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How do we form a nonprofit organization?
You’ve got the passion, the knowledge and the resources to get started. But how do you actually set up a nonprofit organization?
First, it’s important to understand what a nonprofit is from a legal standpoint. A nonprofit is simply an organization that does not distribute profits to shareholders. However, when most people refer to nonprofits, they are talking about recognized tax-exempt organizations.
Here, we’ll discuss the formation of an organization structured as a California Nonprofit Public Benefit Corporation, organized for charitable purposes and exempt under Internal Revenue Code §501©(3) and §23701d of the California Revenue and Taxation Code.
Before you begin.
It’s important to note that there are many steps you’ll need to take prior to legally forming a nonprofit corporation. While you are likely eager to get your mission-driven charitable endeavor off the ground, failure to adequately research the need for your programs and services, and determine fundraising feasibility, will ultimately undermine your efforts.
It’s also possible that your planning phase will reveal alternative legal structures that are better suited to your needs. See, “What other legal structures are there for nonprofits?” for more information.
Setting up your legal structure.
The legal process of forming a nonprofit starts with filing for both federal and state tax-exempt status. At the federal level, this is done through the Internal Revenue Service. Filing with the state in which your nonprofit is located is done through that state’s department of revenue. Keep in mind, while this discussion of federal designation applies to organizations anywhere in the United States, each individual state also has its own laws, so be sure to refer to specific state laws before you begin.
The following steps will help you incorporate a nonprofit organization and obtain tax exemption from the Franchise Tax Board and Internal Revenue Service (IRS):
- Prepare articles of incorporation and file them with the Secretary of State. This process typically takes 10-12 weeks if filed by mail and 2-3 weeks if hand-delivered to Los Angeles or Sacramento.
- Prepare your organization’s bylaws.
- Apply for an Employer Identification Number (EIN) with the IRS. This process typically takes 30 days.
- In California: Register with the California Attorney General’s Registry of Charitable Trusts. California charities must register within 30 days after receiving their first assets.
- Recruit a board of directors and conduct an initial meeting. At this time, directors will accept their role, adopt or ratify bylaws, elect officers and authorize application for tax exemption. You’ll also want to create bank accounts and complete other steps necessary to begin operations.
- Apply to the IRS for recognition of federal tax exemption. This process typically takes 90 days.
- Apply to the Franchise Tax Board for recognition of state tax exemption. This process typically takes 90 days.
The legal process of incorporating and obtaining tax-exempt status is arduous and time-consuming. The steps outlined above note the average processing time for each application, assuming that application materials are complete and that requests for additional information are readily addressed. Regardless of how thorough you are, know that obtaining nonprofit status will take time.
To help navigate the process, you may want to hire an attorney familiar with nonprofit law to assist in preparing and submitting required materials. This can be particularly beneficial if you want to speed up your application or if you encounter problems preparing the required documentation.
What other legal structures are there for nonprofits? What about fiscal sponsors?
During your planning phase, you may determine that an alternative legal structure is better suited to your organization’s needs. In addition to forming a nonprofit corporation as described in “How do we form a nonprofit organization?”, there are four common alternatives.
- You can form an unincorporated association.
- You can form a limited liability company.
- You can be incubated by a fiscal sponsor.
- You can become affiliated with another nonprofit.
While the law does not require organizations to be incorporated in order to be eligible for tax exemption, unincorporated associations cannot offer protection against personal liability to directors and members. In addition, while there may be fewer reporting requirements of unincorporated associations, many foundations are not willing to fund them.
Technically speaking, a nonprofit can be formed as a limited liability company, or LLC. As of 2004, this is legal in California and qualified organizations can gain tax-exempt status. However, the requirements to gain federal 501©(3) status as an LLC frequently disqualify many interested organizations. IRS regulations prohibit individuals as members of the LLC and only allow members that are themselves exempt organizations. In other words, your organization would already have to be a legally recognized 501©(3) in order to apply for federal tax-exempt status as an LLC.
Fiscal sponsorship is an approach that allows an organization with 501©(3) status to extend its legal status to another organization (or initiative or project). Many such organizations offer administrative support and technical assistance to help advance an organization’s goals, generally at low cost. This option provides an opportunity to grow your start-up project and legally accept grants and donations without the red tape associated with establishing a stand-alone entity. Once your program is established, it can transition from the incubator to become a freestanding organization.
