Self-Help Guide to 501(c)(3)

Self-Help Guide
For Obtaining IRS 501(c)(3) Status

INTRODUCTION:

This self-help guide is geared towards "charitable" organizations but may be somewhat helpful also for "educational" and "religious" entities.

To obtain tax exempt status from the IRS you must first create a corporation by filing the appropriate paperwork with your state government (CLICK HERE to download a collection of forms to create a Florida nonprofit corporation suitable for federal tax exemption). Then, you must apply to the IRS for the exemption. This document will not tell you how to answer every question on the application. The IRS has an excellent instruction booklet that you can download (see below). Instead, this article provides background information, suggestions, and tips to help you better understand the issues so that you can avoid mistakes that can delay the approval of your application by the IRS.

WHAT DOES TAX EXEMPT STATUS MEAN?

Every corporation, even nonprofits, must file a corporate tax return UNLESS they are exempt. Section 501(c)(3) of the IRS Code provides an exemption for “charitable, educational, and religious” organizations. There are twenty-two different types of exemptions but 501(c)(3) is often considered the most desirable because of the “goodies” that come with it (see below). Other types of exemptions include civic leagues, social welfare organizations, labor unions, business leagues, social clubs, farmer's coops, etc.

ADVANTAGE OF BEING 501(c)(3)

Contributions to a 501(c)(3) entity are tax deductible for the donor
Only 501(c)(3) organizations qualify for foundation grants.

THE NECESSARY APPLICATION FORMS

Form 1023: Application for Exempt Status
Form 1023 - Instructions
Form SS4: Application for Employer ID Number (click to apply over the internet)
IRS Publication 557, Exempt Status for Your Organization

You can download these forms & publications directly from the website maintained by the IRS. CLICK HERE to go to the IRS download page. Or you can use their toll free number to order them over the phone 800 829-3676 (allow about two weeks for delivery). These forms are also available locally from any IRS walk in office.

WHAT IS A 501(C)(3) ORGANIZATION?

DEFINITION: corporations that are "organized and operate exclusively for charitable, educational, or religious purposes", no substantial part of whose activities are lobbying or trying to influence legislation, and which do not endorse political candidates, and no part of whose income "inures" to the benefit of its members, directors, or others [except as compensation for services actually performed]. Now let's break this down and look at each part of the definition as it relates to a charitable [as opposed to "religious" or "educational"] organizations.

ORGANIZATIONAL TEST: the corporation must be "organized" exclusively for charitable purposes. To meet this test specific language must be included in the articles of incorporation stating that [1] the organization is organized and operated exclusively for specified charitable purposes; [2] none of its earnings or assets can be distributed to officers, directors or other private individuals [although payment of reasonable compensation for services is permitted]; and [3] if it dissolves, the organization's assets are to be transferred to another charitable organization (that is, its assets are currently dedicated to charity). Also, its organizational documents cannot authorize it to engage in political activities or substantial "lobbying" activities. If these requirements are met, then the organizational test is satisfied. The proper working for these paragraphs can be found in IRS Publication 557

CLICK HERE to download a "zip" file containing a complete set forms (with instructions) for creating a new Florida nonprofit corporation with Articles of Incorporation that meet organizational test.

CLICK HERE to download a template for "Articles of Amendment" (to amend the Articles of Incorporation of an existing Florida corporation so that it meets the "organizational test")

OPERATIONAL TEST: To be considered "charitable" the organization must "operate" "exclusively" for charitable purposes. Whether or not you initially meet this test depends on what you tell the IRS in the "narrative" portion of of the application (IRS Form 1023). See below. The following are recognized by the IRS as charitable purposes:

Relief of the poor and the underprivileged. For example, providing low income housing, developing employment opportunities, etc.

Lessening the burdens of government, for example providing community social service facilities, supplementing government assistance programs

Combating community deterioration. For example, commercial area revitalization, housing rehabilitation, increasing or improving housing stock, etc.

It should be recognized, however, that "lessening burdens of government" and "combating community deterioration" are general catch-alls which also cover many nontraditional charitable activities. Therefore, a careful description in the narrative section of your application is needed of the "charitable purposes" to be achieved

Eliminating prejudice and discrimination. For example, operating home purchase programs related to neighborhood integration, or a minority business assistance program.

The Meaning of "Exclusively". To be exempt the organization must be "exclusively" charitable (etc.). You would think it means that an organization can't do anything but conduct charitable activities. However, the IRS and the courts have interpreted "exclusively" to mean "substantially". That is, an organization can carry on "incidental" non charitable activities. For example, a charitable organization can conduct some business activities that are unrelated to its charitable purposes without losing its tax exempt status [see the discussion of "unrelated trade or business" below]. Remember, however, that the IRS will look closely at organizations that operate in a manner that makes charity appear to be only a secondary purpose.

