Steps to Take Before a Nonprofit Applies for Tax-Exempt Status

Use these links to jump to different sections:

• Incorporate or Not?
• Board of Directors
• Determine the Nonprofit’s Exempt Purpose
• Consider Creation of a Business Plan

For a nonprofit to obtain tax-exempt status from the Internal Revenue Service (IRS) under section 501(c)(3), obviously it must file IRS Form 1023 and await a determination. But there are several significant steps nonprofits must take before the application process, as nonprofit attorney and advisor Gene Takagi explains.

Incorporate or Not?

“You’re going to first have to determine what form of entity you’re going to operate. That entity is the party that is preparing and completing the application so that tax-exempt status will relate to that entity,” says Takagi. Nonprofits are generally limited to choosing between forming as a corporation, an unincorporated association, or a trust. “There are other possibilities, like LLCs, but they are rare and a little bit more complicated.” Takagi says an unincorporated association is itself a legal type of entity in California. “An unincorporated nonprofit association actually offers limited liability protection to its members, like a corporation,” says Takagi. He adds that the protection is “perhaps not as strong,” as the protection a corporation receives. The unincorporated association is not required to file with the California secretary of state’s office. “It could be regarded as a legal entity just by the mere fact of operating as a separate entity apart from its members.”

Board of Directors

Another step to take prior to application stage is for the nonprofit to choose its board of directors. “For California nonprofit public benefit corporations, there is a requirement that a majority of the directors not be compensated by the organization, whether as an employee or contractor,” says Takagi, “or (not be) related to anybody compensated by the organization.” Getting a board that meets that state law requirement is necessary. “California doesn’t have a minimum number of directors required, so one person can be the sole board member of a nonprofit as long as it doesn’t violate that compensation limitation rule,” he adds. At Takagi’s firm, he says, “we generally recommend there be at least three directors on the board if applying for tax exempt status. … That is a general rule and there could be exceptions to that.”

Determine the Nonprofit’s Exempt Purpose

Another crucial step is for the nonprofit to determine which one of the eight exempt purposes under the IRS code the nonprofit will perform. “In filing articles of incorporation (or other governing documents), those articles must have certain language, including a statement of the charitable purpose—or, I should say, 501(c)(3) purpose of the organization,” Takagi says. Nonprofits must choose one or more exempt purposes when applying for tax-exempt status as a nonprofit corporation. Organizations “can keep their purpose broad, which gives it more flexibility,” he adds, “or if you want to give further guidance to your board, your future board members in particular, of what the organization’s mission is, you might include a more specific statement in the articles.”

Consider Creation of a Business Plan

Takagi also recommends nonprofit organizers spend the necessary time creating a business plan for the tax-exempt organization prior to applying, “to help facilitate a timely approval of its application, and to ensure consistent compliance. The application will be easier to file if you have a business plan in place.” Part of the business plan should include a three- to four-year budget to conform with the requirements of IRS Form 1023. Another very important task for your nonprofit’s compliance is for the organization to assess whether it will have any conflict of interest issues. “These can get thorny and must be managed properly,” warns Takagi. “Compensation must be fair,” and the organizers “must have an understanding of potential insider transactions.” Takagi advises that figuring out potential conflicts of interest ahead of time is important. Organizers will be required to explain the organization’s policy on conflicts within the application for exemption. The work in obtaining tax-exempt status clearly begins well before the organization applies for the exemption. Put your nonprofit on better footing for a positive determination from the IRS by sitting down with an experienced northern California nonprofit attorney early in the process. For more information on this area, see our business organizations overview.