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Should We Incorporate?

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Imagine you and a group of friends want to start a charity, church, club, or other nonprofit organization or are considering whether to restructure a currently operating organization. An initial question you will need to answer is what form the organization will take. The two most common forms of nonprofit organization are the corporation and the unincorporated association. Organization founders should understand each option in their decision of how best to structure the organization. These days, most people choose the corporate structure, and for good reason. Here’s why.

Advantages and Problems of Unincorporated Association Status

Some founders choose to establish an unincorporated association because they are easy to create and provide flexibility. Most associations do not have to file any documents with a state regulator to be created or dissolved. Associations may be created or dissolved by the simple agreement of their members. The association does not have to adopt a governing document, although it should. A governing document is helpful for organizational purposes and is required before obtaining tax exemption.

Flexibility and ease of creation, however, typically are outweighed by liability risks. Unless a state statute specifically provides otherwise, unincorporated associations generally have no separate legal existence apart from their members. Rather, an association is simply a group of people acting together for a common purpose. Members of an unincorporated association can be held jointly and severally liable for each other’s acts that arise in the context of the association – i.e., personally, and each to the full extent of potential damages sustained by others. No legal protections limit personal liability for acts performed by other officers, members, or other volunteers acting on behalf of the organization. Likewise, no legal protections exist for other members when one member acts negligently in conducting association programs. Indeed, many of the liability issues for unincorporated associations are the same legal deficiencies inherent in a traditional partnership, which gave rise to the development of the limited liability partnership and limited liability company corporate structures.

Additional problems arise for unincorporated associations in states that have not established a law regarding unincorporated associations as legal entities. While several states do treat unincorporated associations as entities for the purpose of suing or being sued, many do not. Also, absent a specific statute, an unincorporated association cannot receive or hold property on its own. Even in states that do regard associations as legal entities, banks and vendors may be wary of doing business with them because they are more familiar with corporations and may be discouraged by the lack of legal guidance regarding associations.

Benefits of Incorporation

What about the other option – incorporation? Incorporating requires more work at the forefront, including filing the proper paperwork and establishing bylaws. The initial investment of effort, however, is often well worth the benefit to members and leaders of the organization. In particular, the statutory guidance and legal protections afforded to nonprofit corporations are much more robust.

Nonprofit corporations benefit from statutory “gap-fillers.” These laws specify default rules for situations the corporation’s governing documents do not address. When a question arises, such as whether members can remove an officer without specific legal cause, or the percentage of votes needed for a particular type of action, nonprofit corporation acts provide an answer. Unincorporated associations lack this statutory framework, which create greater legal challenges when conflict arises.

In addition, personal liability of members, directors, and officers is more greatly limited when the nonprofit organization is incorporated. Generally, liability is limited to assets owned by the nonprofit corporation, and does not extend to members. Volunteer directors and officers of corporations are protected by use of the “business judgment rule,” under which they are presumed to make decisions on an informed basis and in good faith. Except for very limited situations, volunteer directors and officers are not held personally liable for actions performed as part of their leadership roles absent gross negligence or intentional harm. Leaders may be further protected by provision for indemnification by the corporation and insurance policies covering acts of directors and officers.

Nonprofit corporations have several other benefits over unincorporated associations. For example, it is generally easier for a corporation to buy and sell property or to do business with a bank because the nonprofit corporation has a clear governance structure, nonprofit purpose, and legal status. Incorporation may make it easier to obtain certain benefits such as state sales tax exemptions or special nonprofit mailing rates. And incorporating the organization provides certain trademark protections in the organization’s name, establishing it in the state’s records so that other entities in the state cannot use the same name or one that is so similar as to be confusing.

While unincorporated associations may seem inviting for the founder who is eager to quickly begin doing good, incorporating is generally better for the long haul.  Incorporating from the beginning and developing thorough governing documents can help to establish a solid foundational structure for the organization’s benefit for years to come.

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