The Best Way To Start a Nonprofit

Nonprofit organizations provide a wide variety of important social services. But starting a nonprofit can be quite complicated, especially if you’re unfamiliar with tax and corporation laws. In particular, nonprofit businesses need to understand how different state and federal laws affect their structure.

States and the Internal Revenue Service (IRS) highly regulate different types of nonprofit organizations. Failure to follow nonprofit compliance could result in severe tax penalties. Before starting a nonprofit, talk to a local nonprofit organization lawyer about the legal requirements in your state.

Legal Challenges of Setting Up a Nonprofit

For starters, as Park Ridge, Illinois, attorney Jessica M. Wojtowicz Heston succinctly puts it: “Call an attorney.”

“State laws have all sorts of rules that you need to know,” adds Jack Bierig, an attorney at ArentFox Schiff in Chicago who also advises nonprofits. “Unless you have a lawyer who really understands the rules, it’s easy to mess up.”

“Typically, most nonprofits also have to register with their state 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 showing your 501(c)(3) status with the state 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 franchise and sales state taxes.”

Nonprofits Present Obligations Like Any Corporation

“A nonprofit corporation is still a corporation,” says Sandy Tarrant, clinical faculty member at Boston College Law School. “There are no shareholders, but there are directors with fiduciary duties who need to follow and observe corporate formalities, hold board meetings, and review and follow the bylaws.”

At a minimum, your nonprofit board of directors must include a president, a treasurer, and a clerk. But too many cooks in the kitchen can make it hard to get things done.

“You probably don’t want to have 30 people on your board of directors. It’s just a little unwieldy,” says Jane Freedman, a business and corporate attorney in Wellesley Hills, Massachusetts. It’s also wise to create a conflict-of-interest policy to protect voting board members and the organization.

Are Nonprofits Automatically Tax Exempt?

Most nonprofits are not automatically tax-exempt organizations. There’s a legal process involved to claim tax exemption.

In fact, Tarrant says that the biggest mistake nonprofit newbies make is not realizing that incorporation and tax-exempt status are two different things. “You could form a nonprofit corporation, but if you never obtain federal tax-exempt status for it, it will not be tax exempt. It will be a taxable entity, just a nonprofit one.”

And don’t ask for donations until you receive the determination letter from the IRS. “You don’t want a donor to write you a check, and you have to then go back to them and tell them, ‘Don’t file that on your tax return as a deduction because we didn’t get our exemption yet,'” Tarrant says.

Filing for Tax-Exempt Status

To file for a federal tax exemption, be ready to answer a lot of questions about how you spend nonprofit funds, including salaries. You must file applications online, and the review generally takes several months.

“Some of the requirements for tax-exempt status are things you should have filed at the state level, but the state doesn’t require you to do it,” says David A. Wilson, who practices nonprofit law in Douglasville, Georgia. “You’ll file your nonprofit articles of incorporation at the state, go to the IRS, and they’ll send you back to the state. That costs you time and money. If you don’t know both sides, you’re going to get bounced back and forth like a Ping-Pong ball.”

How Does a Nonprofit Become Eligible for Tax-Exempt Status?

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 exempt from paying income taxes. In addition, 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, such as supporting candidates for public office.

At the end of the day, it is a lot like setting up a for-profit company, says Freedman. “You’ve got a lot of the same concerns, starting with: How are you going to operate it from a financial perspective? Do you have a business plan? How are you going to raise money?”

How Should I Form My New Nonprofit?

When clients wishing to start a nonprofit come to Jack Sawyer’s office at Taylor Duma in Atlanta, he first talks about nomenclature. “There is some confusion in the public mind about the term nonprofit,” he says. “It’s really a state law concept.”

Even after opting to incorporate under, say, a 501(c)(3) designation, a new organization faces additional questions. Should you form it as a public charity, such as Habitat for Humanity, with outside donors supporting initiatives? Or do you go with a private foundation, with a single individual or business as the benefactor?

Once your nonprofit is established, Sawyer notes, there are “care and feeding aspects” to attend to. “Though a charitable organization is exempt from income tax, it’s not exempt from filing tax returns,” he says. “The IRS, a few years back, decided to start automatically revoking an organization’s tax-exempt status if it failed to file tax returns.”

In the same vein, Georgia requires nonprofits to file forms annually with the Georgia Secretary of State. “If you fail to [file the annual report] for a number of years, in many cases, the state would revoke your status as an active corporation,” Sawyer says.

Alternatives to a Forming a New Nonprofit

Before you take the plunge, determine whether you really need to establish your own organization. Is your goal to fill an ongoing gap in existing organizations or to host a one-time fundraiser? If it’s the latter, it might make more sense to join forces with an existing group.

Tarrant gives the example of parents who want to give back to the health care facility that treated their sick child. “If they’re really looking to raise money to support the hospital or the particular doctor or practice, there are usually much easier ways to do that,” she says. “You could work with the development office to host a fundraising event, either on a regular basis or one time. You could associate with another charity.”

Those who still want to forge ahead will need to incorporate by filing the proper documents through the Secretary of State’s office.

What Legal Issues Should I Anticipate With Nonprofit Leadership?

Wilson works with founders, many of whom come from the corporate world, to help them understand the nonprofit nuances. “I’m really talking to them about their relationship with the organization,” he says. “There [can be] a sense of entitlement or ownership within their organization.”

Being a founder or writing the mission statement at a nonprofit doesn’t guarantee a lifelong leadership role. “There are things that can affect the donors and the health of the organization,” Wilson says. For example, “you can be removed, or you can lose your tax-exempt status by not acting properly.”

Wilson has seen problems among small churches when operations become too entwined with a particular pastor or generate conflicts of interest. “There are some things that can go sideways inside of churches because they’re more reliant on individuals as opposed to pure philanthropic or charitable deeds,” he says.

The Danger of Privately Benefiting from Your Nonprofit

Private inurement, or arrangements that unduly benefit private parties or interests, can be devastating. “For example,” says Bierig, “if you pay your CEO too much, then you have engaged in private inurement, and [if the nonprofit is a 501(c)(3)], you can actually lose your tax-exempt status.”

“You can’t benefit people that you’re related to unless you’re offering the same types of benefits to the public,” says Jeffrey D. Moss, an attorney at Dawda in Bloomfield Hills, Michigan. “Like, I can’t open the Jeff Moss Scholarship Fund and only give scholarships to my kids,” he says.

Legally Review Nonprofit Fundraising Partnerships

Along similar lines, partnerships with professional fundraisers should be undertaken judiciously. “If you have arrangements with professional fundraisers, they should be looked at by an attorney to make sure the compensation is consistent with IRS guidelines,” says Kim Boike, an attorney with Chuhak & Tecson.

“You always want it to be a written agreement and not a handshake. And if you’re going to explore any percentage-based compensation with a fundraising professional, that should be looked at very closely.”

Set Your Nonprofit Up for Success With Legal Help

Although it’s possible to set up a nonprofit without legal assistance, it can be tricky. “The template IRS forms are supposedly designed to be user-friendly and able to be completed without an attorney,” says Freedman. “However, I find that at times I need to do a deeper dive into the tax regulations and forms. Sometimes clients who try to DIY get themselves into a pickle when their documents are not as clean as they should be.”

Freedman also advises clients to hire an accountant who is familiar with nonprofits. “Keeping really good financial reports and tax records is a big piece of compliance,” she says.

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