Nonprofit FAQs – Getting To Tax-Exemption

So let’s talk nonprofits. We probably all know that nonprofit status gives an organization certain perks. But you may be asking yourself, “hmmm, exactly how do they get these perks?” as you stroke your chin, readjust your monocle, and look pensively into the sky. Well old sport, we have some answers to that general question, and here they are:

1. What benefits do 501(c)(3) organizations and their donors enjoy?

The most obvious benefit for 501(c)(3) organizations is most likely the reason you are interested in starting one in the first place – exemption from state and federal taxes. On the other side of the checkbook, donors may write off contributions to 501(c)(3) organizations as tax deductions, and, because everyone loves a lower tax bill, this often incentivizes people to donate. Note, however, that there are limits to how much is “write-offable” for the donor (yes, that’s the actual legal term the IRS uses…not really though).

Additional benefits as a 501(c)(3) organization:

  • Exempt from property and sales and use taxes;
  • May apply for grants and other public or private allocations available only to IRS-recognized 501(c)(3) organizations;
  • Potentially higher thresholds before incurring federal and/or state unemployment tax liabilities;
  • The public legitimacy of IRS recognition;
  • Discounts on US Postal bulk-mail rates and other services.

2. What are the basic steps needed to fully form a 501(c)(3) organization?

  1. Draft and file the articles of incorporation with the state;
  2. Appoint a board of directors (note: CA requires that no more than 49% of the directors be “interested persons,” which includes anyone being paid by the organization, and anyone closely related to another director);
  3. Draft bylaws and a conflict of interest policy;
  4. Obtain an employer identification number (EIN);
  5. Hold an initial board meeting and record the basic initial board actions, which include:
    1. Adoption of bylaws and conflict of interest policy;
    2. Election of officers;
    3. Adoption of a fiscal year for the organization (generally Jan. 1st – Dec. 31st);
    4. Approving the opening of a bank account for the organization;
    5. Approving the filing of the required form to receive federal tax exemption (the big one);
    6. Approving the officer’s and other employee’s compensation (if any);
  6. File a Statement of Information (Form SI-100) with the Secretary of State (CA only);
  7. Apply (or have your lawyers apply) for tax exempt status (Form 1023) with the IRS;
  8. Receive your tax-exempt status determination letter from the IRS.
  9. Purchase and consumer Champagne.
  10. File the initial registration form (Form CT-1) with the California Attorney General’s Registry of Charitable Trusts;
  11. Apply for California Tax exemption with the California Franchise Tax Board (FTB).

3. Do we need our board of directors in place before we file paperwork?

The short answer is, “yes”. You need an initial board in place because the directors are legally accountable for the organization’s actions. However, some board positions may be filled after you’ve filed the IRS paperwork.

4. What paperwork needs to be filed with the state? 

Nonprofits must be incorporated at the state level by preparing and filing a formation document known as the “Articles of Incorporation”—usually through the state’s Secretary of State, or Corporations division.

Most states make this step relatively easy because they provide boilerplate articles of incorporation templates. However, it is crucial to point out, that not all of these templates meet the IRS’s requirements for obtaining 501(c) status. We would be happy to assist you in meeting these requirements.

5. What paperwork needs to be filed with the federal government?

After incorporating at the state level, budding nonprofits must file Form 1023 with the IRS and await approval in order to become a 501(c)(3), tax-exempt entity.

Form 1023 is a 29-page, comprehensive look at an organization’s structure, programs, and financial projections. The questions can be quite probing and complicated, mainly because the IRS wants to determine which new nonprofits have a high risk of being used as tax avoidance vehicles. Once completed, most Form 1023 filings range between 50-100 pages of information due to the number of additional schedules, attachments and exhibits that the application often requires.

