Chapter 1: Is Nonprofit Incorporation Right for You?

Deciding to form a nonprofit corpo­ration will be a big step for you and the members of your group. It will involve more paperwork and government forms, on both the state and federal level, than anyone will like; and you’ll have to conduct your business within the legal framework of various state and federal laws. Fortunately, there are big payoffs to all this work and attention, including the ability to attract donors and grant funds, obtain real and personal property tax exemptions and special nonprofit mailing rates, avoid corporate income taxes, and shield officers and directors from legal liability. Before starting down the path of nonprofit incorporation, however, you’ll want to learn a little more about who can form a nonprofit and the consequences of doing so. In this chapter, we’ll explain:

• the kinds of groups that can—and can’t—form a nonprofit using this book

• the benefits you’ll enjoy as a nonprofit—and some of the disadvantages to choosing this route

• how nonprofits can raise start-up funds and earn money, should they wish to do so

• the process you’ll go through (following the instructions in this book) to incorporate and obtain your tax-exempt status, and

• for those considering incorporating in another state, considerations to bear in mind before doing so.

Is Your Group a Nonprofit That Can Use This Book?

A for-profit corporation can be formed for any lawful purpose. Nonprofit corporations, how­ever, must be established under California law for one of three broad purposes: (1) for the benefit of the public (a public benefit corpo­ration), (2) for religious purposes (a religious corporation), or (3) for the mutual benefit of the members of the nonprofit (a mutual benefit corporation). It’s easy to form a nonprofit corporation in California: Just prepare articles of incorporation that say you are formed for one of these three broad nonprofit purposes and then file your articles with the California Secretary of State. This creates your legal corporate entity. However, having a nonprofit corporation recognized by the California Secretary of State is only your first hurdle. The next important step is to obtain the neces­sary state and federal corporate income tax exemptions for your nonprofit corporation. To obtain these exemptions, your nonprofit must be formed for one or more specific purposes described in the income tax statutes.

This book has been written specifically for non­profits that want to qualify for a federal income tax exemption under Section 501(c)(3)
of the Internal Revenue Code. This means your nonprofit must be formed for religious, chari­table, scientific, literary, and/or educational purposes. If you want to organize as a religious purpose group, we will show you how to form a California religious nonprofit corporation. If you want to organize as a nonprofit to engage in any of the other 501(c)(3) tax-exempt pur­poses, we will show you how to form a Cali­fornia public benefit corporation. This book is not for groups that want to form a mutual benefit corporation, because mutual benefit nonprofits usually obtain their tax exemption under a subsection of Section 501(c) other than 501(c)(3). It is also not for certain special types of nonprofits (including some public benefit corporations) that do not fall under Section 501(c)(3). See discussion below, “Special Types of California Public Benefit Corporations,” and “Mutual Benefit Corporations.”

When thinking about incorporating your non­profit, consider which purpose you fall under for Section 501(c)(3). Once you know you fall within one of the 501(c)(3) purposes, you can rest assured that this book can help you through the process. First we’ll help you create your corporate entity in California by showing you how to prepare and file articles of incorporation for a public benefit or religious corporation. Then we’ll show you how to obtain your state and federal nonprofit income tax exemptions for 501(c)(3) status.

Corporation Basics

You don’t have to understand all there is to know about corporations in order to follow this book or form your nonprofit. But there are a few basic concepts you’ll want to have under your belt as you go through the process. Here they are, with special emphasis on any differences between for-profit corporations and nonprofits:

•  A corporation is a separate legal entity. A corporation is a legal entity that allows a group of people to pool energy, time, and money for profit or nonprofit activities. It acquires legal existence after its founders comply with their state’s incorporation procedures and formalities. The law treats a corporation as a separate “person,” distinct from the people who own, manage, or operate it. The corporation can enter into contracts, incur debts, and pay taxes. Corporations are either for-profit (business corporations) or nonprofits.

•  For-profit, or business, corporations versus nonprofits. Business corporations can be formed for any legal purpose. They can issue shares of stock to investors in return for money or property, or services performed for the corporation. Shareholders receive a return on their investment if dividends are paid or if, upon dissolution of the corporation, any                      corporate assets remain to be divided among the shareholders after payment of all creditors. Nonprofits, on the other hand, generally cannot issue shares of stock or pay dividends under state law (unless they are some type of hybrid such as consumer or producer co-ops). The federal tax code also prohibits 501(c)(3)
tax-exempt nonprofit corporations from paying dividends or profits to their members or other individuals. When a 501(c)(3) tax-­exempt nonprofit corporation dissolves, it must distribute its remaining assets to another tax-exempt nonprofit group.

•  In-state and out-of-state corporations. Corporations formed in California are known in California as “domestic” corporations. Corporations formed in other states, even if physically present and engaging in activities in California, are called “foreign” corporations. For example, a corporation formed in California is a domestic corporation as far as California is concerned, but a foreign cor­por­ation when considered by other states. At the end of this chapter, we give you more information on doing business outside California and deciding whether to incorporate in another state.

