Americans are often described as the most generous people in the world. An overwhelm- ing majority of us make gifts to religious institutions, schools, cultural organizations and other established charities, big and small. But suppose you want to give more than money, or you wish to address an unmet need, or you have a particular vision of how charitable services should be delivered?These are all good reasons for setting up your own nonprofit organization. Here’s a primer on what you need to know to get started.
Charities are governed by federal tax law as well as by state laws relating to formation, governance, and charitable solicitation. Seeking legal or tax advice to guide you through what can be a confusing process is usually wise. However, before you sit down with your advi- sor, you should answer the following questions:
- What is the purpose of your charity, and what activities will it engage in?
- Will it conduct direct charitable activities or make grants to other organizations?
- Do you plan to actively raise funds?
- Whom do you wish to involve in the organization, and how much control do you want to keep?
- What types of assets do you expect to use to fund the organization?
- Will your organization support another charity?
- What state(s) will you operate in? Will you have operations overseas?
The answers will affect the organizational structure and tax status of your nonprofit.
Choice of Entity
The f irst step in creating a charity is to organize it under state law. Charities may be established as non- profit corporations or as wholly charitable trusts.1
Charitable trusts are easy to set up, requiring only a trust agreement between a donor and one or more trustees. Trusts are useful because they can be created, amended, or dissolved quickly and without the need to file anything with the state. If your charity is to be a grant-making foundation with only a few persons involved, a charitable trust is likely the best choice. If you wish to engage in direct charitable activities (e.g., feeding the hungry), trusts are less advantageous because they carry a greater risk of liability for the trustee, who can be held answerable for simple negligence. Also, if the donor is a corporation, contribu- tions to a trust are only deductible if used within the United States. If you expect to oper- ate overseas and want corporate contributions, your charity must also be a corporation.
To set up a nonprofit corporation, a cer- tificate of incorporation must be filed with the state. Typically you will need a board of directors of at least three members (this var- ies by state) who are named in the certificate. Amendments to the certificate, changes of name, and dissolution are also effected by fil- ing with the state. Depending on the organiza- tion’s purposes, incorporation may also require pre-approval from other state authorities. For example, in New York, organizations with an educational purpose must obtain pre-clearance from the state’s Education Department. A non-
profit corporation that wishes to dissolve or dis- pose of substantially all of its assets may need the approval of the attorney general, a court, or the state taxing authorities. These requirements do not generally apply to trusts.
Once set up, a nonprofit corporation is more flexible than a trust and offers protections to board members even if the organization is sued. A member of the board of directors of a nonprofit corporation is held to a less rigorous standard than a trustee. The “business judg- ment rule” protects directors where they have exercised informed judgment in good faith. Directors will usually only be held liable in cases of self-dealing, willful misconduct, or gross negligence. Nonprofit corporations can indemnify their directors, as well as purchase director and officer liability insurance. Finally, nonprofit corporations have more flexibility in compensating their directors; trustees are often limited to statutory trustee commissions
Choosing a State
States vary in the degree of regulatory over- sight by the state’s attorney general or other authority (which typically applies to charitable trusts as well), so that where you wish the organization to operate is a key question. As examples, New York has a somewhat onerous regulatory regime that requires registration with, and annual reporting to, the attorney general, as well as statutory requirements per- taining to audits and to investment, conflict of interest and whistleblower policies, whereas Delaware has minimal requirements. Choose a state that permits the minimum level of oversight but still allows the charity to operate in the manner intended. For example, a grant- making foundation that holds accounts and has board meetings in New York may nonetheless be incorporated in Delaware without being subject to New York’s registration requirements and regulations.
Many founders want to maintain control of their organizations. If your nonprofit is organized as a trust, you and family members can maintain control by acting as trustees, by retaining the power to remove and replace trustees, and by reserving the power to amend the trust’s charitable purposes and administra- tive provisions. A nonprofit corporation can be organized as a membership corporation with the founder as the member. The member or members, usually designated in the bylaws, elect the board of directors and thereby control
the organization indirectly. Non-membership corporations have self-perpetuating boards, and it is not inconceivable that a founder could lose control of his or her organization.
Tax Classification: Private or Public?
Organizations may seek exemption from federal income taxation under §§501(c)(1) through (c)(29) of the Internal Revenue Code. However, in order for donors to be able to deduct their contributions, a charity must be classified as a §501(c)(3) organization, i.e., organized exclusively for charitable purposes. Within the larger group of §501(c)(3) organiza- tions, a charity will be categorized as a “private foundation” or a “public charity,” depending on its function and sources of income.2
A private foundation is typically set up by an individual, a family or a corporation provid- ing the sole source of funding. A private foun- dation may be endowed and hold a substantial investment portfolio, or may have little or no endowment and be funded from year to year. Private foundations are often used by parents or grandparents to teach younger family members about philanthropy, and they offer families a chance to aggregate contributions and create a lasting impact on their communities. Donors receive a charitable deduction for contributions, but can direct over time how that money is used for charitable purposes. Most private founda- tions do not fundraise and do not engage in direct charitable activities, but rather, are grant- making organizations that fund other charities.
