Published on March 20, 2014
Benjamin Takis Tax-Exempt Solutions, PLLC firstname.lastname@example.org www.taxexemptsolutions.com Ian Shuman Gelman, Rosenberg & Freedman email@example.com www.grfcpa.com LEGAL AND ACCOUNTING CONSIDERATIONS WHEN STARTING A NONPROFIT ORGANIZATION Foundation Center March 18, 2014
Today’s Agenda • Part 1: Preliminary Stage – Basic Concepts – Steps to Take Before Forming an Organization – Accounting Basics • Part 2: Forming the Organization – Corporate Formation – Form 1023 – Tax and Audit Requirements
Professional Bio 3 Benjamin Takis, Attorney Founding Attorney, Tax-Exempt Solutions, PLLC •8 years of experience representing public charities, private foundations, lobbying groups, trade associations, labor unions, retirement plans, health care trusts, and other tax-exempt entities of all types and sizes. •Specializes in tax, corporate governance, and employment issues for non- profits. •Faculty member at the Center for Nonprofit Advancement, and regular speaker at the Foundation Center, Greater Washington Society of CPAs, and elsewhere throughout the DC area.
Professional Bio 4 Ian Shuman, CPA Partner, Gelman, Rosenberg & Freedman CPAs •Director of Client Services •20 years of experience in auditing, consulting and accounting •Specializes in nonprofit outsourced accounting services – Flexible CFO & controllership engagements, guide clients through external audit, help with board reporting, training of client accounting personnel and set up of accounting systems •Nonprofit Involvement: – Treasurer of the Bach Sinfonia, former Treasurer of Sitar Arts Center
Part One: Preliminary Stage 1.Basic Concepts 2.Steps to Take Before Forming an Organization 3.Accounting Basics
What is a Non-Profit? A non-profit is an entity (typically a corporation) that does not distribute net earnings to its owners or shareholders. Non-profit status is determined under state law. Tax status is distinct from non-profit status: non-profit may or may not qualify as tax-exempt under 501(c)(3) (or any other federal code section), and it is possible to have a taxable non-profit.
What is a 501(c)(3)? 501(c)(3) is one of many different tax-exemption classifications under federal law. Other examples: • 501(a): qualified retirement plans • 501(c)(4): social welfare organizations • 501(c)(5): unions • 501(c)(6): trade associations States generally rely on federal 501(c)(3) status when granting tax-exempt status under state law, but not always
Benefits of 501(c)(3) Status • Earnings generally tax-exempt under federal and state law • Donations are tax deductible • Eligible for grants from foundations
Burdens of 501(c)(3) Status • Very complicated to administer: generally requires articles, bylaws, board of directors, corporate policies, plan for distribution of assets at dissolution • Must take steps to show that any payment to yourself is “reasonable” • Finances open to public inspection (ex: Entire Form 990 except names and addresses of donors is public; required to give copy if asked; many nonprofits put audits and other documents online)
Burdens of 501(c)(3) Status • Accounting is more complicated – Tracking costs by funder/project is common – Labor, fringe and overhead allocations are common – Use of timesheets to track labor by projects is common • Compliance requirements much more rigorous – Federal audit requirements start at $500,000 for a 501(c)(3) versus $10,000,000 under SBA 8(a) rules for government contractors – IRS estimates for time required to complete the 990-EZ with common schedules is 25 hours. For a Schedule C (single member LLC) its 2 hours. The 990 is full of non-financial info.
Before Forming an Organization A number of steps should be taken before filing for incorporation or applying for tax-exempt status (1) Consider alternatives to forming a 501(c)(3) (2) Determine whether you qualify for tax-exempt status (3) Recruit a Board of Directors (4) Create a budget and business plan (5) Find a fiscal sponsor
Alternatives to Forming a New 501(c)(3) Cautionary Note: Running a successful non-profit organization requires a compelling and viable mission, a strong network of people to help fund and administer the organization, and a realistic stream of revenue to fund both your activities and the hiring of professionals to assist with the many administrative burdens. Consider the following alternatives before forming a 501(c)(3) • Working with an existing organization to run a pilot program based on your idea. • Run your project as a taxable entity (e.g. LLC) or sole proprietorship before forming a non-profit.
