Starting with an Idea

This article on nonprofit formation is designed to inform and encourage those who are considering forming a nonprofit organization. 

Nonprofit organizations have always been a unique feature of American society. In the 1830s, the French traveler Alexis de Tocqueville observed how everyday Americans formed charitable associations to accomplish things that had traditionally been reserved for the rich and powerful in Europe.¹ Almost two centuries later, de Tocqueville’s observations still hold true. In 2016 alone, over 1.5 million new nonprofits were registered with the IRS and nonprofits made up nearly 6% of the U.S. GDP.²Supporting the tradition of charitable enterprise in America, federal and state governments have historically exempted such organizations from taxation, including sales tax, property tax, and income tax. They have also provided tax incentives to individuals to encourage charitable donations.

Understanding the Difference Between “Nonprofit” and “501(c)(3)”

Although the terms “nonprofit" and “501(c)(3)” are often used interchangeably, they refer to two distinct categories that often overlap. A nonprofit corporation, like any other private legal entity, is created by state law. A corporation is an entity and has a separate legal identity from its incorporators. It is a “person” in the eyes of the law, meaning that it can sue or be sued, buy or sell property, and enter into contracts. Its liabilities and assets are distinct from those of the individuals who operate it.³

The unique characteristic of a nonprofit corporation is that it does not have owners or shareholders. Both a for-profit corporation and a nonprofit corporation can make money. The difference is that with the for-profit corporation, the profits flow to owners/shareholders, but nonprofits technically have no “owners.” A non-profit’s revenues and assets can go towards paying for its operational expenses (e.g., overhead costs, employee salaries, etc.). Excess must be invested back into the nonprofit or donated to another charity.

The term “501(c)(3) organization” refers to an organization that is determined by the IRS to be tax-exempt under the statute 26 U.S.C. § 501(c)(3). Just because an organization is a nonprofit (i.e., formed as a nonprofit on the state level), does not necessarily mean that it is a 501(c)(3) organization. Unless a nonprofit organization is a church or an “integrated auxiliary of a church”⁴ (both of which automatically have tax-exempt status), it will need to apply for tax exempt recognition and receive a formal determination of exemption from the IRS in order to be exempt from federal income taxes and for its donors to deduct contributions on their own personal tax returns.

So all 501(c)(3)s are nonprofits, but not all nonprofits are 501(c)(3)s. Nonprofit status is a form of entity under state law, and 501(c)(3) status is a tax-exempt recognition under federal law.

Exempt Purposes and Activities

Section 501(c)(3) of the tax code states that in order to be tax-exempt, a nonprofit corporation must be organized and operated exclusively for one of the following purposes:

• Religious purposes
• Charitable purposes⁵
• Scientific purposes
• Testing for public safety
• Literary purposes
• Educational purposes
• Fostering national or international amateur sports competition
• Preventing cruelty to children or animals

Although there are other categories of tax-exempt organizations under Section 501, this series focuses on nonprofit organizations under 501(c)(3), since those are the most common.

If you want to form a nonprofit and successfully apply for tax-exempt recognition from the IRS, then all of the purposes and activities of your organization must fit into one or more of the categories listed above. If your organization has or will have operations that are outside of these categories, then those non-exempt activities may require paying taxes on unrelated business income, or even disqualify it from tax-exempt status altogether.

In addition to the requirement that an organization must have exempt purposes and activities, Section 501(c)(3) requires that no part of an organization’s net earnings may benefit any particular private parties, and also that the organization’s activities cannot include political lobbying or campaigning. We will discuss these restrictions in more detail in a subsequent installment in this series.

The first question you should ask when deciding to form a nonprofit is whether your organization’s proposed purposes and activities fit into would be recognized as tax-exempt under section 501(c)(3).

People, Policies, and Papers

This section covers 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.

Presumed Private Until Proven Public

This section discusses the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under Section 501(c)(3). These include public charities, private foundations, and private operating foundations. When you apply for exempt status from the IRS, you will need to specify which of these categories your organization fits into. Misclassifying your organization can result in significant problems down the road and converting from one category to another can take up to five years. So it’s important to understand these categories up front so that you can be confident which of them best fits your organization.

