Many well-intended individuals who want to work on addressing public, social, and environmental needs think about starting a charitable nonprofit. Founding and leading a nonprofit may be viewed as a badge of significance and honor. But before moving forward, founders of a charitable venture should first consider the alternatives.
Similarly, lawyers and bar associations asked to assist in the formation of a charitable nonprofit should consider whether a startup is in a client’s best interests. Absent sufficient research by the client and a good plan for continued viability, a lawyer may best serve the client by introducing alternatives to forming a nonprofit, which include (1) work with an existing nonprofit, (2) fiscal sponsorship, (3) a donor-advised fund, and (4) a for-profit social enterprise.
The mechanics of forming a nonprofit and obtaining tax-exempt status may be simple enough for an experienced lawyer or a diligent client. However, lawfully operating a viable and compliant nonprofit can be exceptionally difficult, even with the best of intentions and initial seed capital. And a poorly planned nonprofit can waste charitable resources, frustrate founders, disillusion donors, and create liability risks for its leaders.
Accordingly, before a decision is finalized to form a nonprofit, lawyers should encourage the founders to understand the fundamentals of operating in compliance with applicable nonprofit and tax-exemption laws, including section 501(c)(3) of the Internal Revenue Code. If the founders intend to be compensated by the nonprofit, they should be particularly aware of the prohibitions against private benefit and private inurement and any state law prohibition against self-dealing transactions.
Work with an Existing Nonprofit
Creation of a new nonprofit that precisely duplicates what an existing nonprofit does may be of greater value to its founders than to the organization’s intended charitable beneficiaries. Founders with a plan to provide services that would otherwise not be provided or to serve beneficiaries who would otherwise not receive services may conversely have greater impact. But sometimes, those additional or expanded services can more efficiently be delivered by an existing nonprofit. Accordingly, one alternative for would-be founders to consider is working with an existing nonprofit.
Working with an existing nonprofit may be more effective and efficient that creating and operating a new nonprofit, especially where prospective founders lack relevant experience or resources. Specific advantages to this option include:
• Avoidance of start-up costs and the administrative burdens of a new nonprofit.
• Increased efficiency in furthering the charitable mission by leveraging established infrastructures.
• Opportunities to develop relevant experience, expertise, and connections.
Fiscal sponsorship is the term used to describe the contractual relationship between an individual or group of individuals who have initiated a charitable project (the “Project”) and an existing tax-exempt organization that has agreed to support the Project (the “Sponsor”). Typically, the Sponsor confers upon the Project the benefit of the Sponsor’s tax-exempt status and provides administrative services in support of the Project. However, the precise nature of the relationship, the support provided by the Sponsor, and the rights of the Project’s initiators may vary widely depending on the agreement between the parties.
Perhaps the most common model of fiscal sponsorship is one in which the Project is housed within the Sponsor, has no separate legal existence, and is operated by the Sponsor’s employees and/or volunteers. This model is commonly referred to as comprehensive or Model A fiscal sponsorship.
The Sponsor usually retains a portion of the donated funds as an intraorganizational administrative fee and the remainder is restricted for advancement of the Project’s charitable purposes. The Project’s initiators may serve as employees or volunteers of the Sponsor delegated with the responsibility of operating the Project. They also typically retain some right to move the Project to another fiscal sponsor or to a new nonprofit organization created to permanently house the Project. Any such rights should be precisely spelled out in the fiscal sponsorship agreement.
Fiscal sponsorship may provide a Project with the benefit of immediate tax-exempt status, advantageous treatment as a public charity without independently passing a public support test, administrative support, and an existing governing body that has a duty to ensure that the Project is operating in compliance with applicable laws. The Project Initiators must weigh such benefits against a lack of autonomy; their limited control over the Project, which remains under the ultimate control of the Sponsor; and the sponsorship fees.
It is likely that a great majority of individuals and groups interested in forming a nonprofit have not considered fiscal sponsorship as an alternative. Yet, fiscal sponsorship may be beneficial in several circumstances, particularly where the sustainability of a new nonprofit is highly questionable, the charitable endeavor has a relatively limited life span, and the Project’s initiators want to focus on the charitable program activities and fundraising and not on the administration and governance.
Project Initiators that are considering fiscal sponsorship should be very selective in choosing a Sponsor. Sponsors differ widely with respect to charitable mission, services, management oversight, fees, experience, legal sophistication, and their own viability.
