(a) Choosing a Category

Do not expect the distinctions among the categories to be clear or logical. The group of exempt organizations has expanded considerably since the Tariff Act of 1894 established a single category of exempt organizations, which included charitable, religious, educational, fraternal, and certain building and loan, savings, and insurance organizations. Since then, the number of categories has expanded to include nearly 30 distinct types.

As with many federal tax matters, the Internal Revenue Code expresses general concepts subject to endless interpretation. Tax rules are often gray, rather than black and white, and require careful study to reach the desired result. For example, only scholars of legislative history can explain why agricultural organizations and labor unions are coupled together. Why aren’t agricultural groups considered business leagues? Why are agricultural auxiliaries classified as business leagues? Why was a separate category carved out for real estate title-holding companies with multiple parents, instead of placing them in the original §501(c)(2) for single-parent organizations?

The choice of category is driven by a number of different factors that are presented in Chapters 2 through 10, along with examples of those that do qualify for exemption compared to those that do not. Often the choice is influenced by the desire to receive tax-deductible revenues. To receive a charitable donation, a §501(c)(3) charitable or (c)(19) veterans’ group classification is required. However, the freedom to lobby is constrained by the (c)(3) category, so the §501(c)(4) structure might be chosen instead by a charitable project that can be accomplished only through the passage of legislation, as discussed in Chapters 6 and 23.

(b) Businesslike Behavior

Ironically, in order to be financially successful, a nonprofit can operate in a businesslike fashion—efficiently and often profitably. Most of the financial management tools applied by for-profit businesses—strategic planning, investment management, responsive organizational structure, budgeting, and others—are appropriately used by an exempt. A thorough consideration of this subject can be found in my book, Nonprofit Financial Planning Made Easy.⁴

The distinguishing characteristic of an exempt organization in this regard is the motivation for undertaking an activity that generates revenue. The fact that a nonprofit charges for the services it performs is not determinative. A school, a hospital, or any other type of exempt organization may pay all of its costs with fees paid by students, patients, and others using its facilities and services. Whether a hospital is exempt, for example, depends on whether it was created and operated to provide health care for the purpose of promoting the general public’s health (see Chapter 4), not necessarily on whether it has a deficiency of patient revenues in comparison to its expenditures.

An exempt organization can generate revenues in excess of its expenses and accumulate a reasonable amount of working capital or fund balances. It can save money to purchase a building, to expand operations, to protect itself with a reserve for lost or reduced funding, to ensure a flow of cash to pay for continuous operations, or for any other valid reason serving its underlying exempt purposes. Many private foundations are endowed with assets that are as much as 20 times their annual expenditures, since they are required to spend only 5 percent of the value of their investment assets each year.⁵ There is no specific tax limitation on the amount of assets other types of exempt organizations can accumulate so long as the amount does not evidence a lack of exempt purpose.⁶ Too high a level of expendable funds in relation to expenditures, however, can hamper an organization’s fund-raising efforts. Public charities, business leagues, clubs, and other membership organizations that depend on annual support commonly have modest asset levels in relation to their annual spending. The level of accumulated assets may also influence funders that are sometimes reluctant to make grants to an exempt with significant reserve funds.

An exempt organization can also seek to borrow money from private or public lenders to finance its activities—to establish a new office or acquire an asset, for example. Basically, an exempt can operate without a profit motive and still produce a profit! It can pay salaries and employee benefits comparable to those of a nonexempt business. So long as the overall compensation is reasonable,⁷ an exempt entity can offer incentive compensation to its employees. What it normally cannot do with its net profit is distribute it as a return on capital to the persons who control the organization or other private individuals.

The focus and purpose of an exempt organization’s activity are outward and unselfish, and are directed at accomplishing a public purpose. One way to think of this characteristic is as a one-way street. Much of the money received by an exempt is one-way money: donations or dues paid out of pure generosity with nothing being received or expected in return. Nonprofits also operate on a two-way street regarding selling goods and services that accomplish their exempt purpose. Such revenue activity cannot be conducted strictly with the intention of producing a return on investment. In contrast, privately owned businesses operate totally on a two-way street. Their activity is directed at selling goods and services for the purpose of reaping return for their owners’ investment.

