Bootstrapped founders in the process of choosing the type of business entity to form may find themselves allured by non-profit organizations, which are exempt from many local, state, and federal taxes. What are the pros and cons of registering your business as a non-profit organization? This article will cover the basics of 501(c)(3) and 501(c)(6) elections.
Registration Process
Non-profit organizations must be registered with the Internal Revenue Service (IRS) to qualify for tax benefits. The approval process normally takes between three and twelve months, meaning that it can take up to a year for your business to qualify under 501(c)(3) or 501(c)(6).
Depending on your industry, this wait time could have seriously negative consequences for your business. If you work in technology, for example, by the time your business is registered, the winds may have already shifted. Your idea may have become obsolete, or it may be much more difficult to find funding. If you work in a more traditional industry, such as hairdressing or law, then the wait time may have less consequence to your business growth.
Profit Generation
Entities that qualify under 501(c)(3) or 501(c)(6) do not have to pay federal taxes to the IRS. The federal tax rate in the United States is roughly twenty percent, so non-profit organizations save much more of their profits than for-profit organizations. This may sound too good to be true to bootstrapped founders. Before you start dreaming of the stars, however, consider that non-profit organizations are not allowed to take profits out. They must reinvest all profits back into the business.
What does this mean for you? You may earn a salary as a director or employee of a non-profit organization, but you can’t share in its profits with the status of an “owner.” Any leftover profits at the end of the fiscal year can’t be divided between partners or members or distributed as dividends on shares. You would not be able to make money from capital gains, which would effectively limit your ability to get rich from your business.
And it isn’t just you. Investors will also be unable to benefit from the profits of your business. While they may enjoy tax breaks from “donating” to a non-profit organization, the purpose of investing in the first place is to reap the rewards of a growing business. Your best bet for fundraising would probably be to seek out other non-profit organizations for capital. These donors might be mandated to invest in other non-profit organizations, even if they wouldn’t be able to see the returns of their investment as traditional venture capital, private equity, or angel investors might. You may want to think about how this would impact your fundraising strategy and ability to leverage the financial resources of investors to scale.
Entity Conversions
Is it possible to convert between non-profit and for-profit organizations? The answer is yes, if you are willing to pay hefty conversion fees and outstanding taxes. Because the taxation of non-profit and for-profit organizations is so different, a conversion may occur a large tax bill from the IRS. This tax bill may be much larger than converting from a corporation to a partnership or limited liability company, and vice versa. In general, it’s best to get the entity type right the first time round.
If you wish to qualify your business under 501(c)(3) and 501(c)(6), make sure that you really want to operate your business in the model of a non-profit organization. This means that you are fine with not taking profits out of your business at the end of each fiscal year. With that said, while converting between a non-profit and for-profit organization can be expensive, it’s not undoable. An attorney can easily help you manage the documents needed to effect the conversion.
Wrapping up
As you may have parsed from this article, a non-profit organization may not be the best fit for an ambitious founder hoping to scale quickly and benefit financially from this speed of growth. Qualifications under 501(c)(3) and 501(c)(6) work better for entities that can afford to reinvest their profits back into themselves. Examples would be research companies, which generally require years to generate profits from successful product development. In choosing the type of entity for your business, your operational model always comes first.
