by Anthony Mancuso, Esq.
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.
Is your organization a nonprofit corporations that could
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 dubs, fraternal societies, credit unions, farmers' coops, and
legal service organizations, to name a few-that may be eligible for tax-exempt
status under other sections of the Internal Revenue Code.
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 (Publisher, Nolo).
HOW TO FORM A NONPROFIT
CORPORATION
Corporation Basics -
You don't have to understand all there is to know about corporations in order
to follow this book or form your nonprofit. But there are a few basic concepts
you'll want to have under your belt as we go through the process. Here they
are, with special emphasis on any differences between forprofit 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.
Limited Liability
Entities (LLC) - 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.
Flexiable Purpose
Corporation (FPC) - California is the only state that 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 FPC is distinguished
from the L3C and Benefit Corporation in that it is primarily intended for use
by for-profit companies seeking traditional capital market investment. 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.
Benefits of the
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. Many groups accomplish their nonprofit
purposes just fine as unincorporated nonprofit associations, without formal
organizational paperwork or written operational rules. If you can continue to
accomplish your nonprofit purposes and goals informally, you may be happier
staying small.
Tax Exemptions -
Nonprofit corporations are eligible for state and federal exemptions from
payment of corporate income taxes, as well as other tax exemptions and
benefits. At federal corporate tax rates of 15% on the first $50,000 of taxable
income, 25% on the next $25,000, and 34% and higher on income over $75,000, it
goes without saying-at least if you expect to earn a substantial amount of
money (from services, exhibits, or performances, for example)-that you'll want
to apply for an exemption. 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.
See an expert or obtain 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 50l(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.
For example, A member of the audience sued a nonprofit symphony
orchestra when the patron fell during a concert, claiming that the symphony
(which also owned the concert hall) provided an unsafe ramp. The patron won a
judgment that exceeded the orchestra's insurance policy limits. The amount of
the judgment in excess of insurance is a debt of the corporation, but not of
its individual directors, members, managers, or officers. By contrast, had the orchestra been an
unincorporated association of musicians, the principals of the unincorporated
group could be held personally liable for the excess judgment amount.
In a few situations, however, people involved with a nonprofit
corporation may be personally liable for the corporation's liabilities. Here
are some major areas of potential personal liability:
• Taxes: State and
federal governments can hold the corporate employee who is responsible for
reporting and paying corporate taxes 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. (A private foundation is a
501(c)3 corporation and 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 the founders could decide to continue this way indefinitely.
However, the founders want to expand the activities and revenues of the
collective. Let’s say as an example, 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
workstudy 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.
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. 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. If 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.
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 Handle
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).
How to Avoid
Self-Dealing - Directors must guard against unauthorized self-dealing-that
is, involving the corporation in any transaction in which the director has a
material, or significant, financial interest without proper approval. The
self-dealing rules and proper approval requirements can arise in many different
types of transactions, including the purchase or sale of corporate property,
the investment of corporate funds, or the payment of corporate fees or
compensation. The nonprofit corporation laws of most states include special
rules for validating self-interested director decisions of this sort. In most
cases, the interest of the director must be disclosed prior to voting, and only
disinterested members of the board may vote on the proposal. For example, a board votes to authorize the
corporation to lease or buy property owned by a director, or to purchase
services or goods from another corporation in which a director owns a
substantial amount of stock. Either of these could be considered a prohibited
self-dealing transaction if not properly disclosed and approved, because a
director has a material financial interest in each transaction and neither
falls within one of the specific statutory exceptions.
Loans and Guarantees
- Most states expressly prohibit a nonprofit from making or guaranteeing a loan
to a director, or require approval by special disclosure or voting rules.
Because of the strict rules prohibiting individuals involved with a nonprofit's
operations from personally benefiting from the nonprofit, it's easy to see why
a loan to a director from tax-exempt funds over which he or she exercises
control might appear questionable. We suggest that you carefully review your
state's nonprofit statutes before considering approval of loans or guarantees
to directors-and, as always, ask a nonprofit lawyer for advice if you have
questions.