Qualifying for Tax-Exempt Status 501(c)(3) Exempt Purposes • Charity • Education • Promotion of Health • Advancement of Religion • Advancement of Science • Lessening the Burdens of Government • Testing for Public Safety • Promotion of Social Welfare • Promotion of the Arts • Literary • Environmental Protection • Fostering Amateur Sports Competition • Prevention of Cruelty to Children or Animals
Qualifying for Tax-Exempt Status The Commerciality Doctrine • Even if you have what seems like a valid exempt purpose, the IRS and the courts may deem your organization unworthy of tax exemption if its activities are too similar to a commercial business. • The commerciality doctrine is very arbitrarily and unevenly applied. • The non-profit sector is becoming more and more commercialized, and the law is not keeping up.
Qualifying for Tax-Exempt Status EXAMPLE: Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991) The organization was formed to promote the tenets of the Seventh Day Adventist Church, one of which is vegetarianism and healthy eating. The organization’s main activity was the operation of two vegetarian restaurants/health food stores. The stores operated on normal business hours, except they were closed on Saturdays (in observation of the Sabbath). Prices were the same as for-profit competitors. Adventist literature was displayed throughout the stores, and cooking classes and bible study classes were held after business hours. Additionally, the organization held a devotional talk and hymn singing every morning before opening. The organization relied entirely on income from the stores and had no plans to solicit donations.
Qualifying for Tax-Exempt Status EXAMPLE: Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991) Result: The court ruled that the organization was operated substantially for a non-exempt purpose and did not qualify for exemption. Key factors: (1) the organization was run just like a commercial business, e.g. with regular business hours, promotion through advertising, etc; (2) competed with similar for-profit businesses; (3) set prices at market rates; and (4) lacked plans to raise money from any other sources. How would you modify the organization’s activities to qualify for exemption?
Recruiting a Board of Directors The ideal Board of Directors has people with the skills, financial means, and connections to help fund the organization and complement the strengths and weaknesses of the founder: • Lawyers • Accountants • Entrepreneurs, Business Owners • Nonprofit Professionals • Well Connected Individuals (politically and financially) Most states require a non-profit corporation to have a minimum of 3 directors.
Recruiting a Board of Directors • Think about getting representation from all of the organization's stakeholders – you want a diverse range of backgrounds, skills and perspectives • Consider setting term limits • Family relationships between directors get disclosed • Reminder: the role of the Board is to make decisions and govern. However new organizations often have more of a “working board”
Budget and Business Plan A business plan must adequately plan for the costs of running the organization. Some necessary expenses that are often left out of budgets include: • Insurance • Accounting, tax preparation and financial audits • Attorney fees • Fundraising consultants • Strategic planning consultants • Payroll, payroll processing and related benefits Remember that budgets should be realistic and achievable!
Fiscal Sponsorship Did you know … It is currently taking about 2 years (!) for the IRS to confirm the tax-exempt status of most new organizations. Fiscal sponsorship enables your organization to raise money while you are waiting to hear from the IRS. Expedited treatment of your Form 1023 is possible, but difficult to obtain
21 Measure the activity showing how we got from one image to another (Statement of Activities) Snapshot Take a photo and capture the image (Statement of Financial Position) Take a photo and capture the image (Statement of Financial Position) December 31st January 1st Accounting Basics
22 • Assets are what you have • Liabilities are what you owe • Equity is the difference. It’s also the sum result of your whole history • Moment in time- a different concept than other reports Smith Consulting Balance Sheet September 30, 2013 Assets Checking account $ 1,000 Savings account 250 Total cash 1,250 Auto 7,000 Total Assets $ 8,250 Liabilities - Car Loan 6,000 Retained Earnings 2,250 Total Liabilities and Equity $ 8,250 Balance Sheet • Nothing here about revenue, expenses or net income Balance Sheet: “a moment in time”
23 Smith Consulting, Inc. Income Statement For the Year Ended December 31, 2013 Revenue Fees $ 10,000 Interest income 100 Total Revenue 10,100 Expenses Salary 7,000 Travel 1,000 Supplies 300 Rent 200 Total Expenses 8,500 Net Income $ 1,600 • Who are the users of this report? Maybe bankers, owners, potential owners or management • What do they want to know? Profitability, ability to repay a loan, etc. Income Statement • Measures activity over time • How much cash do you have? Income Statement: for-profit example