Nonprofits With Legs: Public Charities

Most active 501(c)(3) organizations are public charities. Public charities are nonprofits that do things. They engage in tax-exempt activities. Public charities include churches, hospitals, aid and relief organizations, Little League clubs, private schools, and other nonprofit organizations that conduct religious, educational, and/or charitable activities.

Because public charities do important things that help society, the IRS generally allows donors to these organizations to deduct donations to public charities up to 60% of their gross adjusted income. Public charities also generally have easier annual reporting requirements compared to private foundations.

If your nonprofit organization idea is in the realm of doing things (which most are), then you need to make sure that it can and will meet the requirements for being a public charity. First, in order to be a public charity, an organization must show that it receives (or will receive) a substantial part of its funding from a broad base of public support or government sources and not from just a handful of large donors. This is known as the “Public Support Test.” Second, the board of a public charity must be mostly comprised of directors who are not related to one another by blood, marriage, or outside business relationship.

The gist of these requirements is that a public charity cannot be closely-governed or closely-funded by family members or business partners. Each of these requirements have lots of nuanced exceptions, caveats, and criteria under the tax code and IRS regulations. Organizations should consult with knowledgeable legal counsel or a tax professional to make sure they comply with these rules for obtaining and maintaining public charity status.

Nonprofits With Pockets: Private Foundations

Not all nonprofits do things. Some of them just have things, particularly money for grants to public charities. These are private foundations. The main function of a private foundation is to hold assets tax-free for the purpose of distributing its assets to other nonprofits.

Unlike public charities, private foundations can be governed by directors who are family members or business partners. Moreover, private foundations do not need to meet the Public Support Test. Private foundations can be closely controlled and closely funded.

However, there are significant drawbacks to private foundation status. First, private foundations are generally required to distribute at least 5% of their assets to charitable purposes each year. Second, there are strict rules on self-dealing and transactions that involve directors and their family members. Third, private foundations are subject to an excise tax on their net investment income. Fourth, donors to private foundations can generally only deduct up to 30% of their income for such donations (which is less incentivizing than the deductibility for public charity donations). Finally, private foundations typically have more onerous annual reporting requirements to the IRS.

Despite the substantial limitations associated with being a private foundation, many nonprofits elect this status for the purpose of forming a source of funding and support for one or more charitable purposes, controlled by a single family or corporation.

Tertium Quid: Private Operating Foundations

One subclassification of private foundations is known as a “private operating foundation” (POF). POFs and the rules that govern them are too complex to explain in detail in this post. But what you should know is that they are essentially a hybrid between private foundations and public charities, and they have many of the perks of both without some of the drawbacks.

However, before you go thinking that a POF is the obvious “best-of-both-worlds” option, you should know that maintaining POF status is very complicated and should only be done with guidance from a knowledgeable attorney or tax professional.

Why It Matters: Rebutting the Presumption

It is important to understand that the IRS presumes that an organization applying for 501(c)(3) exemption is a private foundation unless it proves that it meets the criteria for being a public charity (the Public Support Test, board diversity requirements, etc.).

When you apply for 501(c)(3) exempt status, the IRS will send you a determination letter that will specify your organization’s foundation status classification, that is, whether it is a private foundation or a public charity. The basis on which the IRS makes that determination is whether your application demonstrates that you overcome the presumption of private foundation status. The default status is private foundation. To obtain public charity status, the burden is on the applicant to show that the requirements for that status are met.

Also, while a public charity may very easily convert to a private foundation, it is very difficult to convert a private foundation into a public charity. Indeed, it is a five-year process that involves extensive reporting to the IRS. Therefore, you should confirm up front whether you want your organization to be a public charity. And you should complete your application for exemption to the IRS in a way that will ensure that you rebut the presumption of private foundation status and get classified as a public charity.

