Introduction to Nonprofit Organizations - Module 1 of 5

Module 1: Introduction to Nonprofit Organizations

Introduction

You are likely already familiar with for-profit organizations. They comprise most businesses. They exist for the purpose of making and maximizing profits on behalf of their owners, when they be sole proprietors, medium-sized companies or publicly-held corporations owned by shareholders.

Organizations that are run for reasons other than generating profits, such as charities, professional organizations, social clubs, universities, churches and neighborhood cooperatives, are examples of nonprofit organizations. These generally play positive roles in society, promoting the social well-being of the public in some manner on behalf of their stakeholders,[1] who are those that run or support the mission of the nonprofit.[2] Because they are run for the benefit of society, they are granted certain privileges under the law.

There are approximately 1.6 million nonprofit organizations in the United States.[3] The “nonprofit and voluntary sector,” which is the component of the economy made up of nonprofits and employs approximately eleven percent of the American workforce.[4]

Stakeholders looking to incorporate as a nonprofit generally must first draft their ideas into a mission statement or business plan, to memorialize the purpose of the organization. Nonprofits must then incorporate under the laws of a state. This requires drafting and filing of a charter, also referred to as the articles of incorporation, which sets forth the purpose of the organization, and bylaws, which establish rules under which the organization will operate.  

The documents used to incorporate and operate a nonprofit are referred to as its “governing” documents. These documents guide the organization’s leadership, such as its board of directors, officers and subsidiaries.  Some governing documents may be required by state law, including rules for the organization’s board of directors, directories and public policies.

Once incorporated, nonprofit organizations may apply for certain legal benefits available to nonprofits. The most important of these is the ability to obtain tax “exempt” status with the IRS, which allows it to receive donations free of gift tax, allows donors to deduct donations on their income tax returns and exempts some of the organization’s activities from income taxes.  Tax exempt status is vitally important to many nonprofits as it encourages donations that can be used to support the mission of the organization. 

While each state has its own set of laws governing the incorporation of nonprofit organizations, the federal government, specifically the IRS, has established rules governing nonprofit tax-exempt status, which is covered under the Internal Revenue Code’s Section 501. Nonprofit organizations must maintain their nonprofit status by adhering to all IRS rules pertaining to their missions, by filing annual Form 990s (tax returns designated for exempt entities), and by filing various reports required by state law.  Failing to meet state or federal requirements may cause a nonprofit organization to lose its status and to possibly face fines and penalties.[5]

501(c)(3) Organizations

People often refer to an organization’s type by its IRS tax-exempt classification, because these classifications, such as “501(c)(3),” have become synonymous with being a nonprofit. These classifications refer to the section of the Internal Revenue Code, Section 501(c), that lists the types of organizations and the necessary conditions to be considered tax exempt.[6] There are twenty-nine classifications in all. We’ll briefly go over some of the most common types of nonprofit entities. 

501(c)(3) Organizations are often generally referred to as “charitable” organizations but include more than what you might think of as “charities.” An organization can qualify as a 501(c)(3) organization as long as it is “operated exclusively” for religious, charitable, scientific, public safety, literary or educational purposes; to foster national or international sports competition or prevent cruelty to children or animals.  501(c)(3) organizations make up half of all nonprofits.[7]

Charities face particular scrutiny relating to their purposes and activities, because they are in position to collect, handle and spend money on behalf of donors and members. While most charities are no-doubt legitimate, law-abiding organizations, each year, the federal government investigates, freezes and shuts down organizations that, typically through a small number of unscrupulous people, engage in fraudulent financial activities.  

In 2013, the Washington Post published an expose entitled “Inside the hidden world of thefts, scams and phantom purchases at the nation’s nonprofits,” pointing to examples of embezzlement and fraud in financial disclosures required by state and federal governments.[8]  Often, these cases of misconduct make for tantalizing headlines as charities are typically thought of as protecting and promoting the public and social welfare. While it is safe to say that most charitable organizations are honorable, organizations can certainly suffer from some of the same corruption that exists in the for-profit corporate world.   

