A nonprofit corporation is a corporation formed to carry out a charitable, educational, religious, literary or scientific purpose. A nonprofit can raise funds by receiving public and private grant money and donations from individuals and companies. Certain federal, state, and local income, property and sales tax exemptions are available to nonprofit corporations. The federal and state governments do not generally tax nonprofit corporations on money they make that is related to their nonprofit purpose, because of the benefits they contribute to society. The most common federal tax exemption for nonprofits comes from Section 501(c)(3) of the Internal Revenue Code, which is why nonprofits are sometimes called 501(c)(3) corporations. Tax exempt nonprofit organizations offer donors an individual deduction for contributions. (Private donors can claim personal federal income tax deductions of up to 50% of adjusted gross income for donations made to 501 (c) (3) organizations.)
Forming a nonprofit corporation is much like creating a regular corporation, except that nonprofits have to take the extra steps of applying for tax-exempt status with the IRS and their state tax division. The basic steps to follow include:
- Obtain nonprofit materials from your state's corporate filing office. This packet should include sample or fill-in-the blank articles of incorporation and your state's nonprofit corporation laws. It should also contain a filing fee schedule, as well as forms and instructions for checking the availability of your proposed business name. The articles of incorporation will contain the name of your corporation, the corporation's address, a "registered agent" (a person who agrees to receive legal papers on behalf of the corporation), and sometimes the names of the corporation's directors.
- Choose an available business name that meets the requirements of state law. State requirements vary, but generally, the name of your nonprofit cannot be the same as the name of another corporation on file with the corporations division, the name must end with a corporate designator, such as "Corporation," "Incorporated," "Limited," or "Corp.," "Inc." or "Ltd.", and the name cannot contain certain words prohibited by the state, such as Bank, Cooperative, Federal, National, United States or Reserve. Also, you must make sure your name won't violate a trademark owned by another company (in your state or out of state). To do this, you'll need to conduct a trademark search. You aren't usually required to file or reserve the name with your state. Once you file your articles of incorporation, your nonprofit's name will be automatically registered.
- File formal paperwork, usually called "articles of incorporation," and pay a small filing fee (typically $30 or $40).
- Apply for your federal and state tax exemptions. The
IRS requires you to submit a copy of your filed articles with your application.
To apply for your exemption, you must complete IRS Form 8718, User Fee
for Exempt Organization Determination Letter Request, and IRS Package 1023,
Application for Recognition of Exemption. For instructions on filling out
these forms, read IRS Publication 557, Tax-Exempt Status for Your Organization.
After the IRS reviews your application, it will send you a letter indicating that it has approved your nonprofit status, or it might ask you for more information about your organization. The IRS can also deny your application outright.
A few states require you to complete a separate application to get a state tax exemption. In other states, as long as you file nonprofit articles of incorporation and obtain your federal 501(c)(3) tax-exempt status, your state tax exemption will be automatically granted. In still others, to get your state exemption you must send in a copy of the IRS determination letter that granted your federal exemption.
- Create corporate "bylaws," which set out the operating rules for your nonprofit corporation, including procedures for holding meetings, making major business decisions, voting rights and other important guidelines.
- Appoint the initial directors. Directors, who meet and make decisions collectively as the board of directors, have the authority (and responsibility) to manage and run the nonprofit corporation. Many states allow nonprofits to have just one director, but other states require at least three. Some states require the directors to be chosen before filing the articles of incorporation because you must list their names in the document.
- Hold the first meeting of the board of directors. Before you start doing business, you must elect a board of directors and hold an initial meeting of the board. Typically, the bylaws are adopted by the corporation's directors at their first board meeting. The directors also will elect officers -- state law usually requires a president, secretary and treasurer, and sometimes a vice president as well. Then, the directors should authorize the newly elected officers to take actions necessary to start the business of the nonprofit, such as setting up bank accounts and admitting members. Minutes of the meeting should be created and filed in the corporate records book.
- Obtain licenses and permits that may be required for your corporation. A local business license (sometimes called your "tax registration certificate") may be required for your activities, and if you sell anything to consumers, you'll need a sales tax permit.
Like any corporation, a nonprofit has a board of directors to make important policy decisions, officers (president, treasurer and secretary) to oversee and manage the day-to-day operations of the organization, and possibly employees to do the work. Unlike regular corporations, however, nonprofit corporations do not have shareholders or owners. Nonprofits are owned by no one person or group of persons and cannot be sold.
The members, directors and officers of the corporation are generally prohibited from profiting at the expense of the corporation. The assets, income or profits may generally be distributed to such people only as compensation for services, as a distribution of assets upon dissolution of the corporation, as payment of dividends to members as provided for in special instances in articles of incorporation, or when profit derived from sales to members is rebated to members in proportion to fees paid by members.
Every nonprofit corporation must be organized upon a stock or nonstock basis. Some states do not allow for the formation of a stock-issuing nonprofit corporation. Every nonstock corporation is generally organized as either a directorship corporation or a membership corporation, although hybrid forms are sometimes possible. In a directorship corporation, the directors elect their own successors. The corporation may or may not have members, but if it does, such members have no voting power, leaving the decision making up to the directors. In a membership corporation, the members have the exclusive right to elect directors, amend articles and bylaws and vote on a merger or dissolution of the corporation.
All nonprofit corporations must keep proper corporate records to preserve directors' limited personal liability and protect the organization's tax-exempt status. These records should include minutes of directors' and members' meetings and document important corporate decisions.
A corporate records book is usually used to record minutes and also contain a copy of your articles of incorporation, bylaws and tax exemption determination letters from the IRS and your state tax agency, if applicable. Nonprofit corporations must record any financial transactions in a double-entry bookkeeping system and keep other financial records in order to file an annual corporate tax return.
