Non-Profit Formation

New Business Practicum UC Berkeley Law School
Today’s Presentation
Rules of the Game for Tax Exempt NonProfits
II. Getting Into the Game: How to Obtain Tax
Exempt Status
III. Playing Well with Others: Collaborating with
Other Non-Profits and For-Profits
This workshop is intended to provide you with
general legal information, but it does not
substitute for legal advice from an attorney!
I. Rules of the Game
for Tax-Exempt Non-Profit
Myths about Tax Exempt Non-Profits
To get the benefit of tax exempt status, you have to apply to the IRS (?)
For organizations that have tax exempt status:
Can’t make a profit (?)
Can’t engage in political activity (?)
Never have to pay taxes (?)
Always possible for donors to get tax deductions (?)
Have to pay small salaries (?)
Sum: Why Apply for Tax Exempt Status
for Your Organization?
– investment income, except:
• income from activities
unrelated to tax exempt
• investment income from assets
acquired with debt
– Tax Deductions for Charitable
– Can utilize volunteers
– Exemption from other Taxes:
• Activities must be limited to 501c3
exempt purposes
• No substantial Lobbying
• No political activity on behalf/in
opposition to any candidate
• Upon dissolution, assets must be
donated to another 501c3
• Cannot unduly benefit private
• Federal Unemployment Tax
• Greater scrutiny by IRS and State
Attorney General’s Office
• State Property/Franchise Taxes
• Limited Resources (typically)
What’s Different about Being Tax Exempt?
A non-profit is essentially a trust – A custodian of
assets that have been dedicated to the public good.
Guiding Principles (4)
1) Organized and
operated exclusively for
exempt purposes
2) No private benefit
(e.g., no profit sharing)
3) Assets are permanently
dedicated to exempt
4) No advocacy
for/against a candidate
or legislation
1) Organized and Operated for
Exempt Purposes
IRS will only grant tax exempt status to organizations that are
both organized and operated exclusively for one or more
charitable, educational or other exempt purposes
>> see IRS Code, 26 USC section 501(c)(3)
Organization’s bylaws, articles of incorporation, and Board of Directors
A Non-Profit Organization risks losing its tax exemption if it
engages in activities unrelated to its exempt purpose
-- Unless the activities are insubstantial in amount
Exempt Purposes – 26 USC 501(c)(3)
Relief of the poor and distressed or the underprivileged;
Advancement of religion;
Advancement of education, arts, culture or science;
Promotion of amateur sports competition;
Prevention of cruelty to children or animals;
Promotion of social welfare by organizations designed to accomplish any of the above
purposes, or
(i) to lessen neighborhood tensions;
(ii) to eliminate prejudice and discrimination;
(iii) to defend human and civil rights secured by law; or
(iv) to combat community deterioration and juvenile delinquency.
See 26 CFR sec 1.501(c)(3)-1(d)(iv)(2)
Is the Activity Related or Substantial?
What is unrelated ?
Activity that is not exempt (not 501(c)(3) purpose)
Activity that does not further the exempt purposes
stated in the non-profit’s articles of incorporation or
its tax exempt application
What is insubstantial?
 No set test
 IRS Rulings: figure <15% of organization resources
What if the Activity is Unrelated ?
Again, the organization may engage in the activity, without
jeopardizing its tax exemption, as long as the activity is not
more than an insubstantial part of the organization’s overall
The organization may have to pay unrelated business
income tax (UBIT) on profits from the activities
The organization may want to consider establishing a
subsidiary corporation for the unrelated activities (see later)
2) No Private Benefit
>> Basic Rules
No profit sharing
No special perks for Board Members or Staff
Private benefit can only be INCIDENTAL to accomplishing the exempt purpose -- e.g., non profit
hospitals, Oregon Public House
>> Can Tax Exempt Orgs Do Commercial Activities?
Primary purpose needs to be exempt
IRS Inquiry:
Does it operate like and compete with commercial businesses ?
Does it have a “donative element” ?
Fees/prices charged -- Below cost for members of “charitable class”?
Is it a reasonable scale ? -- no larger than necessary for charitable purpose
3) Assets are Permanently
Dedicated to Exempt Purposes
Who owns the non-profit?