Affiliation with an existing nonprofit is another option that may be available to you. If your mission and goals align closely with those of another organization, affiliation may be a wise choice. Potential benefits include a ready source of clients, access to knowledgeable staff and a “home” for your program. When looking at this option, you should consider how well the affiliate’s goals match those of your program, as well as the level of autonomy your program or organization will have within that structure. Also look at the strength of existing relationships with the board, director and staff, and the impact of any financial arrangements you’ll make.
There are many other types of federally exempt organizations allowable by the IRS. For a complete list, refer to IRS Publication 557, Tax-Exempt Status for Your Organization. When choosing a legal structure for your organization, it’s highly recommended that you consult with an attorney experienced in tax and corporate law governing nonprofit organizations.
You should also know that there are many other types of for-profit and profit/nonprofit hybrid structures that vary from state to state. For example, several states allow for the creation of low-profit limited liability companies, or L3Cs, to meet the needs of social ventures. Another option is a B Corporation, which is structured to create benefit for both society and shareholders.
What forms must be filed by a nonprofit each year?
You’re busy starting and running your nonprofit and the last thing you want to think about is filing. But the IRS and the Franchise Tax Board take filing very seriously, so you should too.
All tax-exempt organizations must file a federal return or returns. In California, all tax-exempt organizations must also file a state return or returns. Failure to do so for three consecutive years will cause your tax-exempt status to be automatically revoked by the Franchise Tax Board and the IRS.
For tax years ending on or after December 31, 2010, exempt organizations that normally have more than $50,000 in gross receipts must file either:
- Form 990, Return of Organization Exempt from Income Tax, or
- Form 990-EZ, Short Form Return of Organization Exempt from Income Tax
Exempt organizations that normally have less than $50,000 in gross receipts are eligible to file a Form 990-N (e-postcard) or they may elect to file a full return (Form 990 or 990-EZ).
“Normal” receipts are established based on an average over three years. Prior to December 31, 2010, the threshold for filing the 990-N (e-postcard) was normal gross receipts of less than $25,000. This means that there is a phase-in period to reach the current $50,000 threshold. For assistance on which forms to file, visit the IRS website.
In the state of California, common forms required of tax-exempt organizations include:
- Form 199, California Exempt Organization Annual Information Return (for organizations with gross receipts normally greater than $25,000).
- Form 199N, Annual Electronic Filing Requirement for Small Exempt Organizations (for organizations with gross receipts normally equal to or less than $25,000).
- Form 109, California Exempt Organization Business Income Tax Return (for organizations with unrelated business taxable income greater than $1,000).
- Form 100, California Corporation Franchise or Income Tax Return (for organizations with taxable income greater than $100).
Can nonprofits charge a fee for service?
The short answer is, yes! In fact, revenue-generating activities can be a critical component of your effort to build a sustainable nonprofit organization. Many nonprofits have found ways to create a revenue stream that flows from their programmatic work. Examples include fees for membership, direct services, publications, and nonprofit-organized conferences and seminars.
The law sets no limits on the fees you can charge, although there are several factors to consider when establishing the fee for a particular service. First and foremost, the service being offered must be related to your mission. Otherwise, the revenues should be reported as unrelated business income.
You should also consider the environment in which a fee is being charged. Factors such as the availability of philanthropic or sponsorship support, the full cost of the product or service, market prices for similar services, and your constituents’ ability to pay should be taken into account when establishing a reasonable fee.
To set fees for service, follow these easy steps:
- Prioritize your objectives in charging a fee. Why do you need to charge for this particular product or service?
- Determine the service unit cost.
- Survey the market price of similar goods and services. What are your competitors charging?
- Determine a percentage of costs to be recovered by fees. How much do you need to make to cover your costs?
- Define the fee structure and discounts. For example, will you offer discounts based on a sliding scale?
- Assess the target market’s reaction to the fee. Test your pricing with your constituents.
- Adopt a fee policy. Use this policy moving forward with additional products and services.
- Develop implementation/collection procedures.
- Evaluate and revise, as appropriate.
Adapted from: Charging a Just Fee: A Guidebook for Nonprofit Organizations, by Walter Moreau.
How do we reduce our risks? What kinds of insurance do we need?
Doing good work in the community is not enough protection against possible risks. Like other small businesses, nonprofits need to have proper insurance coverage. An independent insurance agent with experience in policies for nonprofits can help. Remember, these agents only get paid based on commission on policies sold, so there is no cost associated with shopping around. Ask colleagues in the nonprofit world for recommendations or inquire with your attorney.
