How to Form a Nonprofit Corporation
Anthony Mancuso, Attorney
May 2013, 11th Edition
Create a nonprofit in your state without pricey attorney's fees!
The process of becoming a tax-exempt organization may appear intimidating, but with How to Form a Nonprofit Corporation, you can do it quickly, easily, and with confidence.
This bestselling book includes complete instructions for obtaining federal 501(c)(3) tax exemption and for qualifying for public charity status with the IRS. It will help you:
- complete an IRS tax-exemption application
- prepare articles of incorporation
- write the bylaws of your nonprofit
- fill in minutes of the organizational meeting
- understand your state’s specific nonprofit requirements
This edition is completely updated to reflect the latest changes in the law, and includes contact information for finding updated state-specific instructions. You'll also get information on new online services and options related to forming your nonprofit. Plus, all the forms you need are included in this complete guide.
What are you waiting for? Incorporate your nonprofit and pursue your worthy cause!
Are you a California resident? Check out How to Form a Nonprofit Corporation in California.
- Incorporation Checklist
- Application for Reservation of Corporate Name
- Articles of Incorporation
- Articles Filing Letter
- Waiver of Notice and Consent to Holding of First Meeting of Board of Directors
- Minutes of First Meeting of Board of Directors
IRS Forms and Publications and Tax Articles
- Form 1023: Application for Recognition of Exemption (with Notice 1382)
- Instructions for Form 1023
- Form SS-4: Application for Employer Identification Number
- Instructions for Form SS-4
- Form 5768: Election/Revocation of Election By an Eligible Section 501(c)(3) Organization
- To Make Expenditures To Influence Legislation
- Publication 557: Tax-Exempt Status for Your Organization
- Publication 4220: Applying for 501(c)(3) Tax-Exempt Status
- Publication 4221-PC: Compliance Guide for 501(c)(3) Public Charities
- Publication 4221-PF: Compliance Guide for 501(c)(3) Private Foundations
- Publication 1828: Tax Guide for Churches and Religious Organizations
- IRS Revenue Procedure 75-50
- IRC Section 4958, Taxes on Excess Benefit Transactions
- IRS Regulations Section 53.4958-0, Table of Contents
- Public Charity or Private Foundation Status Issues Under IRC §§ 509(a)(1)–(4), 4942(j)(3), and 507
- Disclosure, FOIA and the Privacy Act
- Update: The Final Regulations on the Disclosure Requirements for Annual Information Returns and Applications for Exemption
- Education, Propaganda, and the Methodology Test
- Election Year Issues
- Lobbying Issues
- Private School Update
- UBIT: Current Developments
- Intermediate Sanctions (IRC Section 4958) Update
- IRS Revenue Ruling 2007-41 Political Campaign Prohibition Guidance
- Internal Revenue Bulletin (IRB 2008-18) with T.D. 9390 Final Regulation changes to Section 4958 regulations
How to Locate Incorporation Resources Online
Information and Tear-Out Forms
- Incorporation Checklist
- Special Nonprofit Tax-Exempt Organizations
- Application for Reservation of Corporate Name
- Articles of Incorporation
- Articles Filing Letter
- Bylaws (including Membership Provisions and Adoption of Bylaws clause)
- Waiver of Notice and Consent to Holding of First Meeting of Board of Directors
- Minutes of First Meeting of Board of Directors
- IRS Form 1023: Application for Recognition of Exemption
- IRS Form SS-4: Application for Employer Identification Number
- IRS Form 5768: Election/Revocation of Election by an Eligible Section 501(c)(3) Organization To Make Expenditures To Influence Legislation
Anthony Mancuso is a corporations and limited liability company expert. He graduated from Hastings College of Law in San Francisco, is a member of the California State Bar, writes books and software in the fields of corporate and LLC law, and studies advanced business taxation at Golden Gate University in San Francisco. He has also been a consultant for Silicon Valley EDA (Electronic Design Automation) companies, most recently working on a C++ open-source integrated circuit database project team. He is the author of several Nolo books on forming and operating corporations (both profit and nonprofit) and limited liability companies. His titles include Incorporate Your Business, How to Form a Nonprofit Corporation (national and California editions), Form Your Own Limited Liability Company, The Corporate Records Handbook, and LLC or Corporation? His books have shown over a quarter of a million businesses and organizations how to form a corporation or LLC. He also is a licensed helicopter pilot and has performed for years as a guitarist in many musical idioms.
