This is an overview of the steps to establish a section 501(c)(3) organization that is exempt from paying income tax (including both a private foundation and an operating charitable organization/public charity). Establishing a section 501(c)(3) generally includes the following steps (depending on an organization’s activities or governing state law, not all of these will be applicable):
- Incorporation of a nonstock corporation under state law (or creation of a charitable trust);
- Application for recognition of tax-exempt status with the IRS (Form 1023);
- Applications for applicable state income, sales tax, and property tax exemptions;
- Registration and reporting for state charitable trust and charitable solicitation requirements.
The state tax exemptions and registration and reporting for state charitable trust and charitable solicitations depend on the state(s) in which the organization operates and solicits for funding.
Forming a New Organization Under State Law
The first step is to incorporate a corporation or create a trust (almost all operating section 501(c)(3) organizations are nonstock/nonprofit corporations or trusts, although sometimes other types of legal entities such as LLCs are used). Whether the new organization is formed as a nonstock corporation or trust depends on a number of factors (taxes, liability, and operational requirements), but entities that will conduct activities are typically formed as “nonstock” corporations — nonstock corporations are corporations, but are incorporated under the state’s “nonstock” statute and do not issue stock. (Nonstock corporations may have members for governance purposes as described below).
If Organized as a Charitable Trust, the Trust Must Identify the Initial Trustees.
Most organizations incorporate under the state law of the state in which the organization has its primary location or under the state law of the State of Delaware (which is the favored location of large corporations). A 501(c)(3) organization is typically subject to some level of supervision by the attorney general of the state of incorporation, and this may be a consideration in choosing the state of incorporation.
Incorporating a nonstock corporation requires the following:
- Articles of Incorporation / Certificate of Incorporation. This document goes by different names in different states (such as Articles of Incorporation, Certificate of Formation or Certificate of Incorporation). The filing of this document with the state of incorporation (usually the Secretary of State, but in Wisconsin, it is filed with the Department of Financial Institutions) begins the organization’s existence.
- This document must include certain pieces of information, such as the name and address of the registered agent and the overall purposes of the organization (which may be broadly stated as “charitable, educational, religious, and scientific” but also may be more specifically tailored to the organization’s purposes). Sometimes, state law will allow the articles/certificate to include additional indemnification provisions for the directors. In addition, the IRS requires certain provisions in the articles/certificate to qualify as a section 501(c)(3) (including a provision limiting activities for 501(c)(3) purposes and requiring that assets are paid to a 501(c)(3) upon dissolution). Other than the required information, the articles/certificate are fairly boilerplate. In some states, the initial directors are named in the incorporating document. This document is publicly available.
- Organizational Meeting/Consent to Organizational Matters. If not appointed in the articles/certificate, the incorporator will also appoint the initial directors of the new organization by a written document. The initial directors will either hold an organizational meeting or sign a written consent in lieu of a meeting to take certain actions that allow for operations to begin, including adopting the bylaws (see below), electing the organization’s officers (usually consisting of at least a president, treasurer, and secretary), electing additional directors if desired, and authorizing the officers to file the required applications and open bank accounts (among other start-up activities).
- The board often also adopts a number of policies, such as a conflict of interest policy, a whistleblower policy, and a document retention policy. If the organization is a public charity, the whistleblower and document retention policies are particularly important because the annual Form 990 asks if these policies have been adopted.
- Bylaws. Bylaws provide the governing rules for managing the organization (such as how the directors and officers are elected, the quorum requirements for meetings, voting requirements, etc.). A key issue when drafting bylaws is the membership provisions and whether the organization will have multiple members, a sole member, or no members:
- Multiple Members: Some organizations provide members with rights to elect directors and make other governing decisions (similar to voting shareholders, except that members usually do not receive distributions). This is common when the board will be representative of a larger body. Members can be individuals or corporate entities (including for-profit entities).
- Sole Member: Many organizations have a single member with the right to elect, remove, and replace directors. This is common for company foundations (where the company wants to have control over the organization). It is also true for family foundations and for founder-driven organizations where the founder wants to keep some control. This is also a common structure when an established organization creates a new controlled affiliate for a specific purpose (such as to operate a new project or own a particular piece of property).
- No Members: Many organizations have no members and the Board of Directors elects its own successor directors. Many independent operating organizations have no members. Technically, Delaware non-stock corporations must have members, but the directors also serve as the members of the corporation.
