There comes a time in every arts organization’s life when an important question arises: should I become a 501(c)(3)? Whether it’s straight out of the gate, or years into your organization’s operations, it’s important to have all the facts before taking this leap. This question is one that many of our projects seriously consider during their time with us, so Program Director Dianne Debicella sat down with Gene Takagi, Managing Attorney of NEO Law Group, to discuss all the considerations that go into making this decision.
Dianne Debicella: So let’s say I’m an individual artist who wants to start a 501(c)(3) organization. Can you break down the steps that would be involved in actually doing so?
Gene Takagi: The first step is the planning step, so you’ll want to mobilize the right people to serve on the board of directors before you even form the corporation, and get a business plan in place that is 501(c)(3) compliant. You’ll need to understand the laws and understand what your resource needs are going to be, and then fairly assess whether you’re equipped with sufficient knowledge and resources to advance the mission and the goals of your non-profit. So getting the people and the plan together, that’s the first step.
The second step is forming the entity itself. It’s most typical to form a non-profit corporation, which involves drafting and filing articles of incorporation or a certificate of incorporation with the state agency, typically the secretary of state. And once those articles are filed, you’re officially incorporated.
Once the board has been elected, it’s going to want to take actions, which could include at its initial meeting, electing officers and adopting the bylaws. The bylaws are the instruction manual for how the organization is to be governed by the board. There are a lot of procedural things that are going to be put into the bylaws that relate to how you elect board members, how you have board meetings, what rights the board members have, and whether and how board members, staff, and officers are protected by the organization. The bylaws should include these provisions to avoid disputes and so that the board doesn’t have look for applicable laws when asking “What are we supposed to do when this happens?” Hopefully the bylaws contemplate all of that, and because laws change over time, we have to make sure that the bylaws comply with the external laws as well. This means they should be reviewed from time to time.
After that initial board meeting, you’re still going to have some additional filings. In 39 states, a charity registration is required not only in the state of incorporation but also in any states in which you will actively engage in charitable solicitations. So that’s something to think about, particularly with online fundraising.
You’ll have to get an employer identification number. That has to happen after incorporation because you want that EIN to attach to the corporation itself. And that can easily be done through an online filing.
The next steps may be filing for federal and state tax exemption. Federal tax-exemption can be applied for using IRS Form 1023 or Form 1023-EZ. States vary on whether they have corporate level income taxes and whether a nonprofit needs to file for state tax-exemption. But it’s important to note that as a 501(c)(3) entity, you may not automatically be considered tax-exempt for state tax purposes.
There’s also a deadline on many of these steps, which may need to occur in a certain sequence and within a certain time frame. You generally have about 27 months within incorporation to receive 501(c)(3) status retroactive to your incorporation date, but if you fail to take this step or others in a timely fashion, there could be more problems and challenges to follow.
DD: What should an arts organization know before they consider applying for 501(c)(3) status?
GT: They should first make sure that they have an understanding of all the requirements, not just for setting up a non-profit organization, but also for what will be required to operate that organization over time. So, leaders should make sure they understand all the rules that will apply and affect how they govern and manage the organization. And they should make sure they have adequate resources to be able to comply with all of those rules and operate in an efficient manner in furthering their mission.
In relation to fiscal sponsorship, it’s important for leaders to ask themselves whether they will advance their mission most effectively and efficiently by running an independent non-profit, taking care of all the compliance and administrative issues as well, or if working with a fiscal sponsor is a better option.
DD: Do you think there is a specific point in time that it’s the right move for an existing collective or group to become a 501(c)(3)? What would be some critical questions for an organization in helping to make that decision about the timing of it, and whether or not they should do it?
GT: The first thing to think about is if there’s been money involved — so, if this group of individuals has been collecting money, or pooling their money and then spending it, they have to figure out whether that was reflected in an individual’s or entity’s tax return. If significant sums of money are involved, it’s probably time to talk with a lawyer and an accountant. If personal liability is of any concern, then incorporating is probably a good next step. And if you form a corporation and you know that the things you’re doing fall within the meaning of charitable or educational in 501(c)(3), then forming or applying for 501(c)(3) status probably makes sense. In some cases, however, your activities will not be consistent with 501(c)(3) status, in which case incorporating as a for-profit or forming a limited liability company might be appropriate.
For groups that have been operating without any formal structure, once you have money coming through, and you’re concerned about liability, that’s the time to think about forming a nonprofit and applying for 501(c)(3) status. But you should also consider comprehensive fiscal sponsorship as a possible alternative that allows you to spend more of your focus on programs and fundraising instead of administration.
DD: About a year ago, the IRS released the form 1023-EZ, which is a sort of shortened application to becoming a 501(c)(3). What are the benefits and challenges of completing this form?
GT: There are two big advantages of the Form 1023-EZ. First, it’s very quick and easy to fill out and submit to the IRS. Second, the IRS processes these applications very quickly, sometimes as quickly as within two weeks of receipt.
