The defining factor between a nonprofit and for-profit organization boils down to IRS code 501(c) which excuses nonprofits from federal tax liability. These qualified charitable organizations face a tradeoff since they must distribute surplus earnings to a social cause. The individuals in a nonprofit possess limited liability about the incorporated legal entity, which provides both an upside and downside.
The Definition of a Nonprofit
Nonprofits refer to organizations like public charities, private foundations, churches, fraternal groups, and chambers of commerce, which are built to address a social purpose. They encompass a broad range of structures such as non-governmental organizations (NGO). NGOs tend to tackle larger causes, often on an international scale. In the U.S more than 1.5 million nonprofits exist, according to the National Center for Charitable Statistics (NCCS).
The support of noble causes has only increased as time passes. The 2015 Millennial Impact Report found that 84% of all millennials made a charitable donation in 2014. Whether or not a cause will find success in raising funds and serving the public good will rely primarily on the decision to become a nonprofit or for-profit entity.
The Benefits of Nonprofit Status
Nonprofits can qualify under the 501(c) federal corporate income tax exemption. After establishing this exemption, most nonprofits are exempt under state and local tax law. This status also increases the chance of investments to a nonprofit, as individuals are more willing to donate to organizations that will help reduce their tax liability. One can claim a deduction on their taxes regarding a gift or donation to a 501(c) qualified organization. (For related reading, see: Deducting Your Donations.) Nonprofits may also solicit money from both private and public grants.
When incorporating a nonprofit, the individual founders are completely separated from the nonprofit. This takes the burden off any individual founders in the case of debts, lawsuits, fines, and other legal matters. Employees and board members also possess limited liability. Their private assets are shielded from creditors and courts. However, if the person acts illegally or unethically behind the shield of the nonprofit, he or she will be held accountable if the nonprofit is harmed.
The nonprofit organization holds a legal status and identity that transcends the founders. This aspect is attractive to those looking to start a mission-driven organization that will endure for generations. On the other hand, donors are more willing to give to organizations with legacies that they foresee surviving in the long-term.
Better Off in the Corporate World
The elimination of tax and legal liabilities sounds like an excellent way to mitigate risk when starting a new organization. However, when businesses try to take off the ground, they need to raise capital from investors and attract talent with competitive wages. The public’s reluctance to give nonprofits the same leeway as for-profits severely thwart their ability to succeed. Therefore, many nonprofits need large sums of money up front from well-established families and foundations.
Starting a nonprofit requires considerable funds to pay lawyers, accountants, and consultants. Costly administrative tasks face nonprofits, including applying for federal tax exemptions and public reporting requirements. According to Grantspace, applying for the federal tax exemption alone will cost $200-$850 or more, in addition to varying state fees for incorporation.
There’s a lot of paperwork weighing down the nonprofit operation. Strict deadlines for annual reporting are put in place by the government for a nonprofit to continue to qualify for tax exemption status. Documents include financial statements and reports that must meet particular requirements. Since the nonprofit is in the public domain, these statements are subject to the public’s criticism and the scrutiny of a possible independent or governmental audit. The public is often hypercritical of nonprofit decisions regarding employee pay and use of funding.
The diminished role of founders and individuals of nonprofits also affects management’s decision to start a nonprofit. For leaders who desire a large degree of control over the direction of the nonprofit, he or she may not enjoy the shared control structure, which delegates decisions to several directors and follows relatively stringent procedures.
Nonprofits receive better treatment by the federal government and charitable view from the general public. Holding for-profit status gives business leaders autonomy and empowers companies with an entrepreneurial spirit. Therefore, some organizations have taken a hybrid approach by maintaining a for-profit leg and incorporating a nonprofit into the business, or vice versa.
Many traditional for-profit companies and entire industries have taken on corporate social responsibility standards and initiatives. These companies work to optimize social good and profits side by side. Organizations such as Life is Good, Chipotle, The Body Shop and Tesla, have found that the two goals actually work to enhance one another. Instead of viewing the decision as a zero-sum game, innovators experiment with balancing the proper dose of nonprofit and for-profit roles.
Embrace and Embrace Innovations are examples of a nonprofit that spun off a for-profit leg. Jane Chen founded the Embrace to save babies through innovative, cheap technology in impoverished communities around the world. In a Harvard Business Review article, Chen stated that after setting up as a nonprofit, she felt it was essential to raise money from venture capitalists to scale social impact. The nonprofit side maintains the responsibility for owning intellectual property, receiving donations, distributing the technology in poor communities and serving as the face for education and promotion of the cause. The for-profit spin-off took on the role of managing capital-intensive work and building up business infrastructure to enable the sale of the technology to those who could afford it.
An alternative route, rather than incorporate an entire leg of a business as a nonprofit, is when nonprofits and for-profits choose to work with one another. The affiliation of a brand and a nonprofit cause is a mutually beneficial relationship.
Choose Your Business Model
The hybrid business model works very well for large corporations with a great ability to influence the social good. For different stages of growth and variable long-term growth potentials, considering whether to be a profit or nonprofit will change.
Changing from a nonprofit to a for-profit is doable but requires much administrative mess. The board must first approve the plan. A “statement of nonprofit conversion,” liquidation plan, valuation, and other information must be provided to authorities. Choosing to switch to from a for-profit to a nonprofit means restarting a company. Founders will need to reorganize and plan from scratch.
The Bottom Line
The choice of whether to become a for-profit or nonprofit entity may not be as clear-cut as anticipated. The obvious tax benefits of becoming a nonprofit weigh against the flexibility granted to for-profit organizations that have the leverage to raise money and attract the best talent. Moreover, nonprofits face public scrutiny and strict legislation. Perhaps if we change the way our society views charity, nonprofits would have a better chance up against bigger and more powerful corporate rivals. On the other hand, the nonprofit world seems to have taken innovation upon itself, as social entrepreneurs take up hybrid organizations that demand the public’s respect while strategizing like a for-profit business.