It usually starts with a phone call from a client, or maybe another attorney in your office. Someone wants to set up a nonprofit corporation, usually a tax-exempt charity, often on behalf of a pro-bono client, and assumes it should be pretty easy.
Unfortunately, it’s not.
First, “nonprofit” is not the same as “tax-exempt,” although many people use the terms interchangeably. Nonprofit is a state law concept and is governed by the relevant state statute for nonprofit corporations. In Arizona, that would be Article 10, Chapters 24-40 of the Arizona Revised Statutes. Tax-exempt usually refers to being exempt from federal income tax under section 501(c) of the Internal Revenue Code. Furthermore, there are different types of tax-exempt organizations. The most common are 501(c)(3) organizations such as schools, hospitals, museums, community foundations, etc. But there are also other types of 501(c) organizations such as trade associations, which are exempt under section 501(c)(6), and social welfare organizations, which are exempt under section 501(c)(4).
Second, although the state filings to establish a nonprofit corporation are not unduly burdensome, there are a number of technical requirements that need to be followed. Also, the IRS exemption application, Form 1023, is not a simple one-page form; instead, it requires anywhere from 12-20 pages of information depending on the nature of the organization. With few exceptions, such as churches, an organization must file Form 1023 and receive a determination letter from the IRS in order to be tax-exempt, and cannot represent to potential donors that it is tax-exempt until such time as it receives such letter.
State law requirements for Arizona nonprofit corporations
In order to create the corporation under state law, an Arizona nonprofit corporation must file articles of incorporation. These will contain the name, purpose, powers and directors of the corporation, as well as the statutory agent for the corporation. The articles will also state whether the corporation will have members. Nonprofit corporations are not required to have members; in the absence of members, the directors will govern the corporation. However, if there are members, the members will elect the directors and will vote on major corporate actions. The procedure for electing members, and the rights of such members, is often set forth in the articles, but can also be contained in the bylaws of the corporation.
The articles are signed by the incorporator of the organization and are filed with the Arizona Corporation Commission. The filing fee is $40 ($75 if expedited treatment is desired). The articles are accompanied by a certificate of disclosure, which must be signed by the incorporator and any individuals who are directors or officers at the time the articles are filed. The articles must then be published (within 60 days after the articles are filed) in a newspaper of general circulation in the county in which the corporation carries on its business for three consecutive publications.
Once incorporated, the organization must file annual reports with the Arizona Corporation Commission and the Charities Division of the Secretary of State. The filing fees for such reports are nominal.
IRS tax-exempt filing (Form 1023)
IRS Form 1023 requires fairly extensive information about the operation of the organization. The two most important sections are Part IV (narrative description of activities) and Part IX (financial data). The IRS will want to know, in some detail, what activities the organization will carry on. In order to qualify under section 501(c)(3), the organization must be operated “exclusively for religious, charitable, scientific … literary, or educational purposes.” The narrative description should go into some detail (at least a page) outlining the exempt purposes of the organization and why such purposes qualify under Section 501(c)(3). If possible, prior IRS rulings relating to similar organizations should be cited as evidence that the new organization qualifies as exempt.
In Part IX, assuming the organization in question is a new organization, Form 1023 asks for projected budgets for the current year, plus the next two years. These budgets require both income information Ñ expected contributions, investment income, operational income Ñ and expense information, such as outgoing grants, fundraising expenses, wages, rent, interest and professional fees. The organization should make a good-faith attempt to be as detailed and accurate as possible, even though it is understood that actual operations may diverge from the projections. The IRS is simply interested in understanding the scale of magnitude of the organization’s operations, as well as the relative allocation between internal administrative expenses, and expenses directly used to carry out the exempt purposes of the organization.
The filing fee is currently $750 (reduced to $300 if the organization expects its annual receipts to be under $10,000). The form should be filed within 27 months of its date of incorporation and, if approved by the IRS, will be retroactive to the date of incorporation. The IRS review time will vary substantially depending on the complexity and size of the organization. For a simple charity with no complications, IRS approval may only take six to eight weeks. However, if the organization has substantial activities or is expected to be involved in significant transactions with private parties, such as an organization focused on community development, it may take six to 12 months for IRS approval. If the IRS has any questions or concerns, it will contact the organization in writing while the application is pending and will normally give the organization 21 days to respond.
Once approved, the organization will be required to annually file Form 990 disclosing the income and expenses of the organization, the compensation paid to officers, directors and key employees, and other information. Form 990 does not normally require the payment of any tax, but is an information return for the IRS to monitor the activities of the organization. Form 990, and Form 1023, are publicly available documents and must be disclosed if someone contacts the organization requesting copies. Thus, organizations should keep such potential disclosure in mind when preparing the forms.
Forming a nonprofit and securing tax-exempt status is a little bit more involved than simply filing two pieces of paper with the state and with the IRS. Anyone working with a new nonprofit should also work with an accounting or legal professional that is familiar with the state and federal requirements pertaining to such organizations.
Michael G. Meissner is a partner at Squire, Sanders & Dempsey’s Cleveland office. He works with the firm’s Phoenix office on tax issues. Meissner can be reached at (216) 479-8593 or at email@example.com. The firm’s Phoenix office can be reached at (602) 528-4000.