Legal Needs Relative to Nonprofit and/or Tax-Exempt Status of New Organizations

Copyright, 1998 Eve Rose Borenstein,
Printed with permission of the author.

This information provides general guidance. Organizations are advised to seek advice of an attorney. Readers can contact Eve Rose Borenstein via e-mail or call her at 612-822-2677. This document is referenced from Starting a nonprofit organization.

Introduction

When an entity operates, regardless of its public benefit or social welfare purpose, it will find itself subject to two legal realities: first, that the entity itself (separate from the individuals operating same can be sued for actions taken in its name or under its sponsorship; and second, that when an entity conducts financial activities, it will be considered a "taxpayer" under federal and State statutes.

This treatise addresses the legal framework in which an entity may be operated: specifically detailing the various options available to minimize liability and maximize opportunities under both State nonprofit corporation and federal tax-exemption statutes. Covered herein are the following subjects:

• incorporating as a non-profit entity
• distinction between "non-profit" and "tax-exempt"
• qualifying for tax-deductible dollars (via federal
• "c3" or "charity" tax-exempt status)
• real and potential benefits from qualifying for federal 501(c)(3) status
• disadvantages to qualifying for tax-deductible dollars
• other federal tax-exemption options
• how to apply for federal tax-exempt status (and when)
• State and local jurisdictional issues
• annual federal tax returns
• state returns
• taxpayer/employer identification numbers
• author biogropahy
• disclaimer

Note that this treatise does not address the many areas of legal liability that entities have in common with individuals or for-profit businesses (that is, legal issues which are not unique to public benefit or social welfare purpose operations). Thus, entities or organizations with
questions about contract law, real property issues (such as commercial
leases), personnel and employment law, etc., will have to look to counsel
to review these issues as they arise. Of special concern is one common
area of tax liability that nonprofit and/or nonprofit & tax-exempt entities
or organizations will have with for-profit businesses -- that is the proper
classification of compensated individuals as employees versus contractors.
Please don't pay workers as contractors without very carefully evaluating
the appropriateness of same beforehand!

Need for Incorporation

State laws (and the District of Columbia) allow for incorporation of
entities or organizations for certain legal purposes. Indeed, corporations
may be created for either "for-profit" or "non-profit" purposes. The
notion behind corporate status is simple: same provides a shield or
safeguard protecting the concert of individuals undertaking actions in the
name and right of the group (once incorporated). Without incorporation,
the individuals who have associated together in furthering and promoting a
group's goals will find themselves personally liable for the activities of
the group. By filing the appropriate papers with the State, a
"corporation" is created, thus providing specific protections to the
individuals operating same.

In order to remove the certainty of personal responsibility and thus
protect the individuals who make management decisions for the entity or
organization, incorporation should be effected.

Technical assistance should be sought from those familiar with your State
laws to inform your entity as to what is required to incorporate as a
"non-profit" or "not-for-profit" corporation (entities or organizations
should not form as "for-profit/business" corporations).

Typical issues which are likely to arise in preparing for incorporation
include:

1. The need to define and state the purposes for which the entity is
organized (meaning incorporating) and will operate to further;

2a. The need to include certain restrictions upon the entity's
organizational purposes and operations in accord with the particular
federal tax-exemption classification intended to be pursued, and . . .

2b. The need to include specific dissolution information in accord with
the particular federal tax-exemption classification intended to be pursued
(re the necessity of complying with either of these concerns, see below);

3. Whether or not the entity wants to be legally accountable to a group of
voting stakeholders (typically referred to in State non-profit law as
"members", when such term grants voting rights), and, if so, whether same
will be defined in the incorporation papers, or later in the By-laws;

4. The number or range in number of seats on the Board of Directors (such
group is charged under incorporation statutes with managing the business
affairs of the entity, regardless of whether the Board is
"self-perpetuating" or accountable to voting stakeholders); and

5. Name and street address of legal agent for corporation (often
optional); name and street address of corporation (note that State
officials will not accept a corporation filing which would create a
corporation named deceptively similar to another already-registered
corporation or other entity which has reserved such a name); name and
address of individual(s) filing as "incorporators".

State Status Not to Be Confused with Federal Tax-Exemption

Don't confuse your organization's status as a "non-profit" corporation --
once State incorporation filing has occurred -- with that of federal
tax-exempt classification. The two issues are completely distinct, and
federal tax-exemption must be pursued separately with the Internal Revenue
Service.

Although it is true that federal tax-exempt status is available only to
non-profit entities, the reverse is not true. Thus, you may be non-profit,
but not tax-exempt.

