How to Transfer Ownership of a Nonprofit: Everything You Need to Know about Transferring Ownership of a Nonprofit
How to Transfer Ownership of a Nonprofit: Everything You Need to Know about Transferring Ownership of a Nonprofit
Starting your own nonprofit requires a lot of work, dedication, and understanding of state laws and IRS regulations. You might be surprised to learn, however, that transferring ownership of a nonprofit is even trickier. In a best-case scenario, upon starting the nonprofit, your board of directors drafted an operating agreement with a detailed process of how ownership transfer should be handled. With an operating agreement firmly in place, all you have to do is follow the procedure.
If your organization does not have an operating agreement with a buy-sell procedure, transferring ownership will be more difficult, but not impossible. Start by reading this guide to ownership transfer. Then, consult your operating agreement, corporate bylaws, and board of directors.
If there's a will to transfer ownership or even a single share, there's a way to do it without incurring legal ramifications.
Nonprofit vs. For-profit Ownership
There is a lot to understand regarding the ownership of for-profit entities, but ownership of nonprofits can be summed up very simply: there are no owners.
For-profit entities operate in a manner of different ways. The most common are:
- Sole proprietorship: an informal structure in which one person sells products and or services for profit. In this case, there is no legal distinction between the individual and the business and the individual accepts full responsibility for all liabilities and debts of the business.
- General Partnership: two or more individuals co-own the for-profit company in which there is no distinction between the individual and the company.
- Corporation: a formal structure in which ownership is vested in the shareholders. Corporate entities can be both private and public. The owners are separate entities and are not responsible for any debts or liabilities.
- Limited liability agency (LLC): a formal association in which the members are not personally responsible for the agency’s debts.
In comparison, over 90% of tax-exempt nonprofits are classified as nonprofit corporations. Nonprofit corporations have no owners or shareholders whatsoever. A nonprofit can also be an LLC so long as it is owned by a single tax-exempt organization and meets the requirements set forth by the IRS.
When a nonprofit is formed, they do not declare any shares of stocks as for-profit companies do. This is because nonprofit organizations are formed to carry out a non-commercial purpose that benefits the public, not themselves. In fact, conducting nonprofits in a way that results in personal inurement is prohibited by law and can cost the organization its tax-exempt status.
Importance of a Nonprofit Operating Agreement
An operating agreement is a legal document used by nonprofits to outline the organization's financial and functional decisions such as rules, regulations, and provisions. The purpose of an operating agreement is to govern internal operations in a way that is tailored to the needs of the nonprofit members. Once all members sign the agreement, it acts as a legal contract binding them to the terms.
What is included in an operating agreement?
- Percentage of each member's ownership
- Voting rights and responsibilities
- Duties of members and managers
- Distribution of profits and loses
- Meeting schedules
- Buyout and buy-sell rules (for transferring interest or in the event of a death)
- Terms of ownership and member transfer
Why does a nonprofit need an operating agreement?
- To protect the nonprofit's limited liability status: Operating agreements give members protection from personal liability. Without this specific formality, the organization can be seen as a sole proprietorship or partnership and hold members accountable for debts and liabilities.
- Clarify verbal agreements: Without a legally binding document, misunderstanding or miscommunication can occur between members. Operating agreements can be referred to in the event of a conflict.
- Protect the agreement in the eyes of the state: State default rules govern nonprofits without an official operating agreement, meaning each state’s default laws apply to nonprofits in the event of a buyout or ownership transfer.
In addition to internal governance procedures, the process of ownership transfer is typically covered in an operating agreement. When deciding to make an operating agreement, members should outline the exact process of transferring ownership in the event of a transfer.
Remember, this is a legally binding contract. In the event that an individual wants to transfer ownership or sell their personal shares, they must abide by the ownership transfer process spelled out in their corporate bylaws.
The Importance of a Buy-Sell Agreement to Transfer Ownership
In nonprofit LLCs, anyone over the age of 18 can become a shareholder (typically referred to as a member). Members of LLCs aren’t always individuals as you might think, but can include corporations, other LLCs, and foreign entities.
Unlike other business models, LLC members do not own stock in the corporation because there aren’t any to own. Rather, they receive ownership interests that entitle them to a percentage of the LLC's profits, which is usually proportionate to the amount of capital they contributed to the business.