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TABLE OF CONTENTS
Your Legal Companion for Forming a Nonprofit Corporation 1
Part One: How Nonprofit Corporations Work
Is Nonprofit Incorporation Right for You? 5
Is Your Group a Nonprofit That Can Use This Book? 7
Benefits of the Nonprofit Corporation 9
The Disadvantages of Going Nonprofit 13
How Nonprofits Raise, Spend, and Make Money 16
Your Path to Nonprofit Status 18
Where Should You Incorporate? 18
Legal Rights and Duties of Incorporators,
Directors, Officers, Employees, and Members 21
How Many People Are Needed to Form a Nonprofit Corporation? 22
Incorporators and Their Role as Promoters 22
Membership Nonprofits 36
Requirements for Section 501(c)(3) TaxExemption 39
Section 501(c)(3) Organizational Test 40
Valid Purposes Under Section 501(c)(3) 41
Other Requirements for501(c)(3) Groups 48
Information for Specific Questions About Your Group's Activities 55
Public Charities and Private Foundations 57
The Importance of Public Charity Status 58
How to Qualify for Public Charity Status 59
Private Foundations 74
Other Tax Benefits and Reporting Requirements 77
Federal and State Tax Deductions for Contributions 78
Federal Estate and Gift Tax Exemptions 79
Federal Unrelated BusinessIncome Tax 80
State Corporate Income Tax Exemptions 82
Other State Taxes 82
State Solicitation Regulations 83
State Nonprofit Corporate ReportRequirements 84
Part Two: Incorporating Your Nonprofit
Choose a Name and File Your Articles of Incorporation 87
View Materials From Your Secretary of State 89
Choose a Corporate Name 89
Check Name Availability 94
What to Do When There's a Name Conflict 95
Reserve Your Corporate Name 96
Perform a Name Search 96
Protect Your Name 100
Prepare Your Articles of Incorporation 101
File Your Articles ofÊIncorporation 116
Prepare Your Bylaws 119
Choose a Membership or Nonmembership Structure 120
Purpose and Scope of Our Bylaws 121
Prepare Your Bylaws 123
Prepare Membership Provisions 134
Apply for Your Federal 501(c)(3) Tax Exemption 139
Getting Started 141
Do You Need to File Form 1023? 146
Prepare Your Tax Exemption Application 147
Filling Out the Schedules 186
Assemble and Mail Your Application to the IRS 192
What to Expect From the IRS 194
The Federal Determination Letter 194
Final Steps in Organizing Your Nonprofit Corporation 197
Obtain State Corporate Income Tax Exemption 198
Set Up a Corporate Records Book 198
Prepare the Minutes of Your First Board of Directors Meeting 199
Place Minutes and Attachments in Corporate Records Book 202
Issue Membership Certificates 202
File Fictitious or Assumed Business Name Statement 202
Apply for a Federal Nonprofit Mailing Permit 203
Apply for Property Tax Exemptions 203
File an Initial Corporate Report Form 204
Register With the Attorney General 204
Comply With Political Reporting Requirements 205
Prepare Assignments of Leases andDeeds 205
File Final Papers for Prior Organization 206
Notify Others of YourIncorporation 206
After Your Corporation Is Organized 209
Piercing the Corporate Veil-If You Want to Be Treated
Like a Corporation, It's Best to Act Like One 210
Federal Corporate Tax Returns 211
State Corporate Tax Returns and Reports 213
Federal and State Corporate Employment Taxes 213
Employee Income Tax Returns 214
Sales Tax Forms and Exemption From Sales Tax 214
Licenses and Permits 214
Workers' Compensation 215
Private Insurance Coverage 215
Dissolving a Nonprofit Corporation 215
Lawyers and Accountants 217
Legal Research 219
Accountants and Tax Advice 220
Using the Interactive Forms and Other Online Material 223
Editing RTFs 224
List of Forms 225
Application for Reservation of Corporate Name
Articles of Incorporation
Articles Filing Letter
Waiver of Notice and Consent to Holding of First Meeting of Board of Directors
Minutes of First Meeting of Board of Directors
IRS Forms and Publications and Tax Articles
Form 1023: Application for Recognition of Exemption (with Notice 1382)
Instructions for Form 1023
Form SS-4: Application for Employer Identification Number
Instructions for Form SS-4
Form 5768: Election/Revocation of Election By an Eligible Section 501(c)(3) Organization
To Make Expenditures To Influence Legislation
Publication 557: Tax-Exempt Status for Your Organization
Publication 4220: Applying for 501(c)(3) Tax-Exempt Status
Publication 4221-PC: Compliance Guide for 501(c)(3) Public Charities