Prohibited Pursuits

Now it's time to cover the two biggest “no-no” activities for 501(c)(3) organizations. These activities can get your organization and your directors into big trouble with the IRS. The first set of prohibited activities is known as “private benefit” or “private inurement.” The second involves restrictions on legislative lobbying and political campaigning.

Prohibited Payments, Profits, & Procedures: Private Benefit & Private Inurement

1. The Private Benefit Doctrine

Section 501(c)(3) of the Tax Code provides that a tax-exempt non-profit must be “organized and operated exclusively for religious, charitable, scientific" and other specified purposes. This language in the statute is the basis of the “private benefit doctrine.” This rule, in a nutshell, states that an exempt organization must engage primarily in activities that accomplish one or more exempt purposes and that primarily benefit the public rather than private interests.

The logic behind this restriction is as follows: exempt organizations are excused from taxation and receive tax-deductible contributions from donors because they are supposed to devote all of their funds and assets to benefiting the public. Therefore, it is inappropriate for the money and assets, which are non-taxable and which donors contributed for public, charitable purposes, to end up benefitting private parties.

There are usually incidental private benefits that flow from nonprofit work. But the private benefit doctrine applies when the benefit to one or a few private interests outweighs the general benefit to the public. For example, let’s say there is a non-profit organization that plants trees and removes trash from the banks of a local river. All of the parties who use the river, drink water from the river, or own property along the river will benefit from this organization’s work. However, if this organization only does this work on the riverbanks that are owned by a few private landowners, then the benefit of the organization’s activities will be too concentrated on those landowners to be considered to benefit the public. This would violate the private benefit doctrine.

2. The Private Inurement Doctrine

Section 501(c)(3) further provides that no part of the net earnings of a tax-exempt non-profit may “inure to the benefit of any private shareholder or individual.” This is the basis of the so-called “private inurement doctrine.” Private inurement can be understood as a subset of private benefit. All private inurements are private benefits, but not all private benefits are private inurements. For example, in our river clean-up hypothetical, if those private landowners were also on the board of the nonprofit, there would be private inurement, not just private benefit.

Private inurement refers to a prohibited act of self-dealing. The rules against private inurement require that an organization’s officers, directors, employees, or those persons family members and businesses (all known as “disqualified parties”) not use their positions to derive any excess benefit from the non-profit. The private inurement rule can be understood as a particular application of the private benefit rule to an organization’s insiders. The rule prohibits disqualified persons from using an organization’s assets or influence to benefit them, their family members, or their own businesses.

The rule affirmatively requires an organization’s officers and directors to make decisions in a way that prevents excess benefits to insiders. This can include following a conflicts-of-interest policy and consulting with outside experts or objective market data to determinate reasonable compensation and appraisal of services or property to ensure that a non-profit is not paying too much under a contract.

These restrictions on private benefit and private inurement have several important practical implications for non-profit organizations, which include the following:

• Compensation of officers and employees must not be unreasonably high;
• Insiders of an organization must not use the organization’s activities to promote their own private businesses or those of their family members;
• Directors and officers must not participate in decisions affecting their own compensation;
• Directors, officers, and employees generally must not use the organization’s assets (money, equipment, vehicles, facilities, etc.) for their own personal use;
• The organization must not enter into transactions that confer an excess benefit to private individuals or companies. The organization must pay no more than a fair and reasonable price for purchases or services;
• Anyone purchasing property from the organization must pay fair market value for it;
• No assets or property of the organization can be given to private party outside of a charitable grant program; and
• Upon the dissolution of an exempt organization, all of its assets and funds must be distributed only to one or more other 501(c)(3) organizations.

The rules against private benefit and inurement have very broad implications that can affect a range of scenarios and transactions. Nonprofits should be educated and work with knowledgeable legal counsel to avoid violating these rules.

Prohibited Promotions, Propaganda & Politics: Restrictions on Political Activities

1. Restrictions on Legislative Lobbying

Section 501(c)(3) also includes restrictions on certain political activities. First, the statute provides that “no substantial part of the activities” of an exempt organization can be “carrying on propaganda, or otherwise attempting, to influence legislation.” This restriction prohibits lobbying or other intentional efforts to directly influence legislation at the state, local, or federal level.

