Forming a Charitable Organization
By Michael D. Cross, Jr., J.D.
Those who desire to form a charitable organization should be mindful of two distinct sources of law that govern both the organization and the operation of nonprofit entities. The first source of law is state corporate law involving nonprofit corporations. The second source is federal tax law involving tax exempt organizations. The following is an overview of these two regimes.
State Law – Incorporating
Every state has provided in its laws for the organization of nonprofit corporations. Georgia’s Nonprofit Corporation Code (the statutes that primarily control the organization and operation of nonprofit corporations) is located in the Official Code of Georgia Annotated, Title 14, Chapter 3. (O.C.G.A. § 14-3-100, et. seq.). Generally, to form a nonprofit corporation, the incorporator of the nonprofit must file articles of incorporation with the Georgia Secretary of State along with a filing fee. The articles must set forth the name of the nonprofit, the initial principal place of business of the nonprofit, the name and address of the registered agent of the nonprofit, the purpose of the nonprofit, and whether the nonprofit will have members. The articles may also set forth other matters regarding the operation of the nonprofit, including the extent to which the nonprofit may indemnify its officers and directors. Once the Secretary of State has filed the articles of incorporation, the Secretary will issue a certificate of incorporation officially recognizing the creation of the nonprofit.
The nonprofit must also deliver a notice of intent to incorporate to the legal newspaper of the county in which the registered agent is located along with a publication fee. The legal newspaper is established by statute and may be determined by contacting the clerk of superior court of the county. The newspaper then must publish the notice once a week for two consecutive weeks.
Incorporating the nonprofit corporation, however, does not secure tax-exempt status for the nonprofit either at the federal or the state level. To accomplish this, the nonprofit must file an application for tax-exempt status with the Internal Revenue Service. Generally, those nonprofits that desire to serve the community by engaging in charitable activity may obtain tax-exempt status only by showing the IRS that they fall within the definition of Internal Revenue Code (the “Code”) § 501(c)(3). The IRS has prescribed Form 1023 as the form necessary for this classification. If a nonprofit qualifies as a § 501(c)(3) corporation, those who contribute to the nonprofit may claim a charitable deduction for the contribution under § 170.
Other nonprofit entities operate as trade associations, labor unions, cooperatives, or serve other functions set forth under § 501(c). These organizations generally must file Form 1024 to obtain tax-exempt status. It is important to note, however, that contributions to these organizations do not qualify for treatment as charitable deductions, although many contributions to trade associations, etc., may be deductible as a business expense.
Tax Law – Qualifying for Exemption from Federal Income Tax
Although, as mentioned above, incorporating the nonprofit and filing for tax exempt status are separate processes governed by separate sets of laws, it is essential that tax law be considered while incorporating the nonprofit. This is particularly important when preparing the articles of incorporation for the nonprofit. Although the above section sets forth the requirements of state law, the internal revenue code requires additional language to appear in the articles of incorporation. In particular, the articles must state that the Foundation is limited to engaging in one or more exempt purposes (as set forth in I.R.C. § 501(c)(3)) and, upon dissolution, its assets must be distributed for an exempt purpose, to the federal government or to a state or local government for a public purpose. If this language does not appear in the articles, the nonprofit will be unable to obtain tax exempt status without first filing an amendment with the Secretary of State, thus requiring additional time and money.
Assuming the non-profit corporation has been incorporated properly, it is then necessary to file IRS Form 1023. So long as this form, available on the IRS website at www.irs.gov, is filed within the first fifteen months of the nonprofit’s existence, the filing will relate back to the nonprofit’s date of formation. If the form is not filed timely, it will only be effective as of the date it is actually filed with the IRS.
IRS Form 1023 generally requires identification of the nonprofit, its officers, and directors. In addition, although the form requests substantial information, the remainder of the form generally requires three pieces of information, to wit: (1) a narrative describing, in great detail, the charitable purpose for which the nonprofit is being organized; (2) a pro-forma budget detailing the nonprofit’s anticipated/estimated contributions and expenses; and (3) a series of questions geared toward establishing whether the nonprofit should be classified as a public charity of a private foundation.
With respect to the requirement regarding the detailed narrative description of all the past, present, and planned activities of the nonprofit, the language must be somewhat specific and should explain how each activity furthers the tax exempt purpose for which the nonprofit was organized. It is also helpful to demonstrate how the nonprofit’s activities will lessen the burden of federal, state, and local government. Although this is not specifically required, it is advantageous, as exempt status will result in the nonprofit being “subsidized” by the government and taxpayers. Ergo, if the nonprofit is to receive a benefit, it should demonstrate it provides a service.
