Converting a for-profit business to a nonprofit entity could be a smart move if charity and community impact has become your focus as a business owner. But making the change requires more than applying for tax-exempt status.
The process would largely depend on your stateâs laws regarding business conversions, and not every company can become a nonprofit organization without a good reason for doing so. Only certain types of businesses can turn into a tax-exempt entity, a procedure that requires filing paperwork with state organizations and the IRS.
Keep reading to learn what it takes to turn a for-profit enterprise into a nonprofit organization, and if itâs the right move for your business.
Although there are several tax-exempt designations within the IRSâ Internal Revenue Code, most nonprofits fall under the 501(c)(3) umbrella for charitable, religious and educational organizations.
The benefits of 501(c)(3) status include exemption from federal income tax, as well as the ability to receive tax-deductible charitable donations. Organizations with the 501(c)(3) designation are also more likely to receive recognition from grant-making institutions and foundations.
Before you can be awarded tax-exempt status, you would need to meet the IRSâ criteria. Organizations may not be formed to benefit private interests, and no portion of the organizationâs net earnings can benefit a private shareholder or individual. Nonprofit employees can earn a salary though.
Meeting these requirements could be difficult as a for-profit business, unless youâve had charitable intentions from the start, said Gene Takagi, an attorney with NEO Law Group, which represents nonprofit and tax-exempt organizations.
âConsider making that conversion if the existing for-profit entity really has a goal thatâs not financialâŚbut is really all about providing a public service or public good for charitable or welfare purposes,â he said.
Hereâs an example: A neighborhood store that sells the work of low-income artists started as a for-profit business to get equity investments from community members but was unable to generate substantial interest and capital. Turning the business into a nonprofit organization would allow the owners to collect philanthropic donations to keep the store open. Because the business had a charitable, community-focused intent from the start, it could be approved for tax-exempt status.
But if a business seeks 501(c)(3) status for less charitable reasons, the IRS could deny the request, Takagi said. For instance, a failing business looking to get out of tax obligations couldnât become a nonprofit without making operational changes.
âYouâre really going to have to make a good case to the IRS,â he said. âItâs got to look different than what you were doing in the past.â
Nonprofits are highly scrutinized, and business owners may be faced with more regulations than theyâre used to, said Brenda Asare, president and CEO of The Alford Group, a consulting firm that advises nonprofits.
âThose processes are in place to dissuade people who may want to come into this sector to take advantage of other people philanthropically,â Asare said.
To make sure you correctly convert your for-profit business to a nonprofit, here are a few steps to follow.
When you form a business, you must set up a certain entity, or structure, which determines the number of owners a business can have, the ownersâ personal liability and taxes the business owes. Common entities include sole proprietorships, limited liability companies (LLCs) and corporations. Nonprofits are usually formed as corporations, though they are able to receive tax-exempts status.
When changing your business to a nonprofit, you would have to convert the current structure to a nonprofit corporation structure. Depending on where you live, only some entities may be eligible for conversion.
In Louisiana and California, for example, corporations, LLCs, general partnerships and limited partnerships can convert to another type of entity through the stateâs Secretary of State office. On the other hand, New York does not permit statutory conversions for business entities. Instead, business owners must establish a new entity, then merge the two companies into one.
Check with your stateâs Secretary of State office to make sure you would be permitted to change entities.
Because nonprofits are corporations, they must be incorporated through the local Secretary of State. If your for-profit business was formed as a corporation, a conversion could be as simple as amending your incorporation documents, also known as articles of incorporation. Youâd need to file incorporation forms again to make the conversion, which would typically range in cost from $50 to $150. Additionally, because a nonprofit corporation does not have ownership, as a board of directors shares responsibility of the organization, existing shareholders of the for-profit business would have to forfeit ownership.
If your business is not a corporation, you would need to file new articles of incorporation with your Secretary of State. The articles of incorporation would call for the organizationâs name, the purpose of the nonprofit and a designated registered agent to receive lawsuits and correspondence on behalf of the organization.
Other requirements when forming a nonprofit corporation include appointing a board of directors to make decisions about the organizationâs activities, finances and legal compliance and drafting bylaws that regulate the boardâs management and activities. The board of directors would also approve your compensation as the executive director or CEO of the organization, including your salary, health insurance and paid leave.
