Learn what it means to be nonprofit and tax-exempt, exploring the advantages and disadvantages of both, and when it makes sense to apply for status. Show
In any society, there are rules citizens need to follow. In a good society, these rules have been created to help things run smoothly, for the benefit of individuals and for the community as a whole. As individuals, others help us learn these rules as we grow. Our parents are quick to point out that we must pay for the candy bar at the grocery store; we take courses in government in school; we register to vote when we turn 18; and as we agonize over our tax forms each April, we know where we can go for help, especially the first time we fill out the paper work and agonize over foreign terms such as "earned income credit" and "total taxable income." Organizations are part of the community as well. They don't exist in a vacuum, and therefore, they're bound by laws and regulations, just as private citizens are. And so, like individuals, community groups will go through a "coming of age" when they will decide what their place in society is, what laws affect how they do business, and how they can use those laws to run most effectively. Unfortunately, help sometimes seems a bit harder to come by than it did when we grew up and learned the laws we needed to follow (whether we liked it or not!). Eventually, a community organization will need to consider its legal position. And this brings up a myriad of difficult questions that make us wish all we had to deal with was a 1040-EZ form. Some of the questions that most community groups will face are:
In this section of the Tool Box, we'll walk you through the answers to these questions, and give you an idea of what it means to be nonprofit and tax-exempt. We'll explore the advantages and disadvantages of both, and talk about when it makes most sense for an organization to apply for such status. At the end, we'll give a brief overview of the nuts and bolts of the application processes. Will you be able to fill out these applications on your own at the end of this section? Probably not. In fact, we strongly suggest you get professional help - either from a lawyer or an accountant who is well-versed in nonprofit and corporate law - as you decide what form your organization will take, and to help complete and file the papers. This section is not meant to take the place of an attorney or other legal counsel. What we do hope this section will give you is an understanding of what's out there and what might be useful to your organization. We'd like to demystify some of the "legalese" that's so hard to understand, so you'll be able to make the best choices for your organization. If that makes sense to you, then let's begin. What does it mean to be nonprofit and tax-exempt?Are nonprofit and tax-exempt statuses the same?No, but they are closely related. Nearly all organizations that are nonprofit wish to be tax-exempt as well, so the terms are often confused. Many charitable organizations, for example, are nonprofit organizations and are recognized by the federal government as being tax-exempt. But becoming nonprofit and becoming tax-exempt are different processes, done at different times (usually), and by different government agencies.
To apply for federal tax-exemption, you need to have been granted nonprofit status first. Further, not all nonprofits are eligible to be tax-exempt. Let's look at each term individually. Nonprofit statusA nonprofit organization in its simplest variation, is any organization for which those who control or support it do not earn a profit. This doesn't mean that a nonprofit can't make a profit--quite the contrary is true. A nonprofit organization can produce goods and services, and it can earn a profit while doing so. It can even invest those profits (in the stock market, for example) in hopes of earning more money. However, all of the money made must go back into the organization - there is no "profit sharing" among members. Generally speaking, these organizations don't have any owners. This is one reason that nonprofits are known more and more commonly as "not-for -profits." They may make a profit to help them stay in business, but making money is not their reason for being. Individual states, and not the federal government, grant official nonprofit status. They may do so in slightly different ways, and give slightly different advantages for obtaining it. However, the federal government can recognize your nonprofit status. If you want to apply for tax-exemption, for example, you must be recognized as nonprofit by the federal government. There are three types of nonprofit organizations that are recognized for this purpose by the federal government:
Becoming a corporation is perhaps the most common choice for community organizations. For incorporation, the organization must be structured according to specific state laws. These laws include having a "creating document" commonly known as the articles of incorporation, and rules of operation which are commonly known as bylaws. Usually, there is a board of directors and officers, and state laws (usually) limit the liability of members in varying degrees. Often, incorporation is the best choice for a community organization. Part of this is simply a matter of perception, or of comfort, of the people with whom you work. People are familiar with corporations; they're used to working with them, and often perceive corporations as serious and dependable. Also, the limitations on personal liability mentioned above can be quite helpful.
An unincorporated organization is a group much like a corporation, and often has similar bylaws and purposes. Although the name seems to suggest otherwise, it is still a formal structure with an official structure. However, a constitution or other policies may take the place of the articles of incorporation, and there is no protection against personal liability. Additionally, much less reporting to the state occurs. A trust generally has more narrow interests than a corporation or an unincorporated group. Many laws which govern trusts are created with charitable trusts (i.e, groups that give away money) in mind. Because of this, becoming a trust is rarely appropriate for a community group. Going into depth on each of these types of organizations is beyond the scope of the section; for detailed information on each of them, you might speak with an attorney, or read B.R. Hopkins' Starting and managing a nonprofit organization: A legal guide. And of course, you can certainly be a nonprofit organization in the loose sense of the word without ever filing papers, having a board, or any of those things. For example, a neighborhood group could be very effective without ever incorporating, or having a board, or even elected officers. It's still a nonprofit in practice, though, even if the law does not recognize it. We'll discuss the advantages and disadvantages of becoming officially recognized later in the section. Federal tax-exempt statusOrganizations that are exempt from federal taxes are described sections in the United States Tax Code. The best known type of tax-exemption is 501(c)(3), also known as the "charitable tax exemption." This designation allows exemption from federal corporate and income taxes for most types of revenue. Also, organizations designated as 501(c)(3) are able to solicit tax deductible contributions. 501(c)(3) is most appropriate for many community organizations, and (except where indicated otherwise) it will be used interchangeably with the term tax-exempt for the remainder of this section.
