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Nonprofit Basics: Overview of Nonprofit Charitable Organization Types: Corporation, LLC, Trust, Association and Fiscal Sponsorship

May 30, 2022 Podcast

Welcome to EO Radio Show, Your Nonprofit Legal Resource, brought to you by the Exempt Organizations Group at Farella Braun + Martel. My name is Cynthia Rowland, and I'm a partner at Farella. I'm a business and tax lawyer with more than 30 years of experience advising clients on nonprofit and charity law.

This nonprofit basics episode gives an overview of the choices of legal form for nonprofit organizations that are intended to be tax-exempt under U.S. law. Before we even get to the questions of tax exemption, charitable fundraising, regulatory compliance, governance, and the myriad legal issues that charity and foundation leaders need to think about, a basic understanding of the legal entity is really important. So, that's where I'll start.

There are basically four different types of nonprofit entities. First, there's the nonprofit corporation, second, the limited liability company, third, the charitable trust, and finally, the unincorporated association. After giving an overview of these forms of legal entities, I'll talk a little bit about fiscal sponsorship and what that means as a legal matter.

To understand these categories of nonprofit corporations, we look first to state law which is what defines these entities as legal persons with the right to own property and take actions that are respected by business enterprises and regulatory bodies. Most states follow a format where there are nonprofit public benefit corporations, nonprofit mutual benefit corporations, and nonprofit religious corporations.

Now, these are not to be confused with so-called benefit corporations or public corporations, which tend to be a different kind of vehicle formed for private ownership. Those forms are a separate topic, but not relevant for organizations that are formed exclusively for charitable purposes and intend to attract charitable donations so that they can operate as a tax-exempt charity or foundation.

So, back to the top. A nonprofit public benefit corporation is the most common form of charitable nonprofit that we see in the charitable sector now. State corporations laws describe the basic rules for public benefit corporations, which include the following.

First, nonprofit public benefit corporations do not have shareholders and are formed for charitable purposes. The basic laws that describe the governance provisions and limitations on activities are found in the state corporations code. These rules include special provisions that address insider transactions, director and officer responsibilities, default provisions of the articles of incorporation and bylaws, and some special rules on liquidation that require that all assets remaining can be distributed only to another charitable enterprise. The corporation begins its legal existence with the filing of a document with the secretary of state in the selected state. Once that filing is complete, this fictitious business entity becomes a legal person under state law.

A related form of organization, the nonprofit mutual benefit corporation, is formed for the benefit of its members. Mutual benefit corporations often are also qualified as tax-exempt under the Internal Revenue Code. However, those are formed for the benefit of members and generally are not entitled to receive tax-deductible charitable contributions. So, when we think about a nonprofit corporation that's intended to be a tax-exempt charity or private foundation, we usually want to start with the question of whether a nonprofit public benefit corporation is the preferred form.

The third form of nonprofit we typically see is the religious corporation, which may or may not also be formed as a church. The topic of religious organizations and churches deserves its own podcast. So, we'll cover that in another episode.

The limited liability company as a nonprofit organization is also sometimes a good choice. However, the LLC structure is rarely advantageous as compared to a nonprofit public benefit corporation. An LLC is also a creature formed to meet requirements of state law. But rather than shareholders, an LLC typically has members and the governance structure is very flexible. An LLC that is intended to be a tax-exempt charity that raises charitable contributions must include certain limitations in its articles of the organization and its operating agreement that limit itself to charitable activities and that prohibit private benefit.

As charitable LLC structures become more developed and better understood by the IRS and state charity regulators, we may see them formed more often. However, for the new nonprofit corporation that is looking to use well-known forms and standard documents, founders will most likely find it faster and easier to create a nonprofit public benefit corporation. It will also be less expensive to form and operate.

The charitable trust is a different thing altogether. A little background on trust law. Many years ago, before the advent of nonprofit corporation laws, charitable trusts were the customary format for holding charitable funds rather than a standalone legal entity, which is what a corporation is.