Director Indemnification
and Insurance - In addition to director and officer immunity statutes, most
states have director indemnification laws. These laws typically require a
corporation to indemnify (reimburse) a director for legal expenses incurred as
a result of acts done on behalf of the corporation, if the director is
successful in the legal proceeding. Directors' (and officers') liability
coverage (also called errors and omissions coverage) is, of course, one way to
insulate directors from possible personal liability for their actions on behalf
of the corporation. This type of insurance, however, is normally priced far
beyond the reach of the average small nonprofit organization. Rather than
worrying about trying to obtain this kind of coverage, it often makes more
sense to do everything possible to minimize potential risks that might arise in
the pursuit of your nonprofit purposes. For example, try to make sure that
employees perform their work in a safe manner and that anyone required to
perform skilled tasks is properly trained and licensed. In addition, the
corporation should obtain specific coverage for any likely risks: motor vehicle
insurance to cover drivers of corporate vehicles, general commercial liability
insurance to cover the group's premises, and so on.
Nonprofit Officers -
Most states require a nonprofit corporation to have a president, secretary, and
treasurer. Nonprofits often appoint
additional officers, such as a vice president, or use different tides for their
officer positions, such as a chief operating officer instead of president, or
chief financial officer instead of treasurer. One person can usually hold two
or more offices, but some states prohibit one person from serving
simultaneously as both the president and treasurer and/ or secretary of the
corporation. For proper nonprofit operation (and to help avoid an IRS
implication that you are forming a "closely held" nonprofit to serve
the interests of a small group of founders), it usually is best to appoint
separate people to your nonprofit officer positions.
Duties and
Responsibilities - The powers, duties, and responsibilities of officers are
specified in the corporation's articles or bylaws, or by resolution of the
board of directors. Generally, officers are in charge of supervising and implementing
the day-to-day business of the corporation. This authority does not usually
include the authority to enter into major business transactions, such as the
mortgage or sale of corporate property. These kinds of major transactions are
left to the board of directors. If the board wants the officers to have the
power to make one or more major business decisions, special authority should be
delegated by board resolution. Officers
have a duty to act honestly and in the best interests of the corporation. Officers
are considered agents of the corporation and can subject the corporation to
liability for their negligent or intentional acts if their acts cause damage
and are performed in the scope of their employment.
Officers May Bind the
Corporation - Generally, the actions and transactions of an officer are
legally binding on the corporation. A third party is entitled to rely on the
apparent authority of an officer and can require the corporation to honor a
deal, regardless of whether the officer was actually empowered by the board to
enter into the transaction. To avoid confusion, if you delegate a special task
to an officer outside the realm of the officer's normal duties, it's best to
have your board pass a resolution granting the officer special authority to
enter into the transaction on behalf of the corporation. And, of course, any
action taken by an officer on behalf of a corporation will be binding if the
corporation accepts the benefits of the transaction or if the board ratifies
the action, regardless of whether or not the officer had the legal authority to
act on the corporation's behalf.
Compensation of Officers
- Officers can receive reasonable compensation for services they perform for a
nonprofit corporation. It is appropriate to pay officers who have day-to-day
operational authority, and not to pay the officers who limit themselves to
presiding over the board of directors or making overall nonprofit policy
decisions. In smaller nonprofits, it is more common for officers and directors
to also assume staff positions and be paid for performing these operational
tasks. In a larger nonprofit
organization, a paid executive director or medical director (these are staff
positions, not board of director posts) might oversee routine operations of a
medical clinic, and the paid principal or administrator (also staff positions)
will do the same for a private school. However, in a smaller nonprofit, the
corporate president or other officer may assume these salaried tasks.
Loans, Guarantees, and
Immunity Laws - Loans and guarantees to nonprofit officers are either
prohibited or very strictly regulated, as they are with directors (see
"Loans and Guarantees,'' above). Officers have a duty to act honestly and
in the best interests of the corporation. Officers can be insured or
indemnified against personal liabilities, and they can benefit from the same
immunity statutes that relieve volunteer, and in some states paid, directors
from personal liability for monetary damages. See your state nonprofit statutes
before approving loans or guarantees to officers.
Employees -
Employees of nonprofit corporations work for and under the supervision of the
corporation and are paid a salary in return for their services. Paid directors
and officers are considered employees for purposes of individual income tax
withholding, Social Security, state unemployment, and other payroll taxes the
employer must pay. Employees have the usual duties to report and pay their
taxes, and the usual personal liability for failing to do so.