Qualifying for Tax-deductible dollars: what is "c3" or "Charity" Status?

Many types of tax-exempt status are possible (e.g., country clubs may
qualify under the tax-exemption provisions applicable to social clubs,
veterans organizations or cemetary associations may qualify under
stand-alone provisions applicable to each), but by far the largest category
available is the "charity" category defined by Internal Revenue Code
section 501(c)(3). Groups recognized as operated for charitable purposes,
via a 501(c)(3) exemption letter, are the only type of tax-exempt entity
which is across the board able to receive donations which are
tax-deductible to the donor.

When the public thinks of "tax-exempt" groups, they often equate same with
charities and the possibility of writing off donations to same. But it is
only groups who receive a 501(c)(3) determination letter from the Internal
Revenue Service who do, in fact, qualify to receive tax-deductible dollars
from the public.

Real and Potential Benefits of Qualifying for Federal 501(c)(3) Status

As noted above, the major benefit of being determined to be tax-exempt as a
501(c)(3) entity is the ability to solicit tax-deductible donations. Such
ability also makes it possible to readily apply for and receive grants from
the private foundation community.

There may be other benefits of qualifying as charitable under 501(c)(3),
but these will be applied individually to entities or organizations via
separate application to and qualification under State, local, and Postal
Service authorities. These other benefits could encompass:

- potential qualification (under State or local laws) to purchase goods and
services for use in one's charitable operation without paying sales tax
upon same

- potential qualification (under U.S. Postal regulations) to bulk mail at
non-profit rates

- potential qualification (under local jurisdiction determination in accord
with State laws) to own property exempt from paying real property taxes

- Note -- POTENTIAL sales tax, bulk mail, or real property tax exemption
devolves only upon those 501(c)(3) letter-holders who then meet the even
more stringent mandates of the granting governmental jurisdictions which
convey such exemptions. Word to the wise: don't expect that qualifying as
exempt under 501(c)(3) will allow any of these other exemptions to be
within reach. Your individual circumstances will need be evaluated with
that of the relevant jurisdiction's requirements!

Entities or organizations with 501(c)(3) status will have their
tax-exemption letter serve as a fundraising tool -- allowing corporations
and individual donors to take a tax-deduction for donations paid to you.
Similarly, the private foundation community (which is itself funded by
501(c)(3) tax-deductible dollars) will typically only accept grant
applications from groups holding 501(c)(3) status.

Disadvantages of Qualifying for Tax-deductible Dollars

The major benefit conveyed by 501(c)(3) status -- that of eligibility for
receiving pre-tax dollars -- brings with it substantial scrutiny and
burdens. Congress has imposed many detailed restrictions on 501(c)(3)
groups to ensure that the public policy of furthering charitable programs
does not unduly advance other activities by funding same with
tax-deductible dollars. The most important of these rules, unique to
operating as a 501(c)(3) entity, are as follows:

- Not too much involvement in the legislative process (either via lobbying
legislators directly or by communicating with members or the public to have
them encourage legislative results)

- No contributions of time or money, or assistance in any way (including
endorsements) to candidates for elected office or to political parties

- No misrepresentation to donors of amounts deductible particularly in
regard to payments a donor makes where benefits are returned, such as with
entry fees to fundraisers)

- The need to be funded by a variety of donors (a combination of many large
donations, or small contributions, including memberships, bundled with
larger donations). Tax rules make it unwise, if not impossible, to rest on
the success of winning large grant funding from only several sources over
multiple years!

[See Appendix A for additional information on each of the above-noted
restrictions.!!]

It is imperative that 501(c)(3)-wannabes evaluate the impact of the many
IRS rules they will labor under if such tax-exempt status is awarded. In
the absence of certainty that access to funding sources will be predicated
on tax-deductibility, Entities or organizations need also evaluate the
desireability of proceeding without 501(c)(3) status. In making such
decisions, knowledgeable tax counsel should be sought.

Other Possible Federal Tax-exemption Categories

As discussed in the previous sections, tax-exempt status is not to be
confused with one's non-profit (incorporated) status. In addition, it is
important not to equate tax-exemption with "tax-deductible". These
distinctions are important to keep in mind at all times. For Entities or
organizations who find that tax-deductible 501(c)(3) classification is not
desireable, two options remain. But to understand those options, it is
necessary to understand the benefits of tax-exemption as a whole. Any
Internal Revenue Service determination of tax-exemption means that no
corporate income tax (on a federal level) will be required. Thus, for
Entities or organizations that plan on earning and banking year-end
surpluses, tax-exempt status in general will allow such surpluses to be
earned tax free. If your Entity anticipates healthy operations at more
than a "break-even" level, you should seek counsel as to what, if any, tax
dollars will be saved via tax-exempt classification.