On a limited basis, an exempt is allowed to compete directly with nonexempt businesses and operate a business that does not advance exempt purposes. The Internal Revenue Code places such an exempt on the same footing as competing businesses by imposing a regular income tax on profits from such activity. If the unrelated business activity becomes too substantial, the exempt can lose its exemption. Chapter 21 considers the question of when a business activity is unrelated, describes the level of business activity allowed, and presents the myriad exceptions and modifications that allow much of this type of income to escape taxation.

(a) Question 1: Is a new organization really necessary?

Could the project be carried out under the auspices of an existing organization? Several factors can indicate that a new organization is not necessary. If the proposed project is a short-term or one-time objective with no prospect for ongoing funding, it may not be worth the trouble to set up an independent exempt to handle it. Maybe the project can operate as a branch of an existing exempt organization. If a local branch of an organization holding a group exemption is available through a national organization, the new exempt may be formed as a member of the group, thereby avoiding the need to seek separate qualification for tax exemption.¹² If there would be a costly duplication of administrative effort, or if the cost of obtaining and maintaining independent exemption would be excessive in relation to the total budget, it makes sense to opt for another route.

(b) Question 2: Which category of exemption is appropriate?

If the proposed organization passes the first test, the category of exemption best suited to the goals and purposes of the project must be chosen. Due to the rigidity and limitations of the §501(c)(3) exemption rules, certain activities may be suitable only for other categories of exemption. The (c)(3) rules include a complete prohibition against involvement in political campaigns and limitations on legislative and grassroots lobbying.¹³ For such projects, a §501(c)(4) organization may be more suitable for the purposes of the founding group.

Some projects can conceivably qualify for more than one category. There are garden clubs classified as charities under §501(c)(3), civic welfare societies under §501(c)(4), and social clubs under §501(c)(7). An association of businesspersons, such as a professional association or the Lions Club, most often qualifies as a business league.¹⁴ If the activities of the group involve educational and/or charitable efforts, (c)(3) status, rather than (c)(4)–(6) status, might be sought, or two organizations—a (c)(3) and a (c)(6)—might be formed. A breakfast group composed of representatives of many different types of businesses may not qualify as a business league under §501(c)(6), but might instead easily qualify under §501(c)(7). The tax deductibility of member dues and taxability or limitation on types of income influence the desired choice of category.¹⁵ The creation of a nonexempt nonprofit can also be considered. When profits are expected to be minimal, the projected federal, state, and local taxes due might be less than the cost of obtaining and maintaining tax exemption.

(c) Question 3: Do expected revenue sources indicate nonprofit character?

Next, the proposed sources of revenues expected to support the project must be considered. Exempt organizations are traditionally supported by donations, member dues, and fees for performing exempt functions, such as admission to a museum or fees for certification of professional standing. Certain sources of revenue are not suitable for exemption. Among those sources are sales of goods produced by members (unless handicapped or underprivileged) and income from services rendered in competition with nonexempt businesses (for example, insurance or legal services). Too high a level of revenue from unrelated businesses can disqualify exemption.¹⁶ Self-dealing and certain other insider transactions may be prohibited,¹⁷ and certain sources of support could result in the exempt organization being designated a private foundation subject to stringent operating requirements.¹⁸

(d) Question 4: Are creators motivated by selfish goals?

A tax-exempt organization as a rule must be established to serve persons other than its creators (though creators can participate in its affairs). This question examines the reasons why persons seek to establish the nonprofit. Do the organization’s creators desire economic benefits, other than savings resulting from tax deduction for donations from the formation or ongoing operation of the organization? Will the organization be operated to serve the self-interested purposes of its creators? If so, it is likely the project cannot qualify for tax-exempt status. The one-way-street characteristic of nonprofits is crucial to ongoing qualification for tax exemption. If the founders desire incentive compensation based on funds raised, or wish to gain from profits generated, an exempt organization may not be the appropriate form of organization. Reasonable compensation for services actually and genuinely rendered can be paid, but no private benefit to insiders or significant participants can result from the exempt’s activities.¹⁹

For a variety of reasons, it is sometimes desirable to convert a for-profit business into a nonprofit one. In the health and human services field, for example, funding is often available from both for-profit and nonprofit sources. An organization’s direction may change or funds may become available only for tax-exempt organizations, such as for health issue research programs. When an exempt is created to take over the assets and operations of a for-profit entity, the buyout terms will be carefully scrutinized. Too high a price, ongoing payments having the appearance of dividends, and assumptions of liability that take the creators off the hook are among the issues faced in this situation.

