Creation of a Tax-Exempt Organization
The following is a brief summary of the steps required to create a tax-exempt organization under Section 501(c)(3) of the Internal Revenue Code and 23701d of the California Revenue & Taxation Code. (Other states will have similar statutes.)
Organizing the Nonprofit Corporation and Obtaining Tax-Exempt Status
There are two steps involved in organizing a nonprofit corporation. The first step involves drafting the initial corporate documents: the Articles of Incorporation (the "Articles"), the Bylaws, the Minutes of Action of the Incorporator, and the Minutes of Action of the First Meeting of the Board of Directors. While it is possible to incorporate a nonprofit corporation in one day, the discussions and planning involved in drafting the initial corporate documents can move quickly or slowly, depending on whether or not everyone who is involved in the corporation agrees on matters of corporate governance and structure. The law requires many provisions in the Bylaws, as the main governing document of the corporation; other provisions can be drafted within wide guidelines, such as whether or not the corporation will have members, or the size and composition of the board of directors. After the corporation has been organized, the second step is to prepare and file the applications for tax exemption and obtain the "determination" letters. Both the Internal Revenue Service (the "IRS") and the California Franchise Tax Board (the "FTB") require separate tax exemption applications. Once the planning decisions necessary to prepare the initial corporate documents have been made, you will be able to proceed with the preparation of the exemption applications. Generally, the federal application is filed first and California application is filed after receipt of the determination letter from the IRS. You can expect waiting periods of 90 to 150 days for the IRS to process the application and to receive a determination letter. Responses from the FTB are often received within 30 to 45 days. The initial cost of filing fees of the Articles and the federal and California exemption applications is the total amount of $805: $30 for the Articles filing fee; $750 for the federal exemption application fee (if the gross receipts average more than $10,000 during the first 4 years, otherwise, it is $300); and $25 for the California exemption application fee.
Public Charity/Private Foundation Classification
According to the federal tax law, charities are divided into two categories: public charities and private foundations. A charity is assigned to one of these categories when it applies for a determination of its tax-exempt status. For reasons explained below, it is normally advisable to qualify as a public charity. A private foundation is an exempt organization that is largely funded by one or a small number of private persons. There are complex tax and operating burdens on private foundations that do not apply to public charities. Private foundations are subject to rules against self-dealing, standards for distributing annual income, and impositions of excise taxes on certain prohibited transactions such as excessive holdings in unrelated business enterprises. Further, individual donors to a private foundation may deduct contributions generally only up to 30% of their adjusted gross income, whereas contributions to a public charity are deductible up to 50%. In order to avoid being classified as a private foundation, an organization normally must either receive at least one-third of its funding from the public or from the government.
Additional Filing Requirements
A nonprofit, tax-exempt organization has certain federal and state periodic filing requirements, which are covered within this website. You will also need to obtain a tax identification number for your organization after the Articles have been filed with the Secretary of State and a corporation number has been issued to the corporation. The best way to get started is to begin filling out the included application for legal assistance that requests the information that you and your attorney will need to form the corporation and complete the federal and state tax exemption applications.
Advantages of Forming a Tax-Exempt Nonprofit Organization
State and Federal tax exemptions. Contributions made to the organization are tax deductible for the contributor. The organization is eligible to apply for various grants – many foundations require 501(c)(3) status and will ask for a copy of your Determination Letter. Reduced postal rates. Limited liability. Directors, Officers, and members are not personally liable for the organization's debts. Exceptions to this include:
Unpaid taxes – such as, income and employee withholding taxes. Violation of Statutory duties – Board of Directors and Officers can be liable to the organization for failing to act in the organization’s best interest (the duty of care). Commingled funds – When personal funds are mixed with the organization's funds. Unpaid Dues – Members are liable for fees and dues owed to the corporation. Failure to follow legal formalities – such as, operating by bylaws, hold Board meetings, take minutes & keep records, etc. Imprudent investments – When funds are risked without adequate funds in reserve.
Perpetual legal existence. A corporation is a legal entity – like a separate person -- and continues to exist even when the Directors and Officers change. The organization may be dissolved. Formality. A corporation has structure, rules, and procedures to follow when there is a dispute. It prescribes the delegation of authority and has guidelines that all must follow.
Disadvantages of Forming a Tax-Exempt Nonprofit organization
Paperwork. The initial red tape (articles of incorporation, bylaws, minutes, tax exemption applications, etc.) and the ongoing process of record keeping, include:
Minutes of meetings – Board, general, and annual meetings. Financial records. Accounting records are important and may be complex. New organizations often have an accountant set up initial books and then follow its procedure. The Treasurer should have some knowledge of accounting and nonprofit tax requirements. Statement of Domestic Nonprofit. $20 filing fee every other year. Annual income tax returns. Form RRF-1 (Periodic Report to Attorney General of California). Form RRF-1 must be filed within four and one-half months following the close of the organization’s annual accounting period, along with a completed Form 990, 990-EZ, or 990-PF.
Initial incorporation costs and filing fees – About $800.