- Employer Identification Number (EIN). To open a bank account and begin operations, an organization must obtain an IRS Employer Identification Number (EIN) from the IRS. The EIN is obtained after completing a Form SS-4 and inputting the information to the online IRS portal. The organization’s EIN is required to complete other filings, including filing the Form 1023 and other tax returns.
- Other Documents. The organization should adopt a conflict of interest policy, and possibly a document retention policy and whistleblower policy.
Information Needed to Begin Drafting the State Incorporation Documents
We will need the following to incorporate a nonstock corporation:
- Name of the organization. The name of the organization must be distinguishable from the names of other business entities formed in the state in which it will be incorporated. Wisconsin requires the addition of a word such as “Inc.” or “Corporation”; California, Delaware, D.C., Illinois, and Texas do not.
- Consider a trademark search to avoid a dispute with another entity if you intend widespread use of the name.
- Name of the registered agent. This is the person who will receive mail on behalf of the organization. The registered agent must have an address in the state of incorporation (the address cannot be a P.O. Box). This person can be an officer of the organization. In the alternative, the organization may use a registered agent service (such as CT Corporation). A registered agent service will charge an annual fee.
- Business address for the organization (this can be different from the legal registered agent address).
- Names of the initial board of directors. Most states, including Connecticut, D.C., Illinois, Texas, Utah, and Wisconsin require three directors. In Michigan, a private foundation only requires one director, but other nonprofits require three directors. California and Delaware only require a single director. Additional directors may be elected later.
- Names of officers. An organization should have a president, secretary, and a treasurer. One person may occupy multiple roles. Additional officers may be added, such as one or more vice presidents, a separate board chair in addition to the president, etc. Officers may be (but need not be) directors.
- Social Security number of an officer (usually a president or treasurer). A “responsible party” (usually the president or treasurer) must sign the Form SS-4 and provide his or her Social Security number for the online portal (generally we will obtain the EIN from the IRS online portal).
Once we have this information, we can put together draft organizational documents. The organization can revise these documents and incorporate more specific provisions. For instance, a mission statement is not required, but certainly can be incorporated into the articles of incorporation or bylaws, but may also be adopted later by the board. All of these actions and documents can be amended by act of the member and/or board.
Once the documents are prepared, it usually takes less than a week to file the incorporating document (although in some states like California, this can take up to two weeks) and obtain the EIN. At this point, the organization is a legal entity and can begin operations. In California, a Statement of Information Form SI-100 must be filed with the Secretary of State within 90 days of filing the articles of incorporation.
Application for Recognition of Exemption from Federal Income Tax (Form 1023)
Most organizations are required to file an application for the IRS to recognize the organization’s exempt status.
- If the organization expects to receive over $50,000 per year in annual revenue (either through fundraising or otherwise), it must file a Form 1023. The filing fee for Form 1023 is $600.
- If an organization does not expect to raise over $50,000 per year in the next three years, it may file a shorter Form 1023-EZ application. The filing fee for Form 1023-EZ is $275.
Both the Form 1023 and the Form 1023-EZ are filed electronically. We can prepare either for your review and comment. Once you’ve signed off, we will file with the IRS.
Timing of IRS Response / Interim Period
The IRS takes about three to nine months to review and issue a determination letter for an organization after Form 1023 is filed (timing varies as the IRS is battling staffing issues and delays). The IRS is currently taking about four to six weeks to review and issue a determination letter for an organization that files a Form 1023-EZ.
An expedited review can be requested in certain circumstances: if the organization is formed to address a crisis or if a significant donation or a specific grant will be delayed or lost if the recognition is delayed. An expedited review request must be submitted with the Form 1023 or 1023-EZ filing.
An organization can collect contributions and operate as a section 501(c)(3) once it is formed and organized for state law purposes, even though it does not yet have a section 501(c)(3) determination letter from the IRS. However, certain states require registration for fundraising before an organization can begin collecting contributions.
The determination letter will usually be retroactive to the date of filing the articles/certificate of incorporation, and donors will be eligible to receive a charitable deduction on contributions made after incorporation (and not when the letter arrives). If a donor is requesting a section 501(c)(3) determination letter, the organization may consider a temporary solution such as a “fiscal sponsorship” agreement with another section 501(c)(3) organization that already has exemption. Contributions would be made to the fiscal sponsor and then granted to the new organization until the new organization receives its exemption letter.
