Non-profit Non-Profit Organizations: Formation and Tax Exemption

People create non-profit organizations (also known as "nonprofit" or "not-for-profit" companies) for a purpose other than the profit of the creators. While the business does have a need and incentive to generate revenue, the primary purpose of the entity is to benefit the members of an organization or for a public purpose, such as charitable, religious or educational causes.

The Pros and Cons of Forming a Non-Profit Corporation

While the non-profit business does not need to be a corporation, it is usually advisable to do so since the entity may obtain benefits such as tax-exempt status and special postal rates for mail. Common benefits of incorporating a non-profit entity are:

• It may receive federal, state and local tax exemptions
• It is eligible for government funding and grants from private foundations
• The officers, directors and members have limited liability and are not personally liable for the debts of the non-profit corporation
• A non-profit company can generate revenues through accepting contributions or donations, both of which are tax deductible by the donor

Common disadvantages of incorporating a non-profit entity are:

• If a non-profit corporation has positive earnings, the money cannot be distributed to members
• Profits from activities unrelated to the purpose of the non-profit are taxable
• When a non-profit corporation ends, distribution of corporate assets cannot be made to members but to another non-profit corporation or entity

How to Create a Non-Profit Company

The creation of a non-profit organization requires filing paperwork to comply with federal, state and local laws which includes tax reporting. It is generally advisable that one seeks the advice of an experienced business law attorney before filing to ensure it is done properly, including making sure that the purpose of the organization is sufficient in scope and that the articles of incorporation and corporate by-laws are created properly.

Each state has its own process for filing, but in general, the following applies:

• The filing of corporate documents with the state's division of corporations (usually the Secretary of State) and which includes the "articles of corporation" or "corporate charter." These documents provide information about the non-profit corporation's name, the names of people serving on the board of directors and run the company, the name of the person who will be the "registered agent" and receives official documents for the non-profit corporation (like legal papers and tax documents.)
• The creation of the by-laws of the corporation, which explain how the corporation is to be run, the rules of the voting process for officers and directors and other major operations of the non-profit company
• Filing for an employer identification number (EIN) which identifies the non-profit company (and required if IRC § 501(c)(3) tax-exempt status is desired) and possibly a state EIN if the state requires it
• Filing with the state for tax-exempt status (some states automatically grant the exemption if the IRS approves a non-profit to be a IRC § 501(c)(3) company)
• Filing for IRC § 501(c)(3) tax-exempt status with the Internal Revenue Service (IRS) if the non-profit company qualifies for being within the five IRC § 501(c)(3) types of organizations:
  • has charitable purpose
  • has a literary purpose
  • qualifies as a religious group
  • qualifies as an educational organization
  • qualifies as a scientific organization

Ensuring Non-Profit Tax Exempt Status

The IRS and state tax authority can eliminate a non-profit organization's tax-exempt status if rules and requirements are not satisfied. The following are recommended as safety measures to ensure tax-exempt status for your non-profit company:

• Maintain proper records of all corporation meetings
• Maintain records of all correspondence for all federal and state tax issues
• Maintain proper books and records for all income
• Separate revenue generating from activities not related to the non-profit corporation's primary purpose (taxes must be paid on that income)
• Ensure that salaries paid to employees and board members are reasonable (comparable to the salaries of people in the same positions at other non-profit corporations in your area)