Lesson: Incorporating Your Venture with Augie Rakow

Step #4 Tax Exempt: To profit or to nonprofit?

We talked about Delaware companies. We talked about C-corporations. There's a whole kind of range of other things. There's various types of partnerships and limited liability companies and this happens, I think, more with younger founders as they kind of get the idea that they want their company to be a nonprofit. "I want to better the world, I'm not trying to make a buck, I'm trying to better the world, and I should be a nonprofit.” And that's sort of a leap. That's a simplistic conclusion.

Nonprofit is not really the right term. All enterprises have to be sustainable. All enterprises have to make some money. They can make it from selling a product, they can make it from giving donations, and they can make it from breaking the piggy bank. They need to keep the lights on. They need to pay their employee, they need to pay their accountant. All companies need to be generating money in order to be sustainable. So nonprofit is a little bit of a misnomer.

What people are really getting at is that entity is tax-exempt. Right? So it generates this money, it generates revenue, it generate these donations, it generates money in various ways, and it just doesn't have to pay taxes on that. That's the key concept. Not whether it's making a profit or not. It's whether it’s paying taxes on that or not.

The idea of a tax-exempt organization or a nonprofit is not a free lunch. It doesn't make it any easier to run the business. In fact, it’s harder. And the company has to, in some ways, be more profitable because when you're running a for-profit, tax-paying, regular tax-paying for-profit entity, you have various ways you can compensate people. You, yourself, are probably not taking a salary, but you own this company and if you can build up a big company, you're going to be rich and it’s going to be very valuable and you can sell it for lots of money, so you forgo the salary for now because you own this company and you're getting equity instead.

If you have an employee, you want to hire that sales person. Maybe that sales person wants $150,000 per year. You say "I can't pay $150,000 a year, I can pay $50,000, but I'll give you 5% of my company.” That's a lot. It depends on how important the sales person is. "But I give you some equity." You can't do that with a tax-exempt company. You can't do that with a nonprofit. You don't own it. The state owns it.

And so you have to pay that sales person $150,000. So you need more funds. You need deeper pockets in order to run a tax-exempt company so keep that in mind. If you ever year of a LLC, a Limited Liability Company, that was something that was originally created in Columbia. The country of Columbia. And Ohio caught wind and said, "That’s a good idea. Let’s experiment with that in Ohio.” And they created a new kind of entity which has now spread and it’s now in every state in the United States. So there's a lot of experimentation on the nonprofit side also.