Forming and Organizing a Non-profit 501(c)(3) Organization
Forming and Organizing a Non-profit 501(c)(3) Organization
A Section 501(c)(3) public charity corporation, a type of charitable organization, is a tax-exempt non-profit organized under Section 501(c)(3) of the Internal Revenue Code (the “IRC”). A 501(c)(3) public charity corporation is generally the type of organization that people are referring to when discussing non-profits, though the terminology used to refer to charitable corporations may differ between the IRC and state statutes, and even among states themselves. For instance, some states refer to a charitable corporation as either a non-stock corporation, not-for-profit corporation or non-profit public benefit corporation. Most charitable organizations are formed as corporations because the form is familiar.
Initial Considerations
Select the State of Incorporation
Before forming a non-profit, the founder should determine in which state to incorporate. Corporations, both for-profit and non-profit, are governed by the laws of the state of incorporation. These laws may vary across states, including their requirements for:
What must be included in the articles of incorporation.
The fiduciary duties of the corporation's directors.
The available protections against liability for the acts of the non-profit's directors and officers.
The available protections against liability for the acts of volunteers.
While most for-profit corporations elect to incorporate in Delaware because of, among other things, its well-developed body of corporate law, the same considerations generally do not apply to non-profits. Non-profits face additional concerns unique to their status, such as:
Additional costs of applying to do business as a foreign corporation if incorporated in a state other than where it will primarily conduct its charitable activity. Non-profits, particularly new or small non-profits, generally have tight budgets and must continuously be aware of expenditures that are not used directly for their charitable purposes.
Importance to the non-profit's image that it be incorporated in the state where it will mainly conduct its charitable activities.
State-specific charitable solicitation rules associated with seeking donations from the public.
State's immunity and volunteer protection laws. Some non-profits may rely heavily on volunteers to carry out their purpose and many directors serve without compensation on the non-profit's board.
Complexity and burden of other state and local regulations impacting non-profits and the degree to which state and local authorities (such as the attorney general) oversee and police non-profits.
Name Requirements
Before drafting formation documents or making any filings, the founder should select a name for the non-profit. The name may not be deceptively similar to another for-profit or non-profit entity's name that is filed or reserved with the applicable state office. Different states have different naming requirements and prohibitions.
A non-profit qualifying as a public charity may use the term "foundation" in its name. Doing so does not make it a private foundation and jeopardize its classification by the IRS as a public charity if all the other criteria for being a public charity are met (see IRS Form 1023 instructions).
Before filing the incorporation documents, the founder should check with the applicable state office to see if the selected name is available. There are two methods of checking name availability:
Many state websites provide a free online name check function that provides a general sense of the name's availability.
Filing a name availability form with the applicable state office for a fee, which provides a more official confirmation of a name's availability.
It is best practice to check the name availability in each state that the non-profit intends to conduct its charitable activities.
If the non-profit intends to use its name as a trademark, service mark, domain name or trade name, the founder should also consider running a trademark and copyright search to see if the name is currently registered by another business, either for-profit or non-profit. These searches can be conducted for free online with the United States Patent and Trademark Office and the United States Copyright Office.
Conducting a name availability search, whether online or by filing the name availability form, does not reserve the name or guarantee that the name will be approved. Reserving a name is optional, but if a founder opts to reserve a name, it should act quickly to file a name reservation form. This will prevent the name from being taken by another entity while the organizational documents are being prepared and filed with the state.
It is often a good idea, particularly if an attorney is handling the filing for a client, to have backup name choices in case a name is already taken or rejected. Some states provide the option of listing, in the non-profit's order of preference, multiple name choices on a single name availability or name reservation form. The first available name on the list is then indicated as available or reserved, respectively. This saves both time and cost for the filer because the fee is typically per form and not per name.
To reserve a name, the founder should complete the name reservation form on the applicable state office website. The name can be reserved for a fee for a limited time period in most states. Most states permit a name reservation to be renewed (for a fee), though they vary as to when a renewal must be requested and how many times a name reservation may be renewed.
Complete Pre-incorporation Logistics
Designate the Incorporator
The incorporator is the person who executes the articles of incorporation and takes the initial steps to organize the non-profit (unless initial directors are listed in the articles of incorporation). The incorporator can be the founder, an initial director or an outside third party and does not need to be an attorney.
Prepare Non-profit's Initial Business Plan
The business plan describes how the non-profit intends to implement its mission and achieve its goals. A business plan should generally include:
A purpose clause (also known as a mission statement) that gives a clear reason why the non-profit exists.