Employee Immunity -
Employees are generally not personally liable for any financial loss their acts
or omissions may cause to the corporation or to outsiders, as long as they are
acting within the course and scope of their employment. If the harm is done to
outsiders, it is the corporation, not the employees, which must assume the
burden of paying for the loss. Caution: employees may be personally liable for
taxes. An important exception to the rule of employee nonliability concerns the
employee whose duty it is to report or pay federal or state corporate or
employment taxes. The responsible employee (or officer or director) can be held
personally liable for failure to report or pay such taxes. The IRS may take a
broad view as to who is responsible for such duties.
Employee Compensation
- Salaries paid to officers or regular employees should be reasonable and given
in return for services actually performed. A reasonable salary is one roughly
equal to that received by employees rendering similar services elsewhere. If salaries are unreasonably high, they are
apt to be treated as a simple distribution of net corporate earnings and could
jeopardize the nonprofit's tax-exempt status. Nonprofits should avoid paying
discretionary bonuses at the end of a good year as it may look like a payment
from the earnings and profits of the corporation, a no-no for 501(c)3
tax-exempt nonprofits. In reality, since the pay scale for nonprofit personnel
is usually lower than that of their for-profit counterparts, most of this
cautionary advice shouldn't be needed for smaller nonprofits. If you have any
question about whether a transaction, contract, or compensation decision, or
another economic decision is reasonable or whether it may be outside the safe
harbor provisions of the excess benefit rules, ask a nonprofit lawyer for help.
The last thing you want to have happen is to subject board members, officers,
contractors, sponsors, donors, and others who deal with your nonprofit to the
prospect of having to pay back money or the value of benefits previously paid
out or provided by your nonprofit plus very hefty taxes, interest, and
penalties.
Limitation on Political
Activities - A 501(c)3 corporation is prohibited from participating in any
political campaigns for or against any candidate for public office. Participation in or contributions to
political campaigns can result in the revocation of 501(c)3 tax-exempt status
and the assessment of special excise taxes against the organization and its
managers. (See Internal Revenue Code §§ 4955, 6852, and 7409.) Voter Education
Activities Section 501(c)3 groups can conduct certain voter education
activities if they are done in a nonpartisan manner (see IRS Revenue Ruling
78-248). If you want to engage in this type of political activity, we recommend
you consult an attorney. Your organization can request an IRS letter ruling on
its voter education activities by writing to the address listed in IRS
Publication 557. For information on restrictions on political candidate
campaign activity by 501(c)3 organizations, see Election Year Issues. It
contains information about other laws and restrictions applicable to political
campaign nonprofits non- 501(c)3 groups organized primarily to support or
oppose political candidates, under Internal Revenue Code§ 527.
Influencing Legislation
- Section 501(c)3 organizations are prohibited from acting to influence
legislation, "except to an insubstantial degree." In the past, courts
have found that spending more than 5% of an organization's budget, time, or
effort on political activity was substantial. More recently, courts have tended
to look at the individual facts of each case. Generally, if a nonprofit
corporation contacts, or urges the public to contact, members of a legislative
body, or if it advocates the adoption or rejection of legislation, the IRS
considers it to be acting to influence legislation. Lobbying to influence legislation also
includes: • any attempt to affect the opinions of the general public or a
segment of the public, and • communication with any member or employee of a
legislative body, or with any government official or employee who might
participate in the formulation of legislation. However, lobbying to influence
legislation does not include: • making available the results of nonpartisan analysis,
study, or research • providing technical advice or assistance to a government
body, or to its committee or other subdivision, in response to a written
request from it, where such advice would otherwise constitute the influencing
of legislation • appearing before, or communicating with, any legislative body
with respect to a possible decision that might affect the organization's
existence, powers, tax-exempt status, or the deductibility of contributions to
it, or • communicating with a government official or employee, other than for
the purpose of influencing legislation. Also excluded from the definition of
lobbying efforts are communications between an organization and its members
about legislation (or proposed legislation) of direct interest to the organization
and the members, unless these communications directly encourage members to
influence legislation.
Political Expenditures
Test - Under the political expenditures test in IRC § 501(h), limitations
are imposed on two types of political activities: lobbying expenditures and
grassroots expenditures. Lobbying expenditures are those made for the purpose
of influencing legislation, while grassroots expenditures are those made to
influence public opinion. For examples
of these two types of activities, see IRS Publication 557, the "Lobbying
Expenditures" section. The monetary limits are different for each of the
categories, and the formulas for computing them are somewhat complicated. If
your 501(c)3 nonprofit elects the political expenditures test, you must file
IRS Form 5768, Election-Revocation of Election by an Eligible Section 501(c)(3)
Organization To Make Expenditures To Influence Legislation, within the tax year
in which you wish the election to be effective. This election is also available
under similar rules at the state level. In determining whether a group's
legislative activities are substantial in scope, the IRS looks at the amount of
time, money, or effort the group spends on legislative lobbying. If they are
substantial in relation to other activities, 501(c)3 tax status might be
revoked and, again, special excise taxes can be levied against the organization
and its managers. See IRC § 4912.
