Some aspects of starting a nonprofit are similar to starting a for-profit business, but nuances exist. Incorporate a nonprofit organization can be confusing and complicated so it can be helpful to have a checklist of what you should address. Before I go any further, let’s first chat about what being a nonprofit business means.
The information that I’m about to provide you in this article is not intended as legal, tax, or financial advice. It’s for general knowledge purposes to give you some insight as you prepare to talk with your lawyer, accountant, or licensed professionals who can address your legal, tax, and financial situation and questions.
What Does It Mean to be a “Nonprofit”?
Generally, nonprofits have a mission to serve a public or charitable cause as opposed to making financial gains for business owners, shareholders, or some other entity. “Nonprofit” is a concept of state law. Depending on the state, a nonprofit organization may be set up in different ways (such as a nonprofit corporation or unincorporated nonprofit association), which your state’s Secretary of State office can shed light on.
Nonprofit organizations typically have some restrictions that prevent them from engaging in certain activities and paying dividends. Also, when nonprofits are dissolved, their assets must be distributed to another qualified non-profit group rather than to individual shareholders.
Nonprofit and Tax Exemption Are Not One in the Same
Many people automatically think of nonprofit organizations as being tax-exempt. However, nonprofits must meet certain requirements for eligibility as income tax-exempt entities at the federal and state levels. Some states also grant nonprofit organizations exemptions from paying state sales taxes.
According to the National Council of Nonprofits, there are 29 types of organizations that are tax-exempt under Section 501(c) of the IRS Code. Except for nonprofits that qualify for federal tax exemption under 501(c)(1), 501(c)(3), 501(c)10, 501(c)13, contributions to other nonprofit organizations generally are not tax-deductible for the donors. Any profits (called “surpluses”) that nonprofit businesses make must be reinvested into the nonprofit (for equipment, resources, etc.) to help it further its mission.
Not that some revenue-generating activities carried out by a nonprofit may be subject to income tax. This typically occurs when a nonprofit organization engages in an activity that the IRS considers “unrelated business” to supplement its income.
According to the IRS, an activity is an unrelated business if it meets the following three criteria:
- It’s a trade or business. “The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services.”
- It’s carried on regularly. “Business activities of an exempt organization ordinarily are considered regularly carried on if they show a frequency and continuity, and are pursued in a manner similar to, comparable commercial activities of nonexempt organizations.”
- It’s not related substantially to furthering the organization’s exempt purpose. “Trade or business is related to exempt purposes, in the statutory sense, only when the conduct of the business activities has causal relationship to achieving exempt purposes (other than through the production of income). The causal relationship must be substantial.”
501(c)(3) – The Most Common Tax-Exempt Nonprofit Designation
When we talk about nonprofits, most people think of 501(c)(3) nonprofit corporations. The most common nonprofit designation, the 501(c)(3), exempts qualifying organizations from paying federal income taxes and also allows them to get funding via grants from foundations and government agencies and through collecting tax-deductible donations from individuals and businesses.
To qualify for 501(c)(3) tax-exempt status, a charitable organization must be organized as a corporation (or a limited liability company), unincorporated association, or trust. Also, it must be created to fulfill a cause in one of the following categories:
- Preventing cruelty to children or animals
- Fostering national or international amateur sports competition
- Testing for public safety
- Fostering certain national or international amateur sports competitions
- Preventing cruelty to children or animals
IRS requirements for tax exemption vary for different types of nonprofits, so it’s important for organizers to understand the rules and comply with them to maintain tax-exempt status and follow this handy checklist.
Nonprofit Entity Type Legal and Tax Considerations
Liability Protection for Shareholders
Just as when forming a for-profit corporation, nonprofit corporations offer personal liability protection for their shareholders. So, if someone sues a nonprofit or the organization meets financial hardship and incurs debt it cannot pay, the individual shareholders’ personal assets are not at risk of being used as damages or restitution.
Most tax-exempt nonprofits, even though they don’t have to pay taxes, must still file informational tax returns with the IRS annually. IRS Form 990 is the reporting form that provides details (about the nonprofit’s mission, financial data, and programs) so that the IRS and the general public can evaluate the organization’s operations.
According to the IRS, “Exempt organizations must allow for public inspection and copying of their exemption applications, determination letters, and annual returns. The IRS also makes these documents available for public inspection and copying. For more information about disclosure requirements, see Public Disclosure.”
Individuals who donate to charitable organizations may only take a tax deduction if they itemize their deductions on their personal tax return.
A Getting Started Checklist
Similar to starting a for-profit business, there are steps you must take to incorporate a nonprofit organization successfully and ensure you comply with all the rules to legally operate the organization. Below is an overview of the process.
1. Write a business plan
A Fundamental basis to succeeding and covering all your bases is having a checklist to guide your efforts. A thorough business plan allows you to document your vision and mission for your nonprofit organization as well as capture details that you will need to complete various filings and get funding.
Elements of a nonprofit business plan might include:
- Executive Summary – An overview of what nonprofit business will do (including its mission statement if not documented elsewhere in the business plan) and a summary of the programs, services, or products it provides.