An outline of general goals, concrete objectives and specific planned activities.
An assessment of the non-profit's strengths and weaknesses, including an inventory of resources (such as money, people and expertise) available to it.
Practical ideas about how to use the non-profit's strengths and resources to achieve its goals.
Information in the business plan, including the purpose clause, will be used in:
Discussions with potential directors and employees during the recruitment process and in performance evaluations.
The non-profit's organizational documents.
The IRS forms, including Form 1023 (the application for 501(c)(3) tax-exempt status) and Form 990 (the annual information return for tax-exempt organizations).
Fundraising requests and efforts to build community support.
Order or Create a Minute Book
A minute book (sometimes referred to as a corporation kit) is a loose-ring binder in which a non-profit can store the minutes of the board of directors (sometimes referred to as board of trustees) and members (if any), the articles of incorporation, the by-laws, federal or state tax-exempt status designation letters and copies of annual reports and filings.
The minute book ensures the non-profit's records are maintained, organized and easily referenced. It is important for a non-profit to keep up-to-date copies of the minutes of the board and members (if any) in the event that its actions are challenged by the state's attorney general or scrutinized by a watchdog organization.
A well-maintained and organized minute book can also be helpful when compiling information to file the annual Form 990 with the IRS. Form 990 requires a substantial amount of detail and must be made available to the public. Accurate and complete reporting minimizes the risk of a lawsuit and bad publicity.
A minute book can be purchased through a service company or online. It is usually comprised of: a binder with labeled dividers for each document type, a corporate seal, blank membership certificates, a blank member ledger, blank minute paper, and sample board resolutions and minutes.
Determine if Non-profit Will Have Members
Most non-profits elect to be board-driven, meaning there are no members or the members have limited rights. For example, members of a board-driven non-profit do not have full voting rights. Instead, the board is usually self-perpetuating, with the board electing the directors. However, board-driven non-profits often use the term member when referring to donors to show appreciation and create a sense of community. The by-laws should clearly define "member" when the non-profit does not intend to grant voting or other statutory rights. Section 501(c)(3) public charity corporations tend to be board-driven, unless required by state law to have voting members.
Non-profits electing to have members with the right to vote are known as member-driven non-profits. Some states require non-profits to be member-driven. The non-profit's by-laws generally outline member eligibility and other requirements of membership. Members typically have the right to elect and remove directors and vote on major corporate events such as mergers, asset sales or dissolution.
Some states permit the members of a member-driven non-profit to enter into voting agreements, though the state's non-profit law may restrict the purpose or application of the voting agreement. Other states however expressly declare these agreements unenforceable. Members contemplating a voting agreement should first review the laws of the state of incorporation.
There are additional administrative tasks associated with member-driven non-profits, including: keeping up-to-date member lists, providing notice of member meetings, and recording and filing the minutes of member meetings.
Identify and Recruit Initial Directors
The board of directors is chiefly responsible for ensuring that the non-profit fulfills its mission as stated in the non-profit's articles of incorporation and business plan. The board acts as trustee of the non-profit's assets and ensures that the non-profit is well-managed and remains fiscally sound. In fulfilling its obligations, board members are subject to three basic fiduciary duties.
The duty of care, which requires a director to be fully and adequately informed and to act with care when making decisions and acting for the non-profit.
The duty of loyalty, which requires a director to act and make decisions in the best interest of the non-profit and not in the director's own personal interest.
The duty of obedience, which requires a director to understand and act to promote the non-profit's goals and mission.
Fiduciary duties are the standards of care imposed by state law. A director generally meets these standards by, among other things:
Attending all regular board meetings and committee meetings, if the director is on a committee. Attendance is usually permitted by telephone or video conferencing if all participants can hear each other and participate.
Reviewing and understanding materials provided for the meetings.
Requesting additional information or reports as needed.
Making independent determinations on non-profit actions.
Not relying on information known to be unreliable and communicating those concerns to the board.
Disclosing any conflicts of interest according to the non-profit's policies.
While there are many similarities in the duties of directors of for-profit and non-profit corporations, there are significant differences of which a non-profit director should be aware. For instance, unlike directors of a for-profit corporation who owe fiduciary duties to the corporation's shareholders, non-profit directors do not owe their duties to the non-profit's members. Most non-profits do not have members (the non-profit equivalent to a for-profit's shareholders) and in those that do, the members do not hold a financial stake in the non-profit that must be protected by the directors. Instead, non-profit directors owe their duties to: the non-profit itself, the constituents served by the non-profit according to its purpose clause, and the non-profit's donors, when funds are earmarked for specific activities.