However, this rule is not a categorical bar on such activities, but only prohibits them from being a “substantial part” of an organization’s activities. Moreover, exempt organizations may engage in certain non-partisan voter education activities (e.g., creating public forums and publishing voter education guides). An organization may also engage in programs that promote participation in the democratic process (e.g., voter registration and get-out-the-vote drives).

2. Restrictions on Political Campaigning

Section 501(c)(3) also states that an exempt organization may not “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” This provision is often referred to as the “Johnson Amendment,” as it was introduced in 1954 by then Senator (later President) Lyndon B. Johnson.

Unlike the limitation on “influencing legislation,” the prohibition on election campaign activities is absolute. A 501(c)(3) organization may not publicly endorse or oppose candidates for political office or make contributions to a candidate’s political campaign.

This restriction is very controversial and is subject to considerable First Amendment concerns. Many churches make an annual practice of openly testing this restriction with Election Day sermons that endorse or oppose candidates. However, while the IRS has issued several warning letters for alleged violations, only one church and a handful of other non-profit organizations have ever been subjected to any actual penalties for violating this restriction on campaigning.

Penalties & Pitfalls

The repercussions for violating any of these restrictions can be steep. Usually, low-level or unintentional violations receive no more than a stern warning letter from the IRS, instructing the organization to cease its prohibited activities. However, an organization may be subject to excise taxes as a penalty for violations. An organization’s officers and directors may personally be subject to what are known as “intermediate sanctions,” which are fines of up to $20,000.00 imposed for approving or pursuing decisions or activities that violated the private benefit rule. Recipients of excess benefits in transactions with non-profits (including employment) can also be subject to a special excise tax on those benefits.

Another major penalty for violating either the private benefit rules or the restrictions on political activities can be denial or revocation of an organization’s exempt status. In light of these steep penalties, organizations should generally consult with legal counsel to stay compliant.

Proceed and Persist

Finally, let's examine the process of applying for 501(c)(3) status and how to maintain that status going forward.

Applying for 501(c)(3) Exempt Status

After you have formed a nonprofit corporation on the state level, the next step is to obtain tax exempt recognition from IRS. This is done by starting an account with Pay.gov and completing an application known as a Form 1023. While the Form 1023 will be completed through a series of webpages, a PDF version of the Form 1023 is available here.

The Form 1023 requires producing a substantial amount of information to the IRS. Your organization will be required to disclose the names and address of its directors, information about compensation of employees and contractors, and information about the relationships that exist between and among directors, officers, employees, contractors, and other outside parties. These questions are designed to detect whether your organization may have problems with conflicts of interest or private benefit/private inurement.

The Form 1023 application also requires an applicant organization to provide a detailed description of all its activities, including who conducts the activities, where the activities are conducted, how much of the organization’s time and money are proportionally allocated to each activity, and how each activity furthers its tax-exempt purposes. The Form 1023 includes several dozen “yes or no” questions about specific aspects of the organization’s activities. Most of these questions include prompts to provide additional description.

One part of the Form 1023 that may appear particularly daunting is the requirement to provide 3-5 years of the organization’s detailed financial information. If an organization has been in existence for less than a full tax year (which is typically the case), the organization must provide detailed estimates of its finances for three years into the future. However, the IRS does not expect an applicant to have a crystal ball and to be prophetically accurate. The IRS just wants to ensure that the organization applying for 501(c)(3) status has considered its sources of funding and that its financial planning is consistent with the public-support test (discussed in Part 3 of this series) and other rules governing nonprofit finance and expenditures. Nevertheless, it is wise to consult with a financial professional to advise on this portion of the Form 1023.

There are also a series of specific additional “schedules” or extra sets of questions that an organization may be required to answer if it is a hospital, school, church, housing provider, or other special category of nonprofit. If an organization is a “successor” organization (taking over the assets or activities of another organization), it will have to disclose additional information about the relationship between the two organizations. Also, if more than 27 months has passed between the date of corporate formation and the date of application, an organization must provide additional information about its activities and financial history.

