Setting Up and Maintaining a 501(c)(3) Tax-Exempt Organization By Bob Freideman Freideman, Irelan, Ward & Lamberton, P.C. 1000 Potomac Street, N.W., Suite 400 Washington, DC 20007-3551 Phone: (202) 625-1800 Fax: (202) 625-1616 E-Mail: r.freideman@fiwllaw.com Website: www.fiwllaw.com |. What is a 501(c)(3) organizations is. A. Tax Advantages. 1, A.501(c)(3) organization is one of a number of types of organizations whose income is exempt from federal income taxation (and usually state income taxes as well), 2. But 501(c)(3)s are the only type of tax-exempt organization that let donors deduct their contributions on their income tax returns. B, The Organization and its Mission. 1, A501(c)(3) must be a separate legal entity. ‘The usual form of organization is as a non-profit corporation incorporated in the state in which it operates. 2. The 501(c)(3) must be organized and operated only for “educational” or other purposes listed in Section 501(c)(3), Here, you have history on your side; sailing instruction and training is deemed “educational” 3. The organization must be run for the general benefit of the public, and not for the private benefit of its founders or others (the tax buzzword is “no private inurement”) 4, The organization’s charter must provide that if it goes out of existence or loses its tax exemption, its assets will pass to other exempt organizations thus ensuring that someone will use them for exempt purposes.Note: The IRS publications and forms mentioned in this handout are av: line at IRS’s website www.irs.gov. Just type the number of the form or pul the “Search Forms and Publications for” search box on the IRS’s homepage. II, What 501(c)(3) Status Can Do For Your Program. A. Fund Rai g: a tax deduction can make all the difference. 1. Contributions. As a 501(c)(3), you have something to offer prospective donors: a tax deduction. Some individuals and organizations give only if they can get a deduction; others (who might give anyway) find a deduction a powerful incentive. They have plenty of S01(¢)(3)s to choose from; if your organization is one of them, you can compete for these dollars. 2. The reason donors favor 501 (c)(3)s is that the deduction makes it “cheaper” for the donor to give 3. Cash contributions. An example: Even if a donor is not in the top tax bracket, the combined tax rate (federal plus state) on his/her last $100 of income may still be some 35%. This means that i. If the donor does not make a gift of the $100, IRS and the state take $35 leaving the donor with $65 ii, If-you're not a 501(c)(3) and the donor gives you the $100 anyway, the donor’s out the $100 — and still must pay IRS and the state the $35, so the donor's out $135. iii, But, if you are a 501(c)(3) and the donor contributes $100, the deduction reduces the donor’s taxes by $35, so the cost of contributing to your organization is only $65 ($100 less the $35 the donor would have paid in taxes had the donor not made the gift) 4. Contributions of property. ‘The same principle applies to non-cash contributions (otherwise known as “in-kind contributions”). In the example, donating a dinghy worth $1,500 would save the donor $525 in federal/state taxes (35% of $1,500). 5. Your volunteers’ out-of-pocket expenses. If you are a 501(¢)(3), your Volunteers can take a charitable deduction for certain out-of-pocket expenses (e.£. mileage) they incur while helping out. (They can’t deduct the value of their time, though, that would be too good to be true.) B. Your Income is Tax-Exempt: works for you, instead of going to the IRS.With 501(¢)(3) status, your organization will pay no tax on the following. 1. The contributions and grants you receive; 2. Income your organization generates in performing the educational activities for which it was granted exemption. (Thus, if you charge a reasonable fee for your sailing classes, those fees won't be taxed. ); 3. Investment income (e.g. bank or money market interest); 4. Proceeds from selling donated property that you decide not to keep; and 5. Sponsorship income (if approached with care) Note: Income from any activities “regularly carried on” that are not “related to your exempt purpose” would be taxed. This income would be subject to “unrelated business income tax” (better known as “u-bit”). 1, A ridiculous (yet completely true) example: a charity that was given a factory and tried to claim the profit was tax-exempt. 2. Some areas the IRS watches: advertising and mailing lists. IIL. Getting Started: Forming your 501(¢)(3). A. The Application as Checklist. It can be helpful to review the IRS exemption application (IRS Form 1023, discussed below) at the outset. The areas the form covers give you a checklist of what the IRS considers important. B, Creating the Non-Profit Corporation. In addition, you'll need to follow all the formalities of setting up a non-profit corporation, including 1. Filing Articles of Incorporation with the appropriate state agency (IRS Publication 557 (Tax-Exempt Status for Your Organization) has some examples of the “magic words/provisions” your articles will need to include), 2. Adopting by-laws; 3, Following the corporate formalities (¢.g. meetings to elect officers, approve applying for exemption, etc.), and4. Applying for an employer identification number (IRS Form $S-4. Once you have completed the form; you can apply by phone.), IV. Applying for Recognition