Starting a nonprofit organization can be deeply rewarding, not only for its founders but also for society at large. However, just like starting a for-profit company, forming a nonprofit demands careful planning and due diligence. Counsel for nonprofit founders must not only establish the entity under applicable state law but also structure the organization and its governing documents to support the client’s intended activities and, where applicable, qualify for federal and state corporate tax exemption. This article will attempt to demystify the formation process and provide an overview of the steps involved in creating a nonprofit corporation, from incorporation to obtaining an EIN, drafting corporate documents, and applying for recognition of federal tax-exempt status.
Nonprofits come in all shapes and sizes and can be formed in any state, the District of Columbia (“DC”), and all territories of the United States. For the sake of brevity, this article will focus primarily on the process of forming a DC nonprofit corporation, though the incorporation process is similar in most other jurisdictions.
1. Identify the Nonprofit’s Mission and Organizational Structure
Before preparing the nonprofit’s initial corporate documents, counsel should work with the client to identify the nonprofit’s proposed activities, anticipated funding sources, governance structure, and intended federal tax-exempt classification. At a minimum, counsel should understand the following:
- what activities the nonprofit will conduct
- who will benefit from those activities
- where the nonprofit will operate
- how the nonprofit will be funded
- whether the nonprofit will have statutory members (i.e., individuals or entities who have some level of control and voting power within the nonprofit, such as electing the nonprofit’s directors and officers or the ability to approve a merger or dissolution)
- whether the nonprofit will solicit contributions from the public
- whether the nonprofit will charge for goods or services
These are not merely business planning considerations. They directly inform the nonprofit’s appropriate entity structure, type of federal tax exemption, state and local tax obligations, licensing requirements, and charitable solicitation registration requirements. I recommend advising the client to develop a comprehensive business plan that covers the above and other information about the nonprofit, its business, and finances. Doing this work early on can save a lot of time and expense later in the formation process.
Additionally, counsel should discuss the composition of the nonprofit’s initial board of directors with the client. A nonprofit corporation should have at least three directors (but preferably five or more) who will manage and oversee the nonprofit’s affairs. In many jurisdictions, the initial directors must be listed in the nonprofit’s articles of incorporation (more on articles of incorporation below), so it’s important to identify the initial directors as early in the process as possible. At this time, the client also should be thinking about who will serve as the nonprofit’s initial corporate officers (e.g., president, secretary, treasurer). The officers are charged with carrying out the nonprofit’s day-to-day activities, so those individuals should be genuinely and enthusiastically dedicated to the nonprofit’s mission.
2. Prepare and File Articles of Incorporation, and Obtain an EIN
After those preliminary items are nailed down, the next step is to prepare and file the articles of incorporation. Articles of incorporation state the name of the nonprofit, its initial directors, its office address, its registered agent information, whether the corporation will have statutory members, and other basic information. To qualify for federal tax exemption, some nonprofits also must include certain IRS-required language in their articles of incorporation. For example, a nonprofit that is organized as a 501(c)(3) entity must include a purposes clause and a dissolution clause that complies with the federal Internal Revenue Code’s (and corresponding U.S. Treasury Regulations’) requirements. The articles of incorporation become public record once they are accepted by the jurisdiction of incorporation, so I generally recommend keeping them brief and concise, only disclosing the information required by law and needed to qualify for recognition of federal tax exemption.
Once the articles of incorporation have been drafted, they must be submitted, along with a state filing fee, to the corporation regulator in the jurisdiction of incorporation. In DC, that is the DC Department of Licensing and Consumer Protection. When the articles of incorporation are approved, the DC Department of Licensing and Consumer Protection (or other applicable corporation regulator) will issue a certificate of incorporation recognizing the nonprofit as an officially formed corporation. Some states also have a publication requirement, whereby the nonprofit must publish certain information ora copy of the articles of incorporation in a newspaper of regular circulation in the jurisdiction of incorporation. Be sure to reference the relevant jurisdiction’s nonprofit corporation statutes to determine all requirements for incorporation.
