Part 5: Proceed and Persist
In our first installment in this series on nonprofit formation, we discussed which organizations and activities can qualify for tax exemption and what to consider before starting a nonprofit. In Part 2, we discussed selecting your organization’s initial directors and officers and drawing up your organization’s governance documents. In Part 3, we discussed the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under Section 501(c)(3). In Part 4, we looked at restrictions on private inurement and political activities and how to avoid getting into trouble with the IRS on those issues. In this final installment in this series, we will examine the process of applying for 501(c)(3) status and how to maintain that status going forward.
Applying for 501(c)(3) Exempt Status
After you have formed a nonprofit corporation on the state level, the next step is to obtain tax exempt recognition from IRS. This is done by starting an account with Pay.gov and completing an application known as a Form 1023. While the Form 1023 will be completed through a series of webpages, a PDF version of the Form 1023 is available here.
The Form 1023 requires producing a substantial amount of information to the IRS. Your organization will be required to disclose the names and address of its directors, information about compensation of employees and contractors, and information about the relationships that exist between and among directors, officers, employees, contractors, and other outside parties. These questions are designed to detect whether your organization may have problems with conflicts of interest or private benefit/private inurement.
The Form 1023 application also requires an applicant organization to provide a detailed description of all its activities, including who conducts the activities, where the activities are conducted, how much of the organization’s time and money are proportionally allocated to each activity, and how each activity furthers its tax-exempt purposes. The Form 1023 includes several dozen “yes or no” questions about specific aspects of the organization’s activities. Most of these questions include prompts to provide additional description.
One part of the Form 1023 that may appear particularly daunting is the requirement to provide 3-5 years of the organization’s detailed financial information. If an organization has been in existence for less than a full tax year (which is typically the case), the organization must provide detailed estimates of its finances for three years into the future. However, the IRS does not expect an applicant to have a crystal ball and to be prophetically accurate. The IRS just wants to ensure that the organization applying for 501(c)(3) status has considered its sources of funding and that its financial planning is consistent with the public-support test (discussed in Part 3 of this series) and other rules governing nonprofit finance and expenditures. Nevertheless, it is wise to consult with a financial professional to advise on this portion of the Form 1023.
There are also a series of specific additional “schedules” or extra sets of questions that an organization may be required to answer if it is a hospital, school, church, housing provider, or other special category of nonprofit. If an organization is a “successor” organization (taking over the assets or activities of another organization), it will have to disclose additional information about the relationship between the two organizations. Also, if more than 27 months has passed between the date of corporate formation and the date of application, an organization must provide additional information about its activities and financial history.
In addition to the many questions included in the Form 1023, an applicant will also need to provide several documents as attachments to the application. These include the organization’s articles of incorporation, bylaws, conflicts of interest policy, and other corporate, financial, or explanatory documents that provide the basis for any responses to questions.
The IRS application fee for a standard Form 1023 is $600.00. After submitting a Form 1023 application, the IRS may send the applicant a follow-up questionnaire to request additional information. When this happens, the applicant must complete the responses within the deadline prescribed (often less than a month), or the IRS may reject the application altogether and without refund of the application fee.
Overall, the Form 1023 is a difficult application that can require several hours of preparation and a substantial amount of information. Many charitable entrepreneurs engage with an attorney to complete this complicated process. The IRS does provide a shorter and simplified version of the application (the Form 1023-EZ) for certain categories of nonprofits that are very small (less than $50,000 of annual gross receipts and less than $250,000 in total assets). At $250, the filing fee for the Form 1023-EZ is also cheaper. However, the drawbacks of the Form 1023-EZ are that applicants filing this form are more likely to receive follow-up information requests from the IRS and are also more likely to be audited by the IRS.
In terms of a turnaround response time from the IRS, it can take up to a year. The IRS will not even answer questions about the status of an application until 180 days after the filing of the Form 1023. Once the IRS has determined exempt status, it will send the applicant a determination letter with the date of exemption, the organization’s specific exempt status (i.e., private foundation or public charity), and whether the organization is required to make continual annual filings.
Maintaining 501(c)(3) Exempt Status
After an organization has obtained tax-exempt recognition from the IRS, it must maintain that status actively. With the exception of churches and certain church-related organizations, nonprofits must make an annual filing with the IRS called a Form 990. This is essentially a tax return form for a 501(c)(3). The Form 990 reports the organization’s revenue, expenses, and assets for that fiscal year, as well as compensation given to officers, employees, and contractors. Since these annual filings can be quite complex, many organizations use an accountant to prepare their Form 990 submissions. 501(c)(3) organizations that are private foundations have to submit an even more complicated filing, the Form 990-PF, which also requires disclosure of all grants and distributions made that year. Organizations with less than $50,000 in gross receipts can sometimes file a simplified version called a Form 990-N. Failing to fail a Form 990 with the IRS can result in fines that increase with each additional day the filing is late, and ultimately revocation of tax-exempt status.
In addition to annual IRS reporting, nonprofit organizations must also comply with their relevant state authorities. Most states require nonprofit organizations to file an annual report with the secretary of state or similar corporate entity agency, but some states have longer intervals of time between required filings. Also, the laws of most states require nonprofits to maintain corporate records such as board meeting minutes, bylaws, corporate action resolutions, financial records, and other documents. These records can be inspected by state officials as well as by members of the corporation. Every organization should practice careful recordkeeping and comply with all applicable state laws.
This series on nonprofit formation has given you the basic considerations that you will need to make and the steps you will need to take to transform your nonprofit from an idea into a reality. However, this process can often be complex and challenging. It is always wise to engage with an attorney who is experienced and knowledgeable on nonprofit issues and who can competently advise your organization on properly forming, properly operating, and staying compliant with all applicable laws.
Featured Image by Rebecca Sidebotham.
Because of the generality of the information on this site, it may not apply to a given place, time, or set of facts. It is not intended to be legal advice, and should not be acted upon without specific legal advice based on particular situations