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WHAT YOU SHOULD DO BEFORE CALLING AN ATTORNEY ABOUT STARTING A NONPROFIT

By Justin R. Coleman, Esq. and H. Robert Showers Esq.

So, you have a passion to save the world (or at least some portion of it)? For some, this may mean spending time working at a local soup kitchen, animal shelter, or youth program. Others may feel that their cause is not being adequately addressed or recognized and may desire to create a nonprofit to raise awareness.

Due to the complexity of both state and federal tax-exempt law contacting a knowledgeable attorney about establishing a nonprofit is a wise decision. However, our firm often receives calls and emails from individuals wanting to create a nonprofit and, after a brief discussion, they realize that they have several steps they need take before they are ready to create the nonprofit and hire legal counsel. This article will highlight several of those pre-incorporation steps that a nonprofit should take before contacting a knowledgeable attorney to start the incorporation and tax-exemption application process.

According to the Urban Institute’s National Center for Charitable Statistics, just over 50,000 organization were granted §501(c)(3) tax-exempt status by the IRS in 2005. As of 2015, approximately 64% of them are still registered with the IRS with approximately 28% reporting financial activity.[1] While we do not know the specific reason(s) why the other 36% of nonprofits failed, they typically fall into a couple broad categories, which this article will briefly discuss. Moreover, during the past few years, hundreds of thousands of nonprofits have lost their tax exempt status due to various reasons most of which include inadequate filings. We want to help you prepare wisely, set up correctly, and build with legal and tax-exempt consistency.

  1. NON-PROFIT BUSINESS (MINISTRY) PLAN

Many times, an individual will contact our office stating that they want to create a nonprofit to “help with X.” Our first question to this statement is “Ok, what is your plan for fundraising activities to support it?”  Unfortunately, the person’s response typically is “I don’t have one yet,” or “I don’t know.” More importantly, they do not really know what it is going to take over the next 3-5 years to adequately fund the mission and objectives.

Creating a nonprofit is in many ways like starting a business. A business owner’s goal is to make money by selling goods and services. To do so, the owner needs to know what goods and services it will be providing, how it will market those goods and services to the public, and how it will keep its expenditures down while increasing its revenue.

For a nonprofit, the “big picture” charitable purpose and vision is important (e.g. rescuing animals, environmental conservation, stopping or helping alleviate human trafficking, helping at-risk youth, etc.) so the organization does not lose sight of its end goal. However, the founder(s) needs to have a specific plan as to how the nonprofit is going to find donors to bring in charitable donations to support its purpose. The plan should outline the fundraising activities in which the nonprofit intends to engage, identify any goods or services the nonprofit will be providing to the public, how and through whom will the nonprofit market itself to the public, and how will it distribute those donated funds in support of its charitable purpose.

This plan should cover at least the first three to five (3-5) years of the nonprofit’s life. This longer view serves a dual purpose: 1) it requires the founder(s) to think about what activities and operations it can reasonably undertake in that time-frame and much money and resources will be needed to accomplish its purposes; and 2) it will assist the attorneys in providing the IRS a required narrative of what the nonprofit has done, is doing, and intends to do under the applied-for §501(c)(3) tax-exempt status.

  1. THE INITIAL BOARD OF DIRECTORS

A corporation is a legal entity created by, and subject to, state law. All states have a sub-category for nonprofit corporations within the corporation statutes (sometimes called a non-stock corporation or public benefit corporation, depending on the state). Further, all nonprofit corporations are required to have a Board of Directors. The Board of Directors is responsible for overseeing the administration, legal compliance, property, and finances of the corporation and establishing policies and procedures for the nonprofit to legally operate and to achieve its tax-exempt purposes. For small nonprofits, the Board also serves as the primary ambassador/cheerleader and funder to the organization. Thus, when looking for people to join your initial Board, you should be looking for individuals that will have a passion for your mission who are affluent and/or influential to help promote the new nonprofit venture.

