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Nonprofit entities differ from for-profit organizations in a few key ways. The latter seeks to earn profits through goods and services, while the former seeks to advance a social cause or advocate for specific issues. Nonprofits are not typically publicly or privately owned but managed by a board. Other differences include tax status, organizational culture and funding mechanisms.
While the differences between these two entities are easily delineated, the process of forming and maintaining a nonprofit is decidedly less straightforward. Forming a nonprofit organization can be a complex, multi-step process that requires a lot of coordination and valuable time. In order to make the process as frictionless and error-free as possible, it helps to do your due diligence, or seek assistance from a qualified third-party that specializes in the practice.
With that in mind, let's review some of the most important things to understand before assisting a client with forming a nonprofit entity.
One of the first steps to take when forming a nonprofit is the selection of the right entity structure. This typically entails choosing between a nonprofit corporation or a nonprofit limited liability company (LLC). The nonprofit corporation is the more commonly used of the two, and the structure with which most business leaders and attorneys are most familiar.
Nonprofit corporations operate under well-settled case law and benefit from a strongly defined statutory landscape that offers clarity and certainty. Most states have separate statutes that apply to nonprofit corporations. There is also some degree of uniformity among states, as more than half of U.S. states have chosen to pattern their statutes after the Model Nonprofit Corporation Act. The law governing a nonprofit corporation’s ability to receive an exemption from paying federal and state income taxes is also well established.
LLC law governing nonprofits is much less settled. Many states do not have specific nonprofit LLC statutes. And organizations operating in states without specific nonprofit LLC statutes should first verify that an LLC can, in fact, be formed for a nonprofit purpose. This is not something that should be automatically assumed. Also, the tax laws are not as well settled when to comes whether, and how, a nonprofit LLC can receive tax-exempt status.
However, despite these additional complications, there are some benefits to choosing an LLC. Namely, LLCs provide greater flexibility in terms of managerial structures and have fewer mandatory provisions of governing law.
When forming a nonprofit corporation or a nonprofit LLC, it is essential to follow all existing state requirements. These requirements vary from state to state. Among the most important decisions to make during this period are choosing the right type of entity, the state in which that entity will be formed, the nonprofit’s name and registered agent.
Forming a nonprofit corporation or a nonprofit LLC is done by filing a formation document — generally called Articles of Incorporation for a corporation and Articles of Organization or a Certificate of Formation for an LLC — with the chosen state of formation. The formation state does not have to be where the nonprofit is located. The filing is typically made with the Secretary of State (or whatever the business entity filing office is called) although in some case a county level filing may be required.
The contents of the Articles for nonprofit entities vary significantly from state to state. While they require some of the same information as for-profit forms – such as the name, principal office address and name and address of the registered agent, they require some nonprofit specific information as well. This can include identifying the purpose of the nonprofit and its type: charitable, educational, religious, public benefit, mutual benefit, and so on, asking whether it will have members, and how it will distribute its assets upon dissolution. Some states have multiple forms based on the type of nonprofit being formed. California, for example, has three types of nonprofit corporations and each one has its own form.
It is important to recognize that state nonprofit corporation and nonprofit LLC laws generally do not require the Articles to include the information that the IRS requires for a 501(c) exemption. Therefore their state issued forms will ask for the minimum required statutory information. The forms will not ask for the IRS information — which generally asks for information related to the nonprofit's purpose, inurement of income, operational limitations, and disposition of assets upon dissolution.
However, this information must be added to the Articles by a nonprofit that will be seeking tax-exempt status.
Additionally, in some cases, approval by another state agency may be required. in New York, for example, the Department of Education must approve any new school, library or museum.
The statutes governing sales tax exemptions for nonprofits are not always clear to casual observers, so it's important to research them carefully. Just because a state exempts nonprofit entities from its state income tax does not necessarily mean it exempts nonprofits from paying its sales tax. In order to receive the appropriate exemption, all requirements will need to be fulfilled correctly.
The requirements can vary significantly depending upon the state. Some states, for example, exempt purchases only from certain types of nonprofits — e.g., health care or religious organizations — while others exempt only certain types of purchases. In general, the exemption is limited to purchases made to further its nonprofit purpose.
Most of the states that do provide a sales tax exemption require the nonprofit to file an application with the state tax department. The nonprofit may also have to provide supporting documents like its Articles of Incorporation, bylaws, and copies of filings made with the IRS.