A qualified agent or attorney will also be in a position to help you establish a sound risk management program, including identification of loss exposure, measures to reduce loss, and insurance best suited to your situation.
In many states, insurance tailored to nonprofits is offered through trade organizations or alliances that are themselves 501©(3)s. Such an organization could provide a useful local resource to research and identify your needs and options.
That said, there are several standard policies you’ll likely need. These include General Liability, Auto Liability, Social Service Professional Liability, and Directors & Officers Liability. Depending on your situation, you may also want to consider coverage for volunteers.
Other types of coverage that may be important to your specific organization include:
- Professional malpractice.
- Non-owned or hired auto liability (such as for use of employee or volunteer-owned autos).
- Improper sexual conduct for both the organization and alleged employee or volunteer perpetrator.
- Student/volunteer/participant accident.
Do we need a conflict of interest policy for our board of directors?
You want to safeguard against conflict of interest situations in your organization, but do you really need a policy to do so? Federal law does not require tax-exempt organizations to have a conflict of interest policy in place. However, the IRS strongly encourages it. Such a policy can reduce the appearance of impropriety and help to ensure that the exempt organization is conducting business in a manner that is consistent with its charitable purpose.
It’s important to note that conflicts of interest involving a director are not in and of themselves illegal or improper. They are, in fact, quite common. It’s the manner in which the director and board deal with and disclose the conflict that determines the propriety of a decision or transaction.
So what exactly is a conflict of interest? A conflict is present whenever a transaction has the potential to personally benefit a director. This can occur, for example, when a director has an employment, investment or family involvement with an entity with which the nonprofit is dealing.
A board member’s duty is to act in good faith with regard to the best interests of the exempt organization, not in the board member’s personal interest. This is called “duty of loyalty” in the law, and directors are legally bound to carry it out.
Given the risks and responsibilities, a written conflict of interest policy is strongly recommended. A policy clearly spells out the legal procedures for disclosure of conflict of interest and approving transactions in which a director may have an interest. The board may also wish to go beyond what the law requires and establish more stringent policies, such as forbidding transactions in which the director has an interest.
Adapted in part from: Guidebook for Directors of Nonprofit Organizations, by the American Bar Association.
What documents are needed for board meetings?
What should be retained and for how long? What should be recorded in board minutes?
As an exempt organization, you’ve been keeping an official board book. It should include all corporate documentation such as bylaws, articles of incorporation, conflict of interest policy, a template for board meeting minutes, minutes of board and committee meetings, contact information for all directors, and any other documents that govern your operations.
How long you should keep your record?
The IRS says that you “must keep all of your records as long as they may be needed.” While this may sound like rather loose guidance, it is easy enough to determine how long that might be. Financial records, such as general ledgers and audits, should be kept for seven years. This standard is derived from the ability of the IRS to audit your records for intentional fraud for up to six years; the seventh year is needed to cover starting balances.
Corporate records, which set forth policy decisions such as board minutes, should be kept forever. The goal here is to present a full history of the organization, since an organization may need to review historic decisions (for example, the restrictions placed on a donation).
Minutes of board and committee meetings must be kept within an official board book and a tax-exempt organization is required by law to keep them. All board members should receive copies of the minutes and have access to the minutes at any time.
What you should know about minutes.
Minutes are the permanent record of the proceedings of a board or committee meeting. They need to be clear, accurate, brief and objective. In addition to basic information such as the date, time and location, names of members present or absent, and results of votes, your minutes should include:
- The names of persons abstaining from any vote or requesting that their vote be recorded.
- The names of members who disclosed a potential conflict of interest, the nature of the conflict and disposition.
- A list of all reports and documents introduced during the meeting (with copies attached to the official minutes).
- A summary of significant points raised during discussion.
- Any commitments made by officers or any other person present.
- The time of adjournment.
- The signature of the meeting secretary.
- When appropriate, a brief addendum showing required follow-up activities.
Adapted from: 10 Minutes to Better Board Meetings, by Planned Parenthood Federation of America.
Can a nonprofit lobby?
First and foremost, it’s important to understand how the law defines lobbying. The IRS refers to lobbying as “influencing legislation.” This is done directly (as in communicating directly with a legislator or their staff to express a view about specific legislation) or indirectly (such as communicating with members, encouraging target audiences to contact legislators or speaking with the media about specific legislation).