The Post found that, between 2008 and 2012, more than 1,000 nonprofit organizations checked a box on their IRS Form 990, the tax return form for exempt organizations, that they had experienced a “diversion” of assets, meaning embezzlement or other fraud.

High profile examples of nonprofits that have fallen victim to fraud include The American Legacy Foundation, known for its anti-tobacco advertisements entitled “Truth.” Legacy lost an estimated $3.4 million from purchases linked to a sham business started by a former assistant vice president at the organization. Another example is Georgetown University, who suffered a significant loss by an administrator that paid himself $390,000 in additional compensation from a secret bank account previously unknown to the university.  According to government auditors, these stories are all too common, and serve as cautionary tales for those that endeavor to create and operate a charitable organization.

Charitable Purpose

The IRS defines charitable purpose as including “relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erection or maintenance of public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.[9] Still, courts must sometimes grapple with the question of whether organizations with multiple missions or missions that may violate public policy qualify.

In IHC Health Plans, Inc. v. Commissioner, an organization called “Intermountain Health Care” was formed in 1970 as a Utah nonprofit corporation by the Church of Jesus Christ of Latter-Day Saints to manage 15 hospitals previously owned by the church. In the 1980s, IHC formed a subsidiary called IHC Health Services, and transferred ownership of the hospitals to this subsidiary. Both IHC and IHC Services were granted tax-exempt status under 501(c)(3). IHC then created three health maintenance organizations: “IHC Health Plans,” “IHC Care,” and “IHC Group.” IHC controlled the HMOs, and IHC Health Services provided them with human resources and other business management functions. 

The IRS determined that none of the three HMOs qualified for tax exempt status as “charitable” organizations because they did not demonstrate that they had “charitable purposes” and that the charitable purposes were their primary purposes. The court upheld the IRS decision, holding that the “primary purpose” rule means that a health-care provider must make its services available to all in the community and provide additional community or public benefits, so that the public benefit is the primary purpose for which the nonprofit operates. 

In the case of the HMOs, while their “promotion of health for the benefit of the community” was deemed a charitable purpose, the court determined they did not operate primarily to benefit the community by providing health services “plus” something extra to benefit the community. Thus, the revocation of their exempt status was upheld.[10]  

In 1967, the IRS announced that it would no longer grant tax exempt status to schools receiving state aid that engaged in racial discrimination.  Bob Jones University, a private education and nonprofit organization located in Greenville, South Carolina, was stripped of its tax-exempt status due to a school policy that banned interracial dating by its students, and threatened those who did engage in interracial dating with expulsion.[11]  The school claimed that this policy upheld what it referred to as genuine “fundamentalist Christian beliefs” that people of different races should not marry. The Supreme Court held that the school’s policy on interracial dating meant that the school did not engage in “beneficial and stabilizing influences in community life,” as required by 501(c)(3). Moreover, there was an “overriding government interest” in prohibiting racial discrimination that outweighed the school’s right to free exercise of religion in this manner.[12]

501(c)(5) and 501(c)(6) Organizations

501(c)(5) Organizations are labor unions and agricultural and horticultural associations. Labor unions are organizations that form when workers associate to engage in collective bargaining with an employer regarding to wages and benefits. Agricultural organizations are connected to farming, livestock, crops and the cultivation of aquatic, plant or animal resources.[13] 

These organizations must demonstrate that their purpose comports with the IRS guidelines for their classifications and other laws. Labor unions are also protected by the National Labor Relations Act of 1935, which grants labor unions the legal right to represent employees.[14] Moreover, the National Labor Relations Board adjudicates disputes between labor unions and employers and manages a complaints process and procedure that enforces federal labor laws, with the goal of maintaining a fair and open labor market.[15] 