Most nonprofit clients are going to wish to secure tax-exempt status. This process cannot begin until after the entity is formed and a tax ID is acquired. Once this occurs, it is necessary to file a form with the IRS. There are actually many different kinds of nonprofits that can file for an exemption under Sec. 501(c).
However, the type most attorneys will be dealing with are those nonprofits being formed for religious, charitable, scientific, and educational purposes. They will file IRS Form 1023: Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code.
In order to be granted this recognition, a nonprofit must show that it is being operated in order to further one of the tax-exempt purposes outlined in the organizing document. Other operational activities outside of this mandate may be prohibited.
Organizations granted exempt status under section 501(c)(3) are then classified as public charities or private foundations. These groups are typically differentiated by their funding sources; public charities rely on a broad base of support while a private foundation generally relies on a smaller group of donors who contribute larger sums of money. This is an important distinction, as tax rules vary depending on this classification.
The IRS application is long and features several schedules that are applicable to various organizational types. When completing the application, entities must provide details such as the following:
The application also requests an organizational budget that identifies financial plans for the entity for the first few years of its existence. There is an abbreviated version of Form 1023 that may be used by smaller nonprofits.
LLCs can secure tax-exempt status by filing Form 1023 as well, but they must meet several conditions in order to be approved. Among others, the LLC must be treated as a corporation and not a partnership for taxation purposes and all its members must be tax-exempt as well.
Nonprofit organizations should also consider their timeline when applying for exempt status. Under IRS rules, if a nonprofit files Form 1023 within 27 months of the end of the month is which it was formed—and the IRS approves the application—the formation date of the nonprofit will also serve as the beginning of its exempt status.
If an organization fails to file within 27 months after formation, exempt status will begin later—on the date the Form 1023 was submitted.
Federal exemption is just one step, of course. After this step is accomplished, nonprofit organizations must seek state and local tax exemptions.
Exempt nonprofits are not relieved of the obligation of filing a tax return. Should a nonprofit fail to do so (or file late), penalties may still be assessed by the IRS, even if the nonprofit owes no taxes. If a nonprofit fails to file taxes for three consecutive years, it automatically loses its tax-exempt status.
Nonprofit corporations are still required to comply with the usual formalities governing for-profit corporations, with the exception of issuing stock shares. These can include holding annual meetings for directors/members, establishing bylaws and recording minutes.
Nonprofit corporations must also have a federal tax identification number and may need to secure a state tax ID number as well, depending on the jurisdiction.
Forty states and Washington D.C. also require 501(c)(3) organizations to register with their Department of Charities before being allowed to solicit donations from the public. Some of these departments also mandate that annual or biennial reports be compiled on charitable solicitations.
Nonprofit corporations or LLCs doing business in foreign states must qualify to do business within those jurisdictions and appoint a registered agent in each state. Qualification requires the filing of an application for authority with the Secretary of State. Approval by a state agency may also be required, particularly if a domestic nonprofit would need such approval.
Organizational changes also often come with additional filing obligations. If these obligations are not met, it may endanger a nonprofit's tax-exempt status.
One example of a change that requires additional filings is if a nonprofit changes its name. This would require the filing of Articles of Amendment with the formation state in order for the name change to be effective. If the nonprofit is qualified to do business in foreign states it will also have to amend its certificate of authority to notify that state of the change. Other changes that may require a filing in the domestic and foreign states include a change of purpose, change of principal office, change of entity type or change of jurisdiction of formation.
The instructions, requirements and provisions for when a filing must be made, and how it will be made, vary from state to state. Keeping track of these varying requirements in both domestic and foreign states can be a significant burden for nonprofits.
Some of the things to bear in mind when reporting a change include the following:
Additionally, nonprofits are generally required to file annual reports with the Secretary of State's office in their home jurisdiction and in any foreign-qualified states. Failure to do so can result in significant penalties, including loss of good standing.
Finally, it's a smart idea to stay abreast of recent legislative changes, as the laws governing nonprofits are evolving. Delaware and New York both have made substantial changes to local laws governing nonprofits.
Overall, the process of forming and maintaining a nonprofit entity can be quite challenging, particularly given the myriad web of instructions, requirements, classifications and mandates that must be navigated. Rigorous due diligence and preparation, and the assistance of a third-party expert, can make the process far easier and lower the risk of non-compliance.
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