Publication 4221-PF: Compliance Guide for 501(c)(3) Private Foundations
Publication 1828: Tax Guide for Churches and Religious Organizations
IRS Revenue Procedure 75-50
IRC Section 4958, Taxes on Excess Benefit Transactions
IRS Regulations Section 53.4958-0, Table of Contents
Public Charity or Private Foundation Status Issues Under IRC ¤¤509(a)(1)-(4),
4942(j)(3), and 507
Disclosure, FOIA and the Privacy Act
Update: The Final Regulations on the Disclosure Requirements for Annual Information Returns and Applications for Exemption
Education, Propaganda, and the Methodology Test
Election Year Issues
Private School Update
UBIT: Current Developments
Intermediate Sanctions (IRC Section 4958) Update
IRS Revenue Ruling 2007-41 Political Campaign Prohibition Guidance
Internal Revenue Bulletin (IRB 2008-18) with T.D. 9390 Final Regulation changes to
Section 4958 regulations
How to Locate Incorporation Resources Online 227
Information and Forms 229
Special Nonprofit Tax-Exempt Organizations
Application for Reservation of Corporate Name
Articles of Incorporation
Articles Filing Letter
Bylaws (including Membership Provisions and Adoption of Bylaws clause)
Waiver of Notice and Consent to Holding of First Meeting of Board of Directors
Minutes of First Meeting of Board of Directors
IRS Form 1023: Application for Recognition of Exemption (with Notice 1382)
IRS Form SS-4: Application for Employer Identification Number
IRS Form 5768: Election/Revocation of Election By an Eligible Section 501(c)(3)
Organization To Make Expenditures To Influence Legislation
Is Nonprofit Incorporation Right for You?
Is Your Group a Nonprofit That Can Use This Book?............................ 7
Benefits of the Nonprofit Corporation ....................................................... 9
Tax Exemptions......................................................................................... 9
Receiving Public and Private Donations............................................ 10
Protection From Personal Liability....................................................... 10
Separate and Perpetual Legal Existence........................................... 12
Employee Benefits ................................................................................ 12
Formality and Structure......................................................................... 12
Miscellaneous Benefits......................................................................... 12
The Disadvantages of Going Nonprofit.................................................. 13
Official Paperwork.................................................................................. 13
Incorporation Costs and Fees.............................................................. 14
Time and Energy Needed to Run the Nonprofit................................ 14
Restrictions on Paying Directors and Officers................................... 15
Restrictions Upon Dissolution.............................................................. 15
Restrictions on Your Political Activities............................................... 15
Oversight by the Attorney General....................................................... 16
How Nonprofits Raise, Spend, and Make Money................................. 16
Initial Fundraising................................................................................... 17
Making Money From Related Activities............................................... 17
Making Money From Unrelated Activities (Unrelated Income)....... 17
Making Money from Passive Sources................................................. 18
Your Path to Nonprofit Status................................................................... 18
Where Should You Incorporate? ............................................................ 18
Qualifying as a Foreign Corporation in Your Home State Will
Cost You More...................................................................................... 19
Two Sets of Tax Exemptions................................................................. 19
Two Sets of State Laws.......................................................................... 19
Out-of-State Activities Below the Radar.............................................. 19
When Out-of-State Incorporation Makes Sense............................... 20
Deciding to form a nonprofit corpo-ration 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.