Sales of assets or services = at fair market value
unless providing to a charitable class, e.g., lowincome folks
If close down, have to donate to another tax
exempt organization
Need to get approval from Attorney General
4) No Advocacy for/against a
Candidate or Legislation
Any level of political activity will increase likelihood of 1023 rejection or IRS audit
Section 501(c)(3) organizations are prohibited from directly or indirectly participating
in, or intervening in, any political campaign on behalf of (or in opposition to) any
candidate running for public office. The prohibition applies to all campaigns (federal,
state and local level)
inviting a political candidate to make a campaign speech at an event hosted by the
using the organization's funds to publish materials that support (or oppose) a candidate
donating money from the organization to a political candidate
any statements by the organization's executive director, in his or her official capacity, that
support a candidate
Lobbying is separate from political activity
Not-mention to limit free speech
Section 501(c)(3) organizations may engage in some activities to promote voter
registration, encourage voter participation, and provide voter education
II. Getting Into the Game:
How to Obtain Tax Exempt
Options for Obtaining Tax-Exempt Status
1 - Set up a Fiscal Sponsorship Arrangement with
an Existing Tax Exempt Non-Profit
2 - Form a Non-Profit Corporation and Apply to the
IRS for Recognition
Option 1: Fiscal Sponsorship
Many non-profit organizations are not themselves tax exempt:
instead, they affiliate with an existing tax-exempt organization
The non-profit organization doesn’t have to be incorporated
The non-profit DOES have to further the sponsor’s exempt purposes
Requires a written fiscal sponsorship agreement
Fees normally based on revenues
How it works:
1. Non-exempt non-profit
arranges a grant or
2. Grantor Donor pays the
$$ to the Sponsor on nonexempt’s behalf
3. If giving the $$ to the nonexempt would further the
Sponsor’s purposes, then the
Sponsor grants the $$ to the
non-exempt organization.
5. Sponsor reports the $$
on its tax return (nonexempt doesn’t file a
4. Sponsor has discretion
NOT to grant the $$ (can’t
just be a conduit)
6. Sponsor may provide
other supportive services
to non-exempt (e.g.,
Option 2: Forming a Tax Exempt
Non-Profit Organization in CA
Form the Legal Entity – Usually a Corporation
File Articles of Incorporation with Sec. of State -$30
Must contain “magic” language for 501(c)(3) exemption
- Convene the first meeting of the Board
Board approves Bylaws to govern the Corporation
Additional filings: Secretary of State, Attorney General
Charities Bureau, State tax exemption form
Apply for Federal Tax Exempt Status…
Guidelines for Non-Profit Articles
Government Required:
Other Provisions:
 Limitation on Damages
Boilerplate language
 Decision regarding membership
Specific description of Purposes
 Limiting Corporate Existence
Contact for service of process
IRS Boilerplate
 Creating Special Board
Quorum/Voting Requirements
“No activities not permitted”
“No private inurement”
“No campaigning”
Dissolution language
Signed by Incorporator
 Initial Directors
 Indemnification Language
IRS Application and Process
For Finding Forms and Doing Research:
IRS website:
Publication 557
Form 1023 and Form 1023 EZ Instructions
If filed Within 27 months of incorporation:
- Tax Exempt Status will go back to date of
If filed Late
- Tax Exempt Status starts as of Application Filing
$850 usually, 400 if low-income Organization
IRS Forms: 1023 or 1023 EZ
Any organization may use IRS Form 1023 to apply for exemption from
federal income tax under section 501(c)(3)
Some organizations can use a streamlined version, IRS Form 1023
- Eligibility to use 1023 EZ depends on certain criteria:
The organization projects that annual gross receipts over the next three
years will not exceed $50,000
Annual gross receipts have not exceeded $50,000 in any of the past three
Total assets of the organization do not exceed $250,000
The organization is not formed under the laws of a foreign country
The organization is not organized as an LLC
The organization is not a successor of a for-profit entity
… and other critieria found in the Form 1023 EZ-Eligibility Worksheet
IRS Form 1023 EZ
Identification information
Check the box regarding:
Organizational Structure
Corporation, Unincorporated Association, Trust
Date of formation