The Alternative
Political Expenditures Test - Since it is impossible to know ahead of time
how the IRS will assess the substantiality of a group's legislative activity,
the IRC allows 501(c)3 public charities (most 501(c)3 groups will qualify as
public charities) to elect an alternative expenditures test to measure
permissible legislative activity. Under this test, a group may spend up to 20%
of the first $500,000 of its annual expenditures on lobbying, 15% of the next
$500,000, 10% of the next $500,000, and 5% of its expenditures beyond that, up
to a total limit of $1 million each year.
Caution - Some groups can't use the political expenditures test. This
expenditures test and its provisions for lobbying and grassroots expenditures
are not available to churches, an integrated auxiliary of a church, a member of
an affiliated group of organizations that includes a church, or to private
foundations. If your nonprofit corporation plans to do considerable lobbying
activity, mostly by unpaid volunteers, then electing the expenditures test
might be a good idea. Why? Because the minimal outlay of money to engage in
these activities will probably keep you under the applicable expenditure
limits. If you didn't make this election, your 50l(c)3 tax exemption might be
placed in jeopardy if the IRS considers your political activities to be a
substantial part of your overall purposes and program. If you plan to engage in more than a minimum
amount of political lobbying or legislative efforts, you need to decide whether
it is to your advantage to elect the expenditures test based on the facts of
your situation. If you find that these alternative political expenditures rules
are still too restrictive, you might consider forming a social welfare
organization or civic league under Section 501 (c)(4) of the Internal Revenue
Code, an exemption that requires a different federal exemption application, IRS
Form 1024, and does not carry with it all the attractive benefits of 501 (c)(3)
status (access to grant funds, tax deductible contributions, and so on). See
"Is Your Group a Nonprofit That Can Use This Book?" in Chapter 1 and
IRS Publication 557 for further information on 501(c)4 organizations.
Additional limitations
for certain groups - Federally funded groups may be subject to even more
stringent political expenditure tests than those discussed here (for example,
political activity and expenditure restrictions imposed by the federal Office
of Management and Budget). For a thorough discussion of the rules that apply to
lobbying activities by 501(c)3 organizations and detailed information on the
Section 501 (h) political expenditures test election, see Lobbying Issues by
Charities and Nonprofit Organizations, IRS Publication 4302.
Are You Selling Services
or Information That the Federal Government Offers for Free? - If your
nonprofit plans to sell services or information, check to see if the same
service or information is readily available free (or for a nominal fee) from
the federal government. If so, you may need to tell potential clients and
customers of this alternate source. This rule applies to all tax-exempt
nonprofits (including any 501(c)3 organization, whether classified as a public
charity or private foundation). (IRC § 6711.) Failure to comply with this
disclosure requirement can result in a substantial fine. For further
information on these disclosure requirements, see IRS Publication 557.
The 1% or $5,000 Limit
for Exempt-Purpose Income - There is one major limitation on the amount of
income from exempt-purpose activities that can be included in the one-third
qualified public support figure. In any tax year, receipts from individuals or
government units from the performance of exempt-purpose services that exceed
$5,000 or 1 % of the organization's total support for the year, whichever is
greater, must be excluded from the organization's qualified public support
figure. This limitation applies only to exempt-purpose receipts and not to
gifts, grants, contributions, or membership fees received by the
organization. For example, Van-Go is a
visual arts group that makes art available to people around the nation by
toting it around in specially marked vans. In 2012, Van-Go derives $30,000
total support from the sale of paintings. The funds are receipts related to the
performance of the group's exempt purposes. Any amount over $5,000 paid by any
one individual cannot be included in computing Van-Go's qualified public
support for the year, although the full amount is included in total support. Of
course, if Van-Go's total support for any year is more than $500,000, then the
limitation on individual contributions will be 1 % of the year's total support,
since this figure exceeds $5,000.