Immediately following incorporation, counsel should obtain a federal employer identification number (“EIN”) from the IRS on the nonprofit’s behalf. This can be done by filing an application (called the IRS Form SS-4) online, which usually takes ten to twenty minutes to complete. The nonprofit’s EIN serves as its tax identifier with the IRS and is required to open a bank account in the nonprofit’s name, register for state-level taxes, and apply for recognition of federal tax-exempt status, among other things, so it is important to obtain an EIN early in the formation process.
At this time, if the nonprofit intends to operate as a 501(c)(4) organization, counsel should prepare and file an IRS Form 8976 to notify the IRS that the nonprofit will operate as a 501(c)(4) entity. Note that this filing must be made within sixty days of the nonprofit’s incorporation or financial penalties may apply.
3. Draft Bylaws, Policies, and Organizational Meeting Documents
After incorporation, counsel should prepare bylaws and governance policies for the nonprofit.
The bylaws describe in detail the nonprofit’s internal structure and operating procedures. This includes rules relating to director and officer elections and removals, meetings, board committees and membership, and other matters related to the conduct of the nonprofit’s business and affairs. Counsel should ensure that the bylaws are consistent with the articles of incorporation and the relevant jurisdiction’s nonprofit corporation statutes.
A set of governance policies also should be prepared. An effective set of governance policies enables the nonprofit to follow best practices and comply with applicable laws and regulations while providing clear guidance for navigating typical nonprofit transactions. Standard governance policies include confidentiality, anti-discrimination and harassment, joint venture, whistleblower protection, executive compensation, and conflict of interest policies. Certain nonprofits may require additional policies based on their planned activities, such as a scholarship policy for a nonprofit that will operate a scholarship program or a foreign transactions due diligence policy for a nonprofit that will provide foreign aid or otherwise transfer goods or funds across borders.
Many jurisdictions, including DC, require that the board of directors hold an initial board meeting after incorporation. The first board meeting is called the “organizational meeting.” At the organizational meeting, the board will adopt the bylaws and policies and take care of other initial housekeeping matters and corporate formalities, such as adopting a fiscal year, electing officers, authorizing the opening of a bank account, and ratifying any corporate acts taken prior to the meeting. Often this will be done via unanimous written consent—a document stating the relevant corporate resolutions and signed by all directors—in lieu of holding a meeting. Counsel should prepare draft sample organizational meeting minutes or a unanimous written consent to guide the client through its first board actions.
4. Apply for Recognition of Federal Tax-Exempt Status
Once the nonprofit is incorporated, has adopted bylaws and governance policies, and has held its organizational meeting, the next step is to prepare and file a federal tax exemption application. There are four federal tax exemption applications: IRS Form 1023, IRS Form 1023-EZ, IRS Form 1024, and IRS Form 1024-A. The appropriate application depends on the (anticipated) size of the nonprofit and type of federal tax exemption sought. For example, the IRS Form 1024-A is used to apply for recognition of 501(c)(4) status, while the IRS Form 1023 is used to apply for recognition of 501(c)(3) status. The IRS Form 1023-EZ also is used to apply for recognition of 501(c)(3) status but is reserved for smaller, less complex nonprofits.
The federal tax exemption applications (except for the IRS Form 1023-EZ) are comprehensive and require counsel to explain the nonprofit’s business, finances, and affairs in detail. This includes a detailed description of the nonprofit’s planned activities and financial projections for the first few years of operation. It is important to be as detailed as possible in the federal tax exemption application to maximize the nonprofit’s chances of approval and minimize the chances of questions and requests for additional information.
