Want to be tax-exempt? This is what it takes

Date November 16, 2022
Authors HBK Nonprofit Solutions

You’ve decided to form a nonprofit. Just like forming a for-profit business, you have a lot of decisions to make upfront, many of which will require outside counsel from an accountant, a consultant, or an attorney. Without experienced counsel, your startup will face difficult challenges and could be doomed to failure.

First Step: Create Your Legal Entity.

For the IRS to recognize a nonprofit’s exemption from taxation, it must be organized as a trust, a corporation, or an association. (An unincorporated association can gain recognition as a tax-exempt organization, but this form of organization is not typically recommended for various reasons). Nonprofit incorporation or formation creates your nonprofit entity in your chosen home state. Your Articles of Incorporation/Formation will be required when applying for exempt status. This is also the first place where you will identify your nonprofit’s purpose.

Write Your Bylaws

Bylaws are legal documents, which means there are legal requirements for what should be included. These requirements vary depending on the state in which your nonprofit operates. To ensure your bylaws are in accordance with state laws, get assistance in drafting or amending your bylaws from a qualified professional experienced in nonprofit matters.

Your bylaws are your organization’s operating manual. Typically, they will include:
  • Size of the board and how it will function
  • Roles and duties of directors and officers
  • Rules and procedures for holding meetings, electing directors, and appointing or removing officers
  • Conflict of interest policies and procedures
  • Other essential corporate governance matters
  • As a governing document, your bylaws need to be included in your exemption application. The IRS looks for two key provisions to be included in either your Incorporation/ Formation Document or your bylaws:

  • A purpose clause: What are you going to do, and who will benefit from what you do? The purpose clause will help the IRS determine your organization’s exact exemption code.
  • A dissolution clause. How will you “go out of business” if the organization is not sustainable?
  • If you anticipate filing for 501c3 status, the IRS has specific requirements that apply to your purpose and dissolution clauses.

    The bylaws may be quite different depending on the organization. Is the goal to gain status as a public charity, a private foundation, or some other type of exempt organization such as a membership organization?

    Even with counsel, it’s still the board’s responsibility to provide input throughout the process and to vote to adopt the final product. Although bylaws are not considered public documents, making them public and easily available increases the organization’s accountability and transparency to donors, beneficiaries, and the general public.

    Develop a Business Plan

    Every nonprofit seeking tax-exempt status must have an Employer Identification Number (EIN), whether or not it has employees. File a Form SS-4 with the IRS to obtain your EIN.

    This is the time for the organization to act like a business and develop its business plan. The business plan should address/include the following:

  • Past, present, and planned activities and programs
  • Any planned compensation of directors, officers, trustees, and certain highly paid employees and contractors (“Close Personnel”)
  • Any planned compensation of Close Personnel from related organizations
  • Existing or planned sales and/or contracts between the organization and any Close Personnel (including any organizations they have certain affiliations with)
  • Discussion of family and business relationships among directors, officers, and trustees
  • Goods, services, and/or funds (grants) to be provided to individuals or organizations
  • Fundraising programs planned
  • Conflict of interest policy or explanation of how the organization manages conflicts of interest
  • Financials (actual and/or projected) for three or four years
  • Besides being a business best practice, gathering much of this information will be necessary if you are required to complete a full Form 1023 or 1024 for exempt status.

    Seek Exempt Status

    Incorporating a nonprofit in the state of formation only establishes it as a legal business entity. Creating a nonprofit corporation does not guarantee the organization will be granted tax-exempt status by the Internal Revenue Service (IRS). You must apply for tax-exempt status with the IRS and be approved. There are currently 40 different types of exempt organizations in the Internal Revenue Code. Only organizations that meet the requirements of Internal Revenue Code Section 501(a) are exempt from federal income taxation. And charitable contributions made to some Section 501(a) organizations by individuals and corporations are deductible under Section 170.

    Other benefits may include access to certain grant monies and income and property tax exemptions.

    Determining the correct exempt status for the organization will depend heavily on who will benefit from the mission or its purpose, whether the assets will be dedicated to the mission, and where funding will come from.