A great deal of advocacy does not fall within the definition of lobbying. For example, a 501©(3) is permitted to make the results of nonpartisan research available or broadly discuss social issues. A complete list of permitted activities is available in IRS Publication 557.
Generally speaking, a 501©(3) public-benefit charity is not allowed to make lobbying a “substantial part” of its activities. Unfortunately, this statement is ambiguous at best. In the past, courts have found expenditures of more than 5 percent of an organization’s budget, time and effort to be “substantial.”
A far more defined test is outlined in 501(h) of the Internal Revenue Code. This sets specific dollar limits on an organization’s lobbying activities and counts only lobbying expenditures (money and staff time) toward those limits. In most cases, this will enable an organization to engage in more lobbying activity with greater security that it will not endanger its tax-exempt status. To do so, you must file IRS form 5768 within the first tax year to which the form applies.
It’s also important to note that all 501©(3) organizations are prohibited from campaigning for or against a candidate for elected office.
Private foundations are absolutely prohibited from lobbying. Grant agreements will typically include language noting that the recipient organization agrees to not use any of the granted funds for lobbying activity.
What is the difference between a 'related' and 'unrelated' business activity?
You want to bring in more revenue and you’re thinking about your options. Before you begin, you’ll need to understand how your business activities are perceived from a tax perspective.
When a nonprofit charges a fee for a service or sells a product as an ongoing activity, the law considers whether the activity or product is “related” to the organization’s mission. If the business is “related” to your exempt purposes, then you will not incur corporate income taxes on the net proceeds of that business activity (though you may need to pay sales and other taxes).
Taking care to ensure that your business activity is “related” significantly reduces the risk that your organization will lose its tax exemption for carrying on too much activity that does not further the mission.
An example of “related” business would be a health clinic that charges patients a reduced price for health services. This furthers its mission to provide affordable health care services.
If the business is not related to the organization’s exempt purposes, then it is considered “unrelated” and net income from the business is subject to Unrelated Business Income Tax (UBIT). UBIT is applied when gross income from the unrelated business is $1,000 or more. These are reported and paid by filing a Form 990-T, which is required in addition to any other tax reporting forms required of the exempt organization. Individual states may also have their own filing and tax requirements. For example, in California, the Franchise Tax Board requires a Form 109 to calculate and pay tax on unrelated business.
Keep in mind, there are limitations on the amount of unrelated business activity in which a nonprofit can engage. Under IRS regulations, a nonprofit risks losing its tax exemption if an unrelated business constitutes a “substantial” portion of the organization’s total activities. While the word “substantial” is subject to interpretation, if the unrelated business activity grows to 25 percent of your nonprofit organization’s activity, you should seek legal counsel. One option for continuing to engage in a substantial amount of unrelated business activity is to form a subsidiary corporation or limited liability company to carry on the business.
Still not sure if your activity is related?
Know that the IRS considers an activity to be “unrelated” if all three of the following are present:
- It is a trade or business (i.e., selling of goods or services).
- It is regularly carried on (as distinct from the occasional car wash or bake sale).
- It is not substantially related to furthering the exempt purpose of the organization.
This is a brief description of an area that is complex. If your organization is carrying on or planning to start a business venture, the advice of legal counsel familiar with these complicated tax rules is strongly advised.
Does the IRS regulate how much a nonprofit can pay its employees?
When you’re a nonprofit administrator or director setting salaries for your employees, you’re accountable to many parties, and the IRS is one of them. While the IRS doesn’t regulate specific compensation amounts, it does require that tax-exempt organizations limit the salaries and benefits of executives and staff to “reasonable compensation.” In fact, you’ll need to list compensation of officers, directors, trustees, key employees and others on your 990 federal tax return.
But what is “reasonable”? Simply put, “reasonable” means that the amount of compensation is approximate to what would be provided by a similar organization in similar circumstances. In other words, you’ll need to do some homework to understand the going rate for a particular position.
As a general guideline, all nonprofits should be prepared to justify how the amount of salary was determined for any staff or “significant” position. An annual salary of $50,000 in addition to fringe benefits is a useful benchmark to identify significant positions. In addition, if audited, your nonprofit organization will need to show comparables. To learn more, the Center for Nonprofit Management produces an annual Compensation & Benefits Survey that can be especially useful in determining appropriate compensation.