Public Benefit Corporations

Under state law, public benefit corporations are corporations formed for a “public purpose” or “charitable purpose.” Most groups forming public benefit corporations also want to qualify for Section 501(c)(3) status. These groups usually organize for one of the specified purposes under Section 501(c)(3)—charitable, scientific, literary, or educational. All of these 501(c)(3) purposes are considered “charitable” purposes under California law. For example, a school or educational facility would organize as a California public benefit corporation formed under state law for “charitable” purposes but its 501(c)(3) purposes would be “educational.” The public purpose classification under state law is for groups that want to form civic league or social welfare public benefit corporations (see discussion below on civic league and social welfare groups). Don’t worry—we show you how to fill in your articles so you put in the right purposes under California law and also satisfy the federal and state tax exemption requirements.

Religious Corporations

Just as the name indicates, religious corpo­rations are formed primarily or exclusively for religious purposes. These groups can qualify as religious organizations under both state incorporation law and Section 501(c)(3).
You need not set up a formal church to form a religious nonprofit corporation; these groups can have a general religious purpose. For example, a group organized to promote the study and practice of a particular religion could incorporate as a religious nonprofit corporation. It is unlikely that the California Secretary of State’s office, where you’ll file your articles of incorporation, will question whether your religious activities are genuine. This type of debate is more likely to occur (if it occurs at all) when you apply for your state or federal tax exemptions.

Special Types of California Public Benefit Corporations

This book covers the incorporation of California public benefit and religious nonprofits that want to obtain their tax exemption under Section 501(c)(3) of the Internal Revenue Code. There are several other types of California public benefit corporations that obtain tax exemption under other sections of the Internal Revenue Code or that must meet special state law requirements. Below, we list several of the most common types of these special California nonprofit corporations. If you plan to form one of these special non­profits, you’ll need to do your own research or get legal help to form your corporation—this book does not cover the incorporation of these special groups. See “Where to Go for Help for Non-501(c)(3) Nonprofits,” below.

•  Civic leagues and social welfare groups. Civic leagues and social welfare groups are formed as California public benefit corporations and seek their exemption from federal corporate income taxation under Section 501(c)(4) of the Internal Revenue Code. Because this book covers only nonprofits exempt under Section 501(c)(3) of the Internal Revenue Code, you won’t be able                       to use this book to incorporate these types of public benefit corporations. (See “Special Nonprofit Tax-Exempt Organizations,” in Appendix B, for a list of organizations that qualify for tax-exempt status under a sub­section of 501(c) other than Subsection 3.)

•  Medical or legal service corporations. These are nonprofit corporations operated to assume or defray the cost of medical or legal services. These corporations may be organized as California public benefit corporations or mutual benefit corporations. Special provisions of the California Corporations Code apply (see California Corporations Code §§ 10810–10841).

•  Humane societies. A humane society, formed to prevent cruelty to children or animals, can be formed as a Calif­ornia public benefit corporation. The Department of Justice must perform a criminal history check on all incorporators and issue a certificate before the secretary of state will accept the articles of incorporation for filing (California Corporations Code §§ 10400–10406).

Mutual Benefit Corporations

This book is not intended for mutual benefit corporations. Unlike public benefit corpo­rations and religious corporations, these groups usually qualify for tax-exempt status under a subsection of 501(c) other than 501(c)(3).
Examples of mutual benefit corporations include trade associations, automobile clubs, and social groups, such as tennis clubs. Chambers of commerce, boards of trade, and mechanics’ institutes, which are generally formed to promote trade and commerce, can organize as mutual benefit corporations or as regular, for-profit corporations. Cooperatives, comprising producers or consumers organized for their mutual benefit, can also qualify as mutual benefit nonprofits with special added restrictions applicable to them.

Because these groups do not qualify for tax-exempt status under Section 501(c)(3), they are not entitled to many of the benefits enjoyed by public benefit and religious corporations. For example, contributions to mutual benefit corporations are normally not tax deductible, and other benefits (such as special nonprofit mailing rates and real and personal property tax exemptions) are not available to mutual benefit corporations. Mutual benefit corporations also cannot distribute gains, profits, or dividends to those designated in their articles or bylaws as members, but may provide them with other benefits such as services and facilities. On the other hand, members of a mutual benefit corporation can own part of the corporation. When the corporation dissolves and all its debts and liabilities are paid, the remaining assets, gains, and profits can be distributed to its members.

Benefits of the Nonprofit Corporation

Now that you understand that this book is intended for nonprofits organized for religious, charitable, scientific, literary, and/or educa­tional purposes that want to qualify for a tax exemption under Section 501(c)(3) of the Internal Revenue Code (and hopefully your nonprofit is among them), let’s look at the benefits you’ll enjoy as a 501(c)(3) tax-exempt nonprofit corporation. The relative importance of each of the following benefits will vary from group to group, but at least one of them should be very significant for your organization.