TWO TYPES OF 501(C)(3) ORGANIZATIONS: PUBLIC CHARITY vs PRIVATE FOUNDATION.

In granting 501(c)(3) status the IRS will classify the organization as being either a "public charity" or "private foundation". Simply put, a private foundation is a 501(c)(3) entity that does not qualify as a public charity. The choice is made by the IRS and not the organization based on the sources of the organization's support.

PUBLIC CHARITY (technically: "Publicly Supported Organization") is a 501(c)(3) organization that meets the 1/3 public support test, that is, it receives at least one third of its support from "public" sources such as small contributions, government grants, or from other public charities AND it does not receive too much income from investments. If an organization qualifies it will not be subject to the restrictions applicable to private foundations. For example, The Ford Foundation is a "private foundation" because it does not get any support from the general public or the government and it is not affiliated with or controlled by another organization which itself gets public support. In contrast, your local United Way is a "public charity" because it receives broad public support. Also, an organization that depends on government grants will likely be classified by the IRS as a "public charity" because government grants are considered a public support.

ADVANTAGES OF BEING A "PUBLIC CHARITY":

Private foundations have more restrictions on their activities

The rules governing the deductibility of contributions are more favorable for public charities.

For public charities there is no tax on its investment income [if it has any], while a private foundation must pay a 2% tax

The IRS considers certain organizations to be public charities simply by the nature of their activities (schools, hospitals, religious organizations, etc.) or because the organization is affiliated with or controlled by another public charity.

For most 501(c)(3) organizations, however, the IRS presumes that it will be a private foundation UNLESS that organization can overcome the presumption by demonstrating that a sufficient amount of its financial support comes from "public sources" [small contributions from the general public, grants from governmental agencies, and grants from other public charities].

PRIVATE FOUNDATION STATUS: A "private foundation" is any 501(c)(3) organization that has failed to demonstrate that it is a "publicly charity". Private foundations can only give money to a public charity and they must pay an excise tax on investment income that is not given away as grants in a timely manner. Generally, gifts to a private foundation are not tax deductible and a private foundation cannot receive grants from another private foundation. CLICK HERE to go to an information page on the IRS website

PRIVATE OPERATING FOUNDATION - A "private operating foundation" is a type of private foundation that might be an attractive option for an organization that can't qualify as a "public charity" yet wants to avoid some of the disadvantages of being a normal private foundation. Private operating foundations are less rigorously regulated by the IRS than other types of private foundations and, like public charities, they can offer their donors the possibility of getting a tax deduction for donations. Somewhat like a public charity they can qualify for certain types of grants from other private foundations. What distinguishes "private operating foundations"" from other types of private foundations is that they must devote most of their resources to the active conduct of its exempt activities (rather than simply making grants out of their investment income). CLICK HERE to get more information from the IRS website.

RESTRICTIONS ON 501(C)(3) ORGANIZATIONS:

NO "PRIVATE INUREMENT": The IRS will take away your tax exempt status if feels that the primary purpose is to benefit insiders rather that the exclusive furtherance of charitable purposes. It happens when an insider enters into an arrangement with the nonprofit and receives benefits greater than she or he provides in return. The IRS refers to such insiders as "disqualified persons" - high-level managers, board members, founders, major donors, highest paid employees, family members of any of the above, etc. This is called "private inurement". It can take many forms. Examples include unreasonably high salary payments and certain types of business dealings between the corporation and its directors and officers. This is a MAJOR concern of the IRS and many of the questions on the application (Form 1023) have to do with potential private inurement.

LOBBYING: the basic rule is that a 501 organization cannot attempt to influence legislation either directly or indirectly. This includes local legislation pending before a city or county commission. An "insubstantial" or incidental amount of lobbying is permitted if an organization is a public charity [see definition below]. These terms are difficult to quantify. Five percent is sometimes use used as an informal guideline, i.e., an organization's staff should not devote more than 5% of its time and or 5% of the organization's annual budget for lobbying. But this is not an official IRS guideline. However, a public charity can make lobbying expenditures up to certain specified levels if it files a special "election" under Section 501 of the Internal Revenue Code using IRS Form. Even if the organization exceeds the specified expenditure levels, the worst that can happen is that it will have to pay a tax of 25% of its excessive lobbying expenditures. It doesn't lose its exemption unless it keeps exceeding the limits in subsequent years.

CERTAIN ACTIVITIES ARE NOT TREATED AS "LOBBYING". These include [1] talking to legislators about legislation that might affect an organization's tax exempt status or existence, but this does not include budgetary or funding matters: [2] activities related to non legislative decisions, such as opposing or supporting the issuance of regulations; [3] making available the results of nonpartisan studies; and [4] responding to requests to testify before legislative committees [your organization must be invited in writing by the chairman of the committee].

