Starting a nonprofit, Part 3

By Cynthia Sexton

Before applying to the Internal Revenue Service for tax-exempt status, a new nonprofit must have selected its board of directors and created its two organizational documents — the articles of incorporation and bylaws.

It must also have obtained certification of filing with the appropriate state agency.

Over one million organizations currently benefit from a nonprofit status classification obtained from the IRS.

If their exemption is under Section 501(c)3 of the Internal Revenue Code, the most advantageous classification, they enjoy two benefits.

First, income earned from activities directly related to their charitable purpose is exempt from federal income tax.

Second, charitable contributions received by the organization can be tax deductible by individuals and corporations making the contribution.

Federal exempt status is also recognized for other purposes.

Some states grant exemption from state income, sales and property taxes, and the U.S. Postal service officers some preferred rates to certain organizations.

To be eligible for exempt status, the organization must satisfy three criteria: The organization must be organized as a corporation, trust or association; its purpose, as stated in the corporate documents, must be one of those defined in Section 501(c)3 of the Internal Revenue Code; and it must limit its activities in several areas.

The IRS defines “exempt purpose” as charitable, educational and religions.

There are 28 separate classifications in the section of the Internal Revenue Code, and the organization has to specify in its organizational documents to which one it conforms.

The definition of “charitable” is broadly defined by the code, including relieving the poor, advancing education or science, erecting and maintaining public buildings, lessening the burdens of government, eliminating prejudice and discrimination, promoting and developing the arts, and defending human and civil rights.

“Educational” is defined more narrowly — instruction of individuals or the public for the purposes of improving or developing their capacities. Any other education-related purposes not specified in the Code must quality under the broader “charitable” purposes described above.

Community health education services, for example, would quality as charitable rather than educational activities.

IRS publication 4220, Applying for 501(c)(3) Tax –Exempt Status, lists the following prohibited activities: The organization must “absolutely refrain” from participating in the political campaigns of candidates for local, state, or federal office; it must restrict its lobbying activities to an “insubstantial” part of its total activities; its earnings must not benefit any private shareholder or individual; it must not operate for the primary purpose of conducting a business that is not related to its exempt purpose (a school, for example, cannot operate a factory); it may not conduct illegal activities.

Once the organization is determined to qualify under section 501(c)3, it  is then classified as a public charity or a private foundation.

Every organization is considered a private foundation unless it meets an exception listed in Internal Revenue Code Section 509(a).

Generally, a public charity has a broad base of public support, while a private foundation has more limited sources of revenue.

Organizations that are defined as public charities are schools, churches, hospitals, and organizations that receive most of their support from the general public or government.

A full discussion of requirements for exemption is provided in IRS Publication 557, Tax Exempt Status for Your Organization.  This document is fairly well written and accessible.

If you have determined that your organization qualifies under the two code sections, 501(c)3 and 509(a), then you are ready to start preparing Form 1120, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code.

The form and its instructions are available for download from the IRS website at

The first eleven pages of the application require that you refer to your enclosed organization documents (by page, article and paragraph) to confirm that you fall within the 501(c)3 definitions, and that your activities and relationships with other organizations fall within the charitable guidelines.

The terminology used in these pages is extremely detailed and specific.  It is suggested that the applying organization arrange for a lawyer or accountant experienced in nonprofit issues to complete or review the application before filing.

Next step:  Developing the financial data for your Application.

Other stories in the series:

Starting a nonprofit, Part 1
Starting a nonprofit Part 2

Cynthia Sexton is finance director for the A.J. Fletcher Foundation in Raleigh, N.C. The foundation publishes the Philanthropy Journal.

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