Part 2: People, Policies, and Papers

In our first installment in this series on nonprofit formation, we discussed what organizations and activities can qualify for tax exemption and what to consider before starting a nonprofit.

In this post, we will discuss the first steps to take after you have an idea for an organization that is within the scope of exempt purposes and activities. These steps include selecting your directors and officers, drawing up your organization’s governance documents (articles of incorporation, bylaws, initial policies, etc.), and formalizing your organization on the state level.

People: Selecting Initial Directors and Officers

When forming a new nonprofit organization, you will need to select the organization’s initial directors and officers. Directors (sometimes also called by other titles such as “trustees”) will usually be the organization’s final authority. The IRS generally requires a tax-exempt organization to have at least three directors. Moreover, nonprofit directors should generally not be related to one another by blood, marriage, or outside business relationship, although there are exceptions for family boards in the contexts of private foundations.

In addition to directors, nonprofit corporations also have officers or executives. Officers fill specific corporate leadership roles in the organization. Many states require nonprofit corporations to have at least three officers: a president, a secretary, and a treasurer. But organizations can create additional offices based on their operating needs. As with directors, officers of tax-exempt organizations should generally not be related to one another (or to directors) by blood, marriage, or outside business relationship. However, it is common in smaller organizations for there to be a complete overlap of persons so that all of the officers are also directors.

Selecting directors and officers is one of the more important decisions that nonprofit founders will make with respect to their organizations. It is key to select reliable people who share your values and vision for the new organization. Select persons who will be active and responsible in the organization. Directors and officers have fiduciary responsibilities and legal obligations to the organization, and you should select individuals who understand these obligations and who can be depended upon to meet them.

One other “people” issue you will need to decide is whether your organization will be a “membership” corporation or a “directorship” corporation. A membership corporation has voting members distinct from the board of directors. These members vote on organizational decisions and elect directors and officers. The classic example of a membership nonprofit is a homeowners’ association. A directorship corporation does not have voting members. Rather, the board of directors is self-perpetuating, and the directors elect their successors as well as the officers. The classic example of a directorship nonprofit is a private school board.

Policies: Preparing Governance Documents

After inviting initial directors and officers and deciding whether to be a membership or a directorship, the next crucial step is to begin preparing the chartering and governance documents for your organization. This is a very important and sometimes complicated step, and one for which you should consider seeking expert legal counsel.

The first and most important document you will need to prepare is your organization’s organic or chartering document. In most states, this document is known as the “articles of incorporation,” but is sometimes referred to by other names such as “certificate of formation.” The organic chartering document is the birth certificate for your organization. It sets forth the name, purposes, and basic governance of your organization. You will want to consult with legal counsel to make sure that your chartering document includes all of the necessary provisions the IRS requires for an organization to be tax-exempt.

Another very important document your organization will need is bylaws. The bylaws of an organization are the rules by which the board, officers, or members govern the affairs of the organization. The bylaws should not be so specific as to cover everything your organization does in its day-to-day operations. But they should address all of the major areas of governance and structure for your organization, including duties of officers and directors, how they are elected, how long they serve, how they can be removed, and what happens if one dies or resigns. Bylaws should also establish basic rules and procedures for board meetings and members meetings, such as frequency, notices, locations, quorum requirements, and the like.

In addition to the chartering document and bylaws, you will also need to prepare a few initial policies that the IRS generally requires tax-exempt organizations to have. These include a formal conflicts-of-interest policy that sets forth how your board of directors will avoid conflicts in certain transactions, and a compensation policy that sets rules for how the board will decide upon salaries for officers and employees. Specific types of organizations may need additional initial policies. For example, the IRS requires private schools to adopt formal non-discrimination policies, and religious organizations may want to adopt formal statements of faith or codes of conduct.

Papers: Filing to Formalize with the Secretary of State

Once your organization has its organizational documents in order, the next step is to formalize with the governmental agency in your state that manages corporate formation and records. In almost all states, this office is the state’s Secretary of State’s Office. The process for filing and formalizing with the Secretary of State varies considerably from state to state. You will want to make sure you are aware of what your state requires for corporate filings, including filing fees and if any official forms need to be used.

The day that your initial filings are accepted and approved by the Secretary of State’s office is your organization’s corporate birthday. It’s the day on which your organization began to exist as a separate legal entity from the individuals who formed and operate it. After this formation date, your organization’s directors and officers can begin to take corporate actions such as formally adopting the bylaws and policies, applying for an employee identification number from the IRS, hiring employees, entering into contracts, and, most importantly, working towards the goals for which the organization was formed.

More to Come

In this second installment of this series, we have discussed the early steps of nonprofit formation. In Part 3, we will discuss the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under 501(c)(3) (private foundations vs. public charities) and how to decide which is right for your enterprise. In Part 4, we will look at restrictions on private inurement and political activities and how to avoid getting into trouble with the IRS on those issues. Finally, in Part 5, we will examine the process of applying for 501(c)(3) status and how to maintain that status going forward.

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Featured Image by Rebecca Sidebotham.