6. Within what time period does the federal paperwork need to be filed?

The sooner the better—but at the very least within 27 months of incorporation. An organization can only obtain “tax exempt” status at both the state and federal levels by filing this federal paperwork. The IRS will backdate the effective date of tax exemption to the date the first board meeting was held if the organization files within the 27 month window and is ultimately successful in obtaining a tax-exempt determination. This is important because otherwise any income and donations to the nonprofit would be fully taxable during this interim period. While the IRS may extend the retroactive tax exempt time period beyond 27 months, the organization must qualify under several specific requirements you can learn about here. Retroactive, tax-exempt recognition after 27 months of incorporation is rare.

7. What are the filing fees?

There is a $30 filing fee for filing Articles of Incorporation with the state of California.

The IRS has a two-tiered filing fee structure. Most organizations pay the standard $850 filing fee when sending their application to the IRS. Organizations that expect to have (or have had) no more than $50,000 in gross revenue each year for the first three years can pay a reduced filing fee of $400.

8. How long does it take to complete the paperwork?

Given the breadth of the Form 1023 application, a typical application package is between 50-100 pages of material once completed. More important, however, is the amount of time required to complete the package. The IRS estimates it would take a novice well over 100 hours to prepare Form 1023.

9. How long does it take the IRS to approve 501(c)(3) status?

Typically, IRS 501(c)(3) approval takes between 2 and 12 months, inclusive of likely written follow-up questions from the examing IRS agent. Sometimes the wait is shorter, sometimes longer.

10. Can anyone complete the paperwork?

Technically, anyone can complete Form 1023. From a practical standpoint, it is usually advisable to enlist the help of a professional who specializes in the process. While the IRS rejects slightly less than 10% of applications filed, nearly half are abandoned by the filer, usually out of frustration or inability to answer tough, IRS follow-up questions.

Out of approximately 80,000 applications filed annually, less than half make it through the whole process.

11. What information is requested in the application?

In order for the IRS to make a determination, the entity must answer pages of detailed questions about the organization’s activities as well as specific questions about its legal structure, governing board and potential conflicts of interest. This is in addition to a two-year financial projection (for new organizations) or three years of financial history (for existing organizations), and a written narrative essay outlining the organization’s programs, both current and planned, which will advance the organization’s exempt purpose. Add to that copies of supporting schedules and documentation and you have a basic application package.

12. Will my personal financial situation have any bearing on my nonprofit receiving 501(c)(3) status?

No. There is no direct correlation between the organization and the financial, tax, or credit status of any officer, director or employee.

13. Can I start receiving contributions before my application is approved?

Generally, yes. IRS 501(c)(3) recognition is (usually) effective retroactively to the earlier of 1) the organization’s legal formation or 2) the commencement of its programs. This means that the organization’s activities are retroactively tax-exempt, and donations are retroactively tax-deductible to the donor, extending even to prior tax years. However, in order to claim deductions for donations to pending nonprofits, donors may need to file an amended return.

In order for the program-commencement date to be considered the effective date of tax-exemption there must be an organizing document of some kind. Signed minutes from an initial organizing meeting of the board of directors may be sufficient. Under certain circumstances IRS tax-exemption may only be retroactive to the date of the filing of Form 1023. This is particularly true for organizations that were formed more than 27 months before applying for 501(c)(3) status.

14. Can I apply for grants before my application is approved?

Yes, but don’t expect much success. Most foundations, government agencies, and other potential sources of funding will require an organization to provide their tax-exempt determination letter before even considering making a grant.

15. What happens if my nonprofit’s application for 501(c)(3) status is denied?

A denial by the IRS of 501(c)(3) status, known as an adverse determination, is a very difficult situation. An adverse determination can be appealed, but it is an enormous undertaking absolutely requiring professional representation. Alternatively, the organization may choose to apply again from scratch. In either case, it is usually an uphill battle to acquire 501(c)(3) recognition once the IRS rejects an organization’s initial application. All the more reason to consider acquiring competent assistance at the beginning of the process.

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Photo Credit:  Ashley Gutierrez