There are many benefits to forming a nonprofit organization for your business or social activities with tax exemption status under Section 501(c) of the Internal Revenue Code, especially when there are donation and grants available to further the purpose of your activities.
A nonprofit organization commonly performs some type of public or community benefit, without the purpose of making a profit. There are various categories of nonprofits recognized by the Internal Revenue Service (IRS):
- Charitable or religious organizations
- Social welfare organizations
- Labor and agricultural organizations
- Business leagues
- Veterans organizations
The most common category is “Charitable or religious organizations”, under which an entity’s purpose is charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals, under Section 501(c)(3) of the Internal Revenue Code. To comply with this section, the applicant must draft a statement of purpose to fit into the permitted purposes under the law.
Other than the categories under Section 501(c)(3), your proposed nonprofit organization can be formed under other exemptions as below:
- business leagues (trade associations) under Section 501(c)(6)
- chambers of commerce under Section 501(c)(6)
- civic leagues under Section 501(c)(4)
- employee associations under Section 501(c)(4), (9), or (17)
- labor organizations under Section 501(c)(5)
- lodges under Section 501(c)(10)
- recreational clubs under Section 501(c)(7)
- social clubs under Section 501(c)(7)
- social welfare organizations under Section 501(c)(4)
- veterans' organizations under Section 501(c)(19)
Organizations under 501(c) can accept tax-deductible contributions. Under Section 501(c)(3), an organization can be exempt from paying income taxes for receiving charitable contributions. Under other 501(c) sections, an organization can be exempt from paying income taxes for another reason, for example, for social welfare purposes.
To form a nonprofit organization, the first step is to form a corporation (or choose an existing corporation to convert the status), a trust, or an association. There are pros and cons to each type of entity. Generally, a trust works best for gifts and would expose the trustees to liabilities; an association can expose the members with liabilities, thus works best for non-risky business activities. The most common type of nonprofit entity is a corporation.
There are a few standard steps to form a corporation and apply for nonprofit status in most states:
- Choose an available corporation name in the chosen state. If the ideal name cannot be registered, consider filing a D.B.A. (doing business as) for the organization.
- Point board members and directors. In New York, there is a minimum requirement of three (3) directors for nonprofit organizations.
- Choose a registered agent. It can be someone with the organization.
- Prepare a Statement of Purpose that meets the IRS requirement.
- Prepare a Dissolution Clause dedicating the corporation's assets to another 501(c)(3) organization or to the government upon dissolution.
- Prepare a statement that your nonprofit will not engage in activities unrelated to its exempt purposes or in prohibited political or legislative activity.
- File Articles of Organization or Certification of Incorporation with the state. This filing should include the statement of purpose and a dissolution clause.
- Draft company bylaws and hold a meeting of Board of Directors for approving bylaws, appointing officers, setting an accounting, etc.
- Open a bank account for the corporation.
- Obtain an EIN with the IRS.
- File the application for tax-exempt status, form 1023 https://www.irs.gov/pub/irs-pdf/i1023ez.pdf and forms with the designated state, such as form CT-247 https://www.tax.ny.gov/pdf/current_forms/ct/ct247.pdf
With the obvious tax benefits, it also comes with the downside of forming a nonprofit organization, which include the loss of individual control over the entity. If you are converting an existing corporation into a nonprofit organization, the existing shareholders have to give up their ownership. None of the entity earnings may inure to any private shareholder or individual. Additionally, in states like California, more than half of the board of directors need to be “disinterest” persons to the organization. Organization’s assets and funds are also impressed with a charitable trust. If the organization engages in an excess benefit transaction with a person having substantial influence over the organization, an excise tax may be imposed on the person and any organization managers agreeing to the transaction.
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Silvia Sun, Esq.
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