When a tax-exempt organization ceases to exist, its assets to be distributed on dissolution must essentially be used for the same exempt purposes for which the organization was initially granted tax exemption. Charities exempt under §501(c)(3) can distribute funds only to another (c)(3) organization or in support of a charitable project, and their charters must contain a binding dissolution clause. Assets of a charitable tax-exempt organization must be permanently dedicated to charitable purposes. Again, the one-way-street concept exemplifies the character of a tax-exempt organization. The creators must understand and intend from inception that they will gain no personal economic benefit from the organization’s operations and benefits. Exhibit 1.2 can be used to review the considerations in forming a new exempt organization.

(a) Preliminary Planning

An important start-up question concerns the type of entity to be created. Founders must decide the type of organization that should be formed: corporation, trust, or association. Each structure has its benefits and drawbacks.²⁰

Future sources of funds to operate the proposed nonprofit should next be projected in the planning stage, for several reasons. First and foremost, creators should evaluate the financial feasibility of their ideas. It is laudable to want to feed the poor in one’s country; the question to ask at this stage is whether the group forming the program can put together enough funds to efficiently do so. Second, many categories of exempt organization have special attributes and standards measured by their sources of funding for reasons explained in the chapter pertaining to that particular type of organization. If the exempt organization wishes to be classified as a charity, for example, it is time to see whether the organization will qualify as a public charity or a private foundation. Expected donation levels must be quantified to measure public support.²¹ Social clubs are subject to strict numerical limits on the amount of nonmember revenues they may receive.²² Business leagues and labor unions, like charities, cannot generate an amount of unrelated business income which indicates that the business activity is their primary function. The specific plans for the proposed organization should be tested at this point from a financial standpoint, using the basic rules for qualifying as a tax-exempt organization.²³

Whether the organization will operate as a membership group must be decided. The term membership is often misunderstood and misused. Some organizations use the term member to designate contributors who actually have no voting rights. Under some state governance standards, a membership organization is one whose members elect the persons on the governing board. The democracy afforded by such a form of organization may or may not be desirable. A self-perpetuating board retaining control in the hands of a few persons may be appropriate, indicating that a nonmembership organization should be formed.

A predominance of “yes” answers to the following questions indicates that the proposed organization is NOT a suitable candidate for tax-exempt status or that special rules may apply. Chapter sections cited can be studied for more discussion of each issue.
1. Is a new organization necessary, or could the project be carried out as a branch of an existing organization?	Yes	No
Life of the project is short.
It is a one-time project with no prospect for ongoing funding.
Project could operate under auspices of another EO.
Duplication of administrative effort is too costly.
Cost of obtaining and maintaining independent exemption is excessive in relation to total budget (Ch. 18).
Group exemption is available through a national EO (Sec. 18.2(f)).
2. Which §501(c) category of exemption is appropriate to the goals and purposes of the project?
The organization participates in efforts to influence elections or otherwise participate in political campaigns (Ch. 23).
Purposes of the organization can be accomplished only through legislative and grassroots lobbying activity (Chs. 6 and 23).
Activities benefit a group of businesspersons or a social group (Chs. 7, 8, and 9).
Persons benefited by the proposed activities represent a limited group rather than a charitable class (Sec. 2.2(a)).
3. Are the sources of revenue suitable for an exempt organization?
Organization plans to sell goods produced by members indicating a cooperative (Sec. 2.2(e)).
A significant amount of the revenues will come from services to be rendered in competition with nonexempt businesses, such as legal services or insurance (Sec. 21.8).
More than half of revenues will be from unrelated businesses operated in competition with for-profit companies (Sec. 21.4(b)).
A majority of the funding will come from a particular individual, family, or limited group of people that may require classification as a private foundation (Chs. 11–17).
4. Do the creators desire economic benefits from the operation of the organization?
Transactions with related parties are anticipated (Sec. 20.1).
Proposed financial arrangements with creators will pay portion of revenues to insiders as rent, royalty, or interest (Sec. 20.6).
Creators wish to be paid incentive compensation based on funds raised or profitability of the organization (Secs. 2.1(c) and 20.2(c)).
Assets will be purchased and/or debts of creators assumed (Sec. 20.6).
Project will operate in partnership with for-profit investors (Ch. 22).
Services and activities will be available to a limited group of persons or members instead of a public class (Secs. 2.2(a) and 8.2).
Upon dissolution of the organization, assets can be returned to creators and/or major donors (Sec. 2.1(b)).

