Should You Form a Nonprofit? Advantages and Disadvantages Explained

If you’ve decided to form an entity and aren’t sure if you want to form a for-profit company (think LLC, corporation), nonprofit, or a hybrid entity (L3C or B Corp), then this post will help you understand the full picture, including the advantages and disadvantages of forming as a nonprofit organization.

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Because almost all entrepreneurs setting up nonprofits will want to be a 501(c)(3), we focus on 501(c)(3)’s in particular here. There are other options, like political groups, agricultural groups, and professional associations, but typically if a business owner is pursuing the other options, they’ll have hired an attorney to assist.

If you’re deciding whether your organization should be a nonprofit, consider the benefits to be gained.

What are advantages for forming a Nonprofit Organization? 

The two primary benefits of nonprofit status are taxes and accepting donations. let's dive into each:

You are not required to pay taxes

Paying taxes can hurt your business big time—if you’re just a regular corp, you’ll have to pay 21 percent of your profits in federal corporate income tax. And if your state has its own corporate income tax, then it gets even more expensive. On top of this, you can save on sales, property, and other local government taxes, as well as taxes on dividends.

Note, however, that if a substantial portion of the income your nonprofit generates is unrelated to your nonprofit’s purpose, it can be taxed as unrelated business income.

You can accept tax-deductible donations

As an NPO, your organization may also accept donations and contributions from individuals, companies, and government agencies. People like donating to nonprofits not only to help but because they also get to take a tax deduction for their donations.

Depending on the type of nonprofit you’re running, donors receive deductions on their tax returns. For example, if a donor gives a cash donation to The Salvation Army, this donation would be considered deductible from the donor’s taxable income, thus reducing the amount of tax to be paid. The donor then files an IRS Form 1040 so the deduction can be applied.

Yes that’s great, but nonprofits have drawbacks.

Step-By-Step Nonprofit Startup Guide

Nonprofit Disadvantages

Be aware of these restrictions that come with running a nonprofit:

There are restrictions on how much money you can make.

Simply put, you can’t “profit” off your nonprofit. You can pay yourself a reasonable salary for your work for the nonprofit. But you can’t take profits out of the company like you could if you were an LLC or a corporation. And you can’t get around it by doing certain transactions that the IRS would find to provide private gain for you personally. In other words, self-dealing has major restrictions.

For example, if you have a nonprofit that helps immigrants get their citizenship, you can’t hire your side business that does lawn work and pay the business thousands of dollars for cutting your 1-acre lawn. The same goes for close family members and their private gain.

Ask yourself: Do I want to get any money out of my business besides a reasonable salary?

If no, then nonprofit might be a great choice. If you do, then focus on becoming an LLC or a corporation.

There are restrictions on what you can do with your nonprofit.

If you’re trying to figure out exactly what you want to do with your company and aren’t set on a specific mission, then nonprofits won’t make as much sense.

Nonprofits must also stay compliant with federal tax laws in order to maintain tax-exempt status. This means the nature of activities a nonprofit may carry out is limited. Basically, your activities have to parallel your organization’s goals—you can’t just set up a nonprofit that helps homeless people and then sell bikes to raise money for the organization. The profit from bike sales would be taxable.

And you have to actually be doing something charitable. Otherwise, your nonprofit would be subject to unrelated business income taxes, also called UBITs. This means the nonprofit would be required to pay taxes on income earned from performing any activities unrelated to the charitable purpose of the organization.

Ask yourself: Does my social cause fit into one of the IRS purposes? Is this going to consistently be the main purpose of my organization?

If yes, then nonprofits might make sense for you.

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Requirement for people besides yourself to run the entity

Depending on your state, you’ll typically need to have between 1 to 3 directors. If your state requires 3 directors, then you would need to find two other people interested in your mission.

Restrictions on equity compensation

Compared to regular corporations in which profits are shared by owners, a nonprofit is a non-stock entity, meaning there are no shareholders.

Ask yourself: Do I want to be able to compensate anyone with stock? If so, the NPO is not the right entity choice.

Reporting

The government heavily regulates nonprofits. How the organization makes money and spends money is something the IRS will watch more closely than with for-profit companies.

Summarizing Advantages and Disadvantages

In summary, incorporating your startup nonprofit is ideal if you want to take advantage of local, state, and federal tax exemptions.

If you’re looking to make a lot of money, obviously being a nonprofit is not the best route. You can’t create a nonprofit and then convert the organization to a for-profit corporation once you’ve made a lot of money and think you’re entitled to that money. It doesn’t work that way. But if all you want is to be paid a reasonable salary and you have charitable goals in mind, then think seriously about going the nonprofit route.

But, if you’re on the fence, it might be worth exploring what are called “hybrid entities.” These blend the nonprofit and for-profit worlds.

L3C v. B Corp

These two “entities” are called low-profit LLCs, or L3Cs, and Benefit corps, or B corps. Depending on the type of hybrid entity you chose, you can have the ability to take investments, receive grants, and offer tax deductions to donors. This will allow you to carry out the pro bono services of the organization under the nonprofit and the paid services under the for-profit business. Learn more about those here.

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