References to IRS Articles and Materials
There are references in the book to IRS articles and materials which you can download from Nolo’s website. To access this material from the Nolo website, use the link provided in Appendix A. 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 of these articles 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 as a convenience to the reader and as an alternative to directing you to the IRS website. This material is taken from the exempt organization tax law training articles available from the IRS website at www.irs.gov (enter “EO Tax Law Training Articles” in the search box at the top of the main website page, then follow the links to “Exempt Organizations Continuing Professional Education Technical Instruction Program” main page, where you’ll find a link to an alphabetical index of the articles, “Exempt Organizations CPE Topical Index”).If you are interested in one of the issues, you should check the IRS website for any updated articles or information on your topic.
Is Your Group a Nonprofit That Can Use This Book?
For-profit corporations can usually be formed for “any lawful purpose” under state statutes. Nonprofit corporations, on the other hand, generally must be established to accomplish one or more specific purposes that benefit either the public at large, a segment of the community, or a particular membership. While it may be easy for your group to incorporate as a nonprofit in your state, this is only the first hurdle. The next important step is to obtain tax-exempt status under state and federal tax statutes. To do this, your group must meet specific-purpose requirements contained in state and federal tax statutes.
This book has been written specifically for nonprofit corporations that want to qualify for federal income tax exemption under Section 501(c)(3) of the Internal Revenue Code. This means that your nonprofit corporation must be formed for religious, charitable, scientific, literary, and/or educational purposes. There are other types of groups—labor unions, chambers of commerce, social and recreational clubs, fraternal societies, credit unions, farmers’ co-ops, and legal service organizations, to name a few—that may be eligible for tax-exempt status under other sections of the Internal Revenue Code. (See “Special Nonprofit Tax-Exempt Organizations,” in Appendix C, for a list of organizations that can qualify for tax-exempt status under a subsection of 501(c) other than Subsection (3).) These groups often have more leeway to provide direct financial benefits to their members, but they don’t receive the same tax benefits as a 501(c)(3) group. If you are planning on forming one of these non-501(c)(3) nonprofits, this book can help acquaint you with the process of doing so. It will not, however, guide you step-by-step through the process of preparing articles of incorporation and bylaws for your group or the tax exemption applications you will need for your nonprofit.
If your group falls within one of the 501(c)(3) purposes, however, you can rest assured that this book will help you step-by-step through the process of incorporating and obtaining tax-exempt status. First, we’ll help you create your corporate entity by showing you how to prepare and file articles of incorporation that meet your state’s corporate law requirements. Then we’ll show you how to obtain your state and federal nonprofit income tax exemptions for Section 501(c)(3) tax-exempt status.
If you are forming a nonprofit in California. If you plan to incorporate your nonprofit in California and want additional information about incorporating there, see How to Form a Nonprofit Corporation in California, by Anthony Mancuso (Nolo).
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 we 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. A corporation formed in a particular state is known as a domestic corporation in that state. Corporations formed in other states, even if physically present and engaging in activities in a state, are called foreign corporations in that state. 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. We give more information on deciding whether to incorporate in a particular state below, in “Where Should You Incorporate?”