If you finish this section and conclude that nothing here is very important for your group, you’ll want to consider whether it makes sense to incorporate at all. Many groups accomplish their nonprofit purposes just fine as unincorpo­rated nonprofit associations, without formal organizational paperwork or written operational rules. If you can continue to accomplish your nonprofit purposes and goals informally, you may be happier staying small.

Tax Exemptions

Nonprofit corporations are eligible for state and federal exemptions from payment of cor­po­rate income taxes, as well as other tax exemp­tions and benefits. At federal corporate tax rates of 15% on the first $50,000 of taxable income, 25% on the next $25,000, and 34% and higher on income over $75,000, it goes without saying—at least if you expect to earn a substantial amount of money (from services, exhibits, or performances, for example)—that you’ll want to apply for an exemption. The California corporate income tax exemption is equally attractive, as are county real and personal property tax exemptions. Chapters 3, 4, and 5 cover tax exemptions in detail.

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Receiving Public and Private Donations

One of the primary reasons for becoming a 501(c)(3) nonprofit corporation is that it increases your ability to attract and receive public and private grant funds and donations.

• Public sources. Tax-exempt government foundations (like the National Endowment for the Arts or Humanities, the Corporation for Public Broadcasting, or the National Satellite Program Development Fund) as well as private foundations and charities (such as the Ford Foundation, the United Way, or the American Cancer Society) are usually required by their own operating rules and federal tax regulations to donate their funds only to 501(c)(3) tax-exempt organizations.

• Private sources. Individual private donors can claim personal federal income tax deductions for contributions made to 501(c)(3) tax-exempt groups. At death, a complete federal estate tax exemption is available for bequests made to 501(c)(3) groups.

In short, if you plan to ask people to give you significant amounts of money in furtherance of your nonprofit purpose, you need to demonstrate to your donors that you have 501(c)(3) tax-­exempt status.

Where to Go for Help for Non-501(c)(3) Nonprofits

If you want to form a nonprofit for any purpose other than one recognized under Section 501(c)(3) of the Internal Revenue Code, this book is not for you. For example, if you are a civic league or social welfare group that wants nonprofit status, you will want to organize as a public benefit corporation under Section 501(c)(4) of the Internal Revenue Code. Or, if your group is a California mutual benefit corporation, you will seek tax-exempt status under a subsection of 501(c) other than
501(c)(3). This book is not intended for these special types of nonprofits.

If you are a special nonprofit that is not covered by this book, you can find legal forms and tax exemption help online. For sample articles of incorporation for mutual benefit corporations and public benefit civic leagues and social welfare groups, go to the California Secretary of State Corporations Section website. (See Contact Information in Appendix B.) If you are seeking tax exemption for a nonprofit under a subsection of 501(c) other than 501(c)(3),
go to the IRS website at www.irs.gov and obtain IRS Package 1024. The IRS 1024 package contains forms and instructions to use to apply for a nonprofit tax exemption under Internal Revenue Code Sections 501(c)(2), (4), (5), (6), (7), (8), (9), (10), (12), (13), (15), (17), (19), and (25). The California Franchise Tax Board website at www.ftb.ca.gov has state tax exemption application forms to download and use to apply for your state corporate income tax exemption for these special non-501(c)(3) groups. IRS Publication 557 and IRS Form 1024 also contain information and instructions on forming some of these special purpose nonprofits.

Protection From Personal Liability

Protecting the members of your group from personal liability is one of the main reasons for forming a corporation (either profit or nonprofit). Once you’re incorporated, in most situations directors or trustees, officers, employees, and members of a corporation won’t be personally liable for corporate debts or liabilities, including unpaid organizational debts and unsatisfied lawsuit judgments against the organization, as they normally would be if they conducted their affairs without incorporating. Creditors can go after only corporate assets to satisfy liabilities incurred by the corporation—not the personal assets (car, home, or bank accounts) of the people who manage, work for, or volunteer to help the nonprofit corporation.

Example:

A member of the audience sued a nonprofit symphony orchestra when the patron fell during a concert, claiming that the symphony (which also owned the concert hall) provided an unsafe ramp. The patron won a judgment that exceeded the orchestra’s insurance policy limits. The amount of the judgment in excess of insurance is a debt of the corporation, but not of its individual directors, members, managers, or officers. By contrast, had the orchestra been an unincorporated association of musicians, the principals of the unincorporated group could be held personally liable for the excess judgment amount.

