501c3 Legal Aspects

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:

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 Corporation

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 (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)
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:

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!

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 desirability of proceeding without 501(c)(3) status. In making such decisions, knowledgeable tax counsel should be sought.

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.

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 desirable, 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 desirable, 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. (Contact Elischa Campbell Consulting Services, LLC at 832-439-3542, for a fee, we can prepare this form for you.)

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

  1. Cost: filing fees are currently $600!(Small Entity, anticipating annual income averaging no more than $10,000 per year, can qualify for a reduced fee of  approximately $400.)
  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 $600! (Small Entities, anticipating annual income averaging no more than $10,000 per year, can qualify for a reduced fee of approximately $400.)
  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 (totaling 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, when so ever 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

01(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 maybe 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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