You would need to submit IRS Form 1023 to apply for tax exemption under the 501(c)(3) code. Additionally, you would need to include a statement of your receipts and expenses, a copy of your articles of incorporation, a written description of your organizationâs activities and a copy of your bylaws. You may need to apply for tax exemption at the state level as well.
For instance, nonprofits in California must file Form 3500A with the California Franchise Tax Board to be exempt from state income taxes. Organizations in Texas need to file Form AP-204 with the Texas Comptroller of Public Accounts, while nonprofits in Florida must submit Form DR-5 to the stateâs Department of Revenue.
Timing is key when forming a nonprofit and requesting 501(c)(3) status, Takagi said. Make sure your organization is compliant as a nonprofit â meaning you have a charitable purpose, board members and bylaws in place â as soon as you make the entity conversion. This could help you avoid getting turned down for tax-exempt status and owing taxes to the IRS, he said.
After you convert a for-profit corporation to a nonprofit organization, all existing business assets would be held in a charitable trust, which means assets could only be used for the organizationâs charitable purposes going forward. Intellectual property could be included as well, such as books, music or art.
You could take assets out of the business before making the conversion if you want to limit the assets that are put into the nonprofit, Takagi said. Then, any assets you decide to put into the nonprofit at a later time could be categorized as a charitable donation.
If youâre concerned about a delay in receiving tax-exempt status, you may not want to lock all of your assets in a charitable trust right away. You could form a separate nonprofit and continue running your business to maintain access to your assets, Takagi said.
âIt might be more practical in some cases to not convert but run them side by side for a little while,â he said. âThen either merge or dissolve the company and then donate assets to the nonprofit at that time [when] you already know the nonprofit has 501(c)(3) status.â
Once you no longer run a for-profit business, you must begin collecting charitable donations to keep the operation afloat. Nonprofits need to generate a profit, despite their title, but those profits must be reinvested in the organization rather than distributed to owners and shareholders, as a business would do.
State laws regulate fundraising activities. You may be required to register with a state entity before you begin soliciting donations from local residents, and you may need to register in multiple states if your donor base crosses state lines. For example, nonprofits in North Carolina must obtain a license from the Charities Division of the Secretary of Stateâs office. Depending on your state, you could be required to renew your registration each year to continue legally accepting donations.
Private and public grants and individual donations are common funding avenues for nonprofits. Donors would likely want to understand the organizationâs mission and target market before giving money. A misconception about the nonprofit sector is that organizations can easily secure money with few strings attached, Asare said. However, donors often scrutinize nonprofits before making a contribution.
âNowadays, there arenât many places you can get money without the expectation that organization is making an impact,â she said.
Donors could be suspicious of a nonprofit that was formerly a for-profit business, Asare said. Be prepared to explain how you plan to spend donations to show youâre not seeking personal financial gain.
âI think a good measure would be looking at what percentage of the dollar is going to the services and programs,â she said. âThis is something donors are interested in and they will ask.â
After youâve made the change from for-profit to nonprofit, youâd need to meet ongoing requirements to remain compliant as an organization. From filing certain tax forms and reports to paying particular taxes, here are some requirements to keep on your radar:
Form 990: Most tax-exempt organizations are required to file IRS Form 990 each year. Nonprofit entities must describe the organizationâs activities, governance, financial information and accomplishments to justify its tax-exempt status.
Organizations that have generated at least $200,000 annually or have assets worth at least $500,000 must file Form 990 yearly, while organizations with fewer assets and a lower income can file Form 990-EZ, a shorter version of the form. Form 990-N, which is even shorter, is available to nonprofits with gross receipts of $50,000 or less.
Employment taxes: Nonprofits with employees must pay employment taxes, which include federal income tax withholding and Social Security and Medicare taxes. You could be responsible for federal unemployment tax as well.
State filings: States often require nonprofits to file reports each year. These reports could include corporate filings, financial reports, fundraising registrations and state tax-exemption forms. Failing to file annual reports with your state office could result in penalties or loss of your tax-exempt status.
The requirements for nonprofits may seem excessive, but policies are in place to ensure that organizations are honest about how the program uses donated money, Asare said. Compliance standards act as a safeguard to make sure money is going toward services and not into the pockets of the people in charge.
âThe window is closing on some of that bad behavior,â she said.
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