The IRS recommends that non-profits recruit active and engaged directors with the commitment, skills, expertise and other characteristics to serve the organization and its needs. When recruiting directors, non-profits should focus on areas of expertise that benefit the non-profit. For instance, a non-profit may wish to recruit directors who are either lawyers, accountants or on the boards of for-profit companies because of the specific skills they have. They may also wish to recruit directors who: have previous experience serving or working for a non-profit and/or are knowledgeable about the constituency the non-profit serves.
It is also common to select directors with an ability to contribute or can direct fundraising on behalf of the non-profit. Non-profits often have a "give-or-get" practice that requires each director to either donate a certain amount each year to the non-profit or fundraise an equivalent amount through the director's contacts.
Procedural Steps
Draft and File Formation Documents
Although the articles of incorporation is the only document required to be filed with the state's secretary of state or similar state agency, there are several other documents needed to properly form and organize a non-profit, as well as to obtain tax-exempt status. The first step is to obtain the necessary information (such as the name of the director(s) and registered agent(s)) before drafting these documents.
Draft and File the Articles of Incorporation
The articles of incorporation is the primary governance document of the corporation and is filed with the state of incorporation. In addition to meeting state requirements when drafting the articles, the following IRC requirements to apply for tax-exempt status should also be included:
A purpose clause that is properly limited to one or more of the exempt purposes set out in Section 501(c)(3) to meet the IRS' organizational test. IRS Publication 557 provides helpful examples of purpose clauses that may or may not meet the organizational test. Some states may require a more specific purpose statement for state tax exemption purposes.
A statement that prohibits the non-profit from engaging in non-exempt activities or using its earnings to benefit an individual.
A dissolution clause that permanently dedicates the non-profit's assets to an exempt purpose. This means that if the non-profit decides to dissolve, the assets will not be returned or distributed to any members or private individuals (unless otherwise required by law). The assets must instead be transferred to another non-profit that is a Section 501(c)(3) entity, or to the federal government or to a state or local government for a public purpose. If going to another non-profit, some states also require that the transferee non-profit have a similar exempt purpose as the dissolving non-profit.
The articles of incorporation must be filed, along with the state-specified fee, with the secretary of state or similar state department of the chosen jurisdiction. Generally, the articles may be submitted to the appropriate department in person, by mail, by fax or, in some states, online. The filing fee is usually significantly lower for non-profits than for for-profits.
Most states offer expedited processing of organizational documents upon the non-profit's request, for an additional fee. The additional fee must usually be paid separately from the regular filing fee. The non-profit's corporate existence begins once the articles of incorporation have been approved by the state agency.
Apply for Agency Approvals
Before filing the articles of incorporation with the state, it should be verified whether any state agencies must first approve the filing. The agencies that must approve the filing typically vary depending on the purpose and activities of the non-profit. For example, approval may be required from the department of health for the establishment of an adult care facility or from the office of children and family services for programs for domestic violence victims. Most states require that these approvals be attached to and filed with the articles of incorporation.
Draft the By-laws
By-laws set forth the governance rules of a non-profit, but are secondary to the articles of incorporation and are not filed with the state. If there is any conflict between the articles of incorporation and the by-laws, the articles of incorporation govern. Typical areas covered by the by-laws include:
The non-profit's purpose.
The meeting procedures for members (if any) and directors (including notice and voting requirements).
The rights, eligibility requirements and responsibilities of members (if any) and directors (including board term limits).
The officer positions.
The types of committees of the non-profit.
Some states also require the by-laws to include a statement identifying the corporation as a non-profit. As best practice, the by-laws should include the following additional provisions:
A provision requiring the non-profit to have conflict of interest and sexual harassment policies.
Procedures for the management and conduct of ordinary business affairs during natural disasters and other similar emergencies where normal procedures cannot be followed, such as notice or quorum requirements for a board meeting.
Indemnification of its directors and officers.
Compensation policies for directors.
Hold Organizational Meeting
After filing the articles of incorporation with the secretary of state or similar state agency, the incorporator must authorize organizational resolutions. This may be done either by holding a meeting or by written consent, if permitted by state law. If the articles identify the initial board of directors, the board should authorize the organizational resolutions. The incorporator or, if applicable, the board should hold an organizational meeting to:
Adopt the by-laws.