    Public Charities and Private Foundations

    Every exempt charitable organization is classified as either a public charity or a private foundation. Generally, organizations classified as public charities are:

  • Churches, hospitals, qualified medical research organizations affiliated with hospitals, schools, colleges, universities, and other organizations that benefit the general public;
  • Have an active program of fundraising and receive contributions from many sources, including the general public, governmental agencies, corporations, private foundations, and/or other public charities;
  • Receive income from the conduct of activities in furtherance of the organization’s exempt purposes; or
  • Actively function in a supporting capacity to one or more existing public charities.
  • Private foundations usually have a single major source of funding, typically a gift from one family or a corporation, and most have as their primary activity the making of grants to other charitable organizations and individuals rather than the direct operation of charitable programs. Some private foundations, called private operating foundations, do directly operate their own charitable programs.

    Political Organizations

    A political organization subject to Section 527 is a party, committee, association, fund, or other entity (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.

    Other Organizations

    Organizations that meet certain requirements may qualify for exemption under subsections other than 501(c)(3). These include social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues.

    Application for Exemption

    Certain types of organizations are automatically considered exempt without actually filing an application with the IRS, most notably, churches, their integrated auxiliaries, and conventions or associations of churches. Others must file either Form 1023, 1023-EZ, 1024, or 1024-A with the IRS seeking status. All applications are now filed online.

    Organizations seeking status under 501c(3) apply using a 1023 or 1023-EZ form. Others seek status by filing Form 1024 or 1024-A.

    When filing for a 501c3 determination, smaller organizations may file the simpler EZ Form— Streamlined Application, 1023-EZ. These applications are much easier and take less time complete, and the filing fee is smaller. Larger organizations will file full 1023 or 1024 forms and require much of the information in your “business plan.”

    To get the most out of your tax-exempt status, file your Application Form within 27 months of the date you file your nonprofit Articles of Incorporation. If you file within this time period, your nonprofit’s tax exemption when granted takes effect on the date you filed your Articles of Incorporation, and all donations received from the point of incorporation forward will be tax-deductible. If you file later and can’t show “reasonable cause” for your delay, your tax-exempt status will begin as of the date on your IRS Application.

    Once You File

    Once you submit your application, you will receive an acknowledgment notice from the IRS confirming receipt of your application. If the IRS needs more information, an Exempt Organization specialist may request further information and will contact you and/or your power of attorney. If you have counsel or another representative assisting you with your application, contact them immediately regarding the additional information being requested. Do not try to answer their questions without their assistance.

    Once the IRS completes its review of the exempt application, they will send you a determination letter, which will either grant your federal tax exemption or issue a proposed adverse determination, a denial of tax exemption that becomes effective 30 days from the date of issuance. If you receive a proposed denial of tax-exempt status, you have the right to appeal and should seek expert advice immediately. Do not delay; waiting to reply will risk the denial of your exemption.

    The IRS review process typically takes several months or longer. Be prepared to wait. The IRS is currently processing 95,000 applications annually. Applicants can review current wait times by going to the IRS website: https://www.irs.gov/charities-non-profits/charitableorganizations/wheres-my-application-for-tax-exempt-status. You can also contact the IRS by phone at 877-829-5500; by fax at 855-204-6184; or by regular mail at:

    Internal Revenue Service

    EO Determinations; Attn: Manager, EO Correspondence;

    P.O. Box 2508; Room 6-403; Cincinnati, OH 45202.

    Compliance Begins Immediately

    Unless you qualify for an exception from the requirement to file an annual return or notice, your filing obligations begin as soon as you are formed. If you have an annual information return or tax return due while your application is pending, complete the return by checking the “Application Pending” box in the heading Item B, and submit the return as indicated in those instructions. You should also determine when you are required to begin your state’s compliance filings, as each state has its own set of requirements.

    Setting up an exempt organization can be confusing, to say the least. The HBK Nonprofit Solutions team is here to help.

    Read the full Fall issue of Insights, the HBK Nonprofit Solutions quarterly newsletter.

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