Nonprofit Moneymakers—The Latest in Hybrid Limited Liability Entities
A number of states allow the formation of hybrid limited liability entities (LLCs and/or corporations) that can make a profit yet also do good. For example, some states authorize the formation of low-profit LLCs (also called “L3Cs”) for educational or charitable purposes as well as for making a profit. States initially created this special type of hybrid entity to allow foundations to more easily distribute funds to a qualified social-purpose organization, although the IRS has not yet formally approved L3Cs for this purpose.
Some states authorize the formation of flexible purpose corporations or benefit corporations, which can be formed to do good works as well as to make money. The advantage of these hybrid entities is that they can allow the principals to spend time and money trying to do good without having to worry about stakeholders’ being upset (and suing them) for not spending all their time trying to turn a profit.
These hybrid entities are sometimes loosely referred to as B corporations. However, this term really refers to a certification (issued by B Labs) that a socially responsive corporation, an LLC, or another entity can seek, not to a separate type of “corporation” or another distinct legal entity. Note that there are other sustainability certifications, including GRI (GRI Global Reporting Initiative) and ULE 880 (a sustainability standard developed by UL Environment, an Underwriters Laboratories initiative). You can find websites of the organizations associated with these certifications online by searching these terms from your Internet browser.
All of these hybrids are profit-making entities, not pure nonprofit corporations organized and operated exclusively for nonprofit purposes. Therefore, it seems unlikely that the IRS would consider them qualified to obtain nonprofit 501(c)(3) income tax exemption.
Benefits of the Nonprofit Corporation
Now that you understand that this book is intended for nonprofit corporations 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.
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. In states with a corporate income tax, a state income tax exemption is equally attractive, as are local, county, real property, and personal property tax exemptions. Chapters 3, 4, and 5 cover tax exemptions in detail.
see an expert
Get the help of a competent tax adviser as soon as you decide to incorporate. Make sure you choose someone experienced in the special field of nonprofit bookkeeping and reporting. Ask the advisor to help you (especially your treasurer) set up a good record-keeping system, which you can use to prepare your annual federal and state nonprofit tax forms and reports. Have the tax helper periodically review the system to be sure that you are maintaining your financial records properly and have filed your tax forms on time.
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 from sources such as:
• Public sources. Tax-exempt government foundations (like the National Endowment for the Arts, the National Endowment for the Humanities, or the Corporation for Public Broadcasting), 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 to only 501(c)(3) tax-exempt organizations.
• Individual private donors can claim personal federal income tax deductions for contributions made to 501(c)(3) tax-exempt groups. At a donor’s 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.
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, directors or trustees, officers, employees, and members of a corporation usually 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 (cars, homes, or bank accounts) of the people who manage, work for, or volunteer to help the nonprofit corporation.
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 personally liable for any unpaid taxes, penalties, and interest due for failure to pay taxes or file necessary returns (for example, the treasurer if the nonprofit board has given this officer full authority to pay all taxes as they become due). With proper planning, your nonprofit corporation should be tax exempt, but you still have to file federal and state informational returns and annual reports to the secretary of state and state attorney general, 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 or a board member who specifically approves the payment of taxes on behalf of your corporation.
• 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 because 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 perpetrated 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 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 for 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.
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.
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).
Does Incorporation Make Sense for Your Group?
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 noninterest-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.
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. 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 tax and reporting returns with the state (the state tax or revenue office 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 usually available from the state corporate filing office online (see Appendix B to locate the website address of your state’s corporate filing office).
Annual nonprofit tax and information 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 adviser, a bookkeeper, or another 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 $600. (Costs are $450 higher for nonprofits that anticipate gross receipts of more than $10,000. These groups pay an $850, rather than a $400, federal tax exemption application fee.) The IRS may offer an online “Cyber Assistant” application process for a lower $200 application fee (if and when this online app is available; the IRS has been promising its availability for years but it isn’t available at the time of this edition). Go to www.irs.gov and search for “user fee information” to get the latest fee information.
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 comes 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.
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.