In a few situations, however, people involved with a nonprofit corporation may be personally liable for the corporation’s liabilities. Here are some major areas of potential personal liability:

• Taxes. State and federal governments can hold the corporate employee who is respon­sible for reporting and paying corporate taxes (usually the treasurer) personally liable for any unpaid taxes, penalties, and interest due for failure to pay taxes or file necessary returns. With proper planning, your non­profit corporation should be tax exempt, but you may still have to file informational returns and annual reports with the secre­tary of state, as well as pay employee with­holding and other payroll taxes and taxes on income unrelated to your nonprofit purposes. IRS penalties for delinquent tax payments and returns are substantial, so keep this exception to limited liability in mind—particularly if you will be the treasurer.

• Dues. Members of a nonprofit corporation are personally liable for any membership fees and dues they owe the corporation. In most cases, this is a minor obligation since dues are normally set at modest amounts.

• Violations of statutory duties. Corporate directors are legally required to act respon­sibly (not recklessly) when managing the corporation. They may be held personally financially liable if they fail to act respon­sibly. Personal liability of this sort is the exception, not the rule. Generally, as long as directors attend meetings and carry out corporate responsibilities conscientiously, they should have little to worry about—the corporate limited liability shield insulates directors from all but the most reckless and irresponsible decisions.

• Intermingling funds or other business dealings. A nonprofit corporation must act so that its separate existence is clear and respected. If it mixes up corporate funds with the personal funds of those in charge, fails to follow legal formalities (such as failing to operate according to bylaws, hold director meetings, or keep minutes of meetings), or risks financial liability without sufficient backup in cash or other assets, a court may disregard the corporate entity and hold the principals responsible for debts and other liabilities of the corporation. In legalese, this is known as “piercing the corporate veil.” Piercing the veil is the exception, not the rule, and only happens when a court decides that it is necessary to prevent a gross injustice or fraud perpetuated by the founders or principals of a corporation.

• Private foundation managers. If the nonprofit corporation is classified as a private foun­dation, foundation managers can be held personally liable for federal excise taxes associated with certain prohibited trans­actions. They may also be held personally liable for penalties and interest charged for failing to file certain tax returns or pay required excise taxes. (As explained in Chapter 4, a private foundation is a 501(c)(3) corporation that does not qualify as a public charity—you’ll see that most 501(c)(3) nonprofits can qualify as public charities and are not subject to the private foundation requirements.)

• Loans. When a nonprofit corporation takes a loan to cover its operating costs or buys property subject to a mortgage, banks and commercial lending institutions sometimes insist on the personal guarantee of its direc­tors or officers. If the directors or officers agree to personally guarantee the loan or mortgage, the protection that they would normally enjoy as a result of their orga­ni­zation’s corporate status goes away. It is somewhat unusual for nonprofit directors or officers to sign a personal guarantee. Obvi­ously, if they do, they will be liable to repay the loan if the corporation cannot do so.

Separate and Perpetual Legal Existence

A corporation is a legal entity that is separate from the people who work in it. Again, one benefit of this separate existence is that corpo­rate liabilities are not the liabilities of the managers, officers, or members of the corpora­tion (known as the corporate characteristic of limited liability). Another benefit is that this corporate legal person is, in a sense, immortal; the nonprofit corporation continues to exist as a legal entity despite changes in management or other corporate personnel caused by the resig­nation, removal, or death of the people associated with it. It may, of course, be dissolved or drastically affected by the loss of key people, but its inherent perpetual existence makes it more likely that the group’s activities will continue, an attractive feature to the private or public donor who prefers funding activities that are organized to operate over the long term.

Employee Benefits

Another benefit of the nonprofit corporation is that its principals can also be employees and, therefore, eligible for employee fringe benefits not generally available to the workers in unincorporated organizations. These benefits include group term life insurance, reimbursement of medical expenses, and coverage by a qualified corporate employee pension or retirement income plan.

Formality and Structure

The formal corporate documents—the articles, bylaws, minutes of meetings, and board resolutions—that you’ll prepare as a nonprofit will actually be quite useful to your organization. They’ll outline the group’s purposes, embody its operating rules, and provide structure and procedures for decision making and dispute resolution. This is important for any collective activity, but for nonprofit groups it is vital, especially if the board includes members of the community with diverse interests and viewpoints. Without the clear-cut delegation of authority and specific operating rules in the articles and bylaws, running the organization might be a divisive, if not futile, affair.

Miscellaneous Benefits

Additional advantages are available to non­profits that engage in particular types of activities or operations. These benefits can be helpful, and in some cases are critical, to the success of a nonprofit organization. Here are examples of some of the benefits available to certain types of tax-­exempt nonprofits:

• Your nonprofit may qualify for exemptions from county real and personal property taxes.

• 501(c)(3) organizations receive lower postal rates on third-class bulk mailings.

• Many publications offer cheaper classified advertising rates to nonprofit organizations.

• Nonprofits are the exclusive beneficiaries of free radio and television public service announcements (PSAs) provided by local media outlets.

• Many stores offer lower membership rates to nonprofit employees.