of Your 501(c)(3) Status. A. What to File. Apply by filing: 1. IRS Form 1023 (the application); 2. IRS Form 8718 (submits the IRS user fee for processing the application. The fee is currently $500 or, if you anticipate operating on less than $10,000 per year, $150); and 3. If someone is representing your organization, IRS Form 2848 (a power of attorney letting IRS communicate directly your representative), B. When to File. ‘As soon as possible after formation (you should anticipate that processing your application will take 4 to 5 months), but in any case within 15 months after you incorporate. If you file within 15 months (and IRS grants exempt status without requiring any changes in your articles or by-laws), IRS will treat you tax-exempt retroactive to the date you formed the organization. Contributions can be accepted while you wait for the IRS to act, C. The Goal. The goal is to give the IRS a complete and accurate application ~ one the IRS examiner feels is an easy case, one the examiner can approve without having to ask for additional information. If the IRS has to go back to you for additional information, this can add months to the processing time. While not required, consider having an attorney write a legal memorandum to submit with your application discussing the statutes, IRS regulations and rulings that support granting your organization 501(c)(3) status. This may well shorten the processing time. ‘The examiner has to write up a report on why your organization qualifies as a 501(c)(3). Why not do some of the heavy lifting for the examiner and make yours the application he or she wants to approve? D. Some Important Areas. ‘The following are some important parts of the Form 1023 application.1. The description of your organization’s activities. This is probably the single most important part of the application; this is where you prove your purpose is “educational”. IRS wants to know: (i) your proposed activities in order of priority; (ii) how each furthers your exempt purpose (i.e. how each is “educational”; (iii) when and where each began or will begin. 2. Describing the assets (e.g. boats, launching dollies) you will use in carrying out your purpose. 3. The names, titles, addresses of your Board and officers and whether they will be compensated. 4. Your ties with other organizations, such as: Are you controlled by or financially accountable to another organization? Will you share facilities or equipment with a yacht club or other organization or perform services for each other? 5. Will you have members and, if so, what benefits will they receive? 6. Will you charge for your courses and other services and how will the charges be determined? 7. Ifyou are just starting out, you must submit a financial statement for your current year pius budgets for the next two years, 8. And last, but not least, what sort of fundraising will you be doing and where do you think your funding will come from? . Deciding Whether to try for Public Charity (vs. Private Foundation) Status. A, There are Two Kinds of 501(c)(3)s. Funding sources are important because there are two kinds of 501(c)(3)s: private foundations and public charities. Essentially, private foundations draw their funding from only a few sources; public charities are deemed to have enough funding sources to be considered publicly supported, B. Why This Matters. Public charity status is desirable because record-keeping and other requirements are less strict. The theory is that the more funding sources, the less need for regulation because there are more people to drag the organization back into line if it strays from its exempt purpose For example, private foundations are subject to strict rules regarding “self dealing”. These tightly regulate the relationship between the private foundationand persons deemed to be “disqualified persons” (e.g. board members and substantial contributors). While the theory (insiders shouldn’t be able to use the organization for their private benefit) is sound, the rules can be quite restrictive. For example, a private foundation located at a yacht club could not reimburse the club for the use of its facilities if the yacht club was one of the foundation’s main funding sources C. An Advance Ruling: go for it if you can, IRS recognizes that a new organization has no way of demonstrating that it will be sufficiently publicly supported. If you think your organization can meet either of the following tests, you should try for an advance ruling. If you get one, your organization will be treated as a public charity for its first five tax years, after which the IRS will determine if your organization qualifies for a permanent ruling that itis a public charity. If your organization fails to qualify, all it needs to do is pay a 2% tax on the net investment income it earned during the five year advance ruling period. Until you have a large amount of cash held in reserve and earning interest, this tax should be minimal. D. Tests for Public Charity Status. If you think your organization will be able to satisfy either of the following tests, go for an advance ruling. If your organization will charge for its programs, it will be more likely to satisfy Test 2 (known as the “509(a)(2) test”). Summarized, the requirements are as follows: 1. Test 1. During your organization’s first five years, one-third of your total support will ‘come