Different types of business structures have different implications for your business.
There are several key differences between these three business entities, from profits that stem from doing good in the community to paychecks that come from fundraising. — Getty Images/SDI Productions

When you’re starting a business, it’s likely you’ll hear the phrases “nonprofit” and “not-for-profit” thrown around. It’s also easy to assume these two terms mean the same thing. However, nonprofits and not-for-profits are business structures with different tax implications, governance and functions. Both of these entities contrast with for-profit organizations. Here are the ins and outs of what all these terms mean so you can figure out which structure is right for your new venture.

[Read more: Getting Ready to Launch? How to Choose the Right Business Structure]

What is a nonprofit organization?

A nonprofit organization is one that qualifies for tax-exempt status by the IRS because its mission and purpose are to further a social cause and provide a public benefit. Nonprofit organizations include hospitals, universities, national charities and foundations.

[Read more: Education, Partnerships and Community Are Essential to Nonprofit Success]

To qualify as a nonprofit, your business must serve the public good in some way. Nonprofits do not distribute profit to anything other than furthering the advancement of the organization. As such, you will be required to make your financial and operating information public so that donors can see how their contributions are being used. An individual or business that makes a donation to a nonprofit is allowed to deduct their donation from their tax return. The nonprofit, likewise, pays no taxes on any money received through fundraising.

What is a not-for-profit organization?

Similar to a nonprofit, a not-for-profit organization (NFPO) is one that does not earn profit for its owners. All money earned through pursuing business activities or through donations goes right back into running the organization.

However, not-for-profits are not required to operate for the benefit of the public good. A not-for-profit can simply serve the goals of its members. A good example is a sports club; the purpose of the club is to exist for its members’ enjoyment. These organizations must apply for tax-exempt status from the IRS, including exemptions from sales tax and property taxes. That also means that money donated by an individual to an NFPO cannot be deducted on that person’s tax return.

Nonprofit vs not-for-profit organizations

There are four key differences between a nonprofit and a not-for-profit:

  • Nonprofits are formed explicitly to benefit the public good; not-for-profits exist to fulfill an owner’s organizational objectives.
  • Nonprofits can have a separate legal entity; not-for-profits cannot have a separate legal entity.
  • Nonprofits run like a business and try to earn a profit, which does not support any single member; not-for-profits are considered “recreational organizations” that do not operate with the business goal of earning revenue.
  • Nonprofits may have employees who are paid, but their paychecks do not come through fundraising; not-for-profits are run by volunteers.

Nonprofits are granted 501(c)(3) status by the IRS. NFPOs are also governed by IRS tax code section 501(c), but depending on their purpose they could fall under a different section, like section 501(c)(7).

What is a for-profit organization?

A for-profit organization is one that operates with the goal of making money. Most businesses are for-profits that serve their customers by selling a product or service. The business owner earns an income from the for-profit and may also pay shareholders and investors from the profits.

Whether you decided to start a for-profit, not-for-profit or nonprofit, the first steps to creating your entity are the same. Start by filing for a business entity in the state in which you wish to run your operations. Your business entity might be a corporation, LLC, sole proprietorship or partnership. All of these entities can operate as for-profit, nonprofit or not-for-profit organizations.

Once the entity has been formed, you will apply for an Employer Identification Number (EIN) with the IRS. It’s during this step that you will select your tax-exempt status using Form 1024 if you wish to run as a nonprofit.

Some businesses start as one type of legal entity and later decide to convert to another.

Can you change your legal entity?

Some businesses start as one type of legal entity and later decide to convert to another. This is possible, but it’s a little complicated depending on the types of entities involved.

From nonprofit to for-profit

There are a few reasons why you may wish to change from a nonprofit to a for-profit. Maybe you believe you can get better access loans or other funding by becoming a for-profit. Or maybe you prefer to operate without the regulations that govern nonprofits.

Regardless, once you’ve carefully considered this option and all shareholders are in agreement, you will need to notify the IRS by writing a "statement of nonprofit conversion." This statement will include:

  • The reason for nonprofit termination;
  • A certified copy of a liquidation plan;
  • The fair market value of the organization;
  • A list of all asset recipients if assets will be distributed.

You will also need to contact your state and local representatives to fill out any forms required in your specific jurisdiction.

From for-profit to nonprofit

Converting a for-profit to a nonprofit is a little more difficult, as the IRS wants to discourage businesses from making this move to avoid paying taxes. It can be done, however, through a process that isn’t so different from starting a nonprofit from scratch.

“While you may be able to retain the for-profit organization name for use by your nonprofit, a nonprofit organization requires you to use the money you raise to suit a purpose other than distribution to shareholders or business owners, and it needs to fulfill the mission and goals of the nonprofit,” explained Small Business Chronicle. “Transitioning to a nonprofit organization requires you to do some planning prior to registering the nonprofit with the state in which it operates.”

This transition includes writing a mission statement, establishing bylaws, and filing articles of incorporation with your Secretary of State, among other things. It’s at the articles of incorporation step that you will need to let the Secretary of State know you’re keeping the same name as your existing for-profit.

Which legal entity is the best?

Ultimately, the legal entity that’s right for your business depends on your goals. As one entrepreneur, Jane Chen, outlined in Harvard Business Review, there are pros and cons to each entity.

“A for-profit can raise money from private investors, for which it must give equity or dividends to shareholders; ultimately, a return on investment is expected,” she wrote. “A nonprofit, on the other hand, can seek donations from individuals, foundations and corporations. Such stakeholders generally expect a ‘social return’ on capital.”

There’s no one-size-fits-all when it comes to establishing a legal entity for your business. And, the good news is you can always change your entity as your business grows. Speak to an expert who can help you choose an entity that optimizes your tax deductions while serving your overarching goal.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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Published April 20, 2021