The federal tax exemption application is filed, along with a mandatory user fee, online with the IRS. While it is hard to gauge exactly how long it will take the IRS to process and approve an application, currently, the general rule of thumb is to expect to wait six to eight months. When the application is approved, the nonprofit will receive a favorable “determination letter” from the IRS that confirms the recognition of its tax-exempt status. While the application is pending, the nonprofit may begin operating, but it is important to remind the client that it must be clear with the public, and especially potential donors, that the nonprofit’s federal tax exemption application is pending with the IRS and, for would-be 501(c)(3) organizations, that donations are not yet tax deductible as charitable contributions. If the application is filed within twenty-seven months of the nonprofit’s incorporation, when the IRS does approve the nonprofit’s application, it will recognize the nonprofit’s exemption retroactively to the date the nonprofit was incorporated, and charitable contributions made to the nonprofit prior to receiving its determination letter then become tax deductible for the donor.
5. Register for DC Taxes and Apply for a Basic Business License and for Charitable Solicitation Purposes, if Necessary
As a corporation, the nonprofit is subject to state and local taxes. Each jurisdiction has different taxes (e.g., income, franchise, sales, use, real and personal property) and tax reporting requirements. In DC, if the nonprofit has employees, it will need to withhold DC-level income tax from wages, consistent with current DC withholding requirements. Generally, the nonprofit must register with the relevant tax authorities in each jurisdiction where it is conducting business or has employees (including remote employees). In DC, corporations must register as a new business with the DC Office of Tax and Revenue (“DC OTR”). To register as a new business, the nonprofit must complete and file Form FR-500 with the DC OTR.
It is important to remember, and to remind the client, that federal tax exemption does not necessarily provide exemption from state and local taxes. Each jurisdiction has different rules for qualifying for, applying for, and maintaining state and local tax exemptions. In many cases, state and local tax exemption is available only after the IRS has issued a favorable determination letter. In DC, certain 501(c)(3) organizations may qualify for exemption from DC’s income and franchise, sales and use, and personal property taxes. To apply for these tax exemptions, counsel should prepare and file Form FR-164 with the DC OTR.
In DC, any entity that provides goods or services for compensation must obtain a Basic Business License from the DC Department of Licensing and Consumer Protection. Accordingly, if the nonprofit’s activities include the sale of goods or services (even at a discounted rate), the nonprofit will need to obtain a Basic Business License.
Finally, most jurisdictions require charitable organizations to register with the appropriate state authority (typically, the state attorney general’s office) if the nonprofit will solicit donations from individuals or businesses located within that jurisdiction. The purpose of these “charitable solicitation registrations” is to protect the public from deceptive or misleading fundraising activities. In DC, charitable organizations intending to solicit donations must apply for a Basic Business License with the DC Department of Licensing and Consumer Protection under the “Charitable Solicitation” category. To maintain its charitable solicitation registration, the nonprofit must file annual reports, which typically include a copy of the nonprofit’s most recently filed IRS Form 990 (annual information return). The definition of “solicitation” varies with each jurisdiction. In several states, simply having a “donate” button on the nonprofit’s website may trigger registration, depending on the circumstances. Counsel should determine if and where the nonprofit must register before the client begins soliciting contributions. The rules and requirements applicable to charitable solicitations vary by jurisdiction, and counsel should not assume that registration is required only where the nonprofit is incorporated or maintains a physical office. Many third-party corporate compliance vendors offer charitable solicitation registration services to nonprofits, so if you are unsure of the requirements in any jurisdiction, the safest option is to refer the client to one of those vendors.
Conclusion
For business attorneys, nonprofit formations should be viewed as more than merely an entity formation exercise. Effective counsel weighs the business considerations against potential risks to ensure that the nonprofit is structured in such a way to accomplish the nonprofit’s mission under the client’s desired structure while qualifying for federal (and, if desired, state) corporate income tax exemption. Each step of the formation process is interconnected. Decisions made at the outset can affect the organization’s governance, fundraising activities, eligibility for tax exemption, and corporate compliance obligations for years to come.
For attorneys who do not regularly handle nonprofit matters, engaging nonprofit counsel—or obtaining specialized advice on nonprofit tax, governance, and charitable solicitation issues—can be particularly valuable where the client’s activities, funding arrangements, or intended tax-exempt classification raise issues beyond routine corporate formation.
For more information, contact the author at [email protected].