Information Needed for IRS Form 1023
The following information is required to prepare a draft Form 1023:
- Narrative description. We will need a description of the organization’s mission and anticipated activities. We can add the legal language and citations to legal and tax authorities, but we need a basic summary of what the organization intends to do and how it plans to accomplish its mission.
- Budget. The Form 1023 requires an estimated budget for revenue and expenses for the organization’s first three years (the year of formation and the following two years). This can be at a fairly high level of detail.
- Scholarship Program. In addition, any scholarship or program that makes grants to individuals must be described in the application.
- Conflicted Transactions. Any arrangements or contracts with insiders (major donors, directors, and officers) may need to be disclosed on the Form 1023.
Typically, we will prepare the Form 1023, complete the questions based on your description of your activities, and then ask you to review it.
The Form 1023 must be completed in good faith, but the organization is not bound by its answers and may change or expand its activities without reapplying (changes are reported on Form 990).
Other State Tax Exemptions
Depending on the states in which the organization is active, it may need to apply for additional state tax exemptions. In most cases, it is easier to make these filings after the IRS determination letter has been received (because the filings usually require you to provide a copy of the IRS determination letter or its date), but that varies by filing.
Additional state filings to consider include:
- Foreign Registration. If an organization is incorporated under one state’s laws and operates in another state, it may need to file a foreign registration in that state. It may also require a business license.
- State Income/Franchise Taxes. The 501(c)(3) organization will, for the most part, be exempt from state income and/or franchise tax. Some states require an application for state exemption.
- California requires filing Form 3500 or 3500A (if already recognized by the IRS as exempt) to be exempt from California franchise tax.
- Delaware, Illinois, Michigan, and Wisconsin do not require an application.
- Texas requires filing a Form AP-204 for franchise tax exemption.
- Sales Tax. Under sales tax law in most states, an organization can apply for a sales tax exemption in order to avoid paying sales tax on its purchases. In general, the organization must collect sales taxes on the organization’s sales to third parties (unless the sales meet an exemption).
- Property Tax Exemption. If the organization owns real property, it may seek a property tax exemption. Recognition of federal tax-exempt status does not automatically confer exemption from property tax. Exemption requires a separate application process, and assessors are often limited in granting property tax exemptions.
State Charitable Trust and Charitable Solicitations
Many states (including California, Illinois, Michigan, Utah, and Wisconsin) require that the organization register (and report annually) for charitable solicitation or for holding charitable assets. Texas does not require registration for charitable solicitation.
- In California, Form CT-1 must be filed within 30 days of first receiving charitable assets. After filing, the corporation must file an Annual Registration Renewal Fee Report (Form RRF-1).
- In Illinois, Form CO-1 must be filed before solicitations begin.
- In Wisconsin, Form 296 must be filed before solicitations begin.
Many states have certain requirements for audited or reviewed financial statements if the organization reaches certain revenue thresholds.
If an organization is soliciting nationally (other than through limited “friends and family” solicitations or a passive solicitation on a website), we recommend that the organization hire a vendor to complete registration and reporting in all of the states with this requirement. We can provide recommendations.
Ongoing Reporting
- Annual State Corporation Filing. A nonstock corporation must generally file an annual report and pay a fee to the state of incorporation and to any other states where the organization has registered as a foreign entity (if the organization is using a registered agent service, this service will also generate an annual bill and forward any annual report reminder notices it may receive). Due dates for annual reports vary by state, for example, in Wisconsin they are due by the end of the calendar quarter in which the anniversary month of incorporation occurs, in Delaware the due date is March 1 for all corporations (including nonstock) and June 1 for all LLCs, in Illinois they are due by the end of the month prior to the anniversary month of incorporation, and in certain other states the due date is the end of the anniversary month of incorporation. The corporation’s officers should confirm the annual report due date(s) and create an annual reminder so the filing is not missed. Some, but not all, states send reminder notices.
- Form 990 or Form 990-PF. A 501(c)(3) organization generally must file an annual income tax return (although there are exceptions for religious organizations and affiliates). This is due five and a half months after the close of the organization’s fiscal year (so, an organization with a fiscal year ending in December will have a tax return due by May 15).
In some cases, it may file an abbreviated online filing (Form 990-N) or a simplified version (Form 990-EZ). Public charities file Form 990; private foundations file Form 990-PF. If a 501(c)(3) organization has unrelated business income tax, it will file Form 990-T (and may need to file a state income tax return as well).
