Starting a Nonprofit Organization
CA Public Benefit Corporation
1. RESEARCH FIRST!
The first step is to do some homework. Of course, you should research the need you are hoping to address. However, you should also research other applicable organizational issues and considerations, such as:
- Who will lead the formation of the Organization?
- Who will lead the operations of the Organization?
- Where will the Organization operate? Where will its principal office be located?
- Who will be served? How will they be served?
- Are there other organizations already addressing the need and/or serving your target service group? If there are, does it still make sense to form the Organization or would it be more effective and efficient to work within such an existing organization?
- How will the Organization differentiate itself from the existing organizations? What needs will it address that are not being and cannot be addressed by the existing organizations?
- Who will provide support to the Organization? Why?
- When will the Organization be established?
- When will the Organization receive its initial funding? Does the Organization have a viable plan to secure adequate funding to further its mission?
- When will the Organization carry out its activities? How is the Organization's funding tied to the expansion of its activities?
- Under what organizational form should the Organization operate?
- Nonprofit or for-profit?
- Corporation or unincorporated association?
- Public benefit, mutual benefit or religious nonprofit corporation?
- Membership or non-membership?
- Tax-exempt under IRC 501(c)(3), 501(c)(4), 501(c)(6), other?
- Fiscally sponsored?
- If exempt under IRC 501(c)(3), public charity or private foundation
2. Define the mission; develop the plan; promote the vision.
3. Recruit the board.
4. Refine the mission and the plan.
5. Determine the exempt status and legal form.
6. Draft and file the Articles of Incorporation (if corporate form).
7. Obtain a Federal Employer Identification Number.
8. Draft the bylaws and conflict of interest policy.
9. Hold and document the first meeting of the board.
10. File all required registrations and statements.
11. Prepare and submit the federal tax exemption application (Form 1023).
12. Prepare and submit the state tax exemption application (Form 3500).
Read more here … “Starting a Nonprofit Organization in California”
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Tax Exemption
Nonprofit vs. Tax-exempt
"Non-profit status is a state law concept. Non-profit status may make an organization eligible for certain benefits, such as state sales, property, and income tax exemptions. Although most federal tax-exempt organizations are non-profit organizations, organizing a non-profit organization at the state level does not automatically grant the organization exemption from federal income tax. To qualify as tax-exempt from federal income tax, an organization must meet requirements set forth in the Internal Revenue Code." - IRS website, Applying for Exemption FAQ #1
Note that tax-exempt, from the IRS perspective, means that an organization is exempt from paying federal corporate income tax on income generated from activities that are substantially related to the purposes for which the entity was organized (and for which the organization received tax-exempt status). The organization must still pay federal corporate income tax on income generated from activities which are not substantially related to its exempt purposes (i.e., unrelated business taxable income).
Further note that tax-exempt status on the federal level does not automatically make an organization tax-exempt on the state level. In California, an organization generally must apply and receive a determination letter from the Franchise Tax Board in order to be exempt from state corporate income tax.
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Internal Revenue Code Section 501(c)(3)
501(c)(3) organizations that are tax-exempt under IRC Section 501(a) are defined as:
"Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office."
Read more here … “Section 501(c)(3) Organizations”
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Internal Revenue Code Section 501(c)(4)
501(c)(4) organizations that are tax-exempt under IRC Section 501(a) are defined as:
“(A) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.
(B) Subparagraph (A) shall not apply to an entity unless no part of the net earnings of such entity inures to the benefit of any private shareholder or individual.”
Read more here … “Social Welfare Organizations” - IRS
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Internal Revenue Code Section 501(c)(6)
501(c)(6) organizations that are tax-exempt under IRC Section 501(a) are defined as:
“Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.”
Read more here … “Business Leagues” – IRS
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Form 1023 (IRS)
Form 1023 is filed by organizations to apply for recognition of exemption from federal income tax under IRC Section 501(c)(3). If the organization qualifies for exemption, the IRS will issue a determination that provides written assurance about the organization’s tax-exempt status and its qualification to receive tax-deductible charitable contributions.
