Even after you’ve incorporated, obtaining federal tax-exempt status is a critical step in forming a nonprofit organization. Most of the real benefits of being a nonprofit flow from your 501(c)(3) tax-exempt status, such as the tax-deductibility of donations, access to grant money, and income and property tax exemptions. To apply for tax-exempt status, you must complete IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Completing this form can be a daunting task because of the legal and tax technicalities you’ll need to understand.
When to File For 501(c)(3) Status
To get the most out of your tax-exempt status, you’ll want to file your Form 1023 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 takes effect on the date you filed your articles of incorporation (and all donations received from the point of incorporation onward will be tax deductible). If you file later than this and can’t show “reasonable cause” for your delay (that is, convince the IRS that your tardiness was understandable and excusable), your group’s tax-exempt status will begin as of the postmark date on its IRS Form 1023 application.
Form 1023-EZ: The Streamlined Application
Smaller nonprofits may be eligible to file Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. This is a shorter, simpler application form that you complete online. Form 1023-EZ may only be filed by nonprofits with less than $50,000 in annual receipts and $250,000 in total assets. If you’re in the ballpark, complete the Form 1023-EZ Eligibility Worksheet contained in the Form 1023-EZ Instructions to determine if your nonprofit meets all the requirements for using the shorter streamlined form. If you are eligible to use it, this version of the form is much easier to complete and will take you much less time. The filing fee is also much smaller.
Identification of Applicant
This section tells the IRS about your organization. It asks for basic information like the name of your nonprofit corporation, contact information, and when you filed your articles of incorporation. Your nonprofit must have a federal employer identification number (EIN) prior to applying for 501(c)(3) tax exemption, even if it doesn’t have employees. This can be done quickly and easily. Even if your organization held an EIN prior to incorporation, you must obtain a new one for the nonprofit corporate entity. For information on how to apply for an EIN, including information about applying online, visit the Employer ID Numbers page on the IRS website.
Organizational Structure
This section requires that you attach a copy of your articles of incorporation and your bylaws to the application form. Most nonprofits seeking 501(c)(3) status are corporations. If your entity is an LLC, unincorporated association, or nonprofit trust, you should seek the help of a lawyer with experience in nonprofit tax law to complete your Form 1023 application.
Required Provisions in Your Organizing Document
There are certain clauses that you must have in your articles of incorporation in order to get your 501(c)(3) exemption, including:
• a clause stating that your corporation was formed for a recognized 501(c)(3) tax-exempt purpose (charitable, religious, scientific, literary, and/or educational), and
• a clause stating that that any assets of the nonprofit that remain after the entity dissolves will be distributed to another 501(c)(3) tax-exempt nonprofit or to a federal, state, or local government for a public purpose. In this section, you state where these clauses can be found in your articles (by page, article, and paragraph).
Narrative Description of Your Activities
Here you provide a detailed, narrative description of all of your organization’s activities — past, present, and future — in their order of importance (that is, in order of the amount of time and resources devoted to each activity).
• the activity itself, how it furthers an exempt purpose of your organization, and the percentage of time your group will devote to it
• when it was begun (or, if it hasn’t yet begun, when it will begin)
• where and by whom it will be conducted, and
• how it will be funded (the financial information or projections you provide later in your application should be consistent with the funding methods).
Compensation and Financial Arrangements
The purpose of this section is to prevent people from creating and operating a nonprofit for the sole benefit of its founders, insiders, or major contributors. You’ll need to give information about all proposed compensation to, and financial arrangements with:
• initial directors
• initial officers (such as the president, chief executive officer, vice president, secretary, treasurer, chief financial officer, or any other officer in your organization)
• trustees
• the five top-paid employees who will earn more than $50,000 per year, and
• the five top-paid independent contractors who will earn more than $50,000 per year.
In computing the amount of compensation paid, include employer contributions made to employee benefit plans, 401(k)s, IRAs, expected bonus payments, and the like. You must also answer questions relating to possible conflicts of interest, which is an important part of the application.
Members and Others That Receive Benefits From the Nonprofit
If your nonprofit will provide goods or services as part of its exempt-purpose activities, you must report this on Form 1023. The IRS wants to ensure that your nonprofit is set up to provide goods and services to all members of the public or at least a segment of the public that is not limited to particular individuals. If your nonprofit is a successor to an incorporated or preexisting organization (such as an unincorporated association), the IRS wants to know this. Your nonprofit is most likely a successor organization if it has:
• taken over the activities of a prior organization
• taken over 25% or more of the assets of a preexisting nonprofit, or
• been legally converted from the previous association to a nonprofit.