If the articles do not identify the initial board of directors, elect and establish the board and any committees.
Elect the officers.
Approve the corporate seal.
Authorize applications for federal and state tax-exempt status.
Set an accounting period and tax year.
For a member-driven non-profit, approve the issuance of memberships, membership certificates, and, if applicable, set and schedule membership dues or assessments.
Approve the initial transactions of the non-profit, such as opening bank accounts.
The non-profit should create minutes that accurately record the actions taken by the incorporator or, if applicable, the board and file those minutes in the non-profit's minute book.
Complete Post-incorporation Logistics
File Any Necessary Foreign Qualifications
If the non-profit is going to conduct its charitable purpose in other states or is located in a state other than its state of incorporation, it needs to be properly qualified. The non-profit should check the specific requirements of each state. This typically involves:
Checking the name availability of the non-profit in the foreign state.
Preparing and filing any necessary documents, often called a certificate of authority. These documents often contain similar information to the articles of incorporation and include a submission to service of process in the jurisdiction.
Payment of fees.
Apply for Employer Identification Number
The non-profit must apply for an employer identification number (EIN) with the IRS, even if there are no employees. A non-profit must have an EIN before it can file its tax-exemption application. An EIN is also necessary for reporting purposes and to identify the non-profit. It is often required before a non-profit can transact business, such as opening a bank account. A non-profit can apply for an EIN at no charge on the IRS' website.
Obtain Licenses or Permits
The non-profit should obtain any licenses or permits the non-profit needs to conduct its activities, such as for gaming, gambling or soliciting donations along a highway.
Apply for Federal Tax-exempt Status
The non-profit must file IRS Form 1023, along with the appropriate fee, for exemption from federal income tax under Section 501(c)(3). Certain small organizations may be able to use Form 1023-EZ. Organizations with Section 501(c)(3) tax-exempt status are able to solicit tax-deductible contributions. When status is granted, the IRS will send a letter of determination that the non-profit can use to prove its tax-exempt status and should keep in its minute book.
The non-profit must promptly file its federal tax exemption application. For federal purposes, the exemption date applies retroactively to the date of formation if the application was filed within 27 months of incorporation. Filings made after that time will have an effective date as of the filing, though the non-profit may file for a waiver of the 27-month rule. The IRS may grant a waiver if cause for the delay is shown.
Apply for State Tax-exempt Status
The non-profit must also apply for state tax-exempt status with the appropriate state agency. While some states will automatically grant tax-exempt status from state income taxes to a non-profit that has been granted federal tax-exempt status, others may have additional or alternative requirements.
The non-profit should also check to see if it needs to file separate applications to obtain other types of state and local tax exemptions, including from sales, use and property taxes and business license fees.
Comply with Charitable Solicitation Laws
The non-profit must comply with state and local charitable solicitation laws. If the non-profit intends to solicit charitable donations from the public in any state, it should:
Register with the applicable authorities in each of those states.
Renew its registrations annually.
File annual financial statements, if required.
Include disclosures on donor materials, if required.
In an effort to simplify and standardize the registration process, the Multi-State Filer Project (MSFP) developed the Unified Registration Statement (URS). Thirty-six states and Washington, D.C. accept the URS in lieu of their own registration forms. Some states may require additional forms so that the URS complies with state law. These additional forms are listed on the MSFP's website.
Non-profits electing to use the URS must:
Fill out the URS form, including any additional state-specific items.
Photocopy the completed form.
Execute and attach any required governance documents.
Include the applicable state's registration fee.
Mail the form to each individual state where the non-profit is registering. The MSFP does not process or mail completed URS forms. This must be handled by the non-profit.
Most states have registration exemptions for fundraising below certain dollar thresholds. Non-profits that are required to register but fail to do so before fundraising may risk incurring penalties and having to return donations.
Comply with Labor and Employment Laws
The non-profit should review and become familiar with relevant labor and employment laws regarding employees, volunteers and contractors.
Obtain Liability Insurance
The non-profit should obtain general and property liability insurance, if determined appropriate. Some states will only grant director or officer immunity if the non-profit either has general liability insurance or shows a good faith effort to obtain insurance.
File Form 990
The non-profit must file IRS Form 990, the annual information return for tax-exempt organizations. It requires the non-profit to provide a detailed report on its: exempt and other activities, finances, governance, compliance with federal tax filings and requirements, and compensation paid.