What happens when nonprofits go out of business?

Summary:

A plan of dissolution is supposed to be filed. Often that doesn't happen. Assets must be passed on to another organization with a similar purpose.

Chip M. Watkins wrote to the cyber-accountability list on May 11, 2000, about the death of nonprofits.
Even if a declining organization has had several years of low income, so it
isn't ordinarily required to file Form 990, it must file a "final" return,
as required by Sec. 6043.

More typically, however, EOs don't formally dissolve. Instead, I surmise
that in their later years, they are manned by the most dedicated, but not
necessarily the most knowledgeable about legal niceties and bureaucratic
requirements. These people are dedicated to the mission but working with declining
resources. At some point, they simply give up, they're out of money, they
box up the files for a few years, and then they throw them away.

Ergo, no final Form 990, no formal dissolution under state law.

In those states where the AG registers charities (regardless of whether they
solicit), the AG should follow up the apparent disappearance of a charity to
ensure that assets haven't been diverted--in smaller cases, my guess is that
the charity just ran out of money. But with limited resources, and a lot
spent on trying to ensure that major nonprofit hospital assets aren't
diverted to for-profit partners, my guess is that the disappearance of a lot
of small charities goes unremarked in most offices.

Mergers are becoming, I believe, slightly more common, as entrepreneurial
EOs find it increasingly difficult to compete for funds for largely
overlapping programs. Some are willing to merge to produce better programs
with less competition for funds. It's certainly happening among trade
associations. (Sec. 501(c)(6)).

Articles of merger must be filed with the state in which each merger partner
is incorporated, and a final return filed for the non-survivor. No reason
for the IRS to act unless a (c)(3) is merged into a non-(c)(3) without
appropriate protection, so that inurement might be present.

Someone asked in Nonprofit (see http://www.rain.org/mailman/listinfo/nonprofit) on April 30, 2004:
It appears that we may have to dissolve our 501(c)(3) organization that has
been in existence for about 10 years. We have approximately $300,000 worth
of real estate assets. If we sell those, is it possible to return money to
the contributors that we have kept very accurate records of since our
inception on a pro-rata basis?

Sandy Deja, Author of "Prepare Your Own 501(c)(3) Application"
an ebook for lay people (http://www.501c3book.com/) responded on May 2:

Short answer: NO

Long answer: According to Section 1.501(c)(3)-1(b)(4) of the Income Tax Regulations:

4) DISTRIBUTION OF ASSETS ON DISSOLUTION. An organization is not
organized exclusively for one or more exempt purposes unless its
assets are dedicated to an exempt purpose. An organization's assets
will be considered dedicated to an exempt purpose, for example, if,
upon dissolution, such assets would...be distributed for
one or more exempt purposes, or...to another organization to be used in
such
manner as in the judgment of the court will best accomplish the
general purposes for which the dissolved organization was organized.
However, an organization does not meet the organizational test if its
articles or the law of the State in which it was created provide that
its assets would, upon dissolution, be distributed to its members or
shareholders.

The IRS said this another way in their Publication 557, TAX-EXEMPT STATUS FOR
YOUR ORGANIZATION (http://www.irs.gov/pub/irs-pdf/p557.pdf):

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 is not met.

(If the organizational test is not met, the organization will lose its exempt status and taxes may well be due; in that case, donors might also lose whatever deductions they had taken for donations in previous years. When the plan of dissolution is filed with the Attorney General -- as Chip Watkins explains should happen in his note above -- one of the things the AG will be looking for is improper distribution of the organization's remaining assets. --Ed.)

(The distribution of any restricted assets will have to be done in accordance with the original terms of the gift that created the asset; a reason why keeping good records of restricted gifts is an important task. Much expense can be incurred if there are disagreements over the distribution of restricted assets. --Ed.)