Officers and staff can be paid a reasonable salary for work they do for the corporation. State laws often provide for this type of compensation, and even if nothing is specified, it is permissible. Directors can also be paid for their expenses and time for attending director meetings. In all cases, however, these payments should be reasonable. Lavish payments or undeserved payouts characterized as “salaries” or “compensation” can be challenged by the IRS and can lead to penalties and even a loss of tax exemption (see “Other Requirements for 501(c)(3) Groups” in Chapter 3).
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. (For more on this, see “Other Requirements for 501(c)(3) Groups” in Chapter 3.)
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 C).
Oversight by the Attorney General
Each state’s attorney general has broad power to oversee the operations of 501(c)(3) nonprofits. The attorney general can take the corporation to court to make sure it complies with the state corporation law. This usually doesn’t happen, however, unless an organization commits a serious offense (such as the founders’ diverting contributions for their personal use) and the organization is on the state attorney general’s enforcement division radar (through a complaint filed by a disgruntled group or a member of the public who feels aggrieved by the nonprofit’s actions or policies).
Religious 501(c)(3) nonprofit corporations have wider flexibility in managing their internal affairs. A state attorney general is less likely to step in and sue a religious nonprofit to enforce compliance with state corporate laws, except in the most extreme and unusual cases of fraud or misappropriation by the principals of a religious-purpose nonprofit.
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. What it cannot do under IRC § 501(c)(3) is distribute any of the profits for the benefit 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.
Under state corporate statutes, a 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, the organization’s 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). Section 501(c)(3) nonprofits are allowed to earn this type of revenue under federal and state tax laws and still maintain their tax-exempt status.
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 shorebirds 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).
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. (For more information, see “Other Requirements for 501(c)(3) Groups” in Chapter 3.)
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 cataloguing 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 state corporate filing office—usually the corporations division of the secretary of state’s office. This is 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. Once the IRS exemption is obtained, a copy of the federal tax exemption determination letter is filed with the state tax or revenue office. This automatically qualifies the nonprofit for a state corporate income tax exemption (assuming the state imposes a corporate tax). In a few states, you must apply for a separate state nonprofit corporate income tax exemption.
In sum, your path to nonprofit status is a usually a two-step process—first you incorporate with the state, then you apply for tax-exempt recognition from the IRS. When you’re done with this book, you’ll have completed each of these steps, plus additional follow-up steps to make sure your corporation is off to a good legal and tax start.
Where Should You Incorporate?
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 in California, and must qualify with the California Secretary of State.
Incorporators who plan to operate in another state besides their home state might wonder whether it makes sense to incorporate in that other state. Maybe the incorporation fees or corporate taxes are lower than those in the home state or the nonprofit statutes are more flexible. Then, the reasoning goes, one could qualify the corporation in the home state as a foreign corporation. As tempting as this end run may appear, it’s usually not 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 Your Home State Will Cost You More
The process of qualifying a foreign corporation to operate in your home state takes about as much time and expense as incorporating a domestic corporation in your home state. This means that you will pay more to incorporate out-of-state since you must pay the regular home state qualification fees plus out-of-state incorporation fees.
Two Sets of 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, which we here assume is a “foreign” state, imposes a corporate income tax, then the nonprofit corporation will need to file for and obtain two state corporate tax exemptions—one for its home state (the state where the corporation will be active and qualify to do business) and one for the foreign state of incorporation. Similarly, double sales, property, and other state tax exemptions may often be necessary or appropriate.
Two Sets of State Laws
Your out-of-state corporation will still be subject to many of the laws that affect corporations in your home state. Many state 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 their home state 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 your home state. Fortunately, there are many things a nonprofit can do as a foreign corporation in another state without obtaining a certificate of authority from the secretary of that state. Here are some activities that can be done in most states without qualifying to do business there:
• 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, as long as none of the activities required of the position amount 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, go online to each state’s corporate filing office website (see Appendix B). Another approach is to check a nonprofit resource center library. For nonprofit library resources online, type “nonprofit resource libraries” into your browser—you’ll find a host of online libraries 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. l