Nonprofit organizations provide a wide variety of important social services to the people of Texas. But starting a nonprofit can be quite complicated, especially if you are unfamiliar with tax and corporation laws. In particular, nonprofit businesses need to understand how different state and federal laws affect their structure.
What Is a 501(c)(3) Organization?
The Internal Revenue Code classifies a broad range of businesses and entities as “tax-exempt.” But when most people think of a nonprofit or a charity, they are referring to one specific type of tax-exempt entity: a Section 501(c)(3) organization. These entities are not only exempt from paying income taxes, but contributions received are tax-deductible on each individual donor’s income tax return.
A nonprofit corporation or other entity may seek 501(c)(3) status if it exists for “religious, charitable, scientific, literary, or educational” purposes. In this context, the term “nonprofit” means that none of the corporation’s net earnings will “inure” or be paid out to any private interests, such as shareholders or individuals who do not actually perform services for the organization. In addition, a 501(c)(3) cannot engage in “substantial” political activities, e.g. support candidates for public office.
Filing a Certificate of Organization
Technically, a nonprofit organization does not have to incorporate to receive 501(c)(3) status, but most do. The process of forming a nonprofit corporation is similar to that of a regular business corporation. It begins with an individual–known as an “organizer”–filing a “Certificate of Formation” with the Texas Secretary of State.
The Certificate contains some basic information such as the corporation’s legal name, its purposes, and the name and address of the organizer. The Certificate must also state if the nonprofit corporation will be managed by a board of directors–which is the norm–or by members. Texas requires a nonprofit corporation to have at least three directors, but they do not have to be residents of the state. However, all corporations must have a registered agent–either an individual who lives in Texas or another entity registered to do business in the state–to receive any legal papers served on the corporation.
Seeking Tax-Exempt Status
501(c)(3) status is not automatic. Forming a nonprofit corporation is just the first step. The new corporation must then file an application with the IRS, known as Form 1023, for tax-exempt status. The IRS will require a significant amount of detail about the nonprofit corporation’s operations (or proposed operations). The IRS will need to see corporate bylaws and other internal governing documents, as well as any financial statements. It may take several months–and responding to multiple requests for additional information–before the IRS grants tax-exempt status.
Separately, the nonprofit corporation needs to seek state tax-exempt status from the Texas Comptroller of Public Accounts. Many 501(c)(3) nonprofits are also eligible for local property tax exemptions.
“Typically, most nonprofits also have to register with the comptroller for purposes of getting their franchise and sales tax exemptions,” says Danika H. Mendrygal
, a business attorney
at Mendrygal Law in Dallas. “You can file that IRS determination letter—that shows your 501(c)(3) status—with the Texas comptroller in lieu of filing a complete application for exemption.
“Although it isn’t a guarantee, as a practical matter, I’ve never had one not approved with respect to an exemption from Texas franchise and sales taxes.”