  1. NUMBER

Each state will require a different number of minimum directors for the Board (e.g. Virginia only requires 1 director for a non-stock corporation[2], while Florida requires at least 3 directors[3]).  However, the IRS will more heavily scrutinize an applicant for §501(c)(3) tax-exempt status that has less than 3 directors on its Board, or that has a majority of Board members with either business or personal conflicts of interest. The reason for this scrutiny is that the IRS wants to ensure that the Board will make decisions in the best interest of the corporation, as opposed to furthering personal interests. Moreover, they want to verify that the corporation is not being used to funnel donations to the personal financial benefit of one or more directors.

We have seen several nonprofits come to us after the IRS has initially denied their application for public charity status. Upon review of their documents we discover that the majority of the Board are comprised of family members (e.g. parent(s) and child(ren), siblings, etc.). Because of this, the IRS does not feel that the Board can make decisions in the best interests of the nonprofit, due to its conflicted majority. We often have had to require some of these related Board members to resign and/or have the Board appoint more unrelated directors before responding to the IRS.

For these reasons, we typically recommend that the founder(s) find and identify between 4 to 6 other individuals to serve on the Board. These individuals should not be related by blood or marriage to the founder(s) to better ensure the collective decisions by the Board are independent and to avoid potential conflicts of interest.

  1. PASSION

When identifying potential directors, a founder should search for certain qualities which will assist the nonprofit in the long run. One of the first qualities to look for in a director candidate is that he or she is passionate about the nonprofit’s purpose.

Particularly during the first few years of operation, the Board of Directors serves as the primary source of support for the nonprofit. This support not only means financial support, but emotional support for the founder, staff, and volunteers. Often, directors will be initially responsible for promoting the nonprofit to other individuals and organizations for fundraising purposes and to help cultivate those relationships for long-term donations. If a director does not have a “heart” for the nonprofit’s overall purpose, he or she will likely not provide their full attention to support the nonprofit or will simply burn out after a year or two and resign from the Board.

Thus, when interviewing potential directors, a founder should ask about the candidate’s hobbies, activities, and other interests to determine if that individual shares your same passion and is not stretched too far with their personal life or involvement with other nonprofits to be able to help your nonprofit.

  1. RELATIONSHIPS

As mentioned in the previous section, the Board will be the primary source of fundraising for the nonprofit through its initial years. Thus, a founder should attempt to seek directors who are affluent and/or have affluent connections.

Affluent directors are ones who have the ability to devote their personal time and resources towards the startup and to maintain the nonprofit’s operations and activities. Influential directors are those individuals who have personal and business connections to other individuals and entities who can financially support the nonprofit. If a director candidate is both affluent and influential and also passionate about the nonprofit’s purpose, then a wise founder would extend an offer to the individual to join the Board of Directors.

NOTE: Although this article is focused on pre-incorporation steps, it is important to note that the above sections regarding ideal qualifications for potential directors may apply throughout the life of the nonprofit, as directors will rotate off the Board from time to time and will need to be replaced.

  • INITIAL EXPENSES AND TIME FRAME

Finally, a nonprofit should be aware that neither the incorporation nor the tax-exemption application process is quick or cheap.

  1. INITIAL EXPENSES

In regard to start-up expenses, a founder must budget for a number of fees and costs including, but not limited to:

  • Between $100-$200 for state filing fees (or more if they want expedited service);
  • The $600 filing fee for the §501(c)(3) tax-exemption application to the IRS; and
  • Professional fees and costs (e.g. legal and accounting fees).

