Converting a For-Profit into a Nonprofit

Increasingly, for-profit corporations are expanding their goals beyond profit-maximization and pursuing social or charitable goals. For owners of some of these corporations whose sole focus becomes a charitable purpose, conversion into a nonprofit organization can provide new sources of financial and social capital. However, whether a corporation should convert its structure into a tax-exempt, nonprofit corporation requires consideration of several factors, including the loss of ownership, potential restructuring of activities and purpose, and the future use of the organization’s assets.

Loss of individual control.

Since a nonprofit corporation is a legal entity that has no ownership (subject to a few exceptions we will not cover here), conversion from a for-profit to a nonprofit corporation will require the existing shareholders to give up their ownership. The corporation‘s board will remain ultimately responsible for the governance and oversight of the corporation but will no longer be responsible for considering the interests of any shareholders, which may or may not be consistent with the shareholders’ desires. While the required number of board members may vary depending on state law, we generally recommended that a nonprofit corporation have a minimum of 3 directors before applying for 501(c)(3) status. Additionally, for California nonprofit public benefit corporations, not more than 49% of the board may be composed of “interested persons,” which includes any person receiving compensation from the nonprofit for services rendered within the past 12 months and anyone related to the compensated person. This, too, may limit the original shareholders’ control over the corporation if they are hoping to be compensated and therefore must add disinterested directors to the board in order to comply with the California law.

Primary goal must be charitable.

While the board of a for-profit corporation may have an obligation to increase shareholder value, the board of a charitable nonprofit corporation has no such obligation and instead has a duty to advance the corporation’s charitable purposes. Although making a profit may be one objective of the nonprofit corporation, it can no longer be the ultimate goal. The activities of the nonprofit corporation must be consistent with its 501(c)(3) tax-exempt status, and the nonprofit corporation may not confer any benefit, monetary or otherwise, on any individual or entity that is not incidental, quantitatively and qualitatively, to furthering the organization’s exempt purpose. For the former for-profit corporation, this may mean changing the nature of its activities, limiting its services to a specific charitable class of beneficiaries, such as low-income individuals, and/or providing its services for free or at substantially below cost. It is important to recognize that the conversion to a nonprofit corporation should not be aimed merely to expand the corporation’s market share to include customers or clients paying a lower than market rate made possible by donations. Instead, the transition typically involves a more radical change in the corporation’s purpose and its targeted markets.

Assets locked in charitable trust.

If a corporation converts from a for-profit to a charitable nonprofit, upon such conversion, all of its assets will be impressed with a charitable trust, meaning that they may only be used in furtherance of the nonprofit’s charitable purposes. Even if the corporation later dissolves or changes its purpose, those assets must still be used for the stated charitable purpose in its governing documents at the time of the conversion. Assets may include intellectual property such as curriculum, books, music or art, which cannot be taken back by the original shareholders after the conversion except in return for payment of at least their fair market value.

Convert the existing entity or form a new entity?

Another consideration for shareholders of a corporation interesting in converting it into a nonprofit corporation is whether to (1) convert the corporation through an amendment to its articles of incorporation or (2) form a new nonprofit corporation and transfer the for-profit corporation’s assets and programs to the new nonprofit. Regardless, the for-profit corporation will need to consider shareholder rights, including minority shareholders, and whether any will need to be bought out. The nonprofit corporation, whether the result of a conversion or newly formed, will need appropriate governing documents and typically desire federal tax exemption under 501(c)(3). It will also need to consider charitable registration and state tax exemption among other things.

If a new nonprofit corporation is formed, the for-profit corporation may gift its assets and programs to the new nonprofit or it may dissolve and its former shareholders may make gifts of the distributions they received in the dissolution to the nonprofit. Generally, it may be simpler for a new nonprofit corporation, as opposed to a converted entity, to obtain tax exemption from the IRS, particularly if the corporation applies within 27 months of incorporation. In that case, the effective date of exemption will be the same as the date of incorporation. This would not be possible in the case of a converted for-profit entity. In either case, the corporation should pay particular attention to Schedule G of Form 1023, Successors to Other Organizations, when applying for tax exemption with the IRS.