Under IRS rules, a nonprofit cannot make political lobbying a substantial part of its total activities, and a nonprofit must make sure that its activities don't personally benefit its directors, officers or members. Nonprofit corporations must abide by the following restrictions to retain their tax-exempt status:
- Nonprofit corporations with a 501(c)(3) tax exemption cannot participate in or contribute money to political campaigns. If they do, the IRS can revoke their nonprofit status, and can assess a special excise tax against the organization and its managers.
- Nonprofit corporations can engage in only limited lobbying activities. Tax-exempt 501(c)(3) nonprofits that influence legislation to any "substantial degree" face the loss of their nonprofit status. However, for tax-exempt nonprofits that want to participate in lobbying, the IRS simply sets a limit on the money they can spend on political activities.
- Nonprofit corporations must not distribute profits to members, officers or directors. A nonprofit corporation cannot be organized to financially benefit its members, officers or directors. However, reasonable salaries and expense reimbursements are permitted.
- Nonprofit corporations must pay taxes on income from "unrelated activities." The IRS requires nonprofits to pay corporate income taxes on such unrelated income over $1,000, whether or not the group uses that money to fund its tax-exempt activities.
- Nonprofit corporations cannot make substantial profits from unrelated activities. If a nonprofit spends too much time on unrelated activities, or if the unrelated activities generate "substantial" income, the group's nonprofit status may be jeopardized.
- When a nonprofit corporation dissolves, its assets must be distributed to another tax-exempt group. Since tax-exempt organizations and their assets cannot be owned, they can never be sold.
Nonprofits are not actually owned by anyone and therefore cannot be sold. If the directors of a nonprofit corporation decide to dissolve it, they must pay off all debts and obligations of the nonprofit and distribute all of its assets to another tax-exempt nonprofit corporation.
Forming a nonprofit corporation generally protects the directors, officers and members of the nonprofit from personal liability for the corporation's debts and other obligations. Only the assets of the corporation may be used to pay off debts and other liabilities. This protection from having personal assets available to pay off debts or judgments is called "limited liability".
In a few situations, people involved with a nonprofit corporation can be held personally liable for its debts. A director or officer of a nonprofit corporation can be held personally liable if she:
- personally and directly injures someone
- personally guarantees a bank loan or a business debt on which the corporation defaults
- fails to deposit taxes or file any necessary tax returns
- does something intentionally fraudulent, illegal or clearly wrong-headed that causes harm, or
- co-mingles nonprofit and personal funds.
To safeguard against some of these exceptions, insurance is available to protect volunteer directors, who may be reluctant to serve without it.
IRC 501 (c) (3) nonprofit corporations must be organized for religious, charitable, educational, scientific or literary purposes for the benefit of the public. To obtain full tax benefits, the organization must also qualify as a public charity. There are three ways to qualify as a public charity:
1. Automatic Public Charity. The following organizations are recognized as as public charities by the IRS:
- Traditional churches, without regard to any particular religion.
- Schools, providing education for public benefit.
- Hospitals and Medical Research Organizations, which provide on-site medical care (excludes convalescent homes).
- Public Safety Organizations, which administer public safety testing.
- Government Organizations which support colleges or universities.
- Support Organizations set up solely to support one of the organizations above.
2. Publicly Supported Organizations. To qualify, the organization must rely on broad-based support individual members of the community or various public and private sources, rather than funding from a few private sources.
3. Meeting the Support Test. To qualify as a public charity under the Support Test, an organization must meet BOTH of the following two requirements:
1. The organization must normally receive more than 1/3rd of total support each tax year as Qualified Public Support. Qualified Public Support is support from any of the following sources;
- gifts, grants, contributions or membership fees
- gross receipts from activities related to the exempt purpose of the nonprofit
2. The organization must normally not receive more than 1/3rd of its annual support from unrelated trades or businesses, or gross investment income. Taxes on business income are deducted before the 1/3rd amount is calculated.
Tax-exempt nonprofits often make money as a result of their activities and use it to cover expenses. As long as a nonprofit's activities are associated with the nonprofit's purpose, any profit made from them isn't taxable. Sometimes nonprofits make money in ways that aren't related to their nonprofit purposes. While nonprofits can usually earn unrelated business income without jeopardizing their nonprofit status, they have to pay corporate income taxes on it, under both state and federal corporate tax rules. Generally, tax is imposed on any amount above the first $1,000 of unrelated income.
Some activities will not be taxed, even if they aren't related to the nonprofit's purpose, including:
- activities in which nearly all the work is done by volunteers
- activities carried on primarily for the benefit of members, students, patients, officers or employees
- sales of merchandise that has been mostly donated to the nonprofit
- the rental or exchange of mailing lists of donors or members, and
- the distribution of items worth less than $5 as incentives for donating money
Profits are exempt from corporate taxation.
A nonprofit is permitted to raise funds by receiving public and private grant money and donations from individuals and companies.
Allows for tax-deductible contributions by donors to nonprofit corporations.
Directors, officers and members have protection from personal liability for the corporation's debts and liabilities.
Profits can be retained and used to pay reasonable salaries.
Some incidental benefits include:
- Special postage rates. Nonprofits can apply for and receive a mailing permit that gives them a special reduced nonprofit rate for mailings. This is especially helpful for organizations that will do a lot of solicitation by mail.
- Property tax exemptions. In addition to an exemption from income taxes, nonprofits are usually exempt from paying property taxes on real estate and other property.This property tax exemption is called a "welfare exemption."
- State sales tax exemptions. Some states offer exemptions from state sales tax to qualified nonprofits.
Cannot distribute profits to members, employees or participants.
Increased corporate formalities; periodic filings with state and federal agencies, mandatory corporate meetings, more rigorous bookkeeping requirements.
Must file the federal tax exemption application.