Assuming tax-exemption (without 501(c)(3) tax-deductibility) is desireable,
the next question is what type of (non-(c)(3)) exempt classifications are
available. Tax-exempt classification for a wide variety of organizations
operating for the common or public good is provided via Code section
501(c)(4). This section grants tax-exemption to what are referred to as
"social welfare" organizations , and will be readily available to Entities.
Importantly, and unlike 501(c)(3) status, "social welfare" classification
does not bring with it any prohibitions against lobbying or electioneering.

Summary: if an entity does not need to be tax-deductible via 501(c)(3),
status under 501(c)(4) may be sought. However, the possibility of not
applying at all for tax-exemption need also be evaluated.

State Tax-Exemption

The two types of tax-exempt status discussed in the prior sections,
501(c)(3) and 501(c)(4), solely grant exemption from the application of
federal corporate income tax. They do not automatically bring exemption
from State or other local jurisdictional income taxes. Entities or
organizations should clarify with taxing authorities their responsibility,
if any, to pay State or local business income taxes even if federal exempt
status is sought or awarded.

Pointer: most States with corporate income taxes do waive the application
of same to groups operating with federal tax-exempt status.

How to Apply for "c3" Exemption (and When)

Assuming a decision has been made to proceed with 501(c)(3) status (in
order to obtain the benefit of tax-deductibility), most Entities or
organizations will want to procure a determination letter quickly.
Application for such status is made to the Internal Revenue Service via
Form 1023.

Typical issues which are likely to arise in making a 501(c)(3) application
include:

1. Cost: filing fees are currently $500! (Small Entity, anticipating
annual income averaging no more than $10,000 per year, can qualify for a
reduced fee of $150.)

2. Timeliness: a 501(c)(3) letter will be retroactive (meaning that the
recipient of a such exempt status will be able to offer tax-deductibility
of donations back to the group's initial incorporation date) if the
application is filed within 27 months from the date of incorporation.

Pointer: for an Entity who has only recently incorporated, be aware that
back periods prior to the date of incorporation will generally not be
covered by the Entity's exemption letter, as activities conducted prior to
incorporation are not considered "owned" by the applicant.

3. Information required: a complete narrative of what activities will be
undertaken by the Entity, accomplished by who (and for what pay, if any)
must be included with the application. Also required are two years of
Entity budgets which need be tied to this narrative.

4. Technical tax stuff: Form 1023 applications should be reviewed by
knowledgeable tax counsel prior to their submission. The Form itself
contains several "red flag" and/or arcane technical points which Entities
or organizations should not answer without assistance.

How to Apply for "c4" Exemption

Application for 501(c)(4) exempt status is made to the Internal Revenue
Service via Form 1024. This Form is substantially shorter than the Form
1023 required for (c)(3) applicants, but has some similar issues:

1. Cost: filing fees are currently $500! (Small Entities, anticipating
annual income averaging no more than $10,000 per year, can qualify for a
reduced fee of $150.)

2. Timeliness: a 501(c)(4) letter is by nature retroactive (and will
cover all prior periods for the corporation which are described in the
application). Thus, unlike the Form 1023, there is no requirement that the
application be filed within any specific period of time.

3. Information required: a complete narrative of what activities have (or
will be) undertaken by the Entity, accomplished by who (and for what pay,
if any) is to be included with the application. Also required are prior
period's actual financials.

State/Local Jurisdictional Issues

Assuming that an entity's State incorporation filing (the "Articles of
Incorporation") limit operations to charitable or social welfare purposes,
the monies the organization solicits are likely to be considered as being
procured for public or charitable purposes within the jurisdictions where
the solicitations occur. Please be aware that this means you may have
registration and filing requirements in the states within which you solicit
and/or are home-based.

State reporting requirements are typically triggered for "public good"
organizations when same employ paid staff or receive and/or solicit more
than a certain baseline amount of donations (which may be measured not just
by pure grant and donation income, but also including net from special
fundraising events and inventory sales).

Check with local officials and knowledgeable counsel concerning State and
local filing requirements!

