A 501(c)(3) organization is a nonprofit that has made a special election with the Internal Revenue Service to be treated as exempt from federal income taxes. The formation and operation of these organizations is governed by both state and federal laws, which require that the business further a specific charitable, scientific, educational or religious purpose. This sets 501(c)(3) organizations apart from for-profit ventures, which are formed for the purpose of generating profits for their owners. Although nonprofits are not prohibited from generating profit from business activities, state and federal laws limit how these profits may be used.
Once a 501(c)(3) nonprofit organization has been formed, it exists independently of its incorporators, directors, officers and employees. This means that all assets acquired by the business, including intellectual property and all revenue generated through its operations, are the property of the nonprofit. In other words, there are no owners of a nonprofit in the traditional sense of the term. Individuals involved in the company may not receive a portion of any profits earned by the business, and nonprofits are not permitted to have shareholders who stand to benefit from the success of the organization through increased stock values. A few states, like Pennsylvania, allow nonprofits to issue stock as a method of determining control, but this activity does not have a profit-sharing component.
Although the IRS prohibits nonprofits from paying dividends to any incorporator, officer, director or employee, it does not preclude the payment of reasonable compensation for their services. Reasonableness is not specifically defined in the Internal Revenue Code; it is determined based on the amount and type of work performed in comparable businesses, both profit and nonprofit. For example, it might be deemed unreasonable for an employee who works two hours a week updating the organization's website to be paid an annual salary of $60,000. However, it may be reasonable for an executive director to be paid $100,000 a year if the work involves more than 60 hours per week, extensive traveling, and significant administrative and managerial duties. The IRS will look to executive pay in similar businesses to decide reasonableness. In auditing 501(c)(3) organizations, the IRS may assess penalties or revoke tax-exempt status if it determines that compensation amounts to profit-sharing in disguise.
Conflict of Interest
Instead of paying out profits to owners, a 501(c)(3) nonprofit is required to use the revenue it generates to improve services consistent with its mission. Although this can be broadly interpreted, an organization can lose its tax-exempt status if directors or staff members place personal financial interests above those of the nonprofit organization. For example, when a director who serves on the board of a non-profit art collective lobbies to have his personal real estate serve as rental space for an upcoming art exhibit. In order to avoid the perception of impropriety, the IRS recommends that a nonprofit adopt a conflict of interest policy that requires board members and staff to disclose potential conflicts and abstain from voting in cases where they may stand to benefit financially from a particular course of action.
Distribution Upon Dissolution
Directors and staff members must not walk away with corporate assets after a 501(c)(3) organization ceases doing business. When a nonprofit is formed, states require that the incorporators specify how assets will be distributed when the organization decides to close its doors. This must be noted in the Articles of Incorporation, which serve as the constitution for the nonprofit and are filed with the state at the formation stage. The IRS requires that all tax-exempt nonprofits distribute property to another tax-exempt entity or to the federal or state government for a public purpose upon dissolution. This differs from for-profit ventures which are allowed to divide remaining assets between owners upon dissolution.
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