NO ENDORSING POLITICAL CANDIDATES: Section 501(c)(3) organizations cannot support or oppose political candidates. No partisan political campaign activities, however minimal, are allowed. Section 501(c)(3) groups can distribute nonpartisan "voter education" information, but such information should be carefully reviewed to make sure that it is a fair presentation of information about all candidates and is not "slanted". It cannot be anything that can be construed as an attempt to persuade the public one way or the other. Also, Section 501(c)(3) organizations are not permitted to allow groups or individuals to use their facilities and equipment to campaign for candidates.

COMPLETING THE APPLICATION (FORM 1023)
Tip: For additional help in filling out Form 1023 go to Nancy Deja's site: Form1023Help.com

STEP 1 - Read the Instructions: Form 1023 has excellent instructions (a separate document from the form itself). Read those instructions carefully. Also, read IRS publication 557.

STEP 2 - Employer ID Number: One of the first questions on the application is your "Employer Identification Number" (EIN) If you don't have one you will need to get it from the IRS. The easiest way to do this is to apply on-line. Or, you can download Form SS4 from the IRS website and follow the instructions. .

STEP 3 - Prepare the "Narrative": Part IV of Form 1023 asks you to describe in detail your organization's past, present, and future activities. An attachment to Form 1023 will always be needed.

This one question [along with the contents of your articles of incorporation] will determine whether or not your organization qualifies for exemption

The rest of the application is merely to determine if there is any improper "private inurement" (etc) and to determine what type of 501(c)(3) organization you will be (a "public charity" for a "private foundation").

Here are some pointers for your "Narrative"

DISCLOSURE: Disclose all existing and planned activities. Your knowing failure to disclose pertinent information might be interpreted by the IRS as a crime (tax fraud). if your organization plans to implement an activity that you know is an "unrelated trade or business" you should either change your mind and not do it OR create separate company that you control to engage in that activity (a "subsidiary). If a particular activity is borderline and you do not want to house it in a separate company you may go ahead and fully disclose it in your narrative describing it in the best light and giving the IRS your best argument for why it should be considered to be "related" to your charitable purposes.

OPTIONAL - INCLUDE A SECTION LABELED "BACKGROUND". To help the IRS better understand your activities you can optionally include a section in your narrative that describes the background or the need that you are trying to address (tip: label this section "Background" or "Statement of Need" so that the IRS knows it is not a description of the activities themselves)

INCLUDE A SECTION LABELED "ACTIVITIES": Describe in detail your proposed or existing activities. Don't include vague ideas that you may or may not implement in the future (include only those proposed activities that you actually plan to implement during the next two years and that you can describe with some detail). Fully describe the identity of your proposed customers or clients. Describe eligibility. Describe the physical facility(ies) that you will use (e.g. location, size, layout, rent, etc.). Describe your proposed or existing staff. Described how you will fund the activity. If you apply without giving sufficient detail the IRS may hold up your application until you answer their written questions. Remember, the IRS does not like to give out exemptions and they look for excuses to deny or hold you up. For each activity provide the following details

What does the activity entail?
Who conducts the activity?
Where is the activity conducted?
When is the activity conducted?
How significant is the activity in relation to your total activities?
Who may participate in the activities?
How are participants selected?
Are fees charged? If so, please provide a fee schedule.
How does the activity further your exempt purpose?
If activity involves real estate development, give details on financing, site, etc.

FOCUS ON EXEMPT PURPOSES: focus your narrative around achieving your organizations exempt purposes. If your activities are to be located in a low income neighborhood, start off your narrative by using a detailed description of that neighborhood. Include statistics on the poverty rate, housing conditions, percentage of underwent mothers, unemployment rates, ethnic breakdown, etc.. In order to establish how "bad" things are, compare the neighborhood's statistics to similar statistics for the county or city as a whole. You can get this data from the City and County Data Book of the U.S. Census Bureau. Often, the county or city government can give you copies of studies that they have previously prepared. When describing the activity, stress over and over how the activity will alleviate poverty and how the beneficiaries of your services will be low income persons, etc.

AVOID "BOOBY TRAPS": don't brag about how you plan to go down to City Hall and demand better code enforcement in order to clean up the neighborhood (etc.). This could easily be interpreted by the IRS to the lobbying. If lobbying will be a major activity for your cooperation you may not qualify for 501(c)(3) status. Also, don't write about the benefits that your "members" will enjoy. The activities of charitable organizations must benefit the entire community and not just their own members. If only the "membership" were to benefit, the IRS would interpret the activity as "private inurement" and would automatically disqualify the corporation. Your members are allowed to benefit but only as part of the larger community but not as a privilege inherent in their "membership". If the whole purpose of your organization is to bring financial benefit to your membership, your organization probably will not qualify for 501(c)(3) exempt status.