Some Gifts Are Gross
Receipts - When someone gives money or property without getting anything of
value in return, we think of it as a gift or contribution. But when people give
a nonprofit money or property in return for admissions, merchandise, services performed,
or facilities furnished to the contributor, these aren't gifts. They are
considered gross receipts from exempt-purpose activities and are subject to the
$5,000 or 1 % limitation. For example,
at its annual fundraising drive, the National Cormorant Preservation League
rewards $100 contributors with a book containing color prints of cormorants.
The book normally retails for $25. Only $75 of each contribution is considered
a gift; the remaining $25 payments are classified as gross receipts from the performance
of the group's exempt purposes and are subject to the $5,000 or 1 % limitation.
Some Grants Are Gross
Receipts - It is sometimes hard to distinguish money received as a grant
from exempt-purpose gross receipts. The IRS rule is that when the granting
agency gets some economic or physical benefit in return for its grant, such as
a service, facility, or product, the grant is classified as gross receipts
related to the exempt activities of the nonprofit organization. This means that
the funds will be subject to the 1 % or $5,000 limitation that applies to
exempt-purpose receipts. Money contributed to benefit the public will be
treated as bona fide grants by the IRS, not as exempt-purpose receipts. This
type of bona fide grant is not subject to the 1 % or $5,000 limitation. For example, A pharmaceutical company,
Amalgamated Mortar & Pestle, provides a research grant to a nonprofit
scientific and medical research organization, Safer Sciences, Inc. The company
specifies that the nonprofit must use the grant to develop a more reliable
childproof cap for prescription drug containers (the results of the nonprofit
research will be shared with the commercial company). The money is treated as
receipts received by Safer Sciences in carrying out its exempt purposes and is
subject to the $5,000 or 1 % limitation. Safer Sciences gets a grant from the
federal Centers for Disease Control and Prevention to build a better petri dish
for epidemiological research. Since the money is used to benefit the public,
the full amount will be included in the nonprofit organization's qualified
public support figure.
Unusual Grants Drop Out
of the Support Computation - To be included as qualified support (in the
numerator of the support fraction), the support must be from permitted sources.
Disqualified persons include founders, directors, or executive officers of the
nonprofit. A large grant from one of these sources could undermine the ability
of the nonprofit to qualify under this public charity test. To avoid this result for nonprofits that
would otherwise qualify under the exempt activities support test, unusual
grants are ignored-that is, they drop out of both the numerator and denominator
of the support calculation. (There is a similar exclusion for unusual grants
under the public support test, discussed above.) A grant will be classified as
unusual if the source of the grant is not regularly relied on or actively
sought out by the nonprofit as part of its support outreach program and if
certain other conditions are met. If you want to learn more about these unusual
grant requirements for groups that qualify as a public charity under the
exempt-activities support test, see IRS Publication 557.
Rents Related to Exempt
Purposes Are Not Gross Investment Income - Rents received from people or
groups whose activities in the rented premises are related to the group's
exempt purpose are generally not considered gross investment income. This is a
good thing. Why? Remember: Under this public charity test, the organization
must normally not receive more than one-third of its total support from
unrelated trades or businesses or from gross investment income.
FORMS AND RESOURCES
• Incorporation Checklist
• Application for Reservation of Corporate Name
• Articles of Incorporation
• Articles Filing Letter Bylaws (including Membership
Provisions and Adoption of Bylaws)
• 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 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 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 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
• Waiver of Notice and Consent to Holding of First Meeting of
Board of Directors
• Minutes of First Meeting of Board of Directors
• IRS Revenue Procedure 75-50
• IRC Section 4958, Taxes on Excess Benefit Transactions
• IRS Regulations Section 53.4958-0
• Final 4958 regulation changes. See Internal Revenue Bulletin
No. 2008-18, T.D. 9390.
• Intermediate Sanctions (IRC Section 4958) Update Conflict of
Interest Provisions Article 9 of the bylaws included in this book contains
rules and procedures for approving or avoiding conflict of interest
transactions, including compensation arrangements. This bylaw provision
contains the conflict of interest language recommended by the IRS (included in
the sample conflict of interest policy in the instructions to IRS Form 1023).
It also has language for the approval of compensation arrangements that
attempts to comply with the safe harbor provisions of the excess benefit rules.
You will need to become familiar with Article 9 of your bylaws and refer to
those provisions whenever your board, or a committee of your board, decides to
set or increase salaries, enter into contracts, or approve deals with
individuals or other organizations.