Donor Advised Fund
For a client considering forming a grantmaking organization, a donor advised fund may be a preferable alternative. A donor advised fund or DAF is generally defined in the Internal Revenue Code as a fund or account (1) which is separately identified by reference to contributions of a donor or donors; (2) which is owned and controlled by a sponsoring organization; and (3) with respect to which the donor or person appointed or designated by the donor has, or reasonably expects to have, advisory privileges with respect to distributions or investments of amounts held in such fund.
A grantmaking organization that will primarily be funded by only a few sources and not through public fundraising is likely to be classified as a private foundation. This will trigger a minimum distribution requirement (generally 5 percent of its investment assets) and a 1.39 percent tax on net investment income. In addition, the private foundation will face a number of prohibitions including against; (1) self-dealing; (2) excess business holdings; (3) jeopardizing investments; and (4) taxable expenditures, including those paid or incurred to lobby, make grants to individuals that do not satisfy certain criteria, or make grants to nonpublic charities other than operating foundations without exercising expenditure responsibility. Moreover, the charitable deduction limits for contributions to a private foundation are lower than those for comparable contributions to a public charity.
From a donor’s perspective, the advantages of a DAF over a private foundation include:
• No formation costs.
• No administrative, investment, or governance responsibilities (and associated risks).
• The possibility of making deductible charitable contributions immediately.
• More generous deduction limits (because the sponsoring organization is a public charity).
• No need to vet recommended grantees or provide oversight over grants.
Additional benefits of a DAF may depend on the nature of the sponsoring organization, which is typically either a community foundation or a public charity affiliated with a financial institution like Fidelity, Vanguard, or Schwab. Community foundations generally offer valuable philanthropic guidance to donors and opportunities to participate in community leadership initiatives and events. Financial institution-related charities typically offer lower administrative fees and costs. Individuals considering a DAF should also track legislative efforts targeting DAFs that may eventually diminish or eliminate some of its benefits.
From a donor’s perspective, the main disadvantage of a DAF as compared to a private foundation is the donor’s lack of legal control after making the contribution. With a private foundation, the donor may control the board of directors, which has final authority on what to do with its funds. In contrast, with a DAF, once the contribution has been made, the donor may provide only recommendations or advice to the sponsoring organization about grantmaking or investing. While the donor may not have legal control over the fund, it is easy to understand why sponsoring organizations generally make a strong attempt to adhere
to their donors’ recommendations so long as they are consistent with the sponsoring organization’s exempt purposes and otherwise in compliance with the law. A sponsoring organization that regularly disregards its donors’ wishes would soon lose goodwill and become an unattractive option in a crowded marketplace.
For-Profit Social Enterprise
A nonprofit entity with 501(c)(3) status may be subject to more limitations than would be considered ideal for advancing certain charitable or socially purposed ventures. The restrictions on private inurement, private benefit, compensation arrangements, equity ownership, substantial lobbying, political campaign intervention, and/or private foundation rules (if applicable) may make a taxable entity a more flexible and appropriate option. Where the venture will not have substantial net income, the income tax implications of a for-profit may be relatively minor.
A for-profit social enterprise may pursue charitable objectives so long as this is consistent with the owner or owners’ wishes. It may raise equity capital from investors with similar goals. It may enter into business transactions with whomever it wishes, and it may compensate employees and others without strict limitations on reasonableness, allowing for more competitive hiring of top talent.
While a for-profit social enterprise might not have the same goodwill associated with it as a nonprofit, there are structures that can help differentiate a for-profit social enterprise from more commercial for-profits. Newer legal entities like the benefit corporation, social purpose corporation, low-profit limited liability company (L3C), and benefit limited liability company, and certifications, most notably the Certified B Corp, can publicly signal more sincere social purposes and not a mere marketing ploy.
A new nonprofit organization may be a good option for a charitable venture, but in many cases, there may be a better option. Insufficient research and imprudent planning are commonly cited as reasons for business and nonprofit failures. Professionals who work on nonprofit formations should help assure their clients have appropriately prepared for the challenging task of creating and operating a viable and compliant organization. A key part of that preparation is determining whether forming a new nonprofit is a reasonable option, and only incidentally for the personal benefit of the founder or any other individual or entity.
For Love or Lucre (Stanford Social Innovation Review)
Fiscal Sponsorship: A Balanced Overview (Nonprofit Quarterly)