The following organizations may be considered tax-exempt under Section 501(c)(3) even if they do not file Form 1023:
- Churches (including synagogues, temples and mosques).
- Integrated auxiliaries and conventions or associations of churches.
- Any organization that has gross receipts in each taxable year of normally not more than $5,000.
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Form 3500 (Franchise Tax Board)
Form 3500 is filed by organizations to apply for recognition of exemption from California franchise and income tax. If the organization qualifies for exemption, the FTB will issue a determination letter as proof of exemption.
Note that California does not provide exceptions from filing for churches and small charities unlike federal law.
Form 3500 Forms & Instructions (2007) – Franchise Tax Board
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Fiscal Sponsorships
A fiscal sponsorship is a type of relationship that a sponsored project (often a new charitable endeavor organized by an individual or group of individuals) has with its fiscal sponsor, typically conferring upon the project the benefit of the sponsor’s 501(c)(3) tax-exempt status and certain administrative services. There are several models of fiscal sponsorship. Accordingly, it is important for a sponsor and its project to understand the exact nature of their relationship, which should be memorialized in a written agreement.
From the sponsor’s perspective, it is essential to ensure that the activity of sponsoring a particular project is done in furtherance of its own exempt (e.g., charitable) purposes. Before entering into a fiscal sponsorship relationship, the sponsor should also be aware of its exposure to liability for the actions of its project.
From the project’s perspective, it is important to recognize that commonly the project will be the under the control of its sponsor, which may be legally responsible for the operations and activities of the project. The benefits of immediate tax-exempt status and administrative support must be weighed against the lack of autonomy and fees typically charged by the sponsor.
A fiscal sponsorship may be a very attractive alternative to formation of an independent tax-exempt entity where the immediate viability of a separate entity is questionable or the charitable endeavor has a relatively short-term. A project’s leaders may find it advantageous to “test the waters” through a fiscal sponsorship before they determine whether the project should become an independent tax-exempt entity. Accordingly, the fiscal sponsorship agreement should contain provisions dealing with termination of the relationship, including a description of what assets and liabilities, if any, will be transferred with the project to the new tax-exempt entity or fiscal sponsor.
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Public Charities and Private Foundations
Public Charities
Organizations described in IRC Section 501(c)(3) fall into two categories: private foundations and public charities. Under Section 509, all organizations, domestic or foreign, described in Section 501(c)(3) are private foundations except the types of organizations described in Sections 509(a)(1), (2), (3) or (4). "Public charities" is the generic term given to the excepted organizations.
(1) Section 509(a)(1) public charities include churches, certain educational organizations, hospitals, public college endowment funds, governmental units, and publicly supported organizations that normally receive a substantial part of their support (exclusive of income received in the exercise of its exempt purpose or function) from a governmental unit or from direct or indirect contributions from the general public. The substantial part of support requirement is met by satisfying a One-Third Support Test or, alternatively, a Facts and Circumstances (10%) Test. The percentages are calculated by using total support as the denominator and public support as the numerator. Both tests generally measure an organization's public support over a four-year period.
(2) A Section 509(a)(2) public charity is a publicly supported organization for which its public support more typically consists of gross receipts derived from an activity that is related to its exempt function. An organization will be excluded from private foundation status under Section 509(a)(2) if it meets both (i) the One-Third Support Test under Section 509(a)(2)(A), and (ii) the Not-More-Than-One-Third Support Test under Section 509(a)(2)(B).
(3) A Section 509(a)(3) public charity is a supporting organization that meets all of the following tests:
(a) Organizational and Operational Tests. The organization must be organized and at all times operated for the benefit of, and to perform the function of, the specified organizations described in Sections 509(a)(1) and (2).
(b) Nature of Relationship Test. The organization must be operated, supervised, or controlled by, or in connection with, one or more organizations described in Sections 509(a)(1) and (2).
(c) Lack of Outside Control Test. The organization must be controlled directly or indirectly by one or more disqualified persons other than foundation managers and other than one or more organizations described in Sections 509(a)(1) or (2).
(4) A Section 501(a)(4) public charity is an organization which is organized and operated exclusively for testing for public safety.
