4 Common Traps When Starting a Nonprofit
The idea of creating, running and growing a successful nonprofit organization appeals to a lot of entrepreneurs and business leaders. That makes sense, since those who hold leadership roles tend to value the notion of improving conditions for underserved communities or want to advance environmental and social causes important to them. However, it can also present a minefield of potential traps for the unwary to navigate. That's why it’s important to identify the following potential obstacles before you undertake the arduous process of securing 501(c)(3) status from the Internal Revenue Service.
1. A 501(c)(3) nonprofit is limited in many ways.
The 501(c)(3) is what most of us think of when we say “nonprofit.” It's an entity named after the special section of the tax code that governs it, and it's limited in how it raises and spends funds by both heavy IRS oversight and prevailing economic realities. Generally, a 501(c)(3) is required to minimize operating expenses in order to maintain a good reputation. Nonprofits that spend a smaller percentage on advancing their mission than on operational expenses are not well-regarded in philanthropic circles. Inefficiencies in fundraising are flashing warning signs for potential donors, especially when paired with a perceived luxury lifestyle for the nonprofit’s board of directors.
Related: The Nonprofit Option
As a result, 501(c)(3)s look for ways to cut spending across the board. That translates into relying heavily on volunteers and ensuring their activities don’t run afoul of IRS regulations. It also leads many in the nonprofit sector to run marketing and fundraising campaigns on bootstrap budgets. The end result is that it’s often much harder to accomplish the same organizational goals through a nonprofit than via a for-profit business entity.
2. It takes longer and is more expensive than you think.
Starting up a business is relatively straightforward and simple in comparison to establishing a 501(c)(3). You can launch a company as a sole proprietorship in a matter of days for little or even no money. An LLC can take a few weeks to a month and might come with a relatively small filing fee. But whether it's a religious organization, private foundation or public charity, any entity seeking nonprofit status from the IRS may have to wait years, with lengthy review and lead times often contributing to the wait. You'll also have to submit a substantial filing fee (currently $600 for those filing Form 1023). This is just the beginning of the expenses, though, as you may also want to retain the services of an attorney. Moreover, to continue operating as an exempt nonprofit organization, you’ll have to comply with stringent financial, legal and other reporting requirements to maintain your tax-exempt status and stay in “business.”
3. It’s harder to raise start-up and operating funds.
With a viable product or service, a smart entrepreneur can hustle up sufficient funds from outside investors to launch a strong small business. The reality of the for-profit business is that investors reward companies that can prove future value and a solid return on investment. Nonprofits, of course, are a completely different ballgame. No dividends get issued to initial investors, except the intangible kind that come from supporting a worthy cause. However, just like for-profit businesses, a nonprofit needs considerable start-up funding to successfully pursue an assertive fundraising program.
Finally, there’s this harsh reality: Even in your local area, nonprofits may exist devoted to the same cause you care about. The net effect is chilling. Every nonprofit is competing against every other nonprofit for an ever-shrinking pot of money.
4. Transparency is a serious mandate.
Running a business means that, to some extent, you get to decide what stays confidential and what gets released to the public. In nonprofits, however, secrets make it very difficult to raise funds and stay viable. The public expects reputable nonprofits to be completely transparent about where funds come from and where they go. Watchdogs like Charity Navigator monitor charitable organizations, ensuring that donated funds go to the cause in question, not huge board-member salaries or perks.
These challenges don't mean you shouldn't create a charitable nonprofit, but it’s important to keep them in mind, as you'll inevitably face difficulties not only in achieving tax exemption, but in generating contributions. Understand where these impediments lie and create an effective plan for overcoming them. This will help you give your nonprofit a strong start on the path to greater success.