Details on Your Specific Activities
This part asks about certain types of activities, such as political activity and fundraising, that the IRS scrutinizes closely. For example:
• 501(c)(3) nonprofit organizations may not participate in political campaigns (although some voter education drives and political debate activities are permitted).
• Certain types of fundraising are restricted, including bingo and gaming activities, fundraising for other nonprofits, or using a professional fundraiser.
Financial Data
All groups wishing to obtain 501(c)(3) exempt status must provide a statement of revenues and expenses and a balance sheet. An organization that has been in existence for five years or more must provide financial data for its most recent five years. Other groups must provide financial data for each year they have been in existence and good faith estimates for future years for a total of three or four years, depending on how long the organization has been in existence. These revised financial data requirements relate to IRS rules that automatically classify all new 501(c)(3) groups as public charities as long as they can show in their Form 1023 that they reasonably expect to receive qualifying public support. If your nonprofit is a public charity, you will want to include all the information necessary to avoid misclassification as a private foundation.
Public Charity or Private Foundation
This section relates to your nonprofit’s classification as a public charity or private foundation. Public charities, which include churches, schools, hospitals, and a number of other groups, derive most of their support from the public or receive most of their revenue from activities related to tax-exempt purposes. Most groups want to be classified as a public charity because private foundations are subject to strict operating rules and regulations. Under IRS regulations all new 501(c)(3) groups are automatically classified as public charities for the first five years as long as they demonstrate in their Form 1023 that they reasonably expect to receive qualifying public support. This way new groups applying for 501(c)(3) tax-exempt status need not seek an advance IRS ruling on their public charity status. For the first five years, the group will maintain its public charity status regardless of how much public support it actually receives. After the initial five-year period, the IRS will start to monitor whether the group receives the public support necessary to qualify as a public charity. You must pay a fee when you submit your Form 1023 application. Check the IRS website for the current user fee.
Additional Schedules
Certain types of nonprofits must attach an additional schedule to their Form 1023 application. Most of these schedules concern statutory public charities–nonprofits like churches and hospitals that are automatically classified as a public charity no matter how much public support they receive. Each schedule asks for additional information geared to the type of nonprofit. For example, Schedule A for churches asks a series of questions designed to show whether the organization really is a church for tax purposes, such as whether it has a creed or form of worship. These schedules include:
• Schedule A: filed by churches
• Schedule B: filed by schools, colleges, and universities
• Schedule C: filed by hospitals and medical research organizations
• Schedule D: filed by supporting organizations
• Schedule E: filed by nonprofits over 27 months old
• Schedule F: filed by homes for the elderly or handicapped, or low income housing
• Schedule G: filed by successors to other nonprofits.
After You File
After reviewing your application, the IRS will do one of three things:
• grant your federal tax exemption
• request further information, or
• issue a proposed adverse determination (a denial of tax exemption that becomes effective 30 days from the date of issuance).
Typically, IRS 501(c)(3) approvals takes between 2 and 12 months, inclusive of likely written follow-up questions. Sometimes it takes a little less; sometimes a little more. Expedited review can be requested if a new organization is being formed to provide immediate disaster relief or if a promised grant is both substantial relative to the organization’s budget and the grant has a specifically- defined expiration date. There is no guarantee the IRS will grant expedited review requests. One of the primary reasons for the long review period is the amount of time it takes for a particular case to assign to a review agent.
What Does a Non-Profit Lawyer Do?
A non-profit attorney handles many of the same issues as a business lawyer, but focuses on the special issues that affect non-profit organizations. An attorney can help your non-profit if you’re just starting up and need guidance on the paperwork that needs to be filed, when you file taxes, or when you need litigation. A non-profit lawyer can help you lay the proper foundation so that your organization can flourish. Your non-profit lawyer can advise you on the right form of entity for your organization, depending on the activities and goals you plan to achieve. For instance, your charitable organization may be able to gain a tax-exempt status if you meet conditions set forth in section 501(c)(3) of the Internal Revenue Code and maintain specific documents. A political organization, private foundation, or religious organization has different legal and tax obligations. With the right lawyer, you can also get advice about the management for your non-profit such as how to form a board of directors, how to appoint officers, and whether you can form an affiliation. A non-profit lawyer can advise you what types of legal forms and documentation you need to maintain your non-profit status, and aid the education of directors, personnel, and other stakeholders so you can run your organization diligently. Depending on what service you need, your lawyer may use different methods of billing. For simple tasks like document drafting or review, a non-profit attorney often charges a flat fee. For longer or more complex matters, your lawyer will likely charge an hourly rate. Rates will vary depending on your industry, the complexity of your case, and where your business is located. Be sure to negotiate a rate up front with your attorney.
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