The distinction between private foundation and public charity classification is critical because public charity status is by far the more advantageous category where there is a choice for a number of reasons, including:
(1) Public charities are subject to fewer regulations.
(2) Public charity reporting requirements are less burdensome.
(3) Private foundations are subject to an absolute ban against self-dealing.
(3) Private foundations are subject to tax on their net investment income.
(4) The deductibility of charitable contributions to a public charity are subject to higher dollar limitations than those established for contributions to a private foundation.
(5) Public charities are not subject to expenditure responsibility rules.
Read more here … “Section 501(c)(3) Organizations”
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Private Foundations
Organizations described in IRC Section 501(c)(3) fall into two categories: private foundations and public charities. Under Section 509, all organizations, domestic or foreign, described in Section 501(c)(3) are by default private foundations unless otherwise excepted.
Private foundations must:
(1) Refrain from acts of self-dealing.
(2) Meet minimum distribution requirements (5% of the distributable amount, which is based on the fair market value of the noncharitable use assets).
(3) Abstain from excess business withholdings.
(4) Abstain from jeopardizing investments.
(5) Refrain from making certain types of expenditures, such as those paid or incurred to lobby, electioneer, make grants to individuals that do not satisfy certain criteria, or make grants to non-public charities or operating foundations without exercising expenditure responsibility.
Private foundations are also subject to 2% tax on their net investment income.
Read more here … “Section 501(c)(3) Organizations”
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Board – Legal Duties and Responsibilities
Legal Duties
The California Corporations Code generally provides that subject to certain limitations relating to action required to be approved by members, the activities and affairs of a nonprofit public benefit or mutual benefit corporation shall be conducted and corporate powers shall be exercised by or under the direction of the board. The board may delegate the management of the activities of the corporation to any person or persons, management company, or committee however composed, provided that the activities and affairs of the corporation shall be managed and all corporate powers shall be exercised under the ultimate direction of the board.
Directors are subject to two fiduciary duties in carrying out their governance responsibilities:
(1) The duty of care generally requires a director to act in a reasonable and informed manner under the given circumstances. The standard of care is that which “an ordinarily prudent person in a like position would use under similar circumstances.”
(2) The duty of loyalty generally requires a director to act in good faith and in the best interests of the corporation. The key to meeting this duty is to place the interests of the corporation before the director’s own interests or the interests of another person or entity.
Read more here … “Nonprofit Governance”
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Exposure to Liability
While directors of a nonprofit corporation may be protected by the limited liability provided by the corporate form, directors should be aware of several areas in which they may be subject to personal liability:
- Breach of the directors’ fiduciary duties.
- Breach of charitable trust.
- Self-dealing transaction by an interested director.
- Excess benefit transaction (e.g., excessive compensation).
- Wrongful actions taken outside of the director’s scope of authority.
- Employment claims (e.g., discrimination, sexual harassment, wrongful termination) against responsible directors.
- Discrimination claims by beneficiaries of the charity (e.g., for wrongfully denied benefits) against responsible directors.
- Other claims (e.g., for torts causing personal injury, breach of contract, defamation, intellectual property infringement, professional misconduct) against responsible directors.
- Failure to pay payroll taxes claim against responsible persons.
- Failure to observe corporate formalities (e.g., commingling personal and organizational assets, failure to hold or record minutes of meetings, failure to appoint or elect directors and officers).
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Minimizing Exposure
The best protection for a director to avoid personal liability is to meet his or her fiduciary duties, acting with due care and loyalty. The following represent some of the steps a director should take in meeting his or her duties:
(1) Be informed of your organization's mission, activities, legal and organizational structure, governance structures/policies/procedures, management structure, financial picture.
(2) Know your legal duties, basic legal requirements affecting your organization (including reporting requirements), your exposure to liability and how to minimize such exposure.
(3) Attend meetings.
(4) Get and review information relevant to board decisions/actions (minutes, financials, information returns, board book containing articles, bylaws, conflict of interest policy, exemption applications and determination letters).
(5) Exercise independent judgment.
(6) Deal openly with potential conflicts of interest.
(7) Delegate authority appropriately.