But it’s not as easy as it seems. In the 1023-EZ, you’re checking boxes, certifying under penalty of perjury, that say that you will operate as an organization that will comply with all of the requirements of the 501(c)(3). Now in the longer form, you get to describe those things in greater detail and you include your articles of incorporation. The 1023-EZ requires neither of those things. You mostly just check off the boxes that state you’re going to comply and that your articles comply. There have been some follow up studies, one from the National Taxpayer Advocate, that showed that in about a third of the applications, the articles of incorporation, when reviewed post-determination, did not comply with the requirements for 501(c)(3) organizations. This would have been picked up for the most part, if these organizations had completed the long Form 1023.
The instructions for Form 1023-EZ are not short and they should be read very carefully and understood before filling them out. Again, boxes on the 1023-EZ are checked by applicants under penalty of perjury, so it’s something to be taken very seriously. I really do prefer the long Form 1023 because it makes people develop a business plan and think about 501(c)(3) compliance before filing. I think that’s very important.
One other potential big disadvantage, and this might hold true particularly for artists, is grantors can tell from an applicant’s IRS determination letter whether a Form 1023 or a Form 1023-EZ was used to get 501(c)(3) recognition. A funder may think the candidate that received its status using the Form 1023-EZ is less attractive than one who used the longer Form 1023. When a foundation can know that an organization went through the long form process with the IRS, I think it’s reasonable that the Foundation would expect that the organization knows more about how to comply not only with 501(c)(3) requirements, but with grant agreement requirements.
DD: What are some of the requirements non-profit organizations face once they have 501(c)(3) status?
GT: Ensuring you recruit and maintain a strong board of directors is a good starting point. It’s important to get a board together of the right individuals who don’t have conflicts of interest and who will be able to meet the legal responsibilities and duties of serving as a board member.
Prior to filing for 501(c)(3) status, the board should have put together a business plan that includes plans for funding, a realistic budget, and a mission and planned activities consistent with 501(c)(3) regulations. Artists, in particular, need to think about whether their mission involves educating the public, which is a 501(c)(3) purpose, rather than creating art for personal and/or commercial purposes. So, while selling art might be something a charity could engage in, the 501(c)(3) purpose of a charity would not be to allow one person or a small group of persons to sell art to make a living; instead, the purpose should be to expose that art to a broader public, and by such exposure, educate them on why such art is important.
Staffing is an essential need — whether it be volunteers, contractors, or employees. On the program side, you need people who can adequately run and operate the program; on the administrative side, you need people who have the time, resources, and experience necessary to adequately administer the organization; and on the funding side, you need people who can and will raise funds for the organization. If the organization is compensating individuals, it must be particularly careful about getting right the distinction between an employee and independent contractor, knowing how to manage any conflicts of interest, paying no more than fair market value, properly withholding payroll taxes, and complying with all applicable employment laws.
Fundraising is subject to various laws and there are many best practices to consider as well to help ensure trust, flexibility, and donor satisfaction. For example, providing the proper form of receipt for a charitable donation may make the difference between a major donor being able to take a charitable contribution deduction or not.
Of course, all activities must be carried on in a legally compliant manner and where there are significant risks, there may need to be policies, practices, and other tools to mitigate such risks. Insurance is a common risk management tool to help protect not only the organization but the directors, officers, employees, and volunteers too. Getting the right forms of insurance is not always an intuitive process so it’s important to discuss your needs with an insurance agent or broker.
There are several ongoing requirements of which 501(c)(3) organizations should be aware include annual filings with the IRS and possibly with a state tax authority. In addition, a charity may need to register in its state of formation and possibly any other state in which it is engaged in active or significant fundraising.
DD: Any additional things you want to address?
GT: Some of the startup procedures can be difficult, but ignoring them can create more and much more difficult problems for the organization. For example, by not thinking about insurance, in a worst case scenario, someone may get harmed and the leadership may be held personally responsible. This could be a disaster if something happens, especially without a non-profit corporation’s limited liability shield to protect them.
Starting a non-profit is in many ways similar to starting a for-profit, in terms of the responsibilities involved, so it shouldn’t be done very lightly. It should be done with a lot of consideration, sufficient startup resources, and a lot of planning to ensure that the human resources are there to both staff a diligent board of directors and accomplish the nonprofit’s projects and goals in an effective and efficient manner.
About Gene Takagi
Gene Takagi is the managing attorney of NEO Law Group and contributing editor of the Nonprofit Law Blog. At NEO, Gene has represented over 400 nonprofit organizations on corporate, tax, and charitable trust law matters. Gene is a popular writer on nonprofit legal topics and has been published by The Nonprofit Quarterly, The Chronicle of Philanthropy, The Nonprofit Times, Taxation of Exempts, and ALI-ABA. He is also a popular speaker who has presented at conferences for Independent Sector, BoardSource, Net Impact, CalNonprofits, the American Bar Association, the Northern California Planned Giving Council, Social Media for Nonprofits, the National Network of Fiscal Sponsors, and numerous local and regional bar and CPA associations. He is a graduate of UCLA School of Law and a recipient of multiple awards for his work. Gene currently serves on the board of CompassPoint and the public policy committee of Independent Sector.
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