24 Carwash for Good Income Statement For the Year Ended December 31, 2013 Revenue Contributions $ 15,000 Interest income 100 Total Revenue 15,100 Expenses Salary 7,000 Consultants 2,000 Travel 700 Program Materials 300 Rent 500 Total Expenses 10,500 Net Income $ 4,600 • For a nonprofit entity, who are the users of the reports? Management, potential donors, funders, board members • Does this format still work? NO, it’s no longer all about net income • Conclusion: Nonprofits’ reports need to address program activities and stewardship responsibilities Income Statement (continued)
25 • The different terminology reflects the change in emphasis • Biggest difference is that expenses are grouped by functional categories (purpose) instead of natural categories (how) • What was travel expense? Carwash for Good Statement of Activities For the Year Ended December 31, 2013 Total Revenue Contributions $ 15,000 Interest income 100 Total Revenue 15,100 Expenses Treatment 7,450 Advocacy 2,000 Total Program Expenses 9,450 Administration 1,050 Total Expenses 10,500 Change in Net Assets $ 4,600 Statement of Activities
26 • Functional -- Expenses grouped according to the purpose for which the costs are incurred (program, administrative, fundraising) • Natural -- Expenses grouped according to the kind of economic benefit received (such as salary, printing, rent, travel, etc.) Functional and Natural Expenses
27 • Columns are used to separate restricted and unrestricted activity • There’s nowhere to show the natural expense categories except on a separate page Carwash for Good Statement of Activities For the Year Ended December 31, 2012 Temporarily Unrestricted Restricted Total Revenue Contributions $ 4,500 $ 10,500 $ 15,000 Interest income 100 - 100 Release from restriction 9,000 (9,000) - Total Revenue 13,600 1,500 15,100 Expenses Treatment 7,450 - 7,450 Advocacy 2,000 - 2,000 Total Program Expenses 9,450 - 9,450 Administration 1,050 - 1,050 Total Expenses 10,500 - 10,500 Change in Net Assets $ 3,100 $ 1,500 $ 4,600 Restricted Activity
28 • The limitation must come from the donor. A limitation set by the board is called designated instead. • Temporarily Restricted- donor specifies a limitation based on time (when the contribution can be used) or purpose (what the contribution can be used for). • Restricted donations are recorded in full at the date of pledge and are then “released” to unrestricted as the donor’s limitations are fulfilled (if temporary). You can think of this as temporary storage. • Permanently Restricted- donor specifies that only the donation’s related investment earnings can be spent. Restricted Contributions
29 • This report is unique to nonprofit organizations and provides a detailed breakout of the functional totals by natural line items Carwash for Good Statement of Functional Expenses For the Year Ended December 31, 2013 Program Services Treatment Advocacy Admin. Total Expenses Salary $ 5,050 $ 1,500 $ 450 $ 7,000 Consultants 1,600 300 100 2,000 Travel 500 200 - 700 Program Materials 300 - - 300 Rent - - 500 500 Total Expenses $ 7,450 $ 2,000 $ 1,050 $ 10,500 These terms are sometimes used interchangeably: "administrative,” “management and general,” “general and administrative,” and "overhead" Statement of Functional Expenses
Part Two: Forming the Organization 1.Corporate Formation 2.Preparing the Form 1023 3.Tax and Audit Requirements
Basic Steps to Forming a 501(c)(3) After you have laid the groundwork, these are the basic steps: (1) File Articles of Incorporation with the state (2) Get an Employer Identification Number (3) Have your first Board Meeting: adopt Bylaws, Resolutions, and Policies (4) Open a bank account (5) File Form 1023 and applications under state law (27-month deadline) (6) File Forms 990 while you wait for tax-exempt status
Articles of Incorporation Elements of the Articles of Incorporation •Corporate name •Duration (“perpetual”) •Statement of Purpose (required for Form 1023) •Whether or not you have members •Authority of the Board of Directors, and the process for appointment •Plan for dissolution of assets (required for Form 1023) •Names of initial Directors, Incorporators, and Registered Agent •Authority to amend
Employer Identification Number An employer identification number (“EIN”) is necessary to apply for tax-exempt status, open a bank account, hire employees, etc. •Easy to obtain online from the IRS website: https://sa.www4.irs.gov/modiein/individual/index.jsp (or google “EIN online”) •Can also submit Form SS-4 on paper. Don’t make a mistake – if the IRS has more than one EIN on record for your organization, this causes major headaches
First Board Meeting Once Articles of Incorporation have been filed, the Board of Directors should have their first meeting and take care of initial business: • Adopt Bylaws • Appoint Officers (Executive Director, Secretary, Treasurer) • Adopt Policies (Conflict of Interest, Whistleblower and Document Retention) • Establish the authority of selected officers to open a bank account and sign checks on behalf of the organization • Establish the authority of selected officers to apply for tax-exempt status and sign a power of attorney This meeting should be documented by written resolutions and minutes
