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Editorial 7 MIN READ

The nonprofit corporation, examined: two filings, two sovereigns

A state-chartered entity and a federal tax ruling are different legal acts, and conflating them is the most common way founders burn the first year

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 5 sections
  1. The state charter
  2. The federal recognition
  3. The state side, after federal
  4. Where it breaks
  5. Sources

orming a nonprofit corporation in May 2017 is two transactions, not one. The first is chartering a nonstock entity under your state's nonprofit corporation statute. The second is applying to the IRS for recognition as a tax-exempt organization under § 501(c)(3). The two steps happen in sequence, take money at two different counters, and answer to two sovereigns whose rules do not line up neatly.

Founders who treat the state filing as the end of the job discover in year two that contributions are not deductible, that the state franchise tax board is asking why no exemption is on file, and that the bank will not open a charitable account without a federal determination letter.

The state charter

Every state has a nonprofit corporation act, and in most of them it is a separate statute from the business corporation act. California codified its Nonprofit Corporation Law at Corporations Code §§ 5000–9927, split into three parts: public benefit (§ 5110 et seq.), mutual benefit (§ 7110 et seq.), and religious (§ 9110 et seq.). Texas consolidated business and nonprofit entities in the Business Organizations Code, with nonprofit corporations governed by Chapter 22. New York's Not-for-Profit Corporation Law was rewritten under the Nonprofit Revitalization Act of 2013, which effective July 1, 2014 collapsed the old Type A / B / C / D classification into simply "charitable" or "non-charitable." Delaware does not have a separate statute at all; a nonprofit in Delaware is a nonstock corporation chartered under the General Corporation Law, with 8 Del. C. § 114 telling you how the rest of Title 8 applies when there are no shares and the stockholders are members.

The filing is usually cheap and fast. California charges $30 for articles of incorporation of a nonprofit public benefit corporation. Texas charges $25 for a Form 202 certificate of formation. Delaware charges $89 for a certificate of incorporation of an exempt corporation. The drafting matters more than the fee. For federal exemption the articles must contain specific language — an exempt-purposes clause that tracks § 501(c)(3), and a dissolution clause committing the assets to another exempt organization or to a government. The IRS publishes suggested language in the Form 1023 instructions; most state SOS templates do not. A nonprofit whose articles do not include the purposes and dissolution clauses will file its 1023, receive a letter asking for amended articles, and pay the state a second fee to amend before the IRS will proceed.

A nonprofit at the state level is not automatically a charity, not automatically tax-exempt, and not automatically able to receive deductible contributions. Those are federal attributes and require a separate filing.

The federal recognition

The IRS ruling on exempt status comes from Form 1023 or its short cousin, Form 1023-EZ. Both apply for recognition under § 501(c)(3) — the code section covering organizations organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, among others. The full Form 1023 runs about twenty-six pages with schedules and asks for narrative descriptions of activities, three to five years of budgets, conflict-of-interest policy, compensation for directors and officers, and a detailed classification under § 509(a). The user fee is $600, set by Rev. Proc. 2017-5, 2017-1 I.R.B. 230, the annual Exempt Organizations procedure in force for applications submitted this year.

Form 1023-EZ is the streamlined application the IRS rolled out in 2014 for small organizations. It is three pages, filed through Pay.gov, and limited to applicants whose annual gross receipts have not exceeded $50,000 in any of the past three years (and are not projected to exceed $50,000 in any of the next three years), and whose total assets do not exceed $250,000. Churches, schools, hospitals, supporting organizations, and private foundations are among the categories ineligible for the EZ. The user fee is $275, reduced from $400 by Rev. Proc. 2016-32 and carried into the 2017 procedure. The EZ is approved in roughly two to four weeks in typical cases. The full 1023 runs three to six months and sometimes more when the IRS requests additional information.

Part of the 1023 that trips first-time filers is the § 509(a) classification. Every § 501(c)(3) is presumed to be a private foundation unless it fits one of the carve-outs in § 509(a)(1)–(4). Public charity status matters: private foundations face a 1% or 2% excise tax on net investment income under § 4940, mandatory distribution rules under § 4942, and tighter self-dealing prohibitions under § 4941. Public charities do not. Most operating charities qualify under § 509(a)(1) cross-referenced to § 170(b)(1)(A)(vi), which requires that at least one-third of support over a five-year rolling window come from the general public or government, or under § 509(a)(2), which looks at a mix of public support and exempt-purpose program revenue. Organizations that cannot meet either test default to private-foundation status and its heavier compliance load.

The IRS issues a determination letter when the application is approved. The letter states the § 501(c)(3) status, the foundation classification, and — importantly for donors — the effective date. If Form 1023 is filed within 27 months after the end of the month in which the entity was formed, the exemption is retroactive to the formation date. Miss that window and exemption runs from the postmark date of the application, leaving a gap during which contributions were not deductible and the organization was, technically, a taxable corporation.

The state side, after federal

Federal exemption is not state exemption. California requires a separate filing with the Franchise Tax Board, either Form 3500 (full application) or Form 3500A (submission of the federal determination letter for organizations that already have one under § 501(c)(3) or similar). Until the FTB issues its own determination, the organization owes the state $800 minimum franchise tax like any other corporation. Texas is gentler: a Texas nonprofit with a federal 501(c)(3) determination applies to the Comptroller for state franchise and sales tax exemption using Form AP-204. New York exempt organizations register with the Attorney General's Charities Bureau under Article 7-A of the Executive Law if they solicit contributions from New York residents, and separately with the Department of Taxation and Finance for sales-tax exemption under Tax Law § 1116(a)(4). In every state the registration clock starts running the moment fundraising begins, not the moment the IRS letter arrives.

Charitable solicitation registration is its own apparatus. Forty states plus D.C. require a registration before soliciting donations from their residents, each with its own form, fee, and renewal schedule. The Unified Registration Statement is accepted by most of them, but several — New York, Florida, and California among them — require state-specific supplements. A small nonprofit soliciting online will trigger registration in more states than its founders expect.

Where it breaks

Three failure modes recur. The first is missing the 27-month retroactivity window for Form 1023 and discovering that the first-year donors' deductions are void. The second is using Form 1023-EZ for an organization that will plainly exceed the $50,000 receipts threshold inside three years, then getting the EZ questioned on audit and the application reopened on the full Form 1023. The third is the foundation-classification problem: an organization that expected to qualify under § 509(a)(1) because its founders can write large checks finds that single-donor funding fails the public-support test's 2% cap on any one contributor, and at year five slides into private-foundation status with the excise-tax and distribution obligations that come with it.

The cost of doing this right in 2017 is modest. Figure $25 to $100 for the state filing, $275 or $600 for the IRS user fee, and whatever a lawyer charges to draft articles and bylaws that will survive the 1023 review without a second amendment. The cost of doing it wrong is usually paid by the donors, who find out after the fact that their contributions were not deductible, and by the board, which spends year two explaining that to them.

Sources

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