(8) Exercise proper oversight (regular financial reports, systems to evaluate progress at furthering mission, systems to ensure legal compliance).
(9) Consider public perception of organization.
Another strategy for minimizing personal exposure to liability is through indemnification. Section 5238 of the California Corporations Code provides for the indemnification of agents (including past and present directors, officers and employees) by a nonprofit public benefit corporation. Indemnification, in this context, means that the corporation will reimburse a person for any expenses (including attorneys' fees), judgments, fines, settlements and other amounts actually and reasonably incurred in connection with a proceeding (threatened, pending or completed, whether civil, criminal, administrative or investigative) against such person by reason of the fact such person is or was an agent of the corporation.
California law makes indemnification mandatory in certain cases, discretionary in other cases, and prohibited in the rest. An organization’s bylaws may address what level of indemnification is desired by the board and whether the organization will also advance expenses.
A third strategy for minimizing exposure is the use of insurance. Nonprofit organizations should assess their insurance needs by consulting with a qualified insurance agent or broker. Insurance products may vary widely in terms of coverage and cost among different insurance companies.
Commercial General Liability. The Commercial General Liability ("CGL") insurance policy typically provides broad liability coverage to the insured (i.e., the nonprofit corporation) for acts by the insured causing bodily injury, personal injury, property damage or advertising injury to a third party. CGL policies may provide coverage on either a claims made or occurrence basis.
Claims made policies require the claims to be made within the policy period (i.e., while the policy is in force). They may or may not provide coverage for acts occurring prior to the policy period. Generally, an insured nonprofit may prefer to have continuous coverage since its formation that will cover all acts no matter when the claims are made. For this reason, it may be prudent to ensure that a claims made policy has "full prior acts" coverage with no retroactive date as to how long ago the prior act may have taken place. Moreover, it may be critically important that the insured immediately notify the insurance company if it learns of a situation that could lead to a claim or receives notice of a claim. If the insured notifies the insurance company a day after the policy expires, it may not be covered. To address such problem, it may be prudent to purchase an Extended Reporting Period (or "tail") which extends the claims reporting provisions of the policy for a specific time period. An Extended Reporting Period may be of particular value if the insured switches from a claims made to an occurrence policy.
Occurrence policies provide coverage for acts occurring within the policy period even if the claims arising out of such acts are filed after the policy period terminates. Generally, occurrence policies are preferred by nonprofits over claims made policies without prior acts coverage even though the occurrence policies may be more expensive.
Directors and Officers Liability. The Directors and Officers Liability ("D&O") insurance policy typically provides coverage of damages resulting from the wrongful acts of directors and officers (and possibly other volunteers and agents of the corporation), including wrongful decisions and actions of the board. D&O policies are different from, and complementary to, CGL policies (e.g., D&O policies generally do not cover bodily injury or property damage resulting from negligence). Rather, they may cover claims such as employment-related actions (e.g., discrimination, harassment, wrongful termination) and mismanagement of assets.
D&O insurance may serve not only to provide important protection to the directors, officers and volunteers of the nonprofit, but also to help in the recruitment and retention of such individuals. Many persons with qualifications and experience valuable to a nonprofit will not serve on a board without requiring that the organization maintain adequate D&O coverage.
- Other Insurance Products.
- Property coverage.
- Non-owned auto coverage.
- Business-owned auto coverage.
- Professional liability (errors and omissions) coverage.
- Workers' compensation coverage (mandatory for employers).
- Improper sexual conduct coverage.
- Employee benefits liability coverage.
- Employee fidelity/dishonesty coverage.
- Student/volunteer/participant accident (no-fault) coverage.
- Liquor liability coverage.
- Umbrella coverage.
Links:
- Nonprofit Risk Management Center
– Articles
- Nonprofit Insurance Alliance of California
– Home Page
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Insider Transactions
Intermediate Sanctions
Section 4958 of the Internal Revenue Code ("IRC") provides for excise taxes (also referred to as "intermediate sanctions") on excess benefit transactions between a public charity and a disqualified person (defined below). An excess benefit transaction includes any transaction in which an economic benefit is provided by a public charity to a disqualified person where such benefit exceeds the value of the consideration (including the performance of services) received by the organization in return.