With the potential for so many hands to be in one pot, wise nonprofit members employ a buy-sell agreement.
A buy-sell agreement is a written contract between two or more nonprofit members. The contract outlines the plan for the orderly transfer of any member's share in the case of a “triggering event”. A triggering event can include death, disability, divorce, insolvency, employment termination, or retirement.
A buy-sell agreement ensures no one member can sell their share of the corporation without the consent of the other members. It safeguards the integrity of the nonprofit and its shareholders in a legally binding contract.
Consider a buy-sell agreement if:
- Your nonprofit has two or more shareholders
- You want to protect yourself and the organization were a “triggering event” to occur
- You want to outline the procedure for an orderly transfer of ownership before a “triggering event” occurs
How buy-sell agreements help nonprofit shareholders:
- Prevent shares from being sold to outsiders and undesirable members (for instance, a disgruntled family member of a former member)
- Ensure an orderly transfer of shares or ownership
- Establish a method to value the stock of the departing member
- Establish a procedure for removing members under specific circumstances
- Prevents leaving members from taking customers and leads
In the event that a member wants or needs to sell their share of the corporation, their share doesn’t necessarily have to be purchased by another member or an outside unit. It can be repurchased by the nonprofit itself. This is typically the case when a member needs to sell their share and the remaining members would rather consolidate the business than bring in another member.
In the case of a nonprofit buying back shares, the shares are typically redistributed to the remaining members unless otherwise specified in the buy-sell agreement.
Transferring Ownership Through a Non-Profit Organization Buyout
In the event that one corporation member wants to buy out another member, follow the bylaws established in the buy-sell agreement. Part of this agreement should be handling the valuation of the shares being sold. This is done first by appraising the total value of the agency and then multiplying the total by the ownership percentage.
The two most commonly used valuation methods are:
- Market value method: the market value method compares other nonprofits that have recently changed ownership. When using the market value method, make sure to find a nonprofit with similar financial metrics as your own.
- Income method: The income method bases the nonprofit's value on the income or profit it produces. To use this method, first calculate your nonprofit's average monthly income, subtract any debts, and add the amount of any cash reserves. Multiply this result by a factor mutually agreed upon by the members to get the estimated value of the business.
Step 2: negotiate the terms of the buyout: Even with a buy-sell agreement in place, there are details of a buyout that must be hammered out. A few things to consider are:
- Who will be buying the leaving member’s shares?
- Do the other members have the “right of first refusal,” meaning the right to purchase shares before a third party?
- How will the purchase price be paid?
- Will responsibilities or titles change among remaining members?
- Will the leaving member take any physical or financial property with them?
Step 3: Draft the buyout agreement. Once all the terms have been established, make an agreement to be signed by all involved parties and submit it to your registered agent (an individual or agency that accepts official paperwork such as service of process (lawsuits) and annual registration fee notices).
Step 4: Pay for the member’s share. The final step in a buyout is paying the agreed-upon price for the leaving member’s share.
However you decide to handle a buyout in your nonprofit, make sure you have the approval of every member when drafting a buy-sell agreement. Discord among owners can be detrimental to a nonprofit and what matters most in the end is maintaining the mission of your organization.
Selling an LLC
There might come a time when someone approaches your organization with an interest in purchasing it, or, for whatever reason, the members want to sell the business altogether instead of a single share. In these scenarios, you will need to follow the guidelines for your specific state.
While state laws can differ when selling a business, there will be some common steps all owners will need to follow when selling their nonprofit.
First, you will need to decide on a price for your organization. This is different than identifying the value of a share, as in the case of a buyout or selling singular shares.
When valuing the entire business, calculate the sum of your assets including real estate, equipment, and inventory. Then, calculate your debts and liabilities. Subtract the sum of your liabilities from the assets and the result is the value of your agency.
If calculating the value of your agency sounds intimidating, don’t worry. You can always employ the help of an online business valuation calculator like Western & Southern Financial Group or Nationwide . You can also work with an individual trained in calculating formal agency valuations. The American Society of Appraisers can help with this.