Inside the Form 1023 Overview of what’s needed •IRS fee: $400 or $850 •Certified copy of Articles of Incorporation •Bylaws •Narrative •Conflict of Interest Policy •Copies of contracts and information on how compensation was determined •Financial data •Answers to many, many questions
Form 1023: Part I Line 10: your organization may be exempt from the requirement to file a Form 990 or Form 990-EZ if it is (1) a church or affiliated with a church; (2) a state or local government unit or affiliated with a state or local government unit; or (3) an organization that normally receives $50,000 or less in annual gross receipts. •Note: organizations with less than $50,000 in annual gross receipts are still required to file Form 990-N. Line 11: date of incorporation is important because you must file within 27 months of incorporation to receive 501(c)(3) status retroactive to the date of incorporation – may otherwise qualify as 501(c)(4)
Form 1023: Part II Official governing documents are required to obtain tax-exempt status – your organization must formally exist as (1) a corporation; (2) a limited liability company; (3) a trust; or (4) an unincorporated association (with Articles of Association, Constitution, etc.) Sole proprietorships, partnerships, or loose affiliations are not eligible for tax-exempt status. The recommended form of entity is the non-profit corporation •Attach Articles of Incorporation (certified by state government) and Bylaws (showing date of adoption by Board)
Form 1023: Part III Required Provisions in organizational documents: •Statement of purpose: the Articles of Incorporation must state that the organization is operated for a purpose consistent with section 501(c)(3), and may not engage in activities that are prohibited for a 501(c)(3) organization. •Dissolution: if the organization dissolves, its assets must continue to be used for 501(c)(3) purposes rather than returned to the founders. Easiest way to satisfy this requirement is to require that assets be contributed to another 501(c)(3) organization. – It is not recommended that you rely on state law for your dissolution provision
Form 1023: Part IV The Narrative •Describe your major activities, and give some concrete examples (3-5 paragraphs is usually enough) •The Form 1023 narrative is not a grant proposal and shouldn’t look like one. •You should know all the IRS hot-button issues associated with organizations likes yours, and avoid triggering IRS concerns •Note: if you later engage in activities that are not described in the narrative or elsewhere in the Form 1023, the validity of your tax-exemption letter may be called into question.
Form 1023: Part V Compensation of Officers, Directors, Employees and Independent Contractors Background Law: •Private Inurement: organization “insiders” may not be paid more than “reasonable” compensation •Intermediate Sanctions: penalty excise taxes imposed on “excess benefit transactions” with “disqualified persons” •Private Benefit: a 501(c)(3) organization may not use its assets to the benefit of a private party, except to the extent that such benefit is incidental to the organization’s tax-exempt purpose
Form 1023: Part V Line 2: describe family and business relationships among your officers, directors, highest compensated employees or independent contractors. • Business relationships include common ownership of a business (i.e. related parties together hold more than 35% ownership), as well as employment and contractual relationships. • The IRS is looking for conflicts of interest that may compromise the independence of the organization and lead to private inurement and private benefit violations. • EXAMPLE: one organization board member is also on the board of a for-profit business that is a client of a law firm of which another board member is a partner.
Form 1023: Part V Line 3: list name, qualifications, average hours worked and duties of each officer, director, highest compensated employee, and highest compensated independent contractor •The IRS is looking to ensure that the people running the organization have actual qualifications and duties, and not just handpicked by the founder to act as “rubber stamp”
Form 1023: Part V Line 4: you should answer “yes” to all these questions if you want your Form 1023 approved without complications •Follow Conflict of Interest Policy (see IRS sample) •Approve compensation in advance •Document compensation arrangements in writing •Record board decision (i.e. minutes of board meeting) •Obtain comparability data from at least 3 similarly situated organizations •Document the data and its source in the meeting minutes
Form 1023: Part V Line 5: Conflict of Interest Policy (see IRS sample) is optional but highly recommended Line 6: non-fixed payments such as discretionary bonuses and revenue- based payments are inherently suspect and should be avoided, if possible Lines 7, 8, 9: transactions should be negotiated at arm’s length (i.e. decided by an independent board) and at fair market value (based on comparable data). •Good board procedures are of the utmost importance
Form 1023: Part VI Provision of goods, services, or funds to individuals and organizations Again, the IRS is concerned about possible private inurement and private benefit violations. Any disbursements must directly further the organization’s exempt purpose, and not unduly benefit insiders.
