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DIY: Choosing Your Tax Status

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DIY (do it yourself) is a weekly series about launching your own education enterprise. The series will focus on addressing the need for quality at scale. Topics will focus on the challenges of private enterprise, but most will have application for nonprofit leaders and school district administrators.

This first post is about the monthly call I get from an edupreneur asking, "Should we form a nonprofit or for-profit corporation?" There is no simple answer. Twenty years ago a mission-focused organization would have been formed as a nonprofit but these days there are lots of dot-coms as focused on impact as return.

Let's first examine the benefits of forming a nonprofit corporation (one that qualifies as tax exempt under IRS code section 501(c)(3)):

  • You are eligible for private and government grants (not available to for-profits).
  • If you can find grants, you don't have to give the money back.
  • Donations are tax deductible for your donors.
  • If you make a profit, you don't need to pay federal corporate income taxes.
  • In most instances, do not pay state corporate income, franchise, excise, use, and sales tax.
  • You may receive generally favorable treatment from educators with a nonprofit bias.

Other random benefits include lower postage rates, free (but limited) public service announcements, and the ability to do some donation supported lobbying (with a 501(h) election).

The biggest downside of a nonprofit corporation is the loss of control. You need to put together a board of directors that become your boss--and they can fire you. You may be subjected to more scrutiny because your finances are open to public inspection. If organizations grows and becomes profitable you can't sell it. Nonprofits may pay lower salaries and have less incentive compensation than for-profits that can make it a challenge attracting talent.

Nonprofits may earn a surplus but if revenues are not related to the mission, they may be liable for unrelated business income tax for activities construed as commercial,

Below are a few distinct benefits of a forming a for-profit corporation:
  • At some point you need to provide a return, but it may be easier raising return-seeking capital especially if you need a lot.
  • It may be easier to hire and incentivize good people.
  • There are inherent incentives for speed, quality and scale.
  • You may be able to sell the company for more than you and your investors contributed.

The decision may be heavily influenced by where you think you can raise initial capital. But give some thought how much you'll need to raise down the road. It may be easier to raise a large amount of capital from return-seeking investors--assuming you have a great plan and some early traction. In general, if you want to work at scale I recommend a for-profit structure.

It is becoming increasingly common to use a hybrid structure to take advantage of grant, equity and debt investment. This can be accomplished with affiliated organizations (that, like Purpose.com, may be transparent to partners) or a nonprofit with a for-profit subsidiary. The subsidiary structure worked out pretty well for NCEE which sold its for-profit subsidiary, America's Choice, to Pearson creating a $3.6 million-per-year endowment for NCEE.

There is a small movement of hybrid impact-oriented organizations called Benefit Corporations. You can check it out but I don't think it's big enough to consider.

The good news is that it's not a forever decision--you can always convert or augment your first approach. Stay focused on the impact you want to create, get clear about your strategy, find investors that appreciate your focus and passion and they will help you make the right structure decision. If you want the ability to work at scale, consider forming return-seeking corporation so that you have the chance to work with serious investors.

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