How to become a 501(c)(3) nonprofit organization

Wait… What did we just get ourselves into?

Most nonprofit organizations begin when someone imagines a solution to an unmet need in our community. The process for forming an nonprofit organization can be confusing, and a good attorney can help substantially. For most of my organizational clients, the process to prepare to file a request for tax-exempt status takes at least 6 months — but only if the application is correct the first time. If you want to become tax-exempt, it is important to keep that goal front and center as you take the first steps.

First Step

The first thing to do is make sure that the mission or purpose of your organization is a qualified exempt purpose. The exempt purposes set forth in section 501(c)(3) are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. These categories are considered broadly; for example, most nonprofit musical groups fall under the “educational” exempt purpose, while food banks have a “charitable” purpose.

Next, file to incorporate with the Secretary of State. To do this, you will need articles of incorporation (that specifically state your exempt purpose), by-laws, and founding board members. If you later change your purpose, you will need to amend your articles with the Secretary of State — which is why it’s so important to keep your exempt purpose in front of you while you go through this process.

Three other required clauses for your articles of incorporation are:

  • What happens to your assets should the nonprofit be dissolved (hint: they go to other nonprofit organizations);

  • Nondiscrimination clause: the organization does not discriminate on the basis of race, national origin, sex, gender, ethnicity, or any other protected class status; and

  • Conflict of interest: that no director or officer should privately benefit from the business of the nonprofit organization.

The Secretary of State will mail you a certificate of formation, along with a letter that includes your Uniform Business Identification (UBI) number. With your UBI, you can request an Employer Identification Number (EIN) from the IRS. These two numbers can be used to open business bank accounts, which is very important. You never want to mingle your monies with the monies of your organization (the IRS might decide all of the donations are your personal income — eek!). You can also use these numbers to hire employees, but you should have an EIN even if you do not intend to hire anyone in the foreseeable future. You cannot apply for 501(c)(3) status without an EIN.

You are now ready to submit Form 1023 to request tax-exempt status. In the next post, I’ll discuss the items you need line by line.

The Do's and Do Not's of Fundraising

Fundraising is an important activity of most charities. Without fundraising, many charities would not be able to carry out their exempt purpose. How an organization raises funds, however, is regulated by the IRS, and there are important tax implications that organizations need to consider before beginning a new fundraising campaign.

Types of fund-raisers

While there are always new ways to fund raise, they generally fall into one of four buckets: direct solicitation, grants, in-kind, and events or sales.

Direct solicitation is familiar. If you have ever received a phone call or letter from your alma matter requesting a donation, then you have been directly solicited. Direct solicitation can happen in person, over the phone, by mail or email, or by any other means of direct communication. It is a “straight up ask” — no need to attend an event or buy a product.

Grants are another common method for raising funds. Grants can be given from the government (think scientific research) or from nonprofit foundations. In either case, the applications are often lengthy, and require oversight. Different foundations or government branches will target their grant-making toward different problems or causes. Additionally, nearly all domestic grant-makers require that the grant recipient have 501(c)(3) status, which makes it nearly impossible for smaller clubs and organizations to rely on grant monies.

In-kind donations are another common fundraising strategy. Instead of paying for a service (for example, website design or manual labor to clear a park), individuals (or businesses) will donate their time and expertise for free. This is usually a net gain for everyone, as the individuals or businesses can write-off the donation on their taxes, while the nonprofit receives the benefit of the donation without having to pay for it.

Lastly, events and sales are common ways for organizations to fund raise. Events include things like auctions or carnivals, and sales include everything from candy bars and bake-sales to t-shirts and hats with the organization’s logo or motto.

Pitfalls

The first pitfall that organizations should watch out for is Unrelated Business Income. Unrelated Business Income (abbreviated UBI) is a complicated topic, but basically it includes any income that comes from activities not related to the exempt purpose of the organization. And it’s taxable.

There’s a three-part test for determining whether income is UBI:
1. Is the income from a trade or business? If someone could do the same thing without being part of the nonprofit (for example, for-profit businesses also sell t-shirts), then it is income from a trade or business.
2. Is it regularly carried on? To use the t-shirt example again, if your nonprofit sells shirts once a year, then it is NOT regularly carried on. But if the t-shirts are always available for purchase, year-round, then it IS regularly carried on.
3. Is the activity substantially related to the exempt purpose of the organization? Or, if it isn’t, is the activity taking up more time and effort than the exempt purpose of the organization? For most nonprofits, selling t-shirts is not substantially related to their exempt purpose. However, one example of an organization where selling t-shirts is substantially related to their exempt purpose is Goodwill. Their purpose is to provide employment placement services and job training, and specifically retail sales training, to individuals with barriers to employment. In this specific case, they cannot provide retail sales training without selling a t-shirt. Their purpose isn’t to sell t-shirts, but they cannot do their purpose without selling t-shirts either.