• Nonprofit employees are often eligible to participate in job training, student intern, work-study, and other federal, state, and local employment incentive programs (where salaries are paid substantially out of federal and state funds).

• 501(c)(3) performing arts groups are qualified to participate in the performance programs sponsored by federally supported colleges and universities.

• Certain 501(c)(3) educational organizations are eligible for a tax refund for gasoline expenses (for example, in running school buses).

Example:

A senior citizens’ botany club began as an informal organization. Initially, six members took a monthly nature walk to study and photograph regional flora. Everyone chipped in to buy gas for whoever drove to the hike’s starting point. Recently, however, membership increased to 15 and the group decided to collect dues from members to pay the increased expenses—gas money, guidebooks, maps, and club T-shirts—associated with more frequent field trips. To avoid mixing club monies with personal funds, a treasurer was designated to open a bank account on behalf of the organization. Several people suggest that it is time to incorporate the club.

Does incorporation make sense at this time? Probably not. There is no new pressing need to adopt the corporate form or to obtain formal recognition as a tax-exempt nonprofit. Most banks will allow an unincorporated group without a federal Employer Identification Number or IRS tax exemption to open up a non-interest-bearing account. However, should the club decide to seek funding and contributions to spearhead a drive to save open space in the community, it might be a good idea to incorporate.

The Disadvantages of Going Nonprofit

If your group has come together for 501(c)(3) tax-exempt purposes, and if reading about the benefits of becoming a nonprofit above prompted a “Wow! We would really like to be able to do that!   ” then chances are you’ve decided to tackle the rules and forms necessary to establish your status as a legal nonprofit. Before jumping in, however, take a minute to read the following descriptions of some of the hurdles and work you’ll encounter along the way, especially if you have been operating informally (and successfully) without financial or employee record keeping or controls. If any of the following appear insurmountable to you, think again about incorporating.

Official Paperwork

One disadvantage in forming any corporation is the red tape and paperwork. You’ll begin by preparing initial incorporation documents (articles of incorporation, bylaws, and minutes of first meeting of the board of directors). Although this book will show you how to pre­pare your own incorporation forms and bylaws with a minimum of time and trouble, the process will still take you a few hours at the very least. You and your compatriots must be prepared for some old-fashioned hard work.

After you’ve set up your corporation, you’ll need to file annual information returns with the state (the Franchise Tax Board and the attorney general) as well as the Internal Revenue Service. Also, you will need to regularly prepare minutes of ongoing corporate meetings, and, occasion­ally, forms for amending articles and bylaws. The annual tax reporting forms will require the implementation of an organized bookkeeping system plus the help of an experienced non­profit tax adviser, as explained below. Fortunately, keeping minutes of these meetings is not all that difficult to do once someone volunteers for the task (typically the person you appoint as corporate secretary). Sample forms for amending nonprofit articles are available from the California Secretary of State Corporations Section (see Appendix B).

Annual nonprofit informational tax returns do present a challenge to a new group unfamiliar with state tax reporting forms and require­ments. Other record-keeping and reporting chores, such as double-entry accounting procedures and payroll tax withholding and reporting, can be equally daunting. At least at the start, most nonprofits rely on the experience of a tax advisor, bookkeeper, or other legal or tax specialist on the board or in the community to help them set up their books and establish a system for preparing tax forms on time. See Chapter 11 for recommendations on finding legal and tax professionals for your nonprofit.

Incorporation Costs and Fees

For nonprofit incorporators unwilling to do the job themselves, a main disadvantage of incorporating a nonprofit organization is the cost of paying an attorney to prepare the incorporation forms and tax exemption applications. Putting some time and effort into understanding the material in this book can help you eliminate this disadvantage, leaving you with only the actual cost of incor­poration. Including the typical $400 federal tax exemption application fee, total fees to incorporate are approximately $450 to $500. (Costs are $450 higher for nonprofits that anticipate gross receipts of more than $10,000. These groups pay a $850, rather than a $400, federal tax exemption application fee.) The IRS may reduce these fees if it completes plans to offer an online preparation and filing application on its website through a new program called the “Cyber Assistant.” Check for current fees by searching “User Fee Information” on the IRS website.

Time and Energy Needed to Run the Nonprofit

When a group decides to incorporate, the legal decision is often part of a broader decision to increase not just the structure, but the overall scope, scale, and visibility of the nonprofit. With a larger, more accountable organization come a number of new tasks: setting up and balancing books and bank accounts, depositing and reporting payroll taxes, and meeting with an accountant to extract and report year-end figures for annual informational returns. Although these financial, payroll, and tax concerns are not exclusively corporate chores, you’ll find that most unincorporated nonprofits keep a low employment, tax, and financial profile and get by with minimum attention to legal and tax formalities.

