Forming a nonprofit involves more than just a strong mission and innovative programs. It also entails investing a significant amount of time and effort into the initial formation process, which can seem daunting at first. How do you prepare to apply for incorporation and tax-exempt status?
To help address some of the legal background in setting up a nonprofit, the Foundation Center, in collaboration with New York Lawyers for the Public Interest, offered a workshop on June 13, Legal Considerations Before Starting a Nonprofit. The seminar was led by Laura E. Butzel and Jean L. Tom from the Tax-Exempt Organizations Group at Patterson Belknap Webb & Tyler LLP, who offered a wealth of information on the legal issues you should understand before diving into the application process. Here are some key issues that they covered during the discussion.
There are multiple forms your nonprofit can take.
The most widely recommended structure for a nonprofit is a corporation. As a corporation, you receive the maximum protection from personal liability, and the corporation will shoulder responsibility for any debts accrued, which will make the venture much less risky for you. However, forming a corporation involves a fair amount of formal paperwork, requires that you file a Certificate of Incorporation with the Secretary of State, and involves some strict governance rules.
It's common for nonprofits to get incorporated in the primary state in which they do business, but sometimes in order to expedite the process, nonprofits will incorporate in Delaware, where rules are considerably more lenient (it's faster to incorporate, the description of your charitable purposes can be more broad and more malleable, and only one director is required for your board). If, however, you plan to get state funding from New York, you will need to incorporate in New York.
Some alternate forms for a nonprofit can include unincorporated associations and trusts. An unincorporated association may be somewhat simpler to form, as you can create an informal agreement rather than filing a Certificate of Incorporation, but these associations can be risky, as they offer little to no liability protection.
Meanwhile, a trust is especially simple to create, as it only requires you to put together a trust agreement, with no need to file with the Secretary of State, and while it offers less protection than a corporation, it offers more than an unincorporated association. Forming a trust is easy, but it's best for those who want to engage in small-scale grantmaking, rather than for someone who wants to run programs.
If you want to avoid the complexity of forming your own nonprofit corporation, you also have the option of running your program while using a fiscal sponsor. We've discussed fiscal sponsorship extensively on Philanthropy Front & Center in the past, but in summary, fiscal sponsorship entails a formal agreement between you and an existing nonprofit organization in which your program will operate under the existing nonprofit's auspices. You will cede a certain amount of sovereignty to your fiscal sponsor, and they will be able to accept grants and donations on your behalf and disburse the funds to your program. Fiscal sponsorship can be a permanent state for your project if need be, but it's also helpful as an early incarnation of your program, allowing you to test out your project before acquiring tax-exempt status of your own. You have the option to incorporate while working with a fiscal sponsor, but it's not required.
Have your ducks in a row before filing for exemption.
Assuming for the sake of example that you're opting to form a nonprofit corporation, there are some issues to understand while you're filing for tax-exempt status, which is a separate step from the initial filing of the Certificate of Incorporation. You already named your founding board of directors while getting incorporated, but now you'll need to create bylaws.
Nonprofit bylaws outline the ways in which your organization will be managed, including more detailed information about your board and its duties, how meetings and committees will be run, whether or not you'll have members, how funding will be distributed, and details on your conflict of interest policies. To get an idea of what a set of nonprofit bylaws should look like, you can find many samples on GrantSpace and on Simplenonprofit, Nonprofit Organizations @suite101, and Nonprofit Resources, Inc.
You also need to begin getting your finances in order, because when you file for 501(c)(3) tax-exempt status, the application will request three years' worth of financial data, and a balance sheet for the organization's most recently completed tax year.
If your nonprofit is new enough that it hasn't completed a tax year, you'll need to submit a statement of actual assets, liabilities, and fund balances based on your most current information. Also related to this topic is the prohibition on private inurement, in which you must indicate that your nonprofit will not distribute any profits or assets to individuals, as tax-exempt groups may not have shareholders (if you make any profits, they need to be reinvested into the organization).
Finally, if you have paid staff, or if you are paying any directors, officers, or trustees, you will be required to disclose that compensation information.
Applying for exemption requires you to fulfill organizational and operational tests. The organizational test means that your Certificate of Incorporation should state the limits on your organization's activities, as well as the fact that upon dissolution your assets will go toward charitable purposes.
For the operational test, you need to indicate that your nonprofit will operate for at least one of the following purposes: charitable (including nonprofits established "for purposes that are beneficial to the public interest", IRS, Pub. 557; see p. 30 for details), religious, scientific, educational, literary, or testing for public safety.
Filing for tax-exempt status means completing Form 1023 with the IRS. Fortunately, the IRS has posted a helpful FAQs on their web site to assist you with any further questions you might have during the application process (and you will probably have questions).
Understand the limits on lobbying and political activity.
Another thing to be aware of is that as a tax-exempt organization, you are permitted to engage in a limited amount of lobbying, but according to the IRS, it must be "insubstantial." The simplest way of ensuring that any lobbying activity doesn't interfere with your tax-exempt status is by keeping all lobbying-related expenditures under 5% of your budget.
Alternately, you can file Form 5768 in order to request to be evaluated by the IRS's 501(h) expenditure test, which includes more clear-cut definitions of what constitutes lobbying, and sets a maximum ceiling on how much you may spend on these activities. The Center for Nonprofit Management has some handy advice on lobbying posted online.
Furthermore, as a 501(c)(3) organization, you are not allowed to participate in any political campaigns on behalf of or in opposition to any candidates for public office. This includes making political contributions, or engaging in any voter education or registration efforts with evidence of political bias. You are allowed to get involved in voter education activities, but they must be nonpartisan. If you don't abide by these restrictions, you run the risk of losing your tax-exempt status. If you do want to participate in any greater amounts of lobbying or political activity, you might want to consider forming a 501(c)(4) organization (a social welfare organization) instead of a 501(c)(3).
Even if you're tax-exempt, be aware of UBI.
One more important thing: even though your nonprofit is tax-exempt, you may still have unrelated business taxable income, or UBI. UBI refers to income generated from an ongoing trade or business that is not directly related to your charitable purpose. This means that it is not illegal for your organization to generate income from an activity that isn't related to charitable purposes, but you do have to pay taxes on it at standard corporate rates. If you're unsure whether a certain activity counts as UBI or not, read about UBI and non-UBI activities in this useful guide.
Understanding these items will give you a basic background on what you need to know before forming your nonprofit, but it would be strongly advisable for you to have a lawyer guide you through the process to ensure successful results. New York Lawyers for the Public Interest offers assistance to nonprofits, as do the Lawyers Alliance for New York and the Pro Bono Partnership.
You can also read more about what goes into launching a nonprofit by reviewing the relevant information on the IRS web site and the site for New York State's Division of Corporations, State Records & UCC. In addition, visit Grantspace for information and resources to help you along the way. On it, you will find Nonprofit Startup Resources by State, a mapping tool that makes finding relevant government agencies and service providers a snap! Finally, be sure to check out some of the useful books, reports, and articles in our library about legal issues and nonprofit formation; one of our most thorough resources is Anthony Mancuso's book How to Form a Nonprofit Corporation.
-- Tracy Kaufman
Foundation Center-New York
Disclaimer: The information provided in this post is not legal advice. If you have a legal question, we suggest that you consult an attorney.