A charitable trust is not an entity, rather it's a fiduciary relationship between the trustee or trustees and the assets of the trust. The trustees hold the assets and trusts for the charitable beneficiaries or charitable purposes. There are a number of legal consequences to using a charitable trust form rather than a nonprofit corporation. And while there are certainly situations where charitable trust is a better alternative, the biggest downside is that the trustees of a charitable trust don't have the level of protection from personal liability that directors of a corporation have under state law. Financial institutions and state regulators are also less familiar with charitable trusts than they are with nonprofit corporations.

So again, the nonprofit public benefit corporation is almost always going to be easier, quicker to form, and less complicated to operate.

The final legal form to mention here is the unincorporated association. These associations are also addressed in some state laws. This type of organization often is governed by bylaws that may or may not follow a typical corporate structure. In my 30 years in practice, I don't remember a single unincorporated association that successfully operates as a tax-exempt public charity. While it's theoretically possible, it's not a good way to go and it would be quite difficult to gain federal tax-exempt status for an unincorporated association. So, let's just leave that as a theory and not a practical solution for a founder looking to create a new charity or foundation.

As promised, here's a word about fiscal sponsorships. The idea of fiscal sponsors took root in the 1990s and has evolved into an array of very flexible structures and relationships between a wide variety of large nonprofit public benefit corporations that offer support systems and services to incubate the ideas and programs brought to them by individuals, groups, and even businesses that want to raise charitable contributions to fund an effort. But they usually don't want to or don't have the time to create a free-standing, charitable nonprofit enterprise with its own tax-exempt status. Right now, as this episode is being recorded, the lead time for IRS recognition of exempt status for an organization of any substantial size is about nine to 12 months.

So, for many organizations, the appeal of being able to begin operations under the umbrella of an incubator organization is quite appealing. The legal implications though sometimes surprise the founders who try the fiscal sponsor route. The sponsoring organization, also often known as an incubator or just simply a fiscal sponsor, by law must own and legally control the project and all of its assets. While the incubator organization can make grants or payments to other entities, at the beginning and the end of the day, the legal entity with all authority and responsibility is the incubator, not the sponsored project or its founders.

On the plus side, if the sponsoring organization's policies and procedures are acceptable to the founders, the sponsored project gets all the corporate infrastructure in a turnkey package. Personnel policies, payroll benefits, insurance, accounting, audit, and all that back office detail is already built in for all the projects of the sponsoring organization. There is, of course, an overhead cost associated with that infrastructure. But especially for small organizations, the cost may be much lower than trying to create a startup venture in a standalone corporation.

So, once the decision as to the choice of form has been made and assuming the organizers are not proceeding as a project of a sponsoring organization but rather want to be an independent legal entity, the next detail to confirm is which state will be the domicile for the entity. The first state to look at would be the state where the founders are located and expect to be operating the charity.

If a charity will be operating in many states or if the founders are not necessarily tied to operating only in the state where they reside, Delaware is often a good choice for incorporating a nonprofit public benefit corporation. While the Delaware nonprofit law is not as robust in terms of default provisions and ease of governance by comparison to some other states, the benefit to Delaware is that it is generally a corporation-friendly state and the secretary of state's office is quick off the mark and relatively easy to work with. Delaware can be slightly more expensive choice though since the corporation may also have to qualify to do business in the state or states where it is operating, which adds a layer of government and service fees. Incorporating in Delaware doesn't relieve the nonprofit of the need to register with a supervising body in the states where it's operating such as the Registry of Charitable Trusts in California.

So, wrapping up, the first legal question for creating a new nonprofit entity is the formation under state law. The most common form is a nonprofit public benefit corporation since it's the simplest and usually easiest to form and operate. When quick tax exemption is the issue or the organization needs the infrastructure of a sponsoring organization, a fiscally sponsored project may be the better route.

Well, that's it for today. I'm Cynthia Rowland and you've been listening to EO Radio Show, Your Nonprofit Legal Resource, brought to you by the Exempt Organizations Group at Farella Braun + Martel. If you have suggestions for topics you would like for us to discuss, please email us at [email protected]. Thank you for joining us. Until next time, make a difference.

Show Notes:

The ABCs of Nonprofits, Second Edition By Lisa Runquist 

Delaware Model Certificates of Incorporation

Model Nonprofit Corporation Act, and states where adopted

Uniform Law Commission on Uniform Unincorporated Association Act status

Additional episodes can be found at EORadioShowByFarella.com

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