Public charities consist of certain traditional organizations, such as schools, hospitals and churches.3 The category also includes organiza- tions that are supported by the general public through donations or from gross receipts in connection with the performance of its chari- table purposes.
A third type of public charity is the support- ing organization, which is created to support or perform the functions of another public char- ity. Often these are “friends of ” organizations related to larger public charities. They require that the supported charity maintain control, and have interlocking boards of directors or another relationship with, the supported orga- nization such that the supported organization is responsive to and involved in the operations of the supporting organization. Using supporting organizations is way for a donor to maintain some control and oversight over contributions to the supported organization, while getting the benefits of a public charity.
If you intend to fundraise, a public charity is the way to go. Donors to public charities may deduct each year up to 50 percent of their AGI4 for cash contributions or 30 percent of AGI for contributions of other property to a public char- ity. Individuals may only deduct in any year up to 30 percent of their AGI for cash contribu- tions or 20 percent of AGI for contributions of other property to a private foundation.
Private foundations are more heavily regu- lated by the tax laws than public charities. A private foundation will pay an annual excise tax of 1 or 2 percent of its net investment income. It is required to make annual qualify- ing distributions (typically to public charities) of approximately 5 percent of its assets and actively oversee distributions to non-qualifying entities (called expenditure responsibility). Transactions between a foundation and insiders are sharply limited, as are a private foundation’s ability to hold closely held stock. Investments that jeopardize the foundation’s charitable pur- poses are prohibited. Violations of these rules will result in stiff penalties.
Public charities are less heavily regulated, on the theory that an active donor base or affiliation with another public charity will prevent abuses once seen with private founda- tions. Public charities are not subject to tax on investment income, expenditure responsibility or jeopardizing investment rules, or penal- ties for holding onto closely held stock. Nor are they punished for many transactions with insiders that would be considered self-dealing if engaged in by a private foundation, provided that state governance conflict-of-interest rules are observed. This is not to suggest, however, that public charities are not scrutinized. They are. Like private foundations, they are subject to the following:
- Sanctions on “excess benefits” transac- tions, which often result from over-compensa- tion of executives.
- Unrelated business income tax. Chari- ties that regularly engage in business activities unrelated to their charitable purposes are taxed on the net income from such activities.
- Limitations on political activities.
- Prohibition against private inurement. The charity must benefit the public, not private interests.
- State conflict-of-interest and fundraising rules. These consist of required governance procedures and reporting.
How Quickly Can I Set Up a Nonprofit?
The simple answer is very quickly. A trust agreement can be signed or a certificate of incorporation filed within a matter of days, particularly if the organization is a “plain
vanilla” grant-making foundation. However, once the entity is created, there is much more to do. The nonprofit will need an employer ID number from the IRS and, if a nonprofit cor- poration, an organizational meeting to adopt bylaws and appoint officers. An application to the IRS (Form 1023) must be filed within 27 months to obtain recognition of the organiza- tion’s tax-exempt status retroactive to the date the organization was created. However, it can take months for the IRS to confirm tax-exempt status, which may inhibit fundraising efforts in the short term. Finally, the organization must register with any states in which it is operating, typically within a period of time after it receives assets or before it engages in fundraising.
How Much Will It Cost?
Setting up and maintaining a charity costs money. It is usually necessary to have a law- yer draft the trust agreement or certificate of incorporation and bylaws, and to advise you on governance and tax issues, although pro bono counsel is available to many small organiza- tions. There are filing fees paid to the state and the IRS. (The fee to file the organization’s Form 1023 with the IRS is currently $850.) Depend- ing on the state in which you incorporate, there may be an annual franchise tax and fee paid to the charity’s registered agent, as well as registration fees to file with the state’s charities overseer.
The nonprofit will need an accountant to prepare its annual information return (Form 990-PF, Form 990, Form 990-EZ or Form 990-N). Also, depending on your state and size, your nonprofit may need audited financial statements. The accountant will also prepare the annual report to state authorities.
The rules applicable to nonprofit organiza- tions are complex; however, with a vision and proper guidance, creating your own nonprofit organization can be rewarding in terms of the tax benefits conferred, the benefit to the public and, best of all, personal satisfaction.