ORGANIZATIONAL ISSUES:
Suitability for exempt organization status (see Exhibit 1.2.)
Form of organization/corporation, trust, or association (Sec. 1.7)
Organizational documents
Mission statement/purpose clause (Sec. 2.1)
Membership or not
Provisions of bylaws
Board composition and terms for advisors
Choose name and check availability
Federal tax considerations
Qualification for tax exemptions (Chs. 2–10)
Amount of business activity planned (Ch. 21)
Transactions with creators, directors, and officers (Chs. 14 and 20)
Private vs. public charity (Ch. 11)
FINANCIAL CONSIDERATIONS:
Capitalization needs
Future need for capital and ability to raise funds
Reliability of funding sources
Financial planning systems (see Exhibit 1.3.)
Long- and short-range financial plans (budgets)
Maximizing cash flow and investment income
Billing, collection, and bill-paying policies
Internal control systems
RECORDKEEPING SYSTEMS:
Primary accounting records (banking records, original invoices, and customer/patron/client billings)
Secondary records (cash, general, payroll, and other ledgers)
Cash vs. accrual method
Cost accounting systems
Fund accounting and donor/member database software
Filing systems
Paid bills in alphabetical order
Permanent assets (individual files by objects or type)
Establish “throwaway” date system
Exempt activity records (archives)
Tax compliance systems (Ch. 19)
Application for federal identification number and exemption
Complete federal tax compliance checklist
State and local registration, permits, and/or taxes
Employees vs. independent contractors (Ch. 25)
Tax aspects: proper classification, withholding, and reporting requirements
Personnel policies: vacation, sick leave, written contracts, and job descriptions
Fringe benefits
Travel and expense documentation requirements

The rules governing the organization’s future decision-making procedures are outlined in the bylaws. The answers to the following questions, among many others, are found in the bylaws: How will officers be elected? When will meetings be held, and who can call them? Who will serve as advisors? Who signs checks? What credentials will be required of board members, and what length of term will they serve? A skilled attorney can be very helpful in designing appropriate bylaws. The IRS and some states are not particularly interested in parliamentary procedure. No sample bylaws are provided in IRS Publication 557, Tax-Exempt Status for Your Organization. However, this guide does prescribe very particular provisions that must be contained in an organization’s articles of organization for exemption to be granted. For groups affiliated with a state or national group, model articles and bylaws may be available.

This is a good time to think about what name to bestow on the organization. A name that accurately presents the organization’s purpose should be chosen. The words fund or foundation might not be suitable in a name for a nonprofit that intends to do fund-raising for operating support because the words connote that it already has resources. Similarly, the word center connotes a place where people gather for a variety of reasons, and institute, a place where people meet to talk and study. The name cannot repeat or conflict with names already in use. If there is already a Center for Genetic Research chartered in the state, a newly created Center for Genetic Study may not be permitted. The availability of the chosen name can be investigated through the local and state authorities. In Texas, the office of the secretary of state can be called to check availability and to reserve a name.

