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Do nonprofits go out of business?

Of course they do.

Nonprofits complete their work, merge with other nonprofits, discover that their services are no longer needed, and (of course) sometimes just run out of money and the energy to keep going. The same state laws that set up the framework for starting a nonprofit also include requirements for closing down – called "dissolution."

Unfortunately, though, many organizations don't formally dissolve. At some point, they just stop. Maybe they run out of money, or volunteer energy. Someone may keep the files for a few years. Eventually, someone else may toss them away.

The administrative procedures of many states result in "involuntary" or "automatic" dissolution if necessary reports are not filed for several years in a row. Since federal standing as a tax-exempt organization depends on the continued existence of the corporation, the result of failing to observe these rules may be a federal tax liability and denying donors the possibility of receiving a tax-deduction for their gifts. The IRS also revokes tax-exempt status for recognized groups that fail to file for three consecutive years. If that happens, an organization that is actually still working has to re-apply for recognition – an expensive and time-consuming process. So just fading away may not be the wisest approach.

Here's how to do it right in five sections:

Charter documents

Articles of incorporation (and maybe also bylaws) usually contain a section dealing with what should happen if (or when) the organization ceases to operate. Taking care to observe any requirements found there is important for avoiding difficulties in the process.

State rules

The process of closing down the state registration for a nonprofit corporation can be quite complicated. The dissolution process is designed to ensure that proper attention is paid to all the stakeholders:

  • state and local governments – paying all taxes and fees that may be due
  • granting and contracting agencies – completing the work and handling funds
  • donors — honoring their intentions
  • employees, vendors and contractors – making final payments
  • members (if there are any) – delivering any final benefits or services they might be entitled to
  • and, in an important way, the community at large – respecting the purposes and benefits which underlie the organization's status as a nonprofit in the first place

For a large organization there can be a lot to it, especially if there are gifts that were received long ago and carry restrictions about their use or what must happen to them in this event.

The way these arrangements will be made is presented (usually to the attorney general) in a "plan of dissolution" for the organization. It will describe how the organization will wind up its affairs and answer what will be done with any remaining assets.

All of this can get very complicated, even for relatively small organizations. The best course is to find an experienced professional advisor (a lawyer or an accountant, or both) who can help sort things out.

Nonprofits also "go out of business" by merging

Sometimes one organization just closes down, as described above, and passes on all of its assets, and maybe even some or all of its programs, to another. In that case, the plan of dissolution might be pretty simple, though the continuing organization needs to do some careful review ("due diligence") to be sure there are no unpaid taxes or other obligations that might appear later to everyone's embarrassment.

More complicated is a full-fledged corporate merger. If the two organizations are of any size, with full boards, lots of volunteers, and many programs, then the planning for the merger presents not only legal but also organizational and management challenges. Typically, lawyers and other consultants are required to help sort out, and resolve, the details.

Articles of merger will have to be filed with each state where a merger partner is incorporated. The IRS will have to be notified about the organization (or organizations) that will no longer be operating, and about the changes for the organization that will maintain the merged activities. (This notice is usually provided using IRS Form 990, the annual information return most nonprofits file each year.) The IRS is not likely to question a merger unless one or more elements of the plan raise concerns about diversion of charitable assets or drifting away from the exempt purposes on which exemption is based.

Federal requirements

Every federally recognized exempt organization must file a "final" return. There is a check box on the Form 990 to announce that this is the last one that will be sent.

Generally, to obtain federal tax-exempt status, a new organization must make a commitment that if (or when) it closes down it will pass along any remaining assets to other tax-exempt organizations with similar missions. (The requirements for handling any restricted gifts will also have to be observed.) This final Form 990 will explain how that has been done.

Since the passage of the Pension Protection Act in 2006, nearly all federally recognized charities have been required to file an annual information return with the IRS. If no return is received for three consecutive years, the organization is automatically removed from the list of exempt organizations. If it has stopped operating and there were no significant assets at stake, this outcome may be acceptable. If the organization is still operating, though, then it will need to reapply for exempt status, with can be a time-consuming and expensive distraction. Without exempt status, too, the organization may owe taxes and contributors will not be able to deduct donations.

The IRS offers a "Mini-Publication" as guidance to organizations that are closing or merging on its website at http://www.irs.gov/pub/irs-pdf/p4779.pdf.

Is it possible to return money to contributors on a pro-rata basis?

The short answer is "no."

The IRS says this another way in their Publication 557, Tax-Exempt Status for Your Organization:

Assets of an organization must be permanently DEDICATED to an exempt purpose. This means that should an organization dissolve, its assets must be DISTRIBUTED for an exempt purpose described in this chapter, or to the federal government or to a state or local government for a public purpose. If the assets could be distributed to members or private individuals or for any other purpose, the organizational test [for exempt status] is not met.