Tax law also has some specific exemptions for UBI. First, activities conducted by volunteers, like an all-volunteer bake sale, will probably be exempted.

Second, businesses that are carried on for the primary benefit of the organization’s members are exempted. A typical example is a school cafeteria.

Third, any trade or business selling merchandise, substantially all of which is donated to the organization, is not taxed. Many thrift shop operations of exempt organizations would meet this exception.

Also, just because an activity creates UBI and may result in a tax liability does not mean that the organization has to discontinue the activity. It's only when unrelated activities are substantial compared to all of the organization's exempt activities, that those activities could jeopardize an organization's tax-exempt status.

UBI is a complicated topic, but I hope this has provided a framework to begin thinking about how your organization solicits donations. For more details and the reporting requirements, go to IRS.gov and download or order Publication 598, Tax on Unrelated Business Income of Exempt Organizations.

Estate Planning in the News

It’s fun to read about estate planning for the rich and famous! Here are some recent articles that were fun and informative!

Interested in creating or revising your estate plan? Make an appointment today!

Board of Directors

Congratulations! You’ve been recruited and elected to serve on a board of directors for your favorite nonprofit organization!

Now what?

Being a board member is an important and enjoyable way to give back to a community or organization that matters to you. The board of directors is tasked with ensuring that the organization carries out its exempt purpose. But what does that mean exactly?

You have three primary legal and fiduciary duties:

  1. The duty of care means that you must take care of the assets of the organization, whether monetary, staffing, volunteers, facility, or goodwill. Be a good steward of the organization’s funds.

  2. The duty of loyalty requires you to put the organization and its mission first. This includes recognizing and disclosing conflicts of interest, and making decisions that are in the best interest of the organization and not in the best interest of an individual board member or for-profit entity. It’s your job to make sure that the organization is working to fulfill its stated mission.

  3. The duty of obedience covers your role in making sure that the organization follows all applicable laws and regulations, and its own bylaws.

What does this look like in practice?

As a board member, you are responsible for advancing the mission of the organization. I recommend reviewing your mission statement regularly, such as at every board meeting, so as to keep that mission at the forefront of your discussions. It is also important to track what other similar organizations are doing, whether in your area or across the country. If your organization is membership-based, it is helpful to keep communication open with your members. In a membership organization, you also “represent” the members.

If your organization has an executive director, the board of directors is responsible for hiring, setting compensation, and supervising this person. This is a key relationship, as the executive director typically manages the other staff and volunteers (directly or indirectly), fund raises with donors, and is often the “face” of the organization.

The board of directors is responsible for setting the budget for the year and overseeing that income and expenses stay on track. It is helpful to learn how to read and interpret financial statements, including profit/loss statements and balance sheets. Similarly, you are responsible to make sure the minutes and agendas are accurate, as this is the best legal protection should a potential issue arise. This is also a great time to brush up on Robert’s Rules of Order.

You are a walking advertisement for your organization. Spreading the word about your organization helps it grow, and part of the duty of care is to make sure your organization is growing. For most board members, this means sharing the mission with people you meet. For some, in can include public relations and talking with the media.

Board members should be involved in the work of the mission. This could be working on a committee, taking a lead role in a fundraising activity, or volunteering in another capacity. It’s hard to know if the organization is advancing its mission by reading a report. The more you are able to be a part of the work, the better you will be able to make decisions in the best interest of the organization.

Board members are fundraisers. This means both that you are contributing financially to the organization, and that you are helping to solicit donations too — whether by helping to put together a fundraising event or by asking the people in your network to contribute.

Lastly, board members are always recruiting new board members. It may seem odd to think about finding your own replacement as soon as you are elected, but many board members find that their time goes fast. Continual recruitment allows for greater continuity.

If you are welcoming new members to your board, I strongly recommend having an orientation to review their legal and fiduciary duties, your organization’s mission and bylaws, and their particular role and responsibilities. This should be an annual event, as you welcome new members every year, and separate from any all-board retreats that focus on long-term planning and mission.

If you are interested in setting up a new-members orientation and would like more information, please let me know.

Nonprofit Organizations

When most people think of a nonprofit organization, they think of a 501(c)(3) nonprofit corporation. But did you know that there 28 different kinds of nonprofit entities and many of them are easier to form and operate than a 501(c)(3)? When I first meet with a client who is interested in applying for tax-exempt status, I ask whether their goals might be better served by a different form of nonprofit.

So what is a 501(c)(3)?

The most common type of nonprofit is the “charitable organization.” It qualifies for tax exemption under the IRS tax code, section 501 (c) (3). To qualify, organizations must be operated to fulfill one of these purposes: religion, education, science, literature, public safety testing, amateur sports, and the prevention of cruelty to children or animals This is the category that includes museums, churches, libraries, low-income housing, colleges, food banks, hospitals, and symphonies. While the income received by the organization related to its purpose is tax-exempt, these organizations are also limited (but not totally prohibited) in how and whether they can engage in lobbying activities.

