The transfer of the profits from the organization to its owners is pure private inurement—the inurement of net earnings to them in their private (personal) capacity. For-profit organizations are supposed to engage in private inurement.

By contrast, a nonprofit organization is not permitted to distribute its profits (net earnings) to those who control it, such as directors and officers. Normally, a nonprofit entity does not have owners; a few states allow nonprofit corporations to issue non–dividend paying stock. The U.S. Supreme Court has contemplated this point only once, writing that a “nonprofit entity is ordinarily understood to differ from a for-profit corporation principally because it is barred from distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trustees.”

Simply stated, a nonprofit organization is an entity that is not permitted to engage in forms of private inurement. This is why the private inurement doctrine is the substantive defining characteristic that distinguishes nonprofit organizations from for-profit organizations for purposes of the law. To reiterate: Both nonprofit and for-profit organizations are legally able to generate a profit. Yet, as the comparison between the two types of organizations indicates, there are two categories of profit: one is at the entity level and one is at the ownership level. Both categories of entities can yield entity-level profit; the distinction between the two types of entities pivots on the latter category of profit.

Why, then, the confusion as to the meaning in law of the term nonprofit organization? The answer: For-profit and nonprofit organizations often look alike. (This fact is behind, for example, today's raging debates about the difference between tax-exempt and for-profit hospitals and exempt credit unions and commercial banks.) The characteristics of the two categories of organizations are often identical, in that both mandate a legal form (see discussion following), have directors (or trustees) and officers, have employees (and thus pay compensation and other employee benefits), face essentially the same expenses (such as for occupancy, supplies, travel, and, yes, legal and other professional fees), make investments, enter into contracts, can sue or be sued, produce goods and/or services, and (as noted) generate profits.

Legal Form

What form should a prospective nonprofit organization take? A lawyer may say, “It must be a separate legal entity.” What does that mean?

A nonprofit organization generally must be one of three types: a corporation, a trust, or an “other” (usually an unincorporated association). In recent years the limited liability company has emerged as a possible form. (Occasionally, a nonprofit organization is created by a legislature.) A common element in each is that there should be a creating document (articles of organization) and a document containing operational rules (bylaws).

Keep in mind that before an organization can be tax-exempt, it must be a nonprofit organization. Nonprofit organizations are basically creatures of state law; tax-exempt organizations are basically subjects of federal tax law. State tax exemption tends to follow the contours of the federal tax law (although the state real estate tax exemption rules are likely to be more stringent).

Once the decision has been made to form a nonprofit organization, the legal form of the organization must be considered. This is basically a matter of state law; the laws of the state in which the headquarters is based will govern this decision.

Assuming that the nonprofit organization is expected to qualify as a tax-exempt organization under both federal and state law, it is essential to see whether a particular form of organization is dictated by federal tax law. In most cases, federal law is neutral on the point. In a few instances, however, a specific form of organization is required to qualify as a tax-exempt organizati...