Form 1023: Part VII History of any predecessor organizations: •Line 1: If your organization has taken over the activities or assets of another organization, the IRS will take a closer look to ensure that your organization is truly independent and worthy of its own 501(c)(3) – See Schedule G. •To maintain independence from a related organization, be sure to negotiate all dealings at arm’s length, and have either: (1) a majority of different, independent board members, or (2) a different executive director and staff running the day-to-day details of the organization •Line 2: 27-month rule for retroactive 501(c)(3) status
Form 1023: Part VIII Line 1: must check “no” – 501(c)(3) organizations are prohibited from opposing or supporting political candidates Line 2: 501(c)(3) organizations are allowed to influence legislation (i.e. direct lobbying and grassroots lobbying), so long as these activities are not “substantial” •If your organization engages in direct or grassroots lobbying at all, it is generally recommended to file Form 5768 (the “501(h) election”) Line 6: you must be able to show that any economic development activities are charitable and do not just benefit private businesses
Form 1023: Part VIII Line 8: “joint ventures” with non-501(c)(3) organizations are inherently suspect and should be handled with caution •There are specific cases and IRS rulings that should be closely followed – in general, the 501(c)(3) must retain voting control over the project to ensure that the joint venture furthers charitable purposes Line 14: contributions made to your organization that are used for the benefit of a foreign organization will qualify for the charitable deduction only if specific rules are followed: •Your organization must retain discretion over the funds (i.e. no earmarks), and adequate control over the projects abroad
Form 1023: Part VIII Line 15: you have a “close connection” with another organization if: •You control the organization or it controls you through common officers, directors, or trustees, or through authority to approve budgets or expenditures. •You and the organization were created at approximately the same time and by the same persons. •You and the organization operate in a coordinated manner with respect to facilities, programs, employees or other activities. •Persons who exercise substantial influence over you also exercise substantial influence over the other organization, and you either (1) conduct activities in common, or (2) have a financial relationship. Must take steps to maintain the separateness of the organizations
Form 1023: Part IX Financial Data – Statement of Revenue and Expenses •If the organization has existed for 4 years or more: provide actual data for the most recent completed year and the three prior years (4 years total) •If the organization has existed for more than 1 year but less than 4 years: provide actual data for all completed years, and projected data as needed to get to a total of 3 years of financial data •If the organization has existed for less than 1 year: provide projected data for the current year and the following 2 years (3 years total) •Generally speaking, this is the only page that your CPA can do
Form 1023: Part X Public Charity Status- general rules •A 501(c)(3) nonprofit can be either a public charity (ex: Red Cross) or a private foundation (ex: Gates Fdn). •Private Foundations file a different tax return (990-PF), pay tax on investments, are subject to very strict conflict of interest rules, and have to distribute a portion of their assets every year. Most importantly: private foundations are very unlikely to give money to other private foundations. •To be a public charity you have to pass the public support test: done every year on Schedule A of the Form 990. Schools, hospitals, churches and government entities are exempt from this test.
Form 1023: Part X (continued) Public Charity Status- general rules (cont.) •The test calculates what portion of revenue over a five-year cumulative period was “public support.” •You become a private foundation if you fail two years in a row but you get a pass in your first five years. •Use this first five years to develop a broad base of support and remember that any inactive time after formation counts.
Form 1023: Part X (cont.) Public Charity Status: general rules •Form 1023 provides 8 possible versions of this test. Most organizations will choose between option (g) “509(a)(1) and 170(b)(1)(A)(vi)” and option (h) “509(a)(2).” •Option (g) generally seeks to ensure that 1/3 of total support is from contributions and grants, with most sources subject to a 2% limit (support from government and other public charities is not subject to the 2% limit). It’s possible to pass with 10% public support under “facts and circumstances” test. •Option (h) also generally seeks to ensure that 1/3 of total support comes from the public, except “exempt function revenue” is counted.
Tax Filing Requirements • Filing thresholds: – 990: Gross receipts over $200,000 OR totals assets over $500,000 – 990-EZ: Gross receipts from $50,000 to $200,000 AND totals assets under $500,000 – 990-N (“postcard”): gross receipts normally under $50,000 • The 990-N is an online-only version that is mostly just name and address information. • Exempt status is automatically revoked if an organization fails to file for three consecutive years.
Audit Requirements A requirement to have an organization audited can come from any of several sources: • State charitable registration requirements often set thresholds for requiring an audit, review or compilation based on total contributions reported on the 990. • A single audit under A-133 is required if an organization spends $500,000 of federal funding in one fiscal year. • Donors may require an audit (but may also accept a review or compilation). • Bylaws, banks or best practices
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