What you need to know about forming a nonprofit

By Rudman Winchell Attorney

By: Rudman Winchell Attorney Brent A. Singer

                Several times each year I field inquiries from people wanting to form a nonprofit to do good works. Through no fault of their own, they often are very unfamiliar with the basic legal landscape of nonprofits. This article summarizes some of the basics.

                Many people use the term “nonprofit” loosely as synonymous with an organization that pays no taxes and which receives tax deductible donations. It is not quite that simple.

                Taxes come in many shapes and sizes, as we well know. Some nonprofit organizations are exempt from federal or state income taxes—some are not; some nonprofits are exempt from state and local property taxes—some are not; and some nonprofits are exempt from sales and use tax—some are not. Depending upon what an organization does or does not do, or what it thinks it wants to do, it might or might not be important for it to be exempt from income tax, property tax, or sales tax. Something to keep in mind, which many people overlook, is that if the organization makes no money, or loses money, then it will not owe income taxes, anyway—so an “exemption” from tax makes no practical difference. And often people assume that if an organization is exempt from income tax, it doesn’t have to pay property or sales taxes, either. That is wrong. Many organizations exempt from income tax still must pay property and sales taxes.

                The type of organization that can receive tax deductible donations that most people are familiar with is so-called “501(c)(3)” organizations. “501(c)(3)” refers to the section of the Internal Revenue Code (federal tax law) that sets forth the requirements for such organizations.   The fact, however, that donations to such organizations are tax deductible derives from Internal Revenue Code § 170, not § 501. There are many types of organizations that are exempt from federal income tax under § 501, but for which donations are NOT tax deductible under § 170 or otherwise. For example, I once belonged to a golf club that was exempt from income tax under § 501(c)(7) (as a “recreational club”), but my donations to it were not tax deductible—too bad, since if they were, I’d have had plenty of deductions!

                So when many people say they want to form a “nonprofit” what they really mean is that they want to form an organization that is exempt from federal income tax under § 501(c)(3), so that the organization pays no income taxes and can receive tax deductible donations under § 170.

                § 501(c)(3) organizations can be in the form of trusts, unincorporated associations (e.g., local 4-H clubs), nonprofit corporations, and even limited liability companies. Note that I just said that a § 501(c)(3) organization can be in the form of a “nonprofit corporation.” This causes all sorts of confusion among people who use the term “nonprofit corporation,” incorrectly, as synonymous with § 501(c)(3) organization. Here is how this works.

                In order to be a § 501(c)(3) organization, there needs to be an “organization” in the first place. That is a matter of Maine law, namely, how you decide to organize—as a trust, as a nonprofit corporation, as a limited liability company, or as just an unincorporated group of people (like a 4-H Club). In any of these different forms, if you do it “right” in terms of what is said in your organizational documents, and in terms of what your organization actually does (i.e., especially, how it gets its money and how it spends it), then, after you organize, you can apply successfully to IRS for a determination that the organization satisfies the requirements of § 501(c)(3)—or of some other sub-section of § 501, if that is what you were aiming for.

                It is very simple to form a Maine nonprofit corporation (if the organization wants to “incorporate”). This is done pursuant to the Maine Nonprofit Corporation Act. Again, however, just because you are organized as a Maine nonprofit corporation does not mean you are exempt from income tax under § 501(c)(3), or can receive tax deductible donations.   Those latter things depend on what, exactly, the organization does and how it does it. Although the application process to the IRS for a determination of § 501(c)(3) status is now easier for small organizations, it is still not an easy process. For a larger organization, it is downright complicated.

                For purposes of federal tax law, every § 501(c)(3) organization is, basically, also categorized as either a “public charity” or a “private foundation.”   This terminology also causes confusion, since, e.g., the name of the organization might be the “Green Grass Foundation,” but it might be categorized under federal tax law as a public charity and not a private foundation. The name of the organization need not and often does not identify whether it is a public charity or a private foundation.

                The tax laws concerning private foundations are more complicated and private foundation are generally more difficult to operate—but not terribly so. The difference between public charities and private foundations depends mostly on whether the organization receives its financial support mostly from a relatively few private sources, directly or indirectly. If so, it is a private foundation. But donations to private foundations are still tax deductible under § 170 (though not up to the same limits as to public charities) and private foundations do not pay income taxes, generally (although they are subject to some taxes, such as an up to 2% tax on net investment income). Sometimes the mathematical tests to determine whether an organization is a private foundation or not are quite complicated and require the services of a skilled accountant familiar with the rules.

                Most people who want to form “nonprofits” have in mind (vaguely) public charities, and when they run into the complication that what they envision will likely be a private foundation they lose their appetite. Sometimes this is sensible; sometimes this is just being, in my opinion, too worried about the additional reporting and other requirements of private foundations.

                To make matters of terminology even more complicated, under Maine law every nonprofit corporation is categorized as either a “public benefit” or “mutual benefit” corporation. Different corporate rules apply depending on which it is. Furthermore, there is even something under Maine law called a “public charity”—but that term is not the same as the term “public charity” for federal tax purposes.

                The bottom line, unfortunately, is that it is fairly complicated to organize and operate a nonprofit corporation exempt from income tax under § 501(c)(3), for which donations are tax deductible under § 170, unless the organization expects to receive less than $5,000 in support, annually. For very small organizations such as that, no formal application of any kind is necessary to IRS, and no annual filing (other than the so-called “e-Postcard”) is usually required. But if, e.g., you hope to generate more than $50,000 a year in support, or you plan on having assets worth over $250,000, there will be some significant start up costs, including attorneys fees to help you navigate a host of different federal tax laws and Maine tax and other laws.  

Helpful Links:

IRS.gov

CONSUMER CHARITIES GUIDE

MAINE.GOV/CHARITIES    

Disclaimer


These materials have been prepared by Rudman Winchell for educational purposes only. They should not be considered legal advice. The transmission of this information to you is not intended to create a lawyer-client relationship. Readers should not act upon this information without seeking professional counsel. You should not send any confidential or private information to Rudman Winchell until a formal attorney-client relationship has been established, in writing.