How to Form a Nonprofit Organization: Public Charities and a Private Foundations

Tax exempt organizations with religious, charitable, scientific, public safety, literary, or educational purposes are formed for many and varying reasons. This article discusses two broad classifications of exempt organizations the public charity and private foundation, either of which can be organized to serve all of the aforementioned purposes. For simplicity’s sake, the major difference to the lay person between these classifications is that a public charity is funded by a large group of people through small or large donations and a private foundation is funded through a small group of persons, and often just a single person.

Specifically, the public support of a public charity must be fairly broad, not limited to a few individuals or families. Public charities are defined in the Internal Revenue Code in the negative under sections 509(a)(1) through 509(a)(4) as being what a private foundation is not. A private foundation, sometimes called a non-operating foundation, receives most of its income from investments and endowments. This income is used to make grants to other organizations, rather than being dispersed directly for charitable activities. Private foundations are defined in the Internal Revenue Code under section 509(a) as 501(c)(3).

Non-profit organizations are required to register with the state before the process of securing IRS recognition (through incorporation, organization, charter, association, etc.).  There are privileges and exemptions available for nonprofit organizations through local, state and federal governments.  In order to apply to the IRS for exempt status, the organization must first obtain an Employer Identification Number (EIN); instructions for obtaining an EIN are located on the IRS website at: http://www.irs.gov/businesses/small/article/0,,id=97860,00.html.

It is possible to complete all the necessary plans and documents without professional advice.  However, many groups working on the development of a new organization will find it worthwhile to get help from lawyers and accountants who are familiar with the ins and outs of the process. Such advice can cut down on frustrating missteps and delays.

Forming the Organization

Typically, the first step in organizing is to incorporate with your state.  Most states have specific provisions for the formation of a nonprofit corporation.  Usually, there is a form to file that requires attachments including a list of the people who are forming the corporation ("incorporators"); articles of incorporation (a legal document establishing a corporation and its structure and purpose), bylaws (rules that govern the internal management of the organization), an Organizational Consent Resolution; and a fee.

The IRS will look closely at the charter documents when reviewing the application for exempt status, it is therefore important that they contain full and accurate descriptions of the organization's purpose, limitations on the use of revenues and assets to prevent private parties from benefiting from the organization's nonprofit status, and a plan for dissolution that assures that any remaining assets continue to be dedicated solely to charitable purposes.

The second step, possibly the most difficult to complete of the formation process, is the preparation and filing of an IRS Form 1023.  This is an application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code.  Form 1023 is a requirement to be recognized as an exempt organization by federal and state taxing authorities. It is a long and time-consuming document. Not only does it require a great deal of detailed information about your organization's activities, but it also requires financial projections, or historical financial information, depending on the age of your organization when you apply. Generally speaking there are a lot of documents and explanations that must be attached. There is also generally an interaction between the IRS and the applicant to clarify any questions arising from the application submitted.

Organizations that are classified by the IRS as "private foundations" are subject to more stringent limitations on their activities and must pay an excise tax each year based on their investment income.  While those classified as "public charities" have less stringent rules and don't pay this tax. The law requires the IRS to identify 501(c) (3) organizations as a "private foundation" unless it shows that it should not be classified that way.

After IRS approval, the next step is to ensure compliance with state law in soliciting for donations. In many states the charity must obtain a Charitable Solicitation Permit or something like it. This permit or authorization to solicit donations can be obtained from the state in which the organization plans to conduct any sort of fundraising which involves a broad circulation of an appeal to the general public.  Generally, it is also important that the organization also license with the applicable city and state in which they reside and/or operate.  Also, a copy of the IRS approval letter should generally be submitted to your state tax authority to ensure tax exemption on the state level as well.

Ongoing Obligations

In conducting the operations of an exempt organization, directors often have certain legal obligations. Failure to observe these obligations may subject nonprofit directors to liability.  Directors of for-profit and nonprofit institutions have the same two basic legal obligations, the duty of care and the duty of loyalty.  The duty of care requires directors to exercise care, diligence and skill that an ordinary, prudent person would exhibit under similar circumstances.  The duty of loyalty requires pursuit of the organization's best interest, avoidance of self dealing and conflicts of interests, as well as disclosure of potential conflicts and obtaining prior board approval of any transactions or situations that might be considered self-dealing or a conflict.  There is also a duty to keep minutes of board meetings to have on record.

There are reporting requirements and operating restrictions that you need to keep in mind in order to comply with the law and maintain 501(c)(3) exempt status.  There is a need to comply with state corporate laws' formalities for corporate governance, state laws on charitable organizations' record-keeping requirements and IRS regulations on tax exemptions. In many states there are tax advantages to be classified as a exempt organization for sales tax, property tax, and other tax purposes.

The federal, state, and local law, especially tax related law, can be quite onerous as it relates to the formation of charitable organizations. It is highly advisable to seek out the advise of a competent attorney, cpa, or tax adviser in the formation and operation of any charitable organization.

Paul Jones is an Attorney and CPA practicing in Salt Lake City, Utah. Paul assists clients form charitable organizations and provides guidance in their operations. Paul can be reached through his web site www.pauljonesattorney.com or by email at paul@pauljonesattorney.com.