- Services, Programs, and Products – Description of what the nonprofit will offer, and how its services, products, and programs will benefit the nonprofit’s target market.
- Market Analysis – Description of the target market the nonprofit will serve, the needs of that market, the current state of that market and industry outlook, and the opportunities and challenges of serving that market.
- Marketing and Sales Strategies – Description of marketing activities and tactics that will be used to reach your target market, including advertising and public relations plans to promote the nonprofit.
- Management Team – Information about expertise and experience of key members of the organizational team, along with information about members of the board of directors (or what qualities will be sought when developing a board).
- Financial Plan – Critical financial details, including income statements, balance sheets, cash flow statements, grants awarded, large donations, and fundraising plans (if not included in a separate section).
2. Select a business name
A nonprofit’s name can affect how the organization will be perceived, so it’s essential to put a lot of thought into it. After you’ve zeroed in on what you want to call your business, conduct a name search to make sure no other company is already using (or has filed to use) the name. Nonprofits that will operate nationally should do a trademark search, as well, to confirm the name is available in all 50 states.
3. Choose your legal structure
Depending on the state in which your nonprofit will be registered, the following business structures chart of legal entity types might be available:
- Nonprofit corporation
- Nonprofit LLC
- Unincorporated nonprofit association
Most nonprofits choose to register as a nonprofit corporation and then seek 501(c)(3) status from the IRS.
As I mentioned earlier, owners of nonprofit corporations receive personal liability protection. To retain that protection, the nonprofit must meet all business compliance requirements.
4. Appoint a board of directors
The legal entity type you choose for your nonprofit may require establishing a board of directors, a group of individuals that will be accountable for overseeing the organization and helping it fulfill its mission. A board should be diverse in its knowledge and strengths. Collectively, board members should bring experience and expertise that will serve to guide all aspects involved in running the nonprofit.
States’ rules regarding the requirements of how to incorporate a nonprofit organization (such as the number of directors, qualifications, etc.) for boards of directors vary in each state.
5. Draft bylaws for the organization
Bylaws establish how a nonprofit should be run (i.e., how much control does the board of directors have vs. the shareholders; meeting rules, voting procedures, dispute resolution, and other details). Bylaws are usually required when filing incorporation paperwork with the state and when applying for federal tax-exemption.
6. File business registration paperwork with the state
Nonprofit corporations must submit articles of incorporation with the Secretary of State office. The costs to file this documentation varies by state. If a nonprofit will have physical locations or a substantial presence in more than one state, it must be registered in each state where it will maintain operations.
A nonprofit might also have to request permission to engage in fundraising activities if the state’s rules require registration to solicit charitable donations.
If forming a different nonprofit entity type, check with your state about the filing requirements.
7. Apply for an EIN (Employer Identification Number)
Just like a for-profit business, nonprofit organizations need to have an EIN if they want to open a bank account, hire employees, apply for business licenses and permits, and complete certain business documentation.
EIN numbers (also known as Federal Tax ID Number or Tax ID Number) are issued from the IRS by filing Form SS-4.
8. Request a 501(c)(3) tax exemption
To apply for 501(c)(3) tax-exempt status, a nonprofit must file Form 1023 [Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code] with the IRS.
Most other nonprofits that don’t fit the criteria for 501(c)(3) file form 1024 to request tax-exempt status.
9. File for required business licenses and permits
A nonprofit might need to have certain business licenses and permits to operate legally. The requirements depend on the type of activities conducted and where the organization is located.
CorpNet’s Business License Research Package helps nonprofits identify and file for all licensing and permitting requirements at the state, county, and local municipality levels.
10. Fulfill all ongoing compliance requirements
To retain the liability protection benefit of an incorporated business entity and maintain tax-exempt status, nonprofits must stay on top of all compliance obligations.
These include but are not limited to:
- Having a registered agent
- Filing an annual report
- Filing a tax return
- Following its bylaws
- Maintaining charitable solicitation registration
- Renewing business licenses and permits
- Maintaining tax-exemption status by following the IRS’s rules
Helpful Resources for Nonprofits
Knowing how to incorporate a nonprofit organization and maintaining its compliance can be complicated. Because of nonprofits’ tax exemption status, they generally undergo a more intense degree of government scrutiny than most for-profit companies do.
As I mentioned earlier, to understand all the legal, tax, and financial aspects of starting a nonprofit organization, it’s best to consult professionals. An attorney, accountant, tax advisor, and or other qualified professionals can offer much-needed expertise and guidance.
Some other resources you might find helpful if you’re considering starting a nonprofit include:
- Tax Information for Charities & Other Non-Profits section of the IRS website
- National Council of Nonprofits
- National Association of State Charity Officials
- Small Business Administration (SBA)
And of course, CorpNet is here to assist you. We provide registered agent services in all 50 states, and we can help you complete and submit your nonprofit business filings such as:
- Articles of Incorporation
- Articles of Organization
- Federal Tax Identification Number (EIN)
- Business Licenses and Sellers Permits
- Sales Tax Registration
- Initial and Annual Report Filings (Statement of Information)
- Applications for tax-exempt status
- Annual corporate monitoring, compliance, and filing services
Contact us today to help you get your nonprofit organization started!