Example:

A women’s health collective operates as an unincorporated nonprofit organization. It keeps an office open a few days a week where people stop by to read and exchange information on community and women’s health issues. The two founders donate their time and the office space and pay operating costs (such as phone, utilities, and photo­copying) that aren’t covered by contributions from visitors. The organization has never made a profit, there is no payroll, and tax returns have never been filed. There is a mini­mum of paperwork and record keeping.

The founders could decide to continue this way indefinitely. However, the founders want to expand the activities and revenues of the collective. They decide to form a 501(c)(3)
nonprofit corporation in order to be eligible for tax-­deductible contributions and grant funds from the city, and to qualify the group to employ student interns and work-study students. This will require them to prepare and file articles of incorporation and a federal corporate income tax exemption application. They must select an initial board of directors and prepare organizational bylaws and formal written minutes of the first board of directors’ meeting.

After incorporation, the group holds regu­lar board meetings documented with written minutes, sets up and uses a double-entry bookkeeping system, implements regular federal and state payroll and tax pro­ce­dures and controls, files exempt organi­zation tax returns each year, and expands its operations. A full-time staff person is assigned to handle the increased paperwork and bookkeeping chores brought about by the change in structure and increased operations of the organization.

This example highlights what should be one of the first things you consider before you decide to incor­porate: Make sure that you and your coworkers can put in the extra time and effort that an incorporated nonprofit organization will require. If the extra work would overwhelm or overtax your current resources, we suggest you hold off on your incorporation until you get the extra help you need to accomplish this task smoothly (or at least more easily).

Restrictions on Paying Directors and Officers

As a matter of state corporation law and the tax exemption requirements, nonprofits are restricted in how they deal with their directors, officers, and members. None of the gains, profits, or dividends of the corporation can go to individuals associated with the corporation, including directors, officers, and those defined as members in the corporation’s articles or bylaws. State self-dealing rules apply as well, regulating action by the board of directors if a director has a financial interest in a transaction. Finally, with respect to California public benefit corporations (if you form a 501(c)(3) tax-exempt nonprofit corporation for nonreligious purposes, you will form a California public benefit corporation), a majority of the board of directors cannot be paid (other than as a director), or related to other persons who are paid, by the corporation. This can represent a significant restriction because it eliminates the close-knit organization many picture when they think of a small, grassroots nonprofit corporation.

Restrictions Upon Dissolution

One of the requirements for the 501(c)(3) tax exemption is that upon dissolution of the corporation, any assets remaining after the corporation’s debts and liabilities are paid must go to another tax-exempt nonprofit, not to members of the former corporation.

Restrictions on Your Political Activities

Section 501(c)(3) of the Internal Revenue Code establishes a number of restrictions and limitations that apply to nonprofits. Here, we discuss a limitation that may be very signi­ficant to some groups—the limitation on your politi­cal activities. Specifically, your organization may not participate in political campaigns for or against candidates for public office, and cannot substantially engage in legislative or grassroots political activities except as permitted under federal tax regulations.

Example:

Society for a Saner World, Inc., has as one of its primary objectives lobbying hard to pass federal and local legislation that seeks to lessen societal dependency on fossil fuels. Since a substantial portion of the group’s efforts will consist of legislative lobbying, the group’s 501(c)(3) tax exemption probably will be denied by the IRS. Instead, the group should seek a tax-exemption under IRC § 501(c)(4) as a social welfare group, which is not limited in the amount of lobbying the group can undertake. Of course, the benefits of 501(c)(4) tax exemption are fewer too—contributions to the group are not tax-deductible and grant funds will be more difficult to obtain—see “Special Nonprofit Tax-Exempt Organizations,” in Appendix B.

Oversight by the Attorney General

The California Attorney General has broad power to oversee the operations of California public benefit corporations, more so than it does with other California nonprofits. (Remem­ber: If you form a nonreligious 501(c)(3) tax-exempt corporation, you will be forming a California public benefit corporation.) The state can even take the corporation to court to make sure it complies with the law.

By contrast, California religious purpose nonprofit corporations have wider flexibility in managing their internal affairs. If a religious corporation does not set up its own operating rules, provisions of the nonprofit law will apply to its operations by default. These are less stringent than those that would apply to a public benefit corporation under similar circumstances.

How Nonprofits Raise, Spend, and Make Money

Most nonprofits need to deal with money—indeed, being able to attract donations is a prime reason for choosing nonprofit status. Nonprofits can also make money. Nonprofit does not literally mean that a nonprofit corporation cannot make a profit. Under federal tax law and state law, as long as your nonprofit is organized and operating for a recognized nonprofit purpose, it can take in more money than it spends in conducting its activities. A nonprofit may use its tax-free profits for its operating expenses (including salaries for officers, directors, and employees) or for the benefit of its organization. It cannot, however, distribute any of  the profits for the benefits of its officers, directors, or employees (as dividends, for example).

This section explains how nonprofits raise initial funds and how they make money on an ongoing basis.