After you have found a buyer for your nonprofit and agreed on a price, you have three documents left to draft:
- A preliminary memorandum. A preliminary memorandum is an informal written record of an agreement that has not yet become official. It should include the agreed-upon price of the sale and any other applicable terms.
- A formal transfer agreement. This is a legally binding document that transfers an agency from the owner to the buyer. It includes the terms of the transaction and, if applicable, clauses and warranties to protect both the seller and buyer after the transaction has been completed.
- A change of ownership letter. A change of ownership letter is a courtesy to your employees and customer base, letting them know the agency has changed hands. In this letter, introduce the new owner, their background, the reason behind the takeover, and how, if at all, this new ownership will affect the running of the agency.
State Laws, Corporate Bylaws, and Ownership Transfer
A consequence of not drafting an operating agreement upon the formation of a nonprofit corporation can arise when you decide to sell or transfer ownership of the organization. Without a legal document specifying word for word how ownership transfer should be handled, you could be at the mercy of state law.
Organizations that did not include procedures for ownership transfer in their corporate bylaws may be able to add one by drafting an amendment to their operating agreement and voting to approve it by the board of directors.
If your state does not allow amendments, nonprofit members must follow their state laws to dissolve their agency and form a new one after ownership is transferred. This is ultimately starting from the ground up but will spare the seller and purchaser legal consequences with their state and the IRS.
Best Practices for Transferring Ownership in Nonprofits
To avoid the hassle and potential consequences of dissolving your non-profit organization and starting a new one, it is imperative to document the process of ownership transfer in your operating agreement. There's a lot to consider when drafting this part of the operating agreement such as:
- Do existing members get first dibs on another member's share before it's offered to a third party?
- Can a member be removed from their position? If so, how?
- What is the process for bringing in an additional member?
- What is the process for buying out a member?
- If a member leaves, are they able to take any physical or financial property with them?
If this seems overwhelming, don't worry. You don't have to draft your operating agreement alone. Search for a lawyer familiar with nonprofit LLCs and your state laws. They can help you make an operating agreement that protects your nonprofit's tax-exempt status and minimizes the headache of ownership transfer.
What is the difference between transferring ownership in a nonprofit and a for-profit entity?
Transferring ownership of a nonprofit is a bit different than for-profit ownership transfer. For-profit businesses, unless they are an LLC, can sell their business like they would any other piece of property.
Nonprofits must consult their operating agreement and follow the bylaws of ownership transfer. They can also gift the agency to someone else or transfer ownership through nonprofit mergers or acquisitions so long as it is not prohibited by the operating agreement.
Both nonprofits and for-profit entities must abide by state laws and file the proper paperwork with the IRS when the sale is final.
How do state laws impact the ownership transfer process?
Each state has its own laws regarding ownership transfer. When there is no operating agreement in place, nonprofits must follow their state's laws regarding ownership transfer or face penalties from the IRS, including loss of tax-exempt status.
What happens if there's no operating agreement in place?
If a non-profit fails to include ownership transfer procedures in its operating agreement, it might be able to make an amendment to the original agreement and have it voted into approval by the directors. If this is not an option, they will have to dissolve the organization and form a new one after the sale is completed.
How is the value of the nonprofit determined for ownership transfer?
The two most common methods of valuing a nonprofit are the market value method and the income method. The market value method compares the business of one nonprofit to a similar nonprofit that has recently changed hands. The income method calculates the nonprofit's income minus any debts to estimate the value of the organization.
Your Nonprofit Corporation Needs an Operating Agreement
The importance of an operating agreement cannot be understated and we hope this article has helped the process of drafting one feel a little more accessible.
If your nonprofit is in the beginning stages, now is the perfect time to cover all the bases of an operating and buy-sell agreement. Before you write your corporate bylaws, learn about your state and tax laws. Consult an expert. Hire a lawyer to answer your questions and draft everything appropriately.
If you have an operating agreement in place but aren't sure if it includes a buy-sell agreement, bring it up in your annual board meeting. If your bylaws do not include a buy-sell agreement, you might be able to make an amendment. Most states do not require you to file the amended agreement with the state, but each member should be given a copy.
Even if an amendment is not possible and you have to dissolve the nonprofit and begin again, it will be well worth not incurring legal penalties that could hinder the mission of your organization.