legal and accounting considerations when starting a nonprofit organization

Benjamin Takis

Tax-Exempt Solutions, PLLC

[email protected]

www.taxexemptsolutions.com

Ian Shuman

Gelman, Rosenberg & Freedman

[email protected]

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


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.


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.


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

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• 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


Revenue

Contributions $ 15,000

Interest income 100


Expenses

Salary 7,000

Consultants 2,000

Travel 700

Program Materials 300

Rent 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


Total

Revenue

Contributions $ 15,000

Interest income 100


Expenses

Treatment 7,450

Advocacy 2,000

Total Program Expenses 9,450

Administration 1,050


Change in Net Assets $ 4,600


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



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

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• 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

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• 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


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

https://sa.www4.irs.gov/modiein/individual/index.jsp

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


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


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

legal and accounting considerations when starting a nonprofit organization

Economy & Finance