Horticultural and Agricultural organizations have an interest in staying abreast of the laws that govern agriculture.  The United States Department of Agriculture is dedicated to “leadership on food, agriculture, natural resources, rural development, nutrition, and related issues based on public policy, the best available science, and effective management.”[16] The USDA oversees a system of administrative law judges that adjudicate cases related to agriculture.  For-profits and nonprofits alike closely monitor the special rules and case outcomes that drive this area of the economy.  In addition, laws such as the Clean Air Act, Clean Water Act and other environmental laws, impact and be of deep interest to agricultural nonprofits.[17]

501(c)(6) Organizations include business leagues and membership and trade associations. They represent the interests of individual professionals, business chambers of commerce and professional associations of architects, engineers, doctors, lawyers, teachers and other professional groups.  Business leagues, membership and trade associations may engage in legislative activities to promote the development of laws that benefit the interests of their members, as opposed to 501(c)(3) charitable organizations, which may not lobby or establish political action committees or funds. 

There are certain activities that can jeopardize a 501(c)(6) organization’s exempt status. Commercial activities, in particular competing with for-profit corporations for business or sales or maintaining business activities that are unrelated to the tax-exempt purpose of the organization, can cause a 501(c)(6) organization to lose its exempt status.  Likewise, if a membership organization has little or no actual involvement by its members, but is rather driven by a single individual, or when members have little or no influence in the organization, the IRS may revoke its status. 

Beyond the tax code, there are other important federal and state laws and regulations that affect membership organizations. For example, while 501(c)(6) organizations may engage in unlimited lobbying activities, they must also ensure that they comply with all lobbying disclosure requirements related to the 1995 Lobbying Disclosure Act or face stiff penalties. In addition, professional membership organizations for architects, engineers, lawyers and doctors, among others, must also be constantly mindful of federal anti-trust laws. We will discuss some of the federal laws pertaining to business leagues and membership associations in more detail in a later module.

Other Categories of Non-Profit Organizations 

Organizations classified under 501(c)(7), 501(c)8 and 501(c)10 of the Code include social and recreational clubs, fraternal beneficiary societies, and domestic fraternal societies. 

Social clubs that seek 501(c)(7) classification include alumni associations, college fraternities or sororities operating chapter houses, country clubs, hunting, fishing, tennis, swimming and other similar sport clubs, dinner clubs that provide meeting places and resources for members and hobbyist, garden and variety clubs.  Social clubs will not be afforded exempt status if they engage in discrimination based on race, color or religion.  A club may, in good faith, limit its membership to a particular religion to further the principles and teachings of its religion. However, it may not do so to exclude people of a particular race or color.[18] We’ll discuss laws governing discrimination, equal protection and other constitutional law issues in a later module.

A 501(c)8 fraternal beneficiary society must demonstrate that:

1) It is a fraternal organization,

2) it operates under what is referred to as the “lodge” system, or for the exclusive benefit of the members of a fraternal organization operating under the lodge system, and

3) provides for the payment of life, sick, accident, or other benefits to the members of the society, order or association or their dependents.[19] 

By contrast, 501(c)(10) organizations do not provide for payment of insurance benefits to its members, and so may arrange with an insurance company to provide optional insurance without jeopardizing its tax-exempt status.[20]

Credit unions and other mutual financial organizations are classified under 501(c)(14) of the IRS code, and, as part of the banking industry, are heavily regulated. A credit union is “a cooperative association that makes small loans to its members at low interest rates and offers other banking services (such as savings and checking accounts).”[21] Usually, members of a credit union pool their money to secure loan rates and other benefits ordinarily not available to individual consumers.

Federal credit unions are organized under the Federal Credit Union Act and are tax exempt under IRS code Section 501(c)(1).  Other credit unions and nonprofit financial organizations are covered by 501(c)(14). State-chartered credit unions must demonstrate that they are chartered under the relevant state credit union laws. 

In our next module, we will look at the requirements and steps for incorporating as a nonprofit.