Federal Annual Tax Returns (Form 990 or 990-EZ)

Form 990 or 990-EZ, the Exempt Organization Annual Report Form (and a
Schedule A to same required by all 501(c)(3) organizations ) must be filed
annually by organizations recognized as tax-exempt if the organization has
gross receipts normally in excess of $25,000. The relevant tests for
whether current year's gross receipts are "normally in excess of $25,000",
thus triggering a filing requirement, is based on averaging current and
past years receipts.

The Form 990 is (as of the 1995 Form) six pages long (note that 501(c)(3)'s
have to submit with the Form 990 an additional six page Form -- called the
Schedule A). The Form 990 requires disclosure about program undertaking
and accomplishments, listing of Board members and officers (and amounts
paid to them), and much financial information (including how much is spent
on programs versus management and fundraising). These tax returns must be
made available for public inspection.

The Form 990 and 990-EZ is due on the 15th day of the fifth month
following the tax year's end (e.g., November 15th for June 30 year-ended
organizations , May 15th for calendar year organizations ). The return can
be extended by filing Form 2758 by the due date of the return. Proper
filing of the Form 2758 extension request will generate a three-month
extension, and two such extensions may be requested (totalling a six-month
extension).

Alternatively, for organizations who choose not to seek tax-exempt
classification, a corporate federal tax return (Form 1120 or 1120-A) is
required. This return is shorter and simpler than the Form 990, and need
not be made available for public inspection. This filing requirement is
due on the 15th day of the third month following the tax year's end.

Regardless of an entity's exempt status, tax accounting advice from those
familiar with tax-exempt reporting should be sought in establishing
bookkeeping systems for Entities.

Possibility of Federal Income Tax Even if Tax-exempt

Even though an organization holds federal tax-exempt status, an income tax
may still be applicable. The "unrelated business" income tax applies to
otherwise tax-exempt organizations when they engage in activities
regularly that are like those of commercial entities. The possible
application of said tax is reported via the Form 990 or 990EZ, but any
actual calculation of taxable income on unrelated activities subjected to
the tax is reported via Form 990-T, a separate filing.

The Form 990-T is required to be filed by otherwise tax-exempt
organizations who have received gross receipts from sources defined in the
Internal Revenue Code as being subject to the "unrelated business income
tax" of $1,000 or more. The definition of "unrelated businesses" is
complex (e.g., one common example is advertising receipts from periodicals
which carry paid ads on a regular basis and those ads are solicited paid
staff or contractors). This is an area where knowledgeable tax counsel
should be sought.

Annual State returns

As discussed earlier, Entities or organizations (regardless of their
federal tax-exempt status) need clarify with State taxing authorities their
responsibility, if any, to pay State business income taxes. For tax-exempt
Entities, such inquiries need also ask what tax-exempt tax filings are
required by the State, and when.

On non-tax reporting, Entities or organizations must clarify with their
respective States (typically through either the Offices of the Secretary of
State, Commerce Department, or Attorney General) whether any annual
reporting is required on non-profit corporations and of charitably
soliciting organizations.

Taxpayer Identification Number

Entities or organizations will discover that it is virtually impossible to
open a bank account without providing a "taxpayer identification" number to
the depository institution. The Internal Revenue Service assigns taxpayer
identification numbers (also called "employer identification" numbers) upon
request. Entities or organizations working under their own number, who
have yet to incorporate, should evaluate the benefits of maintaining the
same identification number post-incorporation (doing so requires specific
drafting in the Articles of Incorporation).

Obtaining a taxpayer identification is done by completing IRS Form SS-4 in
advance. Numbers can be assigned over the phone by calling into the
Internal Revenue Service (per instructions provided in the SS-4 package).

APPENDIX A - Supplemental Information

Lobbying Restrictions Specific to 501(c)(3)s

Being A Player, 2nd edition, 1995, published by the Alliance for Justice
($15.00; call (202) 822-6070 for order info) is THE resource regarding the
utility and mechanics of operating under the "lobbying election" (Code
section 501(h)) underwhich 501(c)(3) exempt organizations can have their
lobbying limits measured by precise mathematical limits.

Electioneering Restrictions Specific to both 501(c)(3)s and 501(c)(4)s

The Rules of the Game, 1st edition, 1996, published by the Alliance for
Justice ($20.00; call (202) 822-6070 for order info) is a great resource
regarding operating without violating tax and criminal codes applicable to
tax-exempt and nonprofit corporations.