The initial excise tax on the disqualified person receiving the excess benefit (the "Benefited Insider") is 25 percent of the excess benefit. If the excess benefit is not corrected within the taxable period (the period between the date of the transaction and the earlier of the date on which (1) the statutory notice of deficiency is issued, or (2) the 4958 taxes are assessed), an additional excise tax of 200 percent of the excess benefit is imposed on such disqualified person.
If an initial excise tax is imposed on the Benefited Insider, an excise tax of 10 percent of the excess benefit is imposed on any organization manager who participates in the excess benefit transaction knowingly, willfully, and without reasonable cause. An organization manager includes officers, directors and trustees of the organization. Participation includes any affirmative action by such manager as well as silence or inaction if the manager had a duty to speak or act. Participation does not include an action by a manager in opposition to the excess benefit transaction. A manager participates knowingly only if he or she:
(1) Has actual knowledge of sufficient facts so that, based solely upon those facts, such transaction would be an excess benefit transaction;
(2) Is aware that such a transaction under these circumstances may violate the provisions of Federal tax laws governing excess benefit transactions; and
(3) Negligently fails to make reasonable attempts to ascertain whether the transaction is an excess benefit transaction, or is in fact aware that it is such a transaction.
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Disqualified Persons
A disqualified person with respect to a transaction is “(A) any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization [including directors of the corporation], (B) a member of the family of an individual described in subparagraph (A), and (C) a 35-percent controlled entity.” IRC §4958(f)(1).
Persons having substantial influence include: voting members of the governing body (e.g., directors, trustees), presidents, chief executive officers, chief operating officers, and chief financial officers, and chief financial officers. Persons deemed not to have substantial influence include: employees who both: (1) receive economic benefits from the organization of less than $95,000 (in 2005), and (2) do not hold executive or voting powers.
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Executive Compensation
Section 4958(c)(1)(A) of the IRC defines an excess benefit transaction as “any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.” An excess benefit transaction is prohibited and may subject the disqualified person and the directors who knowingly approved such transaction to significant federal excise taxes. IRC §4958(a), (b).
Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. For determining the reasonableness of compensation, all items of compensation are taken into account (with certain exceptions that probably do not apply here), including:
(1) All forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments, and deferred and noncash compensation;
(2) The payment of liability insurance premiums for, or the payment or reimbursement by the organization of, any penalty, tax, expense or correction owed under IRC Section 4958;
(3) All other compensatory benefits, whether or not included in gross income for income tax purposes; and
(4) Taxable and nontaxable fringe benefits, except fringe benefits described in IRC Section 132.
Reasonableness may be determined in part by (1) compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; (2) current compensation surveys compiled by independent firms; and (3) actual written offers from similar institutions competing for the services of the disqualified person.
Payments under a compensation arrangement are presumed to be reasonable if the following three conditions are met:
(1) The transaction is approved by an authorized body of the organization which is composed of individuals who do not have a conflict of interest concerning the transaction.
(2) Prior to making its determination, the authorized body obtained and relied upon appropriate data as to comparability.
(3) The authorized body adequately documents the basis for its determination concurrently with making that determination. Such documentation should include:
a. The terms of the approved transaction and the date approved;
b. The members of the authorized body who were present during debate on the transaction that was approved and those who voted on it;
c. The comparability data obtained and relied upon by the authorized body and how the data was obtained;
d. Any actions by a member of the authorized body having a conflict of interest; and
e. Documentation of the basis for the determination before the later of the next meeting of the authorized body or 60 days after the final actions of the authorized body are taken, and approval of records as reasonable, accurate and complete within a reasonable time thereafter.
Relevant comparability data includes, but is not limited to:
(1) Compensation levels paid by similarly situated organizations, both taxable and non-taxable, for functionally comparable positions;
(2) The availability of similar services in the geographic area of the applicable tax-exempt organization;
(3) Current compensation surveys compiled by independent firms; and
(4) Actual written offers from similar institutions competing for the services of the disqualified person.