Initial Fundraising

A California nonprofit corporation is not legally required to have a specified amount of money in the corporate bank account before commencing operations. This is fortunate, of course, because many beginning nonprofits start out on a shoestring of meager public and private support.

So, where will your seed money come from? As you know, nonprofit corporations cannot issue shares, nor can they provide investment incentives, such as a return on capital through the payment of dividends to investors, bene­factors, or participants in the corporation (see “Corporation Basics,” at the beginning of this chapter).

Nonprofits have their own means and meth­ods of obtaining start-up funds. Obviously, the most common method is to obtain revenue in the form of contributions, grants, and dues from the people, organizations, and governmental agencies that support the nonprofit’s purpose and goals. Also, if you are incorporating an existing organization, its assets are usually transferred to the new corporation—these assets may include the cash reserves of an unincorporated group, which can help your corporation begin operations. You can also borrow start-up funds from a bank, although for newly formed corporations a bank will usually require that incorporators secure the loan with their personal assets—a pledge most nonprofit directors are understandably reluctant to make.

Often, of course, nonprofits receive initial and ongoing revenues from services or activities provided in the pursuit of their exempt purposes (ticket sales, payments for art lessons or dance courses, school tuition, or clinic charges).

For information on meeting California’s special fundraising rules, see “State Solicitation Laws and Requirements,” in Chapter 5.

Making Money From Related Activities

Many nonprofits make money while they further the goals of the organization. The non­profit can use this tax-exempt revenue to pay for operating expenses (including reasonable salaries) and to further its nonprofit purposes. For example, an organization dedicated to the identification and preservation of shore birds might advertise a bird-watching and counting hike for which they charge a fee; the group could then use the proceeds to fund their bird rescue operations. What it cannot do with the money, however, is distribute it for the benefit of officers, directors, or employees of the corporation (as the payment of a patronage dividend, for example).

Example:

Friends of the Library, Inc., is a 501(c)(3) nonprofit organized to ­encourage literary appreciation in the community and to raise money for the support and improvement of the public library. It makes a profit from its sold-out lecture series featuring famous authors and from its annual sale of donated books. Friends can use this tax-exempt profit for its own operating expenses, including salaries for officers and employees, or to benefit the library.

Making Money From Unrelated Activities (Unrelated Income)

Nonprofits can also make money in ways unrelated to their nonprofit purpose. Often this income is essential to the survival of the nonprofit group. This unrelated income, however, is usually taxed as unrelated business income under state and federal corporate income tax rules. While earning money this way is permissible, it’s best not to let unrelated business activities reach the point where you start to look more like a for-profit business than a nonprofit one. This can happen if the unrelated income-generating activities are absorbing a substantial amount of staff time, requiring additional paid staff or volunteers, or producing more income than your exempt-purpose activities. If the unrelated revenue or activities of your tax-exempt nonprofit reach a substantial level, the IRS can decide to revoke the group’s 501(c)(3) tax-exemption—a result your nonprofit will no doubt wish to avoid.

Example:

Many thousands of books are donated to Friends of the Library for its annual book sale, one of its major fund­raising events. Although the sale is always highly successful, thousands of books are left over. Friends decides to sell the more valuable books by advertising in the rare and out-of-print books classified sections in various magazines. The response is overwhelming; soon, there are six employees cataloging books. In addition, Friends begins a business purchasing books from other dealers and reselling them to the public. Such a situation could attract attention from the IRS and prompt it to reconsider Friends’ 501(c)(3) tax-exempt status.

Making Money From Passive Sources

Although it’s not typical for the average non­profit, a nonprofit corporation can make money from passive sources such as rents, royalties, interest, and investments. This income is nontaxable in some cases.

Your Path to Nonprofit Status

Nonprofit organizations first obtain nonprofit corporate status with the California Secretary of State—a simple formality accomplished by filing articles of incorporation. Then they go on to obtain a corporate income tax exemption with the Internal Revenue Service. California recognizes your federal tax exemption, so you don’t have to prepare a separate state tax exemption application. In sum, your path to nonprofit status is a basic two-step process—first you incorporate with the California Secretary of State, then you apply for tax-exempt recognition from the California Franchise Tax Board and the Internal Revenue Service. When you’re done with this book, you’ll have completed each of these steps.

State Law Requirements for Nonprofits

The California Secretary of State must officially recognize all California nonprofit corporations. To obtain state recognition, you’ll file articles of incorporation with the secretary of state’s office stating that your organization is entitled to receive nonprofit corporate status. This book covers the basic requirements for obtaining recognition by California’s Secretary of State as a nonprofit corporation. The California Non­profit Corporation Law (California Corpo­rations Code §§ 5000–9927) governs the organi­zation and operations of California nonprofit corporations.

We focus on public benefit corporations in this book (those formed for public or charitable purposes) because these corporations make up the majority of nonprofit corporations eligible for exemption under Section 501(c)(3) of the Internal Revenue Code. Requirements for religious corporations are noted only if they are different from the requirements for public benefit corporations.