(b) Financial Management

In a nutshell, to be successful a nonprofit organization should be financially managed just like a business. To be financially viable, an exempt organization needs sufficient capitalization similar to a for-profit organization—but it cannot float a stock issue. The reliability of funding sources should be evaluated to ensure sustainable spending levels. Before the final decision to establish a new organization is made, the exempt’s future needs for capital and its ability to raise money must be projected.

The initial projections can be a starting point for an ongoing planning process that can improve the financial well-being of an exempt organization. Short-range budgets and long-range financial plans should be maintained and continually updated. Operating and capital budgets are recommended. Plans for maximizing yield on cash and other investment assets should be formulated. As much of the exempt organization’s money as possible should be kept in interest-bearing accounts, and professional investment managers can be sought once capital reserves exceed immediate needs.

An accounting system and procedure should be established to record, report, and internally control the financial resources in accordance with generally accepted accounting principles. This system should also maximize cash flow by billing customers and collecting from contributors as quickly as possible while at the same time delaying payment of the organization’s own bills for as long as is reasonable. Guidance on this vitally important aspect of the operation of a nonprofit organization can be found in the book Nonprofit Financial Planning Made Easy.²⁴

(a) Corporation

Corporate status is said to be the most flexible form of organization for a nonprofit and is the form of choice in most states. Some nonprofit assistance programs established by local united giving organizations and volunteer lawyer and accountant associations have developed model organizational documents that an organization can use in designing its corporate charter.

Creating a corporation as a separate entity is said to establish a corporate veil that may shield the individuals governing and operating the nonprofit from liabilities incurred by the organization, unless they are negligent or somehow remiss in their duties. Some states have adopted immunity laws augmenting protection against liability for directors and officers of nonprofits. In Texas, the Charitable Immunity and Liability Act of 1987 applies to §501(c)(3) organizations. This statute shields a charity’s officers, directors, and volunteers, regardless of the form of organization, thus obviating one of the advantages in establishing a corporation. These rules are different for the particular state(s) in which the nonprofit operates and should be carefully studied.

Though historically many nonprofit organizations had members, an exempt corporation can be formed with or without members. Unless the charter provides otherwise, members are presumed in some states. The primary role of members in this context is to elect the board of directors, who in turn govern the organization. In a privately funded organization, the members may be family representatives whose job is to retain control. The founder of a charity can be named the sole member. With most public benefit corporations, members broaden the base of financial support and involve the community in the organization’s activities. In such cases, there may be hundreds or thousands of individual contributors who, as a group, control the organization because they elect the directors. Mutual benefit societies, unions, clubs, and the like are usually controlled by their dues-paying members.

The other choice is to allow the board of directors to govern the organization. Closer control can be maintained by a small, self-perpetuating board that chooses its own successors. The charter may also appoint representatives of specified organizations or institutions to occupy board positions. A city arts council board might automatically have a representative of the city museum, the college art department, and the symphony orchestra, as well as an individual artist, alongside those directors elected by members. A charity seeking classification as a supporting organization must very carefully design its governing structure to satisfy one of the tests found in IRC §509(a)(3).²⁶

Bylaws are adopted by a nonprofit corporation to provide rules of governance, such as the number of directors, duration of director terms, and procedures for removing them. Bylaws typically also address the frequency of meetings, notice procedures, type and duties of officers, delegation of authority to committees, and the extent of member responsibility. The manner in which the bylaws can be amended should also be covered in the bylaws. Indemnity to directors may be provided.

An advantage of the corporate form, as compared to a trust, is that its organizational documents can often be easily amended. Usually, the currently serving board has authority to make changes to both the bylaws and the charter. Though such changes may require approval and must be submitted to both the state and the IRS, they are allowed and do not customarily impact tax-exempt status. A nonprofit corporation’s articles can (and normally do) allow its directors and members to mold and change its provisions as the organization evolves throughout its existence.

