How to Reinvest Profits with a Non-Profit

Around election time, politicians like to talk-the-talk about the importance of small businesses to economic vitality. Often overlooked in the rhetoric is the contribution of new non-profit organizations to regional economies.

Non-profits have the same ability to attract outside capital through donations and grant awards, increase employment, and produce a ripple effect of economic activity to other local businesses And of course, non-profits provide extra value in terms of socially-enriching benefits to communities in terms of education, healthcare, poverty relief and other services.

But, here's the surprising gotcha for socially-motivated startup entrepreneurs who want to make a difference in their communities or the larger world without paying income taxes on service profits. Just because they want to operate a non-profit organization, doesn’t mean they will be able to as quickly as they would like, if at all. The decision rests entirely with the Internal Revenue Service.

Here are some recommendations for new applicants:

-Incorporate first. A legal entity must be in place prior to applying to the IRS for 501(c)(3) tax-exempt status. It's not a requirement to be organized as a corporation to obtain 501(c)(3) status, however officers and directors tend to benefit from the liability protection that can be gained from incorporation.

-Use current application forms. The most common reason why applications are rejected is administrative error. Typically social entrepreneurs submit incomplete information or use old IRS forms. Visit www.irs.gov to obtain the most current documentation. Search for Form 1023 and instruction pamphlet 4220.

-Pay attention to mission wording. The IRS evaluates the intended purpose of every applicant. To qualify for 501(c)(3) status, the organization's mission must provide educational, charitable, religious, scientific or other approved tax-exempt purpose. It's not necessary to submit a lengthy business plan of operations to the IRS, but applicants do have to describe the nature of their work and the need-based audience for their services. It's wise for new organizations to clarify their mission prior to forming incorporation documents for consistency of stated purpose.

-Think strategically. Non-profit entities are allowed to generate product and service revenues that are not subject to income taxes. These services are called "program revenues." While net earnings from program-related revenues may be exempt from income taxes, net earnings from revenues that are unrelated to the organization's service mission, would most likely be taxable.

Because non-profit services tend to expand over time, it’s worthwhile to think as broadly as possible about a new entity’s service potential to maximize its tax-free service status. The more service revenues that are exempt from taxes, the more social entrepreneurs can reinvest working capital back into organization growth.

-Pay the correct fee.  Initial application fees are $300 or $750 depending on the revenue status of the organization.

The good news for startup social entrepreneurs is the approval rate for tax-exempt organizations is quite high – about 80 percent. Plus, the majority of new applications are filed by organizations, not their attorneys or accountants.This means that the overall filing process is relatively easy, provided startup entrepreneurs follow application instructions. Expect the review process to take several months. Expedited review services may be available to organizations that having pending grants or other reasons for fast application attention.

Susan Schreter is a 20-year veteran of the venture finance community and a university educator in entrepreneurship.  She is the founder of www.takecommand.org, a community service organization that boasts of offering the largest centralized database of startup and small business funding sources in the U.S.   Ask Susan your questions at susan@takecommand.org