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Choosing the right legal structure for your charity or not for profit organisation

So you know what social activity you want to provide and the social outcomes you want to deliver, but what is the most appropriate legal structure for your organisation? Philip Griffiths, Head of Charity Services at Mitchell Charlesworth discusses this key question.

Getting the legal structure right first time of asking is just as important as identifying the services and beneficiaries you want to support. Questions arise around the availability of external funding, tax exemptions, the ability to pay directors' salaries, returns to investors and ownership of assets, all of which play a part in determining what structure would be the most appropriate.

There are three primary types of legal structure and each is now considered in turn.

Registered Charity

This is by far the most common form of structure to deliver social benefit. Prior to the Charities Act 2006 what constituted a charitable purpose was largely determined by case law over a 400 year period. The Charities Act 2006 codified charitable purposes into 11 core headings, but additionally it also introduced the concept of public benefit. Put simply it means that the activity must be for the benefit of the public in general, or a sufficient section of the public, and that for example, the need to pay for the service in question would not prevent individuals from benefitting.

Charities are governed by a Board of Trustees. Under current legislation, trustees cannot be paid in their roles as trustees, and there are restrictions on the provision of other services by charity trustees, their families and other organisations they may be connected to. What this means in practice is that if you are looking to set up a charity, you cannot have this as your day job and keep control at the same time.

Trustees must always act in the best interests of the charity. By definition charities have an asset lock meaning that assets cannot be transferred out of the charity except at market value. Charities do not have share capital and therefore the question of dividends does not arise. Charities may borrow, but if they are to give security for a debt, the trustees must obtain independent professional advice in writing and any lender will need to see this before affecting the security.

Given the stringent governance arrangements, the registration process is generally longer than for other forms of legal entity.

Charities benefit from an exemption from corporation tax or income tax on its income and gains providing that non charitable income is the lower of 25% of total income or £50,000. A popular misconception is that there are general exemptions from VAT, and whilst there are some limited concessions on things like zero rating for advertising, supplies made are subject to VAT if they fall within the taxable definition. If not, then it is likely that the charity cannot register for VAT so certain costs will be 20% more than a for a VAT registered business.

Charities can take various forms. Historically they were formed as trusts, associations or under a set of rules. This type of charity has no legal form, assets are held in the names of individual trustees and there is potentially no limited liability. This means that if trustees change, the charity should ensure that outgoing trustees are removed and new trustees added to ownership documents.  This can be time consuming and expensive if there are regular changes in trustees.

As an alternative, charities were previously formed as limited by guarantee companies. The charity has a legal form and can own assets in the name of the charity. The downside is that the entity needs to be registered with both the Charity Commission and Companies House and any changes replicated in both. In addition, the charity is exposed to late filing penalties if it is late filing documents at Companies House. As an alternative, in 2013 there was the introduction of the Charitable Incorporated Organisation or CIO for short. This type of charity has its own legal form and affords limited liability to the trustees, but registration is solely with the Charity Commission and therefore takes advantage of the best of both worlds. Any new charity is best utilising this option setting up in future.

Community Interest Company

Community interest Companies or CICs were introduced in 2005 as a special form of limited company, and in addition to being registered with Companies House, are also registered with the Regulator for Community Interest Companies. Similar to charities they have an asset lock which means assets cannot be disposed of for anything less than full market value. CICs can be limited by guarantee or limited by shares, and therefore in the latter case are able to pay dividends out of profits but this is subject to a maximum of 35% of the profit earned in any year.

Directors can be paid as in any other company although this is open to scrutiny if emoluments are excessive. This means that one or more individuals can control the CIC and be paid at the same time, unlike with a charity.

From a tax perspective, CICs are chargeable to corporation tax on its profits like any other company therefore it is important that the accounting policies on which the financial statements are based are appropriate and relevant to the activities and funding of the company so that the company is not paying corporation tax on artificial profits.

VAT applies to CICs in the same way that it applies to charities although certain specific exemptions that are available to charities do not apply.

Generally funding can be available to CICs in the same way that it is available to charities although it is best to check with specific funders beforehand.

Limited companies

Theoretically there is no reason why social activity cannot be carried out through a standard limited company although social funding is unlikely to be available unless the company is itself owned by a charity or CIC.

There would be no restrictions on the way the company can be governed and both directors and shareholders can be remunerated by way of salary and dividends providing the profits are available.

Companies are subject to the normal rules of VAT and corporation tax.

This briefly outlines the key considerations in choosing the correct structure for your organisation, getting it right at the outset can avoid costly professional fees later down the line.

If you need advice and support on choosing the right legal structure for your charity, please contact Philip Griffiths or a member of the charities team below.

Written 20 October 2021.

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