(b) Trust

The trust form of organization is often chosen for an individually or family-funded charitable organization. A trust created while one is living is called an inter vivos (“among the living”) trust. A trust created by a bequest in the creator(s)’ will is called a testamentary trust. A trust is favored by some because, unlike a corporation, a trust can be totally inflexible absent a reformation approved by a court order. A trust can be created without provisions allowing for changes in its purpose or trustees. Thus, a donor with specific wishes may prefer this potentially unalterable form for a substantial testamentary bequest. Another advantage of a trust is that some states require no registration of a charitable trust. Finally, a wholly charitable trust described in §4947(a)(1) is not necessarily required to seek recognition of its tax-exempt status, although many do so to aid in fund-raising.

There is sometimes an argument that a charitable trust violates the rule against perpetuities. To get around this potential obstacle, a trust instrument might contain a provision allowing the trustee(s) to convert the trust into an exempt corporation with identical purposes and organizational restraints. Conversion to a nonprofit corporation might also be allowed if the trustees find that the trust form is disadvantageous. Exempt organization immunity statutes do not apply to trusts in some states, and more stringent fiduciary standards are often imposed upon trustees than on corporate directors. As a rule, trustees are said to be more exposed to potential liability for their actions than are corporate directors. The tax rates on unrelated business income of a trust are higher than the rate applied to corporations, though the charitable deduction allowed for contributions made by a trust to other organizations is 50 percent of its taxable income rather than 10 percent.

(c) Unincorporated Association

The unincorporated association form of nonprofit organization is the easiest to establish and, correspondingly, to reform. To qualify for exemption, an association must have organizing instruments outlining the same basic information found in a corporate charter or trust instrument. Rules of governance must be provided and it must have regularly chosen officers. Particularly for §501(c)(3) status, the IRS requires specific provisions in the documents prohibiting certain activities.²⁷ IRS procedures require that the constitution or articles of association must be signed by at least two persons.²⁸ There are few established statutes or guidelines to follow. National and statewide organizations and nonprofits with branches or chapters can facilitate orderly governance for their subordinates by furnishing a uniform structure document.

An unincorporated group may face substantial pitfalls. The primary concern is lack of protection from legal liability for officers and directors. Banks and creditors may be reluctant to establish business relationships without personal guarantees by the officers or directors.

(d) Limited Liability Companies

A tax-exempt organization might form a single-member limited liability company (LLC) for purposes of isolating itself from the liability associated with conducting certain activities. The check-the-box rules allow the single member to disregard such an entity as separate from itself and treat the activities of the LLC as part of the parent organization. The financial activities of the LLC can be reported on the parent’s own Form 990(s) rather than on a separate return. An LLC electing to be treated as a separate organization is not mentioned, but presumably would file its own return.

An LLC electing to be treated as a separate organization can seek tax exemption under §501(c)(3) if its member(s) are §501(c)(3) organizations.²⁹

Several states have adopted a new form of hybrid for-profit/nonprofit organization called an L3C (“low-profit limited liability company”) designed to allow combined ownership by private investors and nonprofits. The primary purpose of the L3C must be to accomplish one or more charitable purposes. The investment by a nonprofit essentially takes the form of a program-related investment (PRI) allowed for private foundations.³⁰ An L3c organization only qualifies for tax-exemption if all its members are tax exempt. If so, it will file Form 990 annually.³¹ Some advisors to tax-exempt organizations are of the opinion that an investment in an L3C should qualify as a charitable expenditure following the well-established PRI rules that involve LLCs and other for-profit companies.

(e) Conclusion

Once a decision has been made that a tax-exempt entity is suitable, the form of organization is chosen, and the necessary organizational requirements satisfied, the specific category of exemption can be chosen. Exhibit 1.1 lists the more than 30 types of organizations included in the Internal Revenue Code. Chapters 2 through 10 discuss the particulars of the first seven types. Exhibit 1.4 compares the filing requirements and primary characteristics of categories (c)(2) through (c)(7). Chapters 11 through 17 consider the important distinction between public and private charities and thoroughly present the special rules applicable to private foundations. Chapters 18 and 19 contain guidance about IRS filing and tax compliance issues, including comprehensive annual checklists. Chapters 20 through 26 address compliance issues in depth: private inurement, unrelated business income, lobbying and political campaign activities, donor tax deductibility, employment taxes, and transformations such as mergers and bankruptcies.