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Lobbying & Advocacy
Lobbying
IRC §501(c)(3) provides that no substantial part of the activities of an otherwise qualified organization may be the carrying on of propaganda or otherwise attempting to influence legislation (i.e., lobbying). Violation of this prohibition may result in, among other consequences, loss of the organization’s tax-exempt status. It is therefore critical for 501(c)(3) organizations to avoid violating the substantial lobbying prohibition.
But the key is not to rule out engaging in any or all advocacy activities, but to better understand what is (and is not) lobbying and what amount of lobbying is considered substantial. These terms may have different meanings depending on the charity’s decision on the standard by which it chooses to measure its compliance.
By default, a charity falls under the somewhat vague standard provided by the Substantial Part Test. For most charities, it is much more advantageous to file a simple 1-page election to have its lobbying measured under the 501(h) Expenditure Test, which permits lobbying under certain defined limits.
Read more here … “Lobbying and Public Charities”
501(c)(4) and 501(c)(6) organizations may further their exempt purposes through lobbying as their primary activity without jeopardizing their exempt status.
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Non-Lobbying Advocacy
Although the lobbying activities of charities are subject to certain prescribed limits, such limitations do not apply to advocacy activities that are not considered lobbying. For example, the following activities do not fall within the meaning of lobbying:
(1) A communication to an administrative agency advocating a view on a regulation or ruling.
(2) A petition to the President, a governor, or a mayor regarding an executive decision.
(3) A communication whose purpose is to influence legislators on nonlegislative matters (e.g., conducting an investigative hearing, intervening with a government agency).
In addition, for charities making the 501(h) election, the following forms of advocacy are not considered lobbying:
(1) Nonpartisan analysis, study or research.
(2) Examinations and discussions of broad social, economic, and similar problems.
(3) Technical advice or assistance provided to a governmental body.
(4) Communications pertaining to self-defense by the organization.
Read more here … “Lobbying and Public Charities”
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Political Campaign Activities
501(c)(3) organizations are absolutely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate for elective office. Contributions to political campaign funds or public statements of position (verbal or written) made on behalf of the organization in favor of or in opposition to any candidate for public office clearly violate this prohibition. Such violation may result in denial or revocation of tax-exempt status and the imposition of certain excise tax. Note, however, that certain activities or expenditures may not be prohibited depending on the facts and circumstances. For example, certain voter education activities (including the presentation of public forums and the publication of voter education guides) and certain other activities intended to encourage people to participate in the electoral process (e.g., voter registration and get-out-the-vote drives), if conducted in a non-partisan manner, do not constitute prohibited political campaign activity.
501(c)(4) and 501(c)(6) organizations may engage in political campaign activities on behalf of (or in opposition to) candidates for public office; provided that such intervention does not constitute the organization’s primary activity.
Read more here …
“Tax-Exempt Organizations and Political Campaign Intervention” - IRS
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Charitable Solicitation
Charitable Solicitation LawsCharities, commercial fundraisers and fundraising counsel are subject to federal, state and local regulations. Generally, a nonprofit conducting charitable solicitation activities within a state (including by phone or mail) is subject to that state’s laws. Currently, 39 states require some sort of registration. In addition, states typically have specific laws requiring that a charity not misrepresent its purpose or the nature/purpose/beneficiary of the solicitation.
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State Charity Registration and Reporting Requirements
California law requires charities to register with the Attorney General's Office and to file financial disclosure reports. Charities (with certain notable exceptions including educational institutions, religious organizations, and hospitals) must register and file their articles of incorporation within 30 days after initial receipt of property. Charities must file the Annual Registration Renewal Fee Report (Form RRF-1), and those with gross revenue or assets of $25,000 or more must also file annual Form 990 financial reports, with the Attorney General's Registry of Charitable Trusts.
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Unified Registration Statement
The URS is an alternative to filing all of the respective registration forms produced by each of the cooperating states (currently all states requiring registration except Alaska, Colorado, Florida and Oklahoma). In those states, a registering charity may use either the state form or the URS. Note that the URS must be filled out appropriately for each cooperating state (some state-specific items) and filed for each such state.