In total, a nonprofit founder and Board of Directors should initially budget between $4,000-$6,000 in expenses through the first year of the nonprofit’s existence to cover these estimated start-up costs. Please note that online services promise to set the nonprofit up and get tax exemption for $1500-$2000; however, they will not provide you the necessary bylaws, policies, and guidance you will need to be successful in the short or long run. Further, they do not even promise to get your tax exemption, serve as registered agent, get you the EIN, help with the necessary organizational meeting, and other tax and legal services that you will need. Wisdom dictates that making some initial upfront investment in the legal, tax exempt, and accounting set-up with some experience lawyers will more than pay for itself in the short and long run.  Many nonprofits have attempted to take the short cuts and bargain services only to end up realizing that they need to spend much more to correctly establish the nonprofit, or worse, discover too late that they do not have what is needed.

  1. TIME FRAME

The length of the process for states to return a Certificate of Incorporation/Organization will vary state-to-state, but generally may take from 1 to 2 months, unless expedited service is requested and purchased. Once returned, the initial Board members will need to schedule a time to hold the nonprofit’s organizational meeting. At the organizational meeting you will adopt the bylaws, three IRS-required polices, appoint officers, determine who the nonprofit’s bank and account signatories will be and a number of other organizational requirements. Once that meeting occurs which should be facilitated by knowledgeable legal counsel to get the minutes and resolutions legally correct, legal counsel will then need time to work with the you to complete the lengthy and complex tax-exemption application and submit it to the IRS.  Sometimes, a shorter 1020 EZ application may be filed but there are many restrictions and pitfalls that must be clearly understood before proceeding down that road.

Once submitted, the IRS will respond in about 3 to 4 months (depending on if the nonprofit will be operating domestically or internationally). Depending on the how well the application is drafted, the IRS will do one of the following: 1) grant the organization a §501(c)(3) determination; 2) request clarification about its proposed activities or other answers on the application; or 3) request additional substantive information about the nonprofit’s proposed activities. Most of the online services will trigger options 2 or 3 which will make the process longer and, perhaps, ultimately unsuccessful. If the IRS grants the Determination Letter without requesting further information (which is the goal and is achieved in most of our cases) the overall time frame generally falls between 4 to 6 months for a domestic nonprofit and 6 to 9 months for an international nonprofit to receive its §501(c)(3) Determination Letter from the IRS. Obviously, Responses 2 and 3 will extend these time frames.

A nonprofit should keep these time frames in mind when planning fundraising activities, although tax deductions will be retroactive back to the original date of incorporation if tax exemption is ultimately achieved. While possible to get money in the interim, most donors may require you to provide proof of the nonprofit’s §501(c)(3) status while the application is still being processed. This could potentially result in the nonprofit losing out on receiving grants or potentially losing donors.

  1. CONCLUSION

As explained above, the process of creating a nonprofit corporation is complex, time-consuming, costly, and can ultimately result in failure if an individual does have the right pieces and people in place from the start.

The first step should be to develop a plan as to how the nonprofit will support its purpose through various fundraising activities and services. Once in place, initial directors need to be sought out, vetted, and approved to help support the organization. These directors should be passionate about the nonprofits goals and purposes as well as have the ability to support it through the first few years, either directly or indirectly.

Once the plan is finalized and the initial Board established, the nonprofit should begin to raise its start-up capital and then reach out to a knowledgeable tax-exempt attorney to begin the process of incorporation and filing for §501(c)(3) tax-exempt status with the IRS.

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Disclaimer: This memorandum is provided for general information purposes only and is not a substitute for legal advice particular to your situation. No recipients of this memo should act or refrain from acting solely on the basis of this memorandum without seeking professional legal counsel. Simms Showers, LLP expressly disclaims all liability relating to actions taken or not taken based solely on the content of this memorandum.  Please contact Justin R. Coleman, Esq. at jrc@simmsshowerslaw.com or H. Robert Showers, Esq. at hrs@simmsshowerslaw.com for legal advice for churches, nonprofits, and businesses that will meet your specific needs. 

 

[1] nccs-data.urban.org

 

[2] Va. Code Ann. §13.1-855.

 

[3] Fla. Stat. §617.0802.

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