So before deciding to become 501(c)(3), it's a good idea to sit down and study other possibilities with an expert. Together, you can decide on the type of exemption that best meets your needs. That way, you won't be trying to push a square peg into a round hole. More information on the different tax exemptions, as well as other technical details not discussed in this section, may be found on the IRS website. Generally, an organization becomes tax-exempt by applying for the status. This is a fairly long process. The application form (Form 1023 for 501(c)(3) organizations; Form 1024 for others) is approximately 30 pages, and the IRS suggests that it (1023) will take about eight hours to complete--and that's after you have done record keeping (on expenses, revenue, and the like) and learned the law. It usually takes several months to be granted status. However, several weeks after you complete and mail the forms, the IRS will send you a letter saying your status is "pending." This letter is usually enough proof for funders and others who might require proof of your exempt status. When status is granted, the IRS will send a "letter of determination" that your organization can then use to prove its tax-exempt status on a more permanent basis. You might need the letters to show to foundations when applying for a grant, for example, or when you are applying for state tax-exemption. Additionally, however, there are two ways of having tax-exempt status without filing: automatic recognition and a fiscal conduit. Automatic recognitionSome organizations are automatically recognized as having 501(c)(3) status; they don't need to file. These groups include:
Even though these groups are automatically tax-exempt, they may choose to file anyway, in order to have the official letter of determination on file. This often makes it easier to solicit contributions and ask for exemptions from state taxes. Fiscal conduit A fiscal conduit is an organization that is already incorporated and tax-exempt that administers funds and performs other administrative tasks for your group. Also called a "lead agency," they can be invaluable in helping out with the organization of your group, reimbursing contractors, and sharing space. Local United Ways and public health departments are two examples of groups that often serve as fiscal conduits. A fiscal conduit may be what you need at the very beginning. The lead agency can do all the paperwork for you, and provide other kinds of less tangible support that can really help you, at least at the start. Why not use that support if it's available? State tax-exemptionState exemptions can include many different things, including exemptions from sales tax, income tax, and property tax. Again, these laws vary, so check with the Secretary of State's office for rules for your state. In some states, however, the requirements are the same as those of the federal government, and showing proof of 501(c)(3) status is enough to exempt you from many state taxes. What are the advantages of nonprofit and tax-exempt status?There are quite a few advantages to having the official status.For nonprofit status:
For federal tax-exempt status:
What are the disadvantages of nonprofit and tax-exempt status?Although applying for official nonprofit and tax-exempt statuses can be very helpful, there can also be some disadvantages to doing so.
When should you consider applying for nonprofit and tax-exempt status?After taking into account all of the advantages and disadvantages of applying for nonprofit and tax-exempt status, you might decide that they are the right steps for your organization to take. But is now the right time to take the plunge?Maybe so, if:
When you might not want to apply for nonprofit and tax-exempt statusOn the other hand, you might decide that the time isn't right to apply when:
Any of these conditions might be enough, individually, to convince you to consider holding off for a while. However, organizations will want to look over all of the details of their own situation, and decide what makes most sense for them. One more point to take into consideration: if you apply for exemption within the first 15 months of being created, your tax-exempt status can be applied retroactively to the founding date of your organization. The federal government also gives an automatic 12-month extension on this regulation. That means functionally, you must apply within 27 months of being created to avoid taxes for the start-up period of your organization. For groups who know from the outset that they want to be around for the long haul, then, it might make sense to apply relatively early in the life of the organization. How do you apply for nonprofit status?Procedures for becoming an official nonprofit organization will vary greatly from state to state, and so we won't spend too much time talking about it here. But a general overview of the process might look like this:
How do you apply for federal tax-exempt status?The steps for applying for federal tax-exempt status are quite similar to applying for nonprofit status. There are, however, some important differences. Briefly, the steps involved are:
A last word on getting helpThroughout this section, we have suggested getting help from an accountant or a lawyer when you are going through these processes. But those fees add up; how can a relatively poor organization afford this type of counsel? Our advice is to look for professionals who will either donate their time or do the work at a reduced cost. You might find this help:
When looking for help, you might want to try going through all of the channels listed above, and it may take some time before you find someone competent to help you out. Sheer persistence, however, often makes the difference - don't give up the first time someone tells you no. In SummaryUnderstanding the legal system that surrounds the nonprofit world is certainly not an easy thing to do. In this section, we have left out many of the finer points of the law, to give you a general understanding you can use as you talk with legal council, or read through some of the more detailed literature on the system. As you get more in depth into your study of the laws surrounding nonprofit organizations, it's easy to get lost in the details. But remember, the system was set up to help nonprofits, not hinder them. When you have a solid understanding of the system, your organization can use it to its advantage. By doing so, you've made an important step along the path of becoming a successful, self-sustaining organization. |