Organizing Document with “magic” language
Specific activities
Charity v. Foundation
Organizing Document
The Full Application: IRS Form 1023
Identifying information
Narrative Description of Purposes and Activities
Description and Assurances (Checkboxes & Extra Info. Needed)
Attachments for certain programs: churches, child care, grant
Appendices – Attach Organization’s Articles and Bylaws
When Applying, Good to Know the IRS’
Preferences & “Sensitive” Areas
26 USC 501c3: The CATEGORIES of Exempt
Regulations: 26 CFR.. (Says More about the
Publication 557 (Categories, and IRS Expectations for
Exempt Organizations)
> Do EXTRA research with any of the “Sensitive” Areas;
possibly wise to have an attorney draft the application
IRS “Sensitive Areas”:
Need to Research & Describe
Activities CAREFULLY
Private Benefit
E.g., Economic Development
Leadership Conflicts of Interest
Self Dealing
3rd Party Influence on Decisionmaking
Commercial Activity
Primary Purpose Must be Non Profit
Unrelated Business Activity
Activities in Foreign Countries
Fiscal oversight required
= Application Could Go on “THIRD” Pile (12 mo+
Planning Tips
IRS is backlogged with 1023 applications
Consideration of a full Form 1023 application can take
several months to a year
In the meantime, you can seek a fiscal sponsor, or seek
donations based on your application status (can be
May cause difficulty obtaining donations prior to an
IRS response, especially in the latter part of the year
III. Playing Well with Others:
Collaborating with Other NonProfits and For-Profits
Options for Non-Profit/For-Profit Affiliations
1. Contracting
2.Forming a subsidiary
3. Forming a Joint Venture
Tax Exempt Organizations can enter into written
agreements with for-profits for the sale of services or
- e.g., a contract for custodial services
Agreements have to be “arms-length”
- Tax Exempt Org. must get reasonable value for
its services/assets
The Mozilla case
Benefits from Forming a Subsidiary
Allows tax exempt organization to:
Protect its tax-exempt status by parking
unrelated/commercial activities in Sub
Insulate itself from liability associated with these
Obtain financing from conventional sources
Attract staff and board members with business
experience (with competitive wages)
Earn dividends (profits) tax-free from the subsidiary
Process: Establishing a Subsidiary
File Articles
File articles of
for for-profit
corporation with
Secretary of
In CA,
Convene first
meeting of
Board of
Adoption of
By Law
Board of
Issue of
Issue shares
in exchange
for value
(Non-p pays
File Limited
File limited share
offering form with
Dept. of
The Tax Exempt Org and the Subsidiary each must have their own
Boards of Directors, with separate meetings, minutes, accounts, books
and records
There can be overlap but the Boards shouldn’t be the same
The Tax Exempt Org is not involved in the day to day management of
the Subsidiary
Both Tax Exempt Org and Sub Must
Observe Corporate Formalities
As majority shareholder, it appoints and removes directors
Transactions between the Tax Exempt Org and Subsidiary should be
documented and on market terms
Agreements for space and services are common
Private Benefit/Inurement Issues
The Tax Exempt Org cannot provide anything to the
subsidiary at less than market value.
-- Need to avoid private benefit
Directors, officers, managers and other persons with
substantial influence over the Tax Exempt Org cannot
engage in ‘excess benefit transactions’ with the
Need to avoid private inurement
Joint Ventures
The IRS applies a two-part test to joint ventures with for-profits:
1) Does the overall
purpose of the
venture further the
tax exempt org’s
2) Do the terms of the JV
agreement allow the
exempt organization to act
exclusively in furtherance of
its exempt purposes, and
provide no more than
incidental private benefit to
its for profit partner?(See
Rev. Rul. 98-15)
The second part requires a showing that the tax exempt org. has sufficient
control over the overall operations of the venture. The exempt org must play
an active role in the venture’s management and generally have majority voting
power as to the use of the JV’s assets
- The IRS will want to review a written JV agreement.
Additional Resources
NOLO Press has a number of excellent, layfriendly legal resource books – recommended!
Additional Questions? Contact Us:
New Business Practicum
[email protected], 510-642-4050

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