As discussed in prior articles, there are several options for tax-incentivized giving, ranging from the informal and low-involvement to complex and highly involved structures. Many choose to adopt a more formal approach to giving back by forming and funding a nonprofit organization. This option is not to be undertaken lightly; numerous federal and state laws and regulations govern the formation, operation, and dissolution of nonprofits.
This installment discusses five basic steps to forming, qualifying, and operating a nonprofit organization in a manner expected to achieve its purposes and qualify for tax exemption, all without running afoul of state or federal regulation.
Planning for Purpose:
The most important consideration is determining a clear mission for the nonprofit organization from the outset. The organization’s purpose will determine what type of entity to form—for example, a charity, social welfare organization, or political organization—and what rules will govern the organization’s operations. There are twenty eight different forms of tax-exempt entity described in Internal Revenue Code Section 501(c), and, in this area, the proposed function of the organization will determine its legal form. Philanthropists often choose to form a charity (described in Internal Revenue Code Section 501(c)(3)) to perform some activity for the benefit of a charitable class of the public at large. In other scenarios, the organization’s founders choose to form a social benefit organization to provide a benefit to a particular group of people or to lobby for social change. In describing the purpose of the organization, its founders should be able to identify the desired result, the group of people to be benefitted, and what specific programs will be undertaken to achieve that result.
Organization under State Law:
Once the purpose of the organization is settled, the organization must be formed under state law. Most frequently, the appropriate form of organization will be a nonprofit corporation formed under the Nonprofit Corporation Act in effect in the state. It is also possible to form a trust or, less frequently, an alternative form of entity, such as a limited liability company. In each case, the organizing documents for the organization must satisfy certain requirements to ensure that the organization will qualify for tax exemption. Specifically, the organizing documents must dedicate the organization’s assets to the organization’s tax-exempt purpose and, in most cases, prohibit any insider (for example, shareholders, directors or officers) from receiving any benefit from the organization that isn’t available to the organization’s beneficiaries.
As an organization formed under state law, the organization will have certain requirements for appointing directors and officers, holding annual meetings, and taking other actions as may be required under state law. It is imperative that the persons selected to serve as directors and officers be independent and competent to perform these requirements.
Furthermore, most states require that organizations soliciting charitable donations from the public or conducting activities as a charity must also register with the appropriate state regulatory agencies. Registration often requires initial and annual reports detailing the organization’s activities in the state, the management and use of the organization’s funds, and, in some cases, the payment of a nominal fee to cover the cost of the state regulatory program.
Tax Exempt Status:
Despite popular belief, formation of a nonprofit corporation under state law does not mean the corporation is tax-exempt. Rather, the organization must apply for federal tax-exempt status by completing and filing a lengthy application and providing detailed supplementary information. Due to a lengthy history of abuse and the incentive to use tax-exempt status to improperly shield income from federal income taxes, the application process is designed to weed out unprepared applicants and those whose plans are incompatible with tax-exempt status. Often it is best to consult with an attorney, accountant, or enrolled agent familiar with tax-exempt organizations when preparing and filing the application form.
Assembling a Team for Optimal Performance:
Obtaining tax exemption is just the beginning, as a nonprofit organization must be operated in accordance with applicable federal and state regulations in order to maintain exempt status. There are many facets to regulatory compliance, each of which will vary depending on the type of nonprofit organization. At a minimum, tax-exempt entities should expect to file annual tax returns to the IRS reporting the organization’s activity for the year, even though taxes are not often due with the return. Furthermore, there are numerous anti-abuse rules applicable to tax-exempt entities, violation of which can impose stiff excise taxes on the organization and on its directors and officers. In some instances, these rules apply depending on the identity of the organization’s funders, directors, officers, and their family. So, it is vital that the directors and officers of the tax-exempt entity be independent of the primary funders (don’t appoint your relatives), competent to identify situations that may violate applicable law, and capable of exercising independent judgment to resolve issues as they arise.
In short, using an athlete’s platform for the greater good is a worthy endeavor, but is not to be undertaken lightly. A great deal of planning and forethought is needed, as well as identifying a team of qualified staff to operate the organization for maximum effectiveness.