BE CAREFUL ABOUT "UNRELATED TRADE OR BUSINESS": In describing your activities in the narrative be aware that 501(c)(3) organizations can not have a "substantial" amount of "unrelated business activity". Each of your proposed activities must "relate" to your charitable purpose. In other words, each activity must contribute importantly to the achievement of your organization's charitable objectives as specified in your organization's articles of incorporation. It is essentially a "purpose" test. For each activity described in your narrative you must explain why the organization doing it. Is it doing this to make money or is it doing this to achieve a charitable goal? To establish that a business activity is a related business you must be able to show that it is merely an instrument to achieve a charitable purposes and that the activity is not an end in itself. In other words, you must show that the the purpose is not merely to make money (even if that money is to be spent on charitable purposes the activity itself must further a charitable). The bottom line is the issue of unfair competition. You have to convince the IRS that the proposed activity is going to be different from similar activities conducted by non exempt corporations. For example, perhaps the activity will provide employment to members of the charitable class. But many non exempt businesses also provide employment opportunities. You must distinguish what you are proposing to do. Perhaps your proposed activity can be considered "related" if the focus is on helping the employees through providing supportive social services, training, and other assistance that an ordinary employer normally would not furnish so that it is clear that the business is not being operated to achieve profits but for other objectives. The business operation must have factors that make it different from similar commercial businesses.

FINAL CHECKLIST:

On Form 1023, near the end, there is a final checklist page. Assemble your packet for submission following the order of the documents outlined in that checklist. It gives instructions on where to send the application and how to handle the filing fee

COVER LETTER: prepare a short cover letter to be signed by the corporations president explaining that you are applying for tax exempt status and that your application is attached. Include the following statement: "the attached bylaws are a true and correct copy of the bylaws that are currently in effect".

POST APPLICATION

The initial response letter: after submitting the application you can expect a letter from the IRS in about eight weeks. The letter will acknowledge the receipt of your application. Almost always the letter will ask you for additional information. If there are only ten or fewer questions, you are probably in very good shape and you can expect your application to eventually be approved without too much additional hassle. If, on the other hand, there are 15 or more questions, there may be problems with your application. Regardless, answer all questions truthfully and in detail and submit the answers to the IRS within the time deadlines imposed on you in the letter. The letter will give you the name and telephone number of your contact person at the IRS. This is the person who has actually reviewed your file and who wrote the letter (although the letter was probably signed by the district director). It is almost always a good idea to call this contact person and find out exactly what they want to know. Often these contact people can be very helpful and the information that they give to you can help you focus your response to the letter.

Determination letter: eventually the IRS will either send you a favorable or an unfavorable determination letter. If it is unfavorable, good luck and you have our condolences. If it is favorable, congratulations! Save this letter. It is very important. Not only does it give you critical information about compliance and staying out of trouble with the IRS, but your potential funding sources will almost always ask you for a copy of it.

ANNUAL INFORMATIONAL RETURN - FORM 990

Form 990 series returns are required to be filed by most tax-exempt organizations. Form 990 is the IRS' primary tool for gathering information about tax-exempt organizations, for educating organizations about tax law requirements and ensuring their compliance. Organizations use it to inform the public about their programs. CLICK HERE to go to a page on the IRS website that provides more detailed information about the requirements.

SOME IRS PUBLICATIONS THAT WILL BE HELPFUL:
Click Here to go the IRS download page

IRS Publication 526 - Charitable Contributions:Organizations that qualify for status as a charity are described. The publication provides rules for determining the fair market value of donated property and explains limits on the size of a deduction based on 20, 30, or 50% of an individual's adjusted gross income.

IRS Publication 557 - Tax-Exempt Status for Your Organization: (click here for the on-line version). Organizations are guided through the application procedures for obtaining tax-exempt status. Generally, these organizations must complete either Form 1023 or Form 1024 and await a ruling or determination letter from the IRS. If an exemption is granted, it may be effective as of the date of an organization's formation. In some cases, an organization may be issued an advance ruling or determination letter prior to commencing operations. Return and disclosure statements required of exempt organizations are explained.

IRS Publication 598 - Tax on Unrelated Business Income of Exempt Organization:

IRS Publication 1391 - Deductibility of Payments Made to Charities Conducting Fund-Raising Events:Helps sponsors of fund-raising events carefully word the extent of a donor's eligibility for a charitable contributions deduction.

IRS Publication 1771 - Charitable Contributions--Substantiation and Disclosure Requirements:The Revenue Reconciliation Act of 1993's substantiation and disclosure requirements for donors and charities on contributions made after December 31, 1993 are reported. It is recommended that charities familiarize themselves with the new law in order to avoid failure to meet disclosure provisions that might be subject them to penalties.