Properly Notifying Donors of Tax-Deductibility of Donations

It is imperative that all 501(c)(3) tax-exempt entities or organizations
clearly state to donors what constitutes the "tax-deductible" portion of a
payment when same is asked for partly as a gift. The situations to be
concerned about arise from what are called "quid pro quo" (or inducement or
other benefit event) fundraising. Therein, the "donor" makes a payment for
which they get something back of value. IN THESE CASES, THE "SOMETHING OF
VALUE" REDUCES THE AMOUNT OF THE TRUE (i.e., tax-deductible) GIFT!

Under present law, a 501(c)(3) organization must affirmatively disclose to
all payors of more than $75.00 who get anything of value back from the fact
of making a gift payment, that the value returned must be subtracted from
the payment in computing the tax-deductible portion of their gift. Also,
in that affirmative statement, must be included a "good faith" estimate of
the value of the benefit returned. Good practice is thus to provide all
payors, whensoever something of value is returned with a solicited payment,
with both disclosures.

In practical terms, when you ask someone to attend your benefit dinner,
or when you solicit "memberships" and give back a meditation tape, the law
requires that (for anyone paying more than $75.00, which might include the
person purchasing multiple dinner tickets or memberships) the donee
organization disclose on the ticket/membership pledge receipt an estimate
of the fair market value returned (even if the event cost your organization
nothing or the meditation tapes were donated!) and the math formula
stipulated by the IRS.

Under present law, even if no exchange of value occurs, donors of $250 or
more in any one day must procure a written receipt from the recipient
501(c)(3) organization before filing a tax return showing same as a tax
deduction. Such written receipt must state whether the donor was given any
goods and services in exchange for their payment (and if so, provide a good
faith estimate of the value of same as discussed above).

Good practice is thus to thank your donors, in writing, promptly, and
state whether any goods or services (and if so, the value of same) were
provided to the donor in exchange for the donor's payment.

And finally, under present law no tax deduction may be taken by a donor
who has either earmarked his or her donation for use in a 501(c)(3)
entity's lobbying efforts or who contributes to a 501(c)(3) organization
which lobbies on subjects of a direct financial interest to the payor when
the purpose of such contributor is to end-run rules prohibiting the
business expense deductiblity of lobbying costs.

The law requires any 501(c)(3) which earmarks donative receipts for
lobbying to disclose that such payment is not tax deductible.

Public Support Mandates for c3s

501(c)(3) exempt organizations come in two flavors -- public charities and
private foundations. Generally, an entity will want to seek funding from
the private foundation community, which typically requires (although same
is not necessary) that grant applicants show proof of 501(c)(3) PUBLIC
CHARITY status. Such status is granted automatically to churches, schools,
and hospitals, and is otherwise earned by establishing a diversity of
funding sources for the organization. Two alternative "public support
tests" are available -- both are highly technical, but basically require a
(c)(3) to retrospectively show (over a four or five year period) that its
funding is not dependent on a few large donors or purchasers of services.
Since for new or fledgling entities or organizations just applying for a
501(c)(3) letter, such a result can only be hypothesized, in the exemption
determination process, such organizations will be granted favorable public
charity status under either of the "public support tests" only for a five
year advance ruling period. When you see a 501(c)(3) letter that
references the end of such five year period, same is merely stating the
date after which the group will have to do something to modify its first
letter, otherwise funders and the rest of the world will treat your group
as a private foundation c3.

APPENDIX B

ABOUT THE AUTHOR

The author conducts a legal practice (Tax Exempt Law Office of Eve Rose
Borenstein) devoted exclusively to representing tax-exempt organizations
before the Internal Revenue Service and State administrative agencies. She
has represented exempt organizations on federal tax issues and State
charitable law mandates since 1985, first via the Tax Department at the CPA
firm of Ernst & Whinney, and since 1988 in her own law office. She is an
active member of the Exempt Organizations Committee of the Tax Section of
the American Bar Association, and teaches widely on exempt organization
mandates before both the professional and nonprofit communities. She may
be reached by phone at 612 822-2677, fax at 612 822-2626, mail at 3754
Pleasant Avenue South, Minneapolis, MN, 55409, or via e-mail address --
eveb@taxexemptlaw.org.

DISCLAIMER

These materials are designed to provide accurate and authoritative
information regarding the topics covered. Legal requirements and non-legal
administrative practice standards herein addressed are capable of change
due to new legislation, regulatory and judicial pronouncements, and updated
and evolving guidelines. Same are utilized with the understanding that the
provision of this information does not constitute the rendering of legal,
tax, or other professional services by the author. If you require
professional assistance on these or other nonprofit tax and administrative
law issues, please contact the author (phone/address above), or your own
professional advisors.

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