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Substantiation and Disclosure
A donor cannot claim a deduction for a charitable contribution unless the donor maintains a record of the contribution (e.g., bank record, canceled check, written communication from charity), In addition, a donor is responsible for obtaining a “written acknowledgment” from a charity for any single contribution of $250 or more before the donor can claim a charitable contribution on his/her federal income tax return. A written acknowledgment must contain the following information: (a) name; (b)amount of cash contribution; (c) description (but not the value) of non-cash contribution; (d) statement that no goods or services were provided by the organization in return for the contribution, if that was the case; (e) description and good faith estimate of the value of goods or services, if any, that an organization provided in return for the contribution; and (f) statement that goods or services, if any, that an organization provided in return for the contribution consisted entirely of intangible religious benefits, if that was the case.
A charitable organization is required to provide a “written disclosure” to a donor who receives goods or services in exchange for a single payment in excess of $75. Such a payment made in part as a contribution and in part as payment for goods or services is referred to as a quid pro quo contribution. A required written disclosure statement must (a) inform a donor that the amount of the contribution that is deductible for federal income tax purposes is limited to the excess of money (and the fair market value of property other than money) contributed by the donor over the value of goods or services provided by the organization; and (b) provide a donor with a good-faith estimate of the fair market value of the goods or services. A written disclosure statement is not required: (a) where the goods or services given to a donor meet the “token exception,” the “membership benefits exception,” or the “intangible religious benefits exception;” or (b) where there is no donative element involved in a particular transaction, such as in a typical museum gift shop sale.
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Earned Income Strategies
501(c)(3) Limitations
A charity that earns income from its activities must be aware of certain limitations imposed by Section 501(c)(3) of the Internal Revenue Code, particularly the Operational Test, the private inurement doctrine, and the private benefit doctrine.
The Treasury regulations set forth that a 501(c)(3) organization must pass an Operational Test. The test is intended to ensure that the organization is operated primarily for one or more of the exempt purposes set forth in Section 501(c)(3). Only an "insubstantial part" of the organization's activities may be devoted to non-exempt purposes, such as operating an unrelated business. If, however, the organization's primary purpose is the operation of an unrelated trade or business, it may not qualify for 501(c)(3) exempt status, even if all of the profits from such trade or business are to be used in furtherance of its exempt purposes.
An organization will fail the Operational Test if any part of the organization's net earnings inure to the benefit of any private shareholder or individual. The private inurement doctrine generally prohibits an exempt organization from using its assets for the benefit of a person having a personal and private interest in the organization's activities (i.e., an insider such as a director, officer or key employee). An organization that engages in an inurement transaction (e.g., paying an unreasonable compensation to an insider) may face revocation of its exempt status.
An organization will similarly fail the Operational Test unless it serves a public rather than a private interest. To satisfy this requirement, referred to as the private benefit doctrine, the organization must establish that it is not operated for the benefit of private interests. This does not mean that the organization may not confer benefits to individuals; rather, it provides that such benefits must be incidental, quantitatively and qualitatively, to the furthering of the organization's exempt purposes.
While the private benefit and private inurement doctrines appear very similar, there are two important differences. One, the private benefit doctrine is much broader than, and indeed subsumes, the private inurement doctrine because it applies whenever an impermissible benefit is being conferred on any private party, not just insiders. Two, unlike the case with private inurement, an incidental amount of private benefit may not cause a loss or denial of exempt status. Instead, excise taxes, referred to as intermediate sanctions, may be imposed on excess benefit transactions between Section 501(c)(3) public charities and disqualified persons. The IRS takes the position that it may both revoke an organization's exempt status and apply intermediate sanctions to the disqualified persons and any organizational managers who knowingly approved a prohibited private inurement transaction.
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Unrelated Business Income Tax
The general definition of u[Text]nrelated business income (UBI) is income from a trade or business that is regularly carried on and is not substantially related to the organization's exempt purposes. A trade or business is an activity carried on for the production of income from the sale of goods or performance of services. Business activities are "regularly carried on" if they show a frequency and continuity and are pursued in a manner similar to comparable commercial activities of nonexempt organizations. An activity is "not substantially related" if it does not contribute importantly to the accomplishment of the organization's exempt purposes (see your governing documents and exemption application). Expending revenues generated from an activity in furtherance of exempt-related purposes does not make the activity itself substantially related. There are a number of modifications, exclusions and exceptions to the general definition of UBI.
