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

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• 1. Choose Whether or Not to Incorporate
• 2. Select the Board of Directors
• 3. Determine the Nonprofit’s Exempt Purpose
• 4. Create Your Business Plan and Assess Conflicts of Interest
• 5. Find an Attorney with Experience Helping Nonprofit Organizations

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

1. Choose Whether or Not to Incorporate

“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, where he practices. “An unincorporated nonprofit association actually offers limited liability protection to its members, like a corporation.”

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.”

2. Select the Board of Directors

Another step to take prior to the 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.”

3. Determine the Nonprofit’s Exempt Purpose

Another crucial step in starting a nonprofit is to determine which one of the eight exempt purposes under the IRS code the nonprofit will perform (such as a charitable organization).

“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.”

4. Create Your Business Plan and Assess Conflicts of Interest

Takagi also recommends nonprofit organizers spend the necessary time creating a business plan for the tax-exempt organization prior to applying “to help facilitate 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.

5. Find an Attorney with Experience Helping Nonprofit Organizations

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 nonprofit attorney early in the process.

For additional information on types of organizations, see our business organization overview and related content on tax law.