This is the first alert in our three-part series covering the stages of a nonprofit organization’s lifecycle and best practices. In this series, we’ll cover formation, governance and termination of a nonprofit. Whether you’re starting, managing, or closing a nonprofit, these alerts will provide you with the key insights and practical steps to navigate each phase effectively. In our first alert, attorney Erica Townes covers forming a nonprofit.
Starting a nonprofit can be a fulfilling way to give back to your community and champion a cause that matters to you. Starting a nonprofit may also provide a strategic path toward separating your business’s charitable activities from its for-profit operations, providing opportunities for sources of funding that are often not available to for-profit businesses.
However, establishing a nonprofit organization involves careful planning, legal compliance, and a considerable understanding of the regulations that govern tax-exempt entities. This client alert will discuss a few of the essential steps involved in forming a nonprofit organization from a legal compliance perspective and outline key considerations to ensure your organization meets both state and federal requirements for successful operation. For this overview, we focus on 501(c)(3) public charity corporations—the most common type of nonprofit.
What is a Nonprofit? Understanding the Basics
A nonprofit organization is a legal entity formed to serve the public good. Unlike for-profit entities, nonprofits are typically governed by a board of directors, rather than shareholders, and any profits generated are reinvested into the organization to support and advance its mission rather than being distributed to members (if any), directors, or officers.
That said, this general rule does not prohibit nonprofits from compensating or reimbursing individuals altogether. A nonprofit can provide “reasonable compensation”, which the IRS defines as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. If you are still uncertain as to what “reasonable compensation” means, you are not alone. To ensure compliance when determining whether compensation arrangements are in line with the reasonableness test, a nonprofit should consider whether the compensation is fair, aligns with compensation averages for similar positions in the organization’s geographic area, and is consistent with industry standards.
Steps to Form a Nonprofit
1. Ensure Your Nonprofit Falls into a Permissible Category
Nonprofits must serve the public good. Accordingly, one of the first steps in establishing a nonprofit is ensuring that its mission aligns with a legally recognized classification that serves the public good. The IRS, along with Pennsylvania state law, outlines several defined categories to meet this standard. Commonly recognized nonprofit purposes include charitable, educational, religious, or social purposes.
2. Structure the Nonprofit’s Legal Entity
Typically, nonprofits are organized as non-stock corporations. As the name suggests, non-stock corporations do not have owners holding any stock or other economic interest in the assets of the corporation. Instead, they are controlled by members (if any) or the organization’s board of directors. This structure is designed to limit the personal liability of the officers, directors, and members in the event of a lawsuit.
In less common instances, a nonprofit may be formed as a limited liability company. According to IRS regulations, a nonprofit LLC generally must have all of its members be other 501(c)(3) organizations, which limits the pool of eligible LLC members. Additionally, the LLC must have an operating agreement with appropriate restrictions that reflects its nonprofit nature. This structure most commonly makes sense when several 501(c)(3) entities want to work together on a specific, charitable project.
3. File Articles of Incorporation
Once you’ve identified a permissible purpose and determined the type of legal entity that is right for your organization, the next step is filing a document with the state that formally creates the nonprofit. In Pennsylvania, you will need to file Articles of Incorporation. The Articles of Incorporation is the non-profit’s primary governance document and is filed with the Pennsylvania Department of State. An important consideration often overlooked by filers is that in addition to meeting state law requirements, the Articles of Incorporation should include the Internal Revenue Code’s requirements needed to apply for tax-exempt status.
Before filing the Articles of Incorporation with the state, the incorporator should verify whether any state agencies must first approve the filing. The agencies that must approve the filing vary depending on the purpose and activities of the nonprofit. 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.
4. Draft Bylaws
The Bylaws layout the governance rules of a nonprofit and are secondary to the Articles of Incorporation. They are a non-public document that outlines how the organization will operate. While broad latitude is given to organizations to regulate their internal affairs, topics typically covered in the Bylaws include the purpose of the organization, meeting procedures for members (if any) and directors, including quorum and voting requirements, a description of officer positions, and a conflict-of-interest policy.
5. Apply for Federal Tax-Exempt Status
In order to gain tax-exempt status, meaning an organization does not pay federal income taxes on donations or income related to its mission, the organization must file IRS Form 1023. Smaller organizations may qualify to file a simplified version of the application, known as IRS Form 1023-EZ. The 1023 Application requires comprehensive information about the nonprofit’s purpose, activities, and financial projections. Once granted 501(c)(3) tax-exempt status, the organization can solicit tax-deductible contributions. When tax-exempt status is granted, the IRS will send a letter of determination, confirming the organization’s tax-exempt status, which should be kept in the nonprofit’s minute book. In addition to federal tax exemption, your nonprofit may need to apply for tax-exempt status at the state level. State requirements vary and may exempt the organization from state income, sales, and property taxes.
Additional Considerations
This alert is intended to provide a general overview of some of the key components of forming a nonprofit but there are a number of other filings, corporate records, and Pennsylvania-specific requirements (i.e. advertising the formation of the nonprofit in the newspaper) needed to ensure proper formation and compliance. Additionally, a nonprofit should carefully evaluate other considerations such as ongoing compliance filings, whether the nonprofit is required to obtain any licenses or permits (e.g. gaming, gambling) to conduct its fundraising activities, application(s) for foreign qualifications if the nonprofit is going to conduct its charitable purpose in another state, and becoming familiar with relevant labor and employment laws regarding, employees, volunteers, and contractors, and more.
Barley Snyder is here to support you throughout this process, providing the knowledge you need to navigate the intricacies of nonprofit formation and compliance. Whether you are just starting out or looking to enhance your existing organization, Barley Snyder is committed to helping you achieve your goals. If you have any questions, please reach out to attorney Erica Townes or any member of Barley Snyder’s Business Practice Group for tailored guidance that aligns with the mission of your nonprofit. Be on the lookout for the next alert in our series covering governance best practices for nonprofits.