While related business income is not taxed, unrelated business taxable income (gross UBI less the deductions directly connected with carrying on the trade or business) is subject to corporate income taxes. UBI is reported on Form 990-T, which a charity must file if it has gross UBI of $1,000 or more.
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Organizational Structuring
Joint Ventures
A nonprofit and a for-profit organization may, under certain conditions, enter into a joint venture (in the form of a separate legal entity) to undertake economic activity together for their mutual benefit. From the nonprofit's perspective, the cross-sector joint venture may provide additional opportunities to further its charitable purposes, greater access to capital and expertise, the possibility of capital appreciation, flexibility in operation, and protection of the nonprofit co-venturer from liabilities of the venture. From the for-profit's perspective, the joint venture may provide enhanced good will, marketing opportunities, and access to expertise and political capital, and it may open up financial opportunities that might otherwise not be available.
For a nonprofit to enter into a joint venture with a for-profit entity, the joint venture must pass a two-prong test. The first prong requires that the activities of the joint venture further the exempt purposes of the nonprofit. The second prong requires that the structure of the joint venture provide the nonprofit with sufficient control to ensure that the nonprofit's participation (i) is exclusively in furtherance of its exempt purposes, and (ii) does not result in more than incidental private benefit.
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Mergers
Many nonprofits have collaborated with other organizations and experienced the benefits of leveraging their combined resources, sharing information and best practices, and sparking new ideas. An increasing number of nonprofits are taking their collaborations to the next step and merging, hoping to capitalize on synergies, save weaker organizations, and/or pursue growth opportunities. Or course, any consideration of a merger deserves careful attention and experienced assistance.
A merger may result in a surviving organization and a disappearing organization or in the creation of a brand new organization (e.g., the Silicon Valley Community Foundation). A surviving organization may be required to provide notice to the IRS of the material change; a new organization will need to receive determination that it is tax-exempt. If there is any concern about the tax consequences of a proposed merger, the parties may wish to first request a private letter ruling from the IRS.
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Affiliate Organizations
501(c)(3) charitable organizations are sometimes formed as affiliate organizations of 501(c)(4) social welfare organizations or 501(c)(6) business leagues or chambers of commerce. Organizations may be affiliated through overlapping directors, a bylaw provision providing one organization with the right to appoint a majority or all of its affiliate's directors, or through a membership structure in which one organization is the sole member of its affiliate. Examples of such affiliated organizations include the Sierra Club and The Sierra Club Foundation; and the State Bar of California and The Foundation of the State Bar of California.
A 501(c)(4) or (c)(6) organization may desire to form a 501(c)(3) affiliate in order to raise funds for, and operate, its charitable and educational programs. The 501(c)(3) may be eligible to receive grants and contributions which are eligible for a charitable deduction that the 501(c)(4) or (c)(6) would otherwise not be able to receive. A 501(c)(4) may also form an affiliated political organization (Federal PAC, State PAC, 527 Organization), which is used to engage in activities to influence the nomination or election of candidates for public office.
A 501(c)(3) may desire to form a 501(c)(4) as a vehicle in which activities otherwise prohibited may be conducted. For example, a 501(c)(4), unlike a 501(c)(3), can lobby without restriction and engage in some political campaign activities without jeopardizing its exempt status. Affiliate organizations must be structured and operated carefully to ensure that they are treated as separate organizations.
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Subsidiaries
Nonprofit corporations may form, own and control subsidiaries for a number of reasons. For example, a
nonprofit may form a for-profit taxable subsidiary as a vehicle that may engage in a substantial amount of unrelated business activities without jeopardizing the exempt status of the nonprofit. A nonprofit tax-exempt subsidiary may be formed to engage in activities in furtherance of purposes distinct from the parent's exempt purposes. Subsidiaries may also be part of a risk management strategy, providing to the parent protection against liability incurred by the subsidiary.
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