12 Steps to Forming a Charitable Organization

Dan Busby, CPA President, Evangelical Council for Financial Accountability (ECFA)
This article provided by the Engstrom Institute

America's nonprofit organizations are often referred to as the independent sector, the voluntary sector, or the third sector of U.S. society. As a CPA and former practitioner, I have met with many individuals who desired to start a nonprofit organization, invoking the principles of voluntarism. Hope springs eternal with those who have a dream to start a nonprofit to provide service.

This enthusiasm and vision to help others spawns about 80,000 new applications for tax-exempt status each year. The Internal Revenue Service (IRS) approves about three out of every four applications or 60,000 each year.

Terminology. Understanding the nonprofit terminology is a good starting point. You will often see the term "not-for-profit" used in reference to nonprofit organizations. This does not mean the nonprofit organization cannot be profitable (have more revenue than expenses). Rather, a nonprofit organization ideally would have at least a nominal profit as it will use profits to continue its mission. The term "not-for-profit" is a proper term for an activity engaged in without a profit motive, such as a hobby, where the related expenses are not deductible as business expense as contrasted with "for-profit" organizations, who distribute profits to the owners.

Purpose. In order for an organization to be classified as a nonprofit entity, its purpose must be primarily related to qualified charitable or educational endeavors. The essence of a nonprofit is to carry on an activity because it is important, and not as a means of generating profits for investors (as with a for-profit organization). This does not mean that a nonprofit organization cannot hire people and pay them for their work, or that it must operate at a loss. Any surplus gained should generate more "good works."

There are different categories of nonprofit organizations with different treatment, privileges and obligations under the Internal Revenue Code (Code). To qualify for a Federal Tax exemption, your organization must be organized for one or more of the purposes specifically designated in the Code. A few major distinctions are outlined below:

• 501(c)(3) organizations. The most common type of nonprofit organizations are classified as 501(c)(3) organizations under the Code. They must prove that they operate exclusively for religious, educational, scientific, or similar purposes. Churches are included in this category. A 501(c)(3) does not have to pay income taxes and is authorized to issue tax-deductible receipts to donors for contributions. Having tax-deductible status significantly helps in attracting grants and contributions from foundations and individuals that are crucial to a charitable organization.
• Other nonprofits. Some of these types of organizations include: lobbying organizations, fraternities, and various other associations. While they do not have to pay income taxes, they are not able to issue tax-deductible receipts to donors. Therefore, donors to these organizations cannot take deductions on their income taxes. Additionally, these other categories have different constraints and obligations under the Code.

Here are 10 steps in starting a nonprofit you may wish to consider before you dip your toe in tax-exempt application waters:

1. Develop and convey your vision. One of the most fundamental places to begin the formation process is to solidify what your vision is for the organization and how to best convey the vision. This step is crucial in the success of an organization because as a founder your role will be one of gathering others around the vision and rallying them to implement it whether it is through contributions, volunteering, or going out into the mission field.
   
   Mission drift can occur for various reasons—often from a lack of focused direction which can then spiral into an organization's demise. It is therefore important that the organization's vision and mission are firmly grounded before the organization is launched. This is not to say that a mission statement is to be a constraint to growth, but rather that a well crafted vision will inspire growth and keep that growth focused.
2. Find the right advisors. Where do you start in your nonprofit organization trek? First and foremost, seek advice. Find one or more wise counselors. It's biblical—in multitude of counselors, there is safety (Prov. 24:6).
   
   As noted nonprofit attorney Bruce Hopkins says "the label nonprofit does not mean 'no planning.'" Utilize an experienced advisor, one who is an experienced nonprofit professional—an attorney or a CPA—or someone who has helped many people form new nonprofit organizations. This is not the time for advice from a novice, no matter how good a friend.
   
   Your advisors can be a great resource to the founder in formation and operational issues. A review of significant issues by a professional is often desirable to navigate the statutory, tax, and accounting rules pertaining to nonprofit organizations.
   
   It may not take a village to form a nonprofit organization and it may only take one individual to incorporate in your state. But, it usually takes more than a few people to get most nonprofits up and running.
3. Measure the potential of obtaining tax-exempt status and measuring the cost. Discuss your concept for a nonprofit with your advisor. Your advisor will help determine the likelihood of whether your idea for a nonprofit will win IRS approval or not. After discussing your concept with your advisor, you may need to go back to the drawing board before proceeding.
   