Tax Exempt Status Under Federal and State Tax Law

Both state and federal tax laws apply to Cali­fornia nonprofit corporations. To obtain tax-exempt status, nonprofits must comply with initial and ongoing requirements under the federal Internal Revenue Code. California tax law parallels the federal law. In most ways, understanding and complying with state and federal tax rules is more important (and more challenging) than fulfilling the state corporate law requirements. This book focuses on nonprofit corporations seeking tax-exempt status under Section 501(c)(3) of the Internal Revenue Code, which are nonprofits organized for religious, charitable, educational, scientific, or literary purposes.

Incorporating in Another State—Don’t Fall for It

Corporations formed in a particular state are known in that state as domestic corporations. When viewed from outside that state, these corporations are considered foreign. A foreign corporation that plans to engage in a regular or repeated pattern of activity in another state must qualify to do business there by obtaining a certificate of authority from the secretary of state. For example, a corporation formed in Nevada that intends to do regular business in California is a foreign corporation here, and must qualify the corporation with our secretary of state.

Incorporators who plan to operate in another state besides California have naturally considered whether it makes sense to incorporate in that other state. Maybe the incorporation fees or corporate taxes are lower than those in California or the nonprofit statutes are more flexible. Then, the reasoning goes, one could qualify the corporation in California as a foreign corporation. As tempting as this end run may appear, it’s not usually worth it. This section explains why, and also advises you of out-of-state activities that you can engage in without worrying about qualifying in another state.

Qualifying as a Foreign Corporation in California Will Cost You More

The process of qualifying a foreign corporation to operate in California takes about as much time and expense as incorporating a domestic corporation. This means that you will pay more to incorporate out-of-state since you must pay the regular California qualification fees plus out-of-state incorporation fees.

Multiple Tax Exemptions

Your corporation will still be subject to taxa­tion in each state in which it earns or derives income or funds. If the state of incorporation imposes a corporate income tax, then the nonprofit corporation will need to qualify for two state corporate tax exemptions—one in California, the state where the corporation will be active, and one for the state of incor­poration. Similarly, double sales, property, and other state tax exemptions may often be necessary or appropriate.

Multiple State Laws

Your out-of-state corporation will still be subject to many of the laws that affect corpo­ra­tions in California. Many of California’s corpo­rate statutes that apply to domestic corporations also apply to foreign corporations.

Out-of-State Activities Below the Radar

For the above reasons, most readers who flirt with the idea of incorporating in a state other than California would be well advised to skip it. This doesn’t mean, however, that you’ll have to trim all of your activities to stay within California. Fortunately, there are many things nonprofits can do as a foreign corporation in another state without obtaining a certificate of authority from the secretary of that state. Here are some that are recognized in many (but not all) states:

• maintaining, defending, or settling any legal action or administrative proceeding, including securing or collecting debts, and enforcing property rights

• holding meetings of corporate directors or of the membership and distributing information to members

• maintaining bank accounts and making grants of funds

• making sales through independent contractors and engaging in interstate or foreign commerce

• conducting a so-called isolated transaction that is completed within 30 days and is not one of a series of similar transactions, and

• exercising powers as an executor, admini­strator, or trustee, so long as none of the activities required of the position amounts to transacting business.

When Out-of-State Incorporation Makes Sense

There may be a few of you for whom incorpo­ration in another state makes sense. If you plan to set up a multistate nonprofit with corporate offices and activities in more than one state (a tristate environmental fund for example), you may want to consider incorporating in the state that offers the greatest legal, tax, and practical advantages. To help you decide where to incorporate, you can refer to the secretary of state’s website for each state where you operate. Type “nonprofit resource libraries” into your browser’s search box—you’ll find a host of online resources at your disposal. An experienced nonprofit lawyer or consultant can also help you determine which state is the most convenient and least costly to use as the legal home for your new nonprofit corporation. 

References to IRS Articles and Materials

Throughout the book, there are references to IRS articles and materials included on the CD-ROM that comes with this book. Some of this material includes articles and information made available by the IRS on its website as part of its Exempt Organizations Continuing Professional Education Technical Instruction Program, which regularly publishes articles for tax-exempt organizations. The IRS has the following statement on its website regarding this material: “These materials were designed specifically for training purposes only. Under no circumstances should the contents be used or cited as authority for setting or sustaining a technical position.” In other

words, use this material to learn about IRS tax issues, but don’t expect to be able to rely on it if you end up in a dispute with the IRS. Nolo includes this material on the CD-ROM as a convenience to the reader and as an alternative to directing you to an IRS website link to this material. This material is taken directly from the IRS website at www.irs.gov (type “Exempt Organizations Continuing Professional Education Technical Instruction Program” in the search box). If you are interested in one of the issues, you should check the IRS website for any updated articles or information on your topic.