Forming a Nonprofit Corporation
Initial Client Intake
Students in law school clinics representing nonprofit clients should use intake worksheets as a starting point for gathering initial information from clients. This information is extremely important for use in identifying legal issues and in assisting clients through the formation process. In addition, it is helpful for students to have a “checklist” to work from, so that all necessary tasks are completed in a timely manner. Students should also be aware that conflicts can arise when representing nonprofit corporate clients, and performing a conflicts check is an important part of the initial client intake process.
Before forming an entity, the lawyer and law student should thoroughly explore with clients two main issues: the purpose of their proposed enterprise and the constituency they intend to serve. It should not be assumed that a tax exempt organization is always the most appropriate vehicle for accomplishing the clients’ goals until after the interview takes place and facts are thoroughly reviewed. The following considerations should be explored with the client:
- The purpose and mission of the organization;
- Whether or not the organization intends to make a profit in whole or part;
- Sources of funding: E.g., do the clients anticipate obtaining funding from donors, paying clients, government grants, other private sources, and what is the funding plan;
- Technical expertise: Setting up and operating a nonprofit often requires strict compliance with detailed government tax and funding regulations that a for-profit entity usually does not – does the nonprofit have persons capable of managing, and performing, these tasks;
- Time considerations: A for-profit venture usually can be set up and operating within a short time period - the application process for federal tax exemption is often long and involved; the urgency of the organization’s needs, and what are plans for funding the operation prior to receiving tax-exempt status.
- As with for-profit entities, not all nonprofits are created equal. There are several types of nonprofit organizations, and each carries with it many implications. As is mentioned above, this Roadmap deals exclusively with nonprofit corporations.
Creating a Structure
State law governs the creation and operation of a nonprofit. The first step in creating the nonprofit corporation must be to determine what the state requirements are for creating a legal entity: this can be done by contacting the state agency responsible for registering corporations and nonprofits, such as the Secretary of State’s office. Typically such a corporation is formed by filing some type of nonprofit articles of incorporation with the responsible agency. In some states, charities are also required to register with that state’s Department of Justice, Attorney General’s Office, or Corporations Division. The National Association of State Charity Officials (NASCO) is an organization of state officials that regulate charitable organizations and fundraising, and has links to state-specific information. Attorneys advising non-profits should also be aware of a new type of limited liability company (LLC) that is called an L3C. To date, only five states have authorized this type of venture, but it definitely bears consideration by the careful advisor, especially for clients who are interested in for-profit activities, and those interested in participating in program-related investments of non-profit foundations
When forming an entity, the following basic elements should be included in a checklist:
Most states recognize both membership and non-membership organizations. If the clients select to create a membership organization, the lawyer must help the client determine whether those members should have voting rights. This section will not discuss membership organizations, however attorneys should be aware that different requirements apply to membership and non-membership nonprofit corporations. Usually it is much easier for a nonprofit that is just starting out to choose to be a non-membership corporation.
Board Selection and Composition
Increasingly, since Sarbanes-Oxley, the IRS and the courts have given greater scrutiny to the governance of non-profits. Thus, the selection of board members for a start-up organization is one of the most important parts of the entity-formation process. Some things to consider when creating a “start up” board include:
Number: Specific state laws set forth requirements for member and non-member organizations, including the minimum number, composition, and officers on the board. Nonprofits can definitely provide for more that the minimum in the bylaws or articles of incorporation. Organizations should carefully consider factors that will influence the number selected, however, including the amount of work that will be required of members, the number needed to constitute a quorum, and whether the number will be large enough to accomplish the organization’s business but not so large that it is impossible to function efficiently.
Composition: This is arguably the most important element of board selection, and can have the greatest impact upon the organization’s ability to thrive. Once again, a checklist should be developed to assist clients with ensuring the board is well rounded, contains the appropriate operational and substantive expertise required (such as financial, fund-raising ability, etc.), and reflects the community served.
Officers: Most nonprofit corporations also are required to have officer positions; the most common are equivalent to a secretary and a chair or president. Additional officers can be appointed, and most boards include at least a treasurer (or budget and finance position), and fundraising officer as well. It is always a good idea to set forth in the bylaws the guidelines regarding the roles, rights, and responsibilities of board members and officers. In addition, if the Executive Director is to be an officer or board member, the Director’s duties should also be set out in the bylaws.
Selecting a Name, Obtaining an EIN Number, Filing Articles of Incorporation
Name and EIN Number: Before filing Articles of Incorporation, clients must select a name for their nonprofit. States may have specific regulations that may restrict the types of names that can be used, and it is important to check with the governing state agency to make sure the name complies with such regulations before proceeding to file the Articles. It also is important to perform an online search to protect the entity from claims of infringement. If an exempt corporation later changes its name, it must notify the IRS. Once the corporation is formed, you should obtain a state ID number and an EIN (Federal Employer Identification Number) from the IRS. You can then set up a bank account using the EIN – make sure when doing so to designate authorized signers and co-signers.
Articles of Incorporation: Every nonprofit corporation must file Articles of Incorporation with the appropriate state agency. Most state agencies have pre-printed forms with explicit directions that must be followed to the letter. The Internal Revenue Service has information online that can help ensure you insert the correct language. As is noted on the IRS website, to obtain federal tax-exempt status, the Articles must include a statement that the purposes of the organization are exclusively charitable, educational, or scientific within the meaning of Section 501(c)(3), and a section that provides that upon termination or dissolution the organization will transfer assets and liabilities to another 501(c)(3) organization. The corporation will become official once the Articles of Incorporation are filed with the appropriate state agency. Be sure and check with the state agency regarding the specific action it takes that determines the filing process is “complete.” (e.g., the mere process of sending the articles, having the documents stamped by the agency, receipt of a formal letter, etc.) Always make sure to check for filing fees and include them with your submission. Only after the Articles of Incorporation have been filed can the organization hold its first meeting.
Bylaws: The bylaws set forth the structure of, and operational procedures for, the nonprofit. (There are different legal procedures for a membership vs. non-membership organization, which will not be addressed here.) Clinics should develop a checklist of items to be contained in bylaws that carefully track the requirements set forth in the appropriate state statutes. Always check with the state agency to make sure you have updated information. This section will not set forth all the items that should be included; many excellent references and checklists discuss these matters in detail. At the very least, bylaws should contain provisions relating to the following: 1) whether or not the entity is a membership organization; 2) the name and purpose of the corporation; 3) board composition (including qualifications, voting, and operation of meetings); 4) board duties (including number and terms of directors, removal from office, vacancies); 5) number and types of committees; 6) officers (board chair, titles and duties, election); 7) if the Executive Director is to be a board member or officer, enumerate the Director’s duties; 8) a provision for amendments and 9) a conflict of interest policy that conforms with that recommended by the IRS. (See Appendix A of the IRS Instructions for a sample; in addition, state law often provides standards for board conduct in the event of potential conflicts of interest).
All clinics should have on had a copy of the new Governance Section in the IRS Form 990. Although the Form 990 is a tax return and not a form that needs to be filed when applying for exempt status, the form requires specific information regarding nonprofit corporate governance that may need to be addressed in an organization’s bylaws. In addition, there are governance-related questions contained in other areas of the Form 990. Therefore, when drafting the bylaws of a new nonprofit corporation, review the latest version of the Form 990 and the instructions. The Form 990 and instructions are on the IRS Web site, as is background information and commentary.
Bylaws may have to be filed with the state agency where the Articles of Incorporation were filed; practitioners should check specific rules within their states. Nonprofits applying for federal tax-exempt status must file their bylaws with the IRS, however.