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Incorporating and Applying for Tax-Exempt Status

Should You Incorporate?

The decision of whether or not to incorporate depends on how fast you expect to grow and what you intend to do with the group.

If your group will be handling very little money—less than $1,000 a year—and if you will not be doing a lot of high-exposure advocacy work, you can do well as an unincorporated association. And if you expect to grow but are still at the stage where you simply meet and discuss issues, you can start out without incorporating.

As an unincorporated association, you need just one document: a constitution. This is similar to the bylaws of a corporation and should include the group's purpose, rules of procedure, membership qualifications, dues, annual meetings, and planned programs.

If, on the other hand, you plan to be very active and publicly visible and if you will be doing a large amount of fundraising, you need to incorporate. The major reason for incorporating is to limit the liability and protect the personal assets of those involved in the group. If you are not incorporated, you are more vulnerable to lawsuits resulting from actions taken by the group. Obviously, incorporation does not render you immune from the consequences of any illegal or negligent actions.

Also, if your group attacks powerful institutions, they may fight back by investigating your paperwork and accounting. If you are doing anything without filing the proper paperwork, they may use this as an excuse to ask the state's attorney general's office to shut you down.

Filing a Certificate of Incorporation

You may wish to incorporate in the state where you will be doing the majority of your business. Incorporating elsewhere means more paperwork in your home state.

First, contact the secretary of state, whose office is usually in the capital city. Ask for filing instructions and sample forms for nonprofit corporations. What you are filing is an article or certificate of incorporation (different states use different terms). The cost of filing ranges from about $12 to $225, depending on the state, and it takes four to six weeks to get your certificate or charter.

You should seek the advice of a lawyer or consultant experienced in working with nonprofit corporations to be sure that your articles or certificate of incorporation meets federal as well as state requirements. The state forms may seem simple to fill out, but if you do not have professional advice, you may have to amend them later to include language required by the federal government in order to acquire federal tax exemption.

A word of advice: Keep the number of directors on your board to the minimum required by law. The more people there are on the board, the more difficult it may be to reach decisions. Many groups have failed because the well-intentioned people who set them up put too many people on the board. It is extremely difficult to get a large number of people to agree on anything. If you want to accomplish your goals, keep the board small.

Bylaws

You must draft a set of bylaws. The bylaws should cover topics such as annual meetings, the powers of the board of directors, length of terms for board positions (do they expire or are they perpetual?), a list of officers and their authority, provisions for amendments, maintenance of corporate records, and director and officer liability insurances. You don't have to invent these from scratch. You can find sample copies online or at a good library or bookstore.

Becoming Tax-Exempt

First, get a copy of Publication 557 from the IRS. It describes the various federal income-tax rules that apply to charitable organizations. You must file with the federal government to become a tax-exempt charitable corporation, which is referred to as 501(c)(3) status. (In some states, you must also file a separate state-exemption application.) To do this, file a federal Form 1023, "Application for Recognition of Exemption." It comes with an instruction book: Be sure to take careful note of the list of attachments that must be submitted with the form.

The 1023 form determines whether the group's proposed activities fit the requirements for exemption from almost all federal taxes (income, excise, franchise, and unemployment). Having 501(c)(3) status does not exempt the group from social security taxes. It usually takes about four to six months to obtain exempt status, but it is typically retroactive.

One advantage of exemption is that it encourages donations because it allows them to be tax-deductible if itemized (terms may vary under the revised tax laws). Many potential donors will specifically ask if your group is tax-exempt. Another significant advantage is that you will not be taxed on donation revenue!

When filing Form 1023, you should ask for an "advance ruling" rather than a "definitive ruling" or "final ruling." The advance ruling is a probationary status that says that the group may function as a tax-exempt organization subject to review in one to two years. The advance ruling is much easier to obtain than the definitive ruling.

To complete Form 1023, you must develop a projected two-year budget describing expected income and expenses. Keep it as simple as possible. Note that your income should come from broad-based public support. A copy of your bylaws must be included when you file.

The IRS scrutinizes the form very carefully if members of the board of directors are related to each other, since this can be characteristic of groups organized for personal benefit. Try to avoid this, if possible.

Note: The purpose of most local groups is to educate the public. If you intend to lobby, you may not get tax-exempt status. Groups that have 501(c)(3) status are allowed to spend only a very small portion of their budget on direct lobbying, and exceeding that amount will cause them to lose their status. Consider making a so-called 501(h) election using Form 5768.

Also, be sure to indicate that your membership will be broadly based and open to everyone. If it appears that your membership is restrictive, you are not entitled to tax-exempt status.

Once you receive your "letter of determination," as it is called, immediately make copies and put the original somewhere very safe. If you lose it, it is extremely difficult to get a new one.

Apply for various local tax exemptions (sales or property taxes) at state, city, and perhaps county levels. Call the office of the agency that collects the taxes, such as the Department of Taxation or Department of Finance and Revenue, to get forms and instructions.

Employer Identification Number

Apply for a "state registration filing" or "state employer filing"—state employer identification numbers.

When or before you file Form 1023, you must file a Form SS4. This is an application for an employer identification number, a nine-digit number assigned by the IRS. Ask for three copies of this form in case an error is made when typing on the carbons. You need an employer ID number, also known as a taxpayer ID number or TIN, even if you have no employees. The TIN is not the same as a tax-exempt number.

Bulk-Mail Permit

Apply for a bulk-rate third-class mailing permit, which will allow you to send mailings of more than 200 pieces at a reduced cost. You can apply for this without being incorporated and tax-exempt, but it is more difficult and time-consuming.

Charitable Solicitation Certificate

File with your state's Charitable Solicitations Division, which will give you a certificate allowing you to solicit funds in your state. You may be required to list a registered agent—someone who resides in the state and can be served with legal papers if necessary—in order to file. Different states have different thresholds for the amount of money required to file. But even if your group falls below that threshold, you must file for an exemption from formal registration as a charitable organization.

If you intend to solicit funds in other states as well, you need to file forms in those states. Some states require you to file applications for a "certificate of authority to transact business" in the state before you will be allowed to register for charitable solicitation. This may require that you attach a "certificate of good standing" or a "certification of articles of incorporation" from the state in which you are incorporated to your application. After receiving your certificate to transact business, you may have to file it in the county or state of your registered agent.

Annual Forms

After you've completed all the paperwork necessary to set up, you must do the paperwork necessary to continue to exist legally. The federal government requires you to file Form 990, "Return of Organization Exempt From Income Tax," annually.

You may also need to file Form 990-T to report taxable sales that are not related to your tax-exempt purpose. State governments require an "annual report of tax" and an "annual report of domestic nonprofit corporations." If you do not fill out these forms, your organization can be dissolved by the state.

Preserving Documents

You must set up a system for preserving (with copies) corporate documents such as the articles of incorporation, bylaws, amendments, and the minutes of board decisions. Minutes should include board resolutions, financial decisions, policy directives, and major program decisions.

Accounting

Establish an accounting system to maintain tax compliance, assist in management of the organization, and establish a general trend to provide long-range planning for the organization and its resources.

The following elements are necessary for any accounting system:

An annual budget
A simple system for tracking income and expenses by source and use (Record each donor's name, address, and amount and date of donation. Save all receipts.)
If your organization has any employees, it must maintain files for deductions, tax payments, W-2s, and other forms.