In addition to the many questions included in the Form 1023, an applicant will also need to provide several documents as attachments to the application. These include the organization’s articles of incorporation, bylaws, conflicts of interest policy, and other corporate, financial, or explanatory documents that provide the basis for any responses to questions.

The IRS application fee for a standard Form 1023 is $600.00. After submitting a Form 1023 application, the IRS may send the applicant a follow-up questionnaire to request additional information. When this happens, the applicant must complete the responses within the deadline prescribed (often less than a month), or the IRS may reject the application altogether and without refund of the application fee.

Overall, the Form 1023 is a difficult application that can require several hours of preparation and a substantial amount of information. Many charitable entrepreneurs engage with an attorney to complete this complicated process. The IRS does provide a shorter and simplified version of the application (the Form 1023-EZ) for certain categories of nonprofits that are very small (less than $50,000 of annual gross receipts and less than $250,000 in total assets). At $250, the filing fee for the Form 1023-EZ is also cheaper. However, the drawbacks of the Form 1023-EZ are that applicants filing this form are more likely to receive follow-up information requests from the IRS and are also more likely to be audited by the IRS.

In terms of a turnaround response time from the IRS, it can take up to a year. The IRS will not even answer questions about the status of an application until 180 days after the filing of the Form 1023. Once the IRS has determined exempt status, it will send the applicant a determination letter with the date of exemption, the organization’s specific exempt status (i.e., private foundation or public charity), and whether the organization is required to make continual annual filings.

Maintaining 501(c)(3) Exempt Status

After an organization has obtained tax-exempt recognition from the IRS, it must maintain that status actively. With the exception of churches and certain church-related organizations, nonprofits must make an annual filing with the IRS called a Form 990. This is essentially a tax return form for a 501(c)(3). The Form 990 reports the organization’s revenue, expenses, and assets for that fiscal year, as well as compensation given to officers, employees, and contractors. Since these annual filings can be quite complex, many organizations use an accountant to prepare their Form 990 submissions. 501(c)(3) organizations that are private foundations have to submit an even more complicated filing, the Form 990-PF, which also requires disclosure of all grants and distributions made that year. Organizations with less than $50,000 in gross receipts can sometimes file a simplified version called a Form 990-N. Failing to fail a Form 990 with the IRS can result in fines that increase with each additional day the filing is late, and ultimately revocation of tax-exempt status.

In addition to annual IRS reporting, nonprofit organizations must also comply with their relevant state authorities. Most states require nonprofit organizations to file an annual report with the secretary of state or similar corporate entity agency, but some states have longer intervals of time between required filings. Also, the laws of most states require nonprofits to maintain corporate records such as board meeting minutes, bylaws, corporate action resolutions, financial records, and other documents. These records can be inspected by state officials as well as by members of the corporation. Every organization should practice careful recordkeeping and comply with all applicable state laws.

Conclusion

This article on nonprofit formation has given you the basic considerations that you will need to make and the steps you will need to take to transform your nonprofit from an idea into a reality. However, this process can often be complex and challenging. It is always wise to engage with an attorney who is experienced and knowledgeable on nonprofit issues and who can competently advise your organization on properly forming, properly operating, and staying compliant with all applicable laws.

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¹ Alexis de Tocqueville, Democracy in America, Edited and translated by Harvey C. Mansfield and Delba Winthrop (University of Chicago Press, 2000) p. 489.

² See National Center for Charitable Statistics, The Nonprofit Sector in Brief 2019, June 2020.

³ Nonprofit organizations most commonly form as corporations, but they can take other entity forms such as trusts, LLCs, or unincorporated associations.

⁴ The term “integrated auxiliary of a church” refers to a class of organizations that are related to a church or convention or association of churches, but are not such organizations themselves.

⁵ According to the IRS, “the term charitable is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”

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Featured Image by Rebecca Sidebotham.