   Be attentive to their point of view and be cautious about spending time and money to apply for tax-exempt status if a seasoned advisor raises major concerns. Unless you have a qualified counselor who uses the magic phrase "pro bono" with respect to your tax-exempt application, the application process is expensive. Having your articles of incorporation and bylaws prepared by an attorney and having a professional prepare your Form 1023 Application for Exemption from Income Tax can easily cost several thousand dollars—in addition to the user fee charged by the IRS. While these professional fees seem like a high amount these fees are usually well-spent funds in the long run.
   
   
4. Determine the style of governance and board size. The style of governance you choose will determine how your bylaws are written. While there are some variations, the two basic governance styles are:
• Membership style. The membership style is appropriate for certain nonprofits. In the most typical membership governance style, members have the authority to elect board members and change the bylaws.
  
  Many churches embrace the membership style. While the membership style provides representation broader than a nonprofit board, there are challenges that accompany this style of governance. It can be awkward to manage competing interest of members and the nonprofit board. It can also be difficult to persuade a large membership group to make fundamental changes in governing documents.
• Self-perpetuating style. The self-perpetuating board style is most commonly utilized for nonprofits. In this style, the board generally has the power to elect board members and change governing documents.
  
  Board size is an important issue. Most bylaws give the organization flexibility in determining board size, e.g., "The board shall be comprised of between 3 and 9 board members." If this approach is followed, a nonprofit may start with a smaller board and increase board size as the organization grows. The average board size for nonprofits—beginning and mature—is about 15. (Bylaws that specify an exact number of board members, e.g., "there shall be seven board members, establish a very inflexible restriction and this should be avoided unless state law requires this approach.)
  
  Determining whether your board is numerically and functionally independent is also an important decision. The Evangelical Council for Financial Accountability (ECFA) requires an independent board—a board that is primarily comprised on non-staff member and non-relatives. There also has been a significant interest in independent board governance by the Internal Revenue Service. The Form 990 requires the disclosure of whether a board is independent on page one.
  
  
5. Prepare your organizing documents. After you decide which state in which your organization will be formed, developing your organizing documents is a fundamental next step in the tax-exempt application process. While incorporation is usually desirable, it generally is not mandatory. To apply for tax-exempt status, an organization must submit a conformed copy (a copy that agrees with the original document and all amendments to it) of your organization's Articles of Incorporation (and the Certificate of Incorporation, if available), Articles of Association, Trust Indenture, Constitution, or other enabling document. If the organization does not have an organizing document, it will not qualify for exempt status. Bylaws alone are not organizing documents. However, if your organization has adopted bylaws, include a current copy with the application.
   
   
6. Obtain your employer identification number (EIN) You must have an employer identification number (sometimes referred to as a taxpayer identification number) for the new nonprofit organization. The IRS assigns this number after you properly complete and file Form SS-4. When your organizing documents are complete it is a good time to file Form SS-4.
   
   There is often confusion about when a nonprofit organization has a tax-exempt number. The employer identification number is not a tax-exempt number. The identification number has nothing to do with tax-exempt status.
   
   
7. Prepare the Form 1023, if applicable If you apply to the IRS for a ruling or determination regarding your tax-exempt status, you are not asking the IRS to grant tax-exempt status. You are asking them to recognize a tax-exemption that already exists (assuming your organization qualifies).
• Completing and filing Form 1023, Application for Recognition of Exemption, is generally required for organizations desiring to be tax-exempt other than churches, integrated auxiliaries of churches and conventions or associations.
• A user fee, which is adjusted from time to time, must be submitted with the application. Form 1023 is not used to apply for a group exemption, e.g., a central organization with subordinate organizations.
• The Form 1023 should be carefully prepared just as you would a legal document. This form will be subject to review throughout the organization's existence. You will be required to provide a copy of the application, and related correspondence to anyone who requests it under the federal public disclosure rules.
• After your Form 1023 is filed, the application process may take several months, including responses to the IRS concerning additional information that is requested. If the application is not complete, the IRS may return it and ask you to file again. A practical tip here is to have the Form 1023 prepared by a professional who has experience with the form. If there are repeated inquiries or request for reapplication the process can drag on for a significantly longer time. (IRS Publication 557, Tax-Exempt Status for Your Organization, available at www.IRS.gov, may be very helpful in completing Form 1023.)
  
  
8. Structure the organization to avoid private inurement and private benefit. The basic in private inurement principle is to ensure that a nonprofit organization is serving public interests, not private interests. A nonprofit organization must not be organized or operated for the benefit of private interests (the creator of the nonprofit organization, his or her family, persons controlled by private interests, or any persons having a personal and private interest in the activities of the nonprofit.)
   
   The private benefit concept is broader than private inurement and it can operate without the involvement of an insider. This concept may apply even when the beneficiary is a for-profit corporation.
   