from contributions or grants from: 1. States or political subdivisions, 2. Other 501(c)(3) public charities; 3. The general public (contributions exceeding 2% of your total support won't count), or 4. Any combination of these sources. OR 1. Initially 10% of your total support will come from these sources and your organization is set up to actively solicit more. 2. Test 2.During your organization’s first five years, one-third of your total support will come from any combination of 1. Contributions from individuals (part of large donations will be excluded; but the first $5,000 (and sometimes more) will count toward your goal); 2. Grants or contributions from 501(c) (3) public charities; 3. Membership fees; and/or 4, Fees charged for sailing courses and other activities your organization performs to carry out its exempt function AND 5. Less than one-third of your support will come from investment income. VI. Dealing with Contributions and Donors. A. Three General Concepts that Apply to all Donations. 1. Acknowledge all donations in writing as soon as possible. For all but the smallest contributions, the donor needs the receipt to take the deduction (and you want the donor to feel as appreciated as possible). 2. If the donor gets something (of more than minimal value) in return for the contribution, the deduction is what the donor gave less what he/she got in return ~ and your receipt must cover this. 3. You are not responsible for determining the value of “in kind” contributions (e.g, boats, equipment). Your receipt/thank you letter should include a general description of the donated property (e.g. “one 1999 Club 420 sailboat”, “five books on sailing instruction and technique”, “one sailboat launching dolly”), but not what it is worth. 4. Your receipt should state that you are a 501(¢) (3) organization (or that your application is pending); the donor's tax preparer needs to know, B. Some Thresholds. 1. Cash contributions of less than $250. The donor doesn’t have to have a receipt to take the deduction, but send one anyway thanking the donor for the contribution,2. In-kind contributions of less than $250. Same thing as cash contributions of less than $250. Just send the donor the thank you letter. Cash and in-kind contributions of $250 or more. Now the donor must have a receipt. 4, In-kind contributions of $501 to $5,000 (ex. a weary but serviceable dinghy). You have no additional requirements, but the donor will need to supply additional information on his/her tax return. 5, In-kind contributions of more than $5,000 (ex. a well-maintained, front-of-the- fleet racing machine). Now the donor needs an appraisal by an outside appraiser. You cannot do the appraisal (but you can point the donor toward a qualified appraiser). You will need to sign the appraisal summary (IRS Form 8283) the donor files with his/her return, This is just to acknowledge that you know the donor is claiming the deduction; you’re not guaranteeing IRS (or anyone else) that the appraisal is correct VII. Selling Donated Property. Example: The boat you were given is great, but selling it would buy something more suitable for your program. 1. The sales proceeds are tax-exempt, but 2. If (a) you sell donated property within two years of the date of you were given it; and (b) you signed an appraisal summary (e.g. the donor was deducting more than $5,000), you have to report the sale to the IRS on IRS Form 8282 and send a copy to the donor. VII. Some Other Taxes. A. State Income Taxes. If your state has a corporate income tax, qualifying as a 501(c)(3) should exempt your organization from this tax. Since this is a matter of state law, the situation varies from state to state, Your state’s taxing authority can be a good source for determining: (1) whether 501(¢)(3)s are exempt; and (2) what your organization will have to file with the state to be treated as exempt. You will probably find that, once you have done the federal application (Form 1023), you will have assembled everything you need to file with the state. B. State Sales and Use Taxes.As a 501(c)(3), your organization may be exempt from paying sales tax on the items it purchases. Again, this is a matter of state law; if your state has a sales tax, you will need to check what the situation is. ‘Also, remember to check whether your organization will need to collect sales tax on services or items it sells. IX. Recordkeeping and Reporting. A, The Annual Report to IRS. 1. Public charities (including new organization with advance rulings) file IRS Form 990. You can use IRS Form 990-EZ (two pages plus two schedules) for as. long as your assets are worth less than $250,000 and your annual receipts are less than $100,000 2. Private foundations file IRS Form 990-PF instead Form 990 or 990-EZ. 3. Either way, you have until May 15" (or, if your 501(c)(3) is on a fiscal year, five and a half months after it ends) to file B. UBIT. Ifyou had more than $1,000 of income from an “unrelated business income” during the year, file IRS Form 990-T to pay the resulting tax. This return is due at the same time as the Form 990 or 990-PF C. State Filings. ‘These may or may not be required depending on the law of your state. You may swell find that the Form 990, Form 990-EZ or Form 990-PF that you prepared will also satisfy your state’s reporting requirements. X. And Finall Good luck! All this is well worth doing!