The second aspect of the form requires information regarding the nonprofit’s financial records or anticipated budget. It is important to note that this budget must show both anticipated contributions (and their source) as well as anticipated expenditures. This budget must balance. The nonprofit should not plan to accumulate assets. Although the nonprofit certainly should maintain a reasonable amount of operating capital, it should plan to distribute all contributions each year.
The pro-forma budget is used in part to assist with obtaining the third piece of information the IRS is seeking through Form 1023, namely whether the nonprofit should be treated as a public charity as opposed to a private foundation. Most nonprofits desire to be classified as public charities for several reasons. For example, private foundations are subject to a two percent tax on net investment income as well as a two-tier excise tax on “excess business holdings” and certain “self-dealing” transactions. Additionally, contributions to public charities allow the donor to deduct the asset’s fair market value, while contributions to private foundations are generally limited to the donor’s basis. Finally, a donor can deduct contributions to a public charity up to fifty percent of the donor’s “contribution base”, which is based upon the donor’s adjusted gross income. Donors to private charities can deduct only up to thirty percent.
I.R.C. § 509(a)(1) generally defines public charities to include churches or associations of churches, educational organizations, medical and research facilities, organizations that receive a substantial part of their support from an exempt function, a government entity, or the general public. For the purposes of the preceding sentence, the “a substantial part” of a nonprofit’s support requires contributions from the general public of 33 1/3% of its income. Of this 33 1/3%, no more than two percent can be counted from any one donor. Ergo, the nonprofit must demonstrate it has received contributions from at least seventeen separate donors. Failure to qualify as a public charity automatically results in the nonprofit being treated as a private foundation for tax purposes.
When Form 1023 is filed, a lower level IRS agent conducts a technical screening in which he or she reviews the application to make certain that all areas of the form are completed, that the necessary pro-forma budget is attached, and that the application generally contains all necessary information. In essence, the technical screener looks for language he or she believes to be familiar.
After the technical screening is complete, the application is forwarded to an exempt organization specialist. This review occasionally takes as few as two months, but it may take six months or more. The specialist often requests additional information during the course of his or her review. Essentially, the specialist is charged with making certain the Foundation is organized in a manner consistent with the Code and will be operated in a manner consistent with the Code.
As a result of recent IRS restructuring, all Form 1023s are submitted to the IRS office in Covington, Kentucky. From time to time, however, the Covington office becomes overwhelmed, and the applications are distributed to various agents throughout the country for review.
Once the specialist has completed his or her review and determined that the Foundation complies with the Code, the IRS will issue a “determination letter” in which it states that the Foundation is a tax-exempt organization. The letter will also state whether the Foundation has been classified as a public charity or a private foundation, as well as the form that should be used for the Foundation’s annual return (i.e., either Form 990 or Form 990-PF). If the IRS fails to issue a ruling within 270 days of the date the Foundation submitted its application, the Foundation may bring an action in the U.S. District Court for the District of Columbia, the U.S. Court of Federal Claims, or the U.S. Tax Court for a declaratory judgment as to exempt status.
Generally, an organization that requests classification as a public charity must show that it has been supported by the general public for the past several years. The Code prescribes certain tests employed to determine whether the organization is in fact a public charity. See §§ 509(a)(1) and 509(a)(2). An organization that is new and expects to be supported by the general public may request an “advance ruling” when it files Form 1023. If granted, the IRS will treat the organization as a public charity for its first five years. Within 90 days of the end of this five year period, the organization must submit proof to the IRS that it is qualified as a public charity. If it is not qualified, or if it fails to file proof within the time period, the IRS will re-classify the organization as a private charity, and the organization’s donors will be more restricted in what amount they may deduct as a charitable deduction.
The above discussion is merely an overview of the factors to be considered when organizing a nonprofit entity and is not meant to provide legal advice. Moreover, this discussion does not address the various restrictions on the operations of a nonprofit entity. The discussion is meant only to supply an overview of the types of factors to be considered, and it does not take into account the specific laws of any state, nor does it address state and local tax issues. Each nonprofit entity is faced with different challenges and opportunities, and this process should not be undertaken without discussing the nonprofit’s specific objectives and method of operation with legal, tax, and accounting professionals.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.