   
9. Address charitable contribution issues. In addition to professional advisors and formational documents, you must determine if you can raise the charitable funds to get started. Foundations and corporations generally do not fund start-up nonprofits. Those first contribution dollars usually come from friends and associates, who share in the vision and mission of the new nonprofit.
   
   When a new charity is in the process of being formed, it is common for donors to make gifts to the charity and to desire a receipt that may be used for tax deduction purposes. The question often arises whether and when the new charity can legitimately issue charitable receipts.
   
   The earliest date that a charity may appropriately issue donation receipts is the date on which the charitable entity is legally formed (e.g, usually the date the incorporation is approved by the state). The importance of the legal formation is emphasized in the instructions for Form 1023, which state that if Form 1023 is filed within 27 months after the end of the month in which an organization is legally formed, and the IRS approves the application for tax-exempt status, the effective date of the tax-exempt status is retroactive to the legal date of formation. Therefore, it appears that only gifts received on or after the date of incorporation could be appropriately receipted for charitable donation purposes.
   
   For many charities, obtaining tax-exempt status is a relatively routine process. Therefore, it is typical for them to begin to issue receipts as soon as they are incorporated with a high degree of certainty that they will be approved for tax-exempt status. However, some large donors and many foundations require an exemption determination letter. Therefore, a charity whose tax-exempt status has not been approved should alert these particular donors that they do not yet have an exemption determination letter.
   
   
10. Address administrative issues. The following administrative issues are very important:
• Determine your accounting system and related controls. Many nonprofits start with an accounting system as simple as QuickBooks. If donations will be received, it is also important to use an electronic donor management system.
  
  It is vital to establish sound accounting and internal control systems. Procedures or internal controls are generally the most cost effective means to avoid fraud, lawsuits and self-dealing. Furthermore, these will allow the organization to smoothly transition as its personal expands. Here are a few basic concepts:
1. Cash and other revenues. When one individual has control over an entire accounting transaction, fraud is possible. To prevent most types of theft, segregate employee duties. At minimum, the following duties should be segregated to prevent theft: collecting cash, preparing bank deposits, reconciling bank statements, and posting receipts to the general ledger/contribution system.
2. Expenditures. At a minimum the following duties should be segregated: approval of expenditures, writing checks and signing checks.
• Donor management systems. A donor management system will assist you in building and using your donor database. It will also allow you to track contributions and receipting. It is also important to track restrictions associated contributions as a failure to use the funds as instructed could lead to a loss in donors and litigation.
• Policies. It will be important as you expand to ensure you have sufficient policies so as to have uniform momentum between employees and corporately as an organization. While these may not be a priority right at formation, they should be considered during these initial steps and adopted as applicable.
  
  
11. Determine required filings with federal, state, and local governments Your nonprofit organization may be subject to a variety of filing requirements. If you have at least one employee, there are Form 941 and W-2 filings. If you have at least one independent contractor to whom you have paid $600 or more in a calendar year, you have Form 1099-MISC and Form 1096 filings. Most non-church organizations must annually file Form 990 with the IRS.
• Forty-six states have some form of a charitable solicitation act (a statute regulating charitable fund-raising). And many county and local municipalities have similar regulations. Annual filings are often required to satisfy these laws.
• If your charity has at least $1,000 or more of gross unrelated business income in a year, Form 990-T must be filed with the IRS.
  
  
12. Adopt standards and best practices. At an organization's inception is an excellent time to adopt fundamental and biblically-based standards, best practices, and philosophy statements.
    
    Even if your organization is not yet a member of the Evangelical Council for Financial Accountability (ECFA), you can follow their standards of responsible stewardship and best practices found on ECFA's website (www.ECFA.org).
    
    An excellent stewardship philosophy statement that has been jointly developed by the ECFA and the Christian Leadership Alliance (CLA) is available on ECFA'S website (www.ECFA.org).

Summary. While there are a host of other issues that may be important for you to consider early in the development of your nonprofit (use of the Internet, lobbying, political activities, liability insurance, proper fund-raising techniques and much more), this list of ten steps cover some of the most basic issues.

Resources

• www.ECFA.org has resources available free of charge including one of the most extensive libraries of technical research bulletins. For more information on ECFA please check the website or call 1-800-323-9473.
• You can view IRS Publication 557, "Tax Exempt Status for Your Organi¬za¬tion," at www.IRS.gov. This publication outlines the basic procedures for securing charity status and main¬taining it. You can also download Form 1023 (to file for 501(c)(3) status), Form 8718 (to calculate the fee for filing the exemption), and Form SS-4 (to apply for an employer identification number). These forms are available from the IRS on the web at www.IRS.gov or by calling (800) 829-3676.