By Cliff Ennico
“My wife and I have been running a for-profit service business for the past 10 years. We have recently learned that our business may qualify as a nonprofit organization, as we frequently provide our services for free or at an extremely low cost to people who can’t afford them.
“We’re looking to retire shortly and think it would be fun to continue running the business strictly as a nonprofit. What is the best way to do this?”
Before we get to the legal stuff, there are a few things you need to consider before you go the nonprofit route.
First, keep in mind that when you run a nonprofit organization, you are no longer an owner of the business, and you will not be entitled to a share of the business’ profits as you are currently. All profits from a nonprofit’s operations must be devoted to the organization’s tax-exempt mission.
As directors of the nonprofit, you are entitled to reasonable compensation, but this won’t be very much. If the nonprofit is making more than $50,000 a year in donations, you may be required to have your annual compensation approved by independent directors who aren’t involved in day-to-day operations, and they won’t be easy to find or deal with (for example, they may want you to buy liability insurance for them).
Second, there are only three ways a nonprofit can generate a tax-exempt income: donations (which are tax-deductible to the donor if you qualify as a public charity under Section 501c3 of the Internal Revenue Code), government grants and fundraising activities.
If you charge a fee for the services that you are providing folks in a nonprofit, those services must be “reasonably related” to your organization’s tax-exempt purpose. For example, an organization set up to provide care services for the elderly can charge a small fee (below market) for wheelchairs or have its out-of-pocket expenses reimbursed.
Income from services that are unrelated to the organization’s tax-exempt purpose is considered unrelated business income by the IRS; it does not affect your tax-exempt status, but you must pay tax on the “unrelated business income” just the same as if you were a for-profit business (for more information, visit the Unrelated Business Income Tax page on the IRS’s website). An exempt organization with more than $1,000 in unrelated business income must file an IRS Form 990-T each year. An organization must pay an estimated tax using the IRS Form 990-W if it expects its unrelated business income tax for the year will be $500 or more.
You need to have a long chat with your accountant to make sure none of the above will be problematic for you before you decide to pursue the nonprofit path.
Assuming your accountant gives you a green light, there are several ways to convert your for-profit business into a nonprofit.
The easiest way, available in virtually all states, is a three-step process.
First, you form a nonprofit corporation in the state where the nonprofit will operate and obtain exemption from federal income taxes using the IRS Form 1023 or (if you qualify) the IRS Form 1023-EZ. Right now, it’s taking about four to five months to get a “determination letter” from the IRS saying your corporation qualifies for tax-exempt status.
Then, when you have obtained tax-exempt status, your nonprofit corporation will buy all of the assets of your for-profit business for $1. You will need to file an IRS Form 8594 (Asset Acquisition Statement) and allocate the $1 to specific asset categories when you file your first IRS Annual Report for your nonprofit corporation.
Lastly, when the dust has settled, you dissolve and liquidate your for-profit business and file final tax returns for the year in which you go out of business.
A handful of states, such as California, allow the merger or conversion of a for-profit corporation into a nonprofit corporation without having to go through a sale of assets. When doing a merger or conversion, you will need to think about how your ownership stake in the for-profit business (shares of stock in a corporation or membership interests in a limited liability company) will be disposed of because nonprofit organizations do not have owners or shareholders. It may have to be valued, and the value will be treated as a donation to the new nonprofit. Talk to your accountant or a good tax lawyer about that.
Things become a lot more complicated if your for-profit business is organized as a limited liability company, or an LLC. Many states (such as New York) do not allow nonprofit organizations to use the LLC form of organization, so your nonprofit will have to operate as a corporation in those states. Likewise, many states do not allow cross-entity mergers or conversions of an LLC into a corporation, or vice versa, or allow only mergers or conversions into other business (for-profit) entities.
If your nonprofit is going to be located in another state (for example, you are moving to Florida or Texas), your attorney will have to examine the laws in both states before approving a merger or conversion. That’s going to get expensive.
When in doubt, use the sale of assets approach: A good business attorney can do this for a $1,500 to $2,500 fee, which your for-profit business can deduct before it shuts down.
Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”
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