And what is a 501(c)(4)?

This section of the code regulates social welfare organizations, civic leagues, and local employee associations. These tax-exempt organizations are NOT limited from lobbying activities. If you donate money to an exempt organization that engages in lobbying activities, there’s a good chance you are actually donating to two sister organizations — a 501(c)(3) that carries out the mission and a 501(c)(4) that lobbies for the best laws to support that mission.

Both 501(c)(3) and 501(c)(4) organizations are vetted through an lengthy application process, that can take months to complete. In addition, to continue to qualify as tax-exempt, these organizations must submit detailed annual reports of their activities, income and expenses, and publicly identify their key staff and board members.

That still sounds like a lot of work. Are there any easy nonprofit organizations?

There are many nonprofit organizations that are easy to form and maintain, but my favorite is the social club. I have worked with several recreational and hobby clubs who did not need 501(c)(3) status to carry out their charitable purposes. For example, I worked with a model airplane and drone club who was interested in a more formal business structure. They collected membership dues, which helped to pay for a small field that the club owned and maintained. Members were entitled to use the space whenever they liked to fly their airplanes, and the club used the space to host races and '“fly-ins." Another organization that I represented was a recreational bicycle racing team. They collected dues from team members and used that money to enter races and go out after races to celebrate. Both organizations qualified for tax-exemption under 501(c)(7) — Recreational or Social Clubs. While they still need to file annual tax returns for the organization, they are not required to apply for tax-exempt status and do not need to disclose their activities or leadership. Moreover, their annual return is a simple postcard, since neither organization received more than $50,000 in income in a year.

Among the other 25 types of nonprofit organizations are trade or professional associations (like the Chamber of Commerce), fraternal societies (anything that follows the “lodge” model of governance), veterans organizations, and state chartered credit unions.

But our club when through the hassle of getting 501(c)(3) status. Are you saying we didn’t need to do that?

Not necessarily. There are certain benefits to having 501(c)(3) status. First, if you intend to apply for grant money from foundations, it is helpful to have 501(c)(3) status. Many (if not all) foundations require it, as it helps them to guarantee that their funds are being used for exempt purposes. While the IRS doesn’t require foundations to give their money to 501(c)(3) charities, it does require that they only distribute funds to tax-exempt organizations, and the easiest way for a foundation to know that your organization qualifies is for you to have 501(c)(3) status.

Similarly, other businesses may not recognize discounts or other benefits for your organization without 501(c)(3) status. A few years ago, the IRS issued a warning that churches should not allow bands or other musical groups to play in their churches, whether for set ticket prices or for a “free-will donation” to the band. This was because a church, as an exempt organization, may not allow its property to be benefit private individuals or entities, and when the local garage band plays and takes home money from that concert, it isn’t furthering the exempt purpose of the church. However, it is permissible for the church to lease its sanctuary to an organized musical group, like the NW Girlchoir, to perform (even though that concert will have set ticket prices and the choir will earn money from it) because the NW Girlchoir is an exempt organization. The church’s property can be used for the exempt purpose of another exempt organization. So for many music organizations, applying for and receiving tax-exempt status is helpful for booking venues.

If you are interested in possibly starting a nonprofit organization, or if you have questions about an existing nonprofit, let me know. I love working with all kinds of exempt organizations, and would be happy to help you.

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Advance Directives (AKA Living Wills)

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Writing out your advance directive, or living will, is an important part of your estate plan. It allows you to state what kinds of treatments you want to receive should your attending physician determine that you have developed a terminal or hopeless condition, or that you are unable to make your own medical decisions, and a second doctor agrees. It includes a power of attorney for health care, who can act as a guardian should you be unable to make decisions yourself, and will give him or her guidance as to the care you would want to receive.

Specifically, you can sign an advance directive refusing life-saving treatment under a variety of circumstances, including when you are in a coma or unconscious for a determined length of time, when you are diagnosed with dementia or Alzheimer’s, or if you are severe pain requiring sedation such that you cannot communicate. You can also specify which kinds of life-saving treatment you would refuse under those circumstances, including refusing life-saving surgeries and CPR, or simply refusing nutrition and hydration other than normal food and water received orally. This is also the time to indicate how aggressively you would like to receive treatment for pain.

Lastly, you can indicate what should happen with your body after you pass. Would you like to donate organs or tissues? Allow it to be used to advance medical education and research? Who should make arrangements for your funeral? And what should ultimately happen with your remains?

To be effective, your advance directive must be signed before two witnesses (another reason why it’s helpful to do it at the same time as your will). Yet it can be revoked by a written statement to that effect at any time.

Once you have signed your advance directive, give photocopies to your designated health care agent, your spouse and (adult) children, your doctors, your close friends, your clergy, and the person you designate to make funeral arrangements. While it may be uncomfortable, it is important that these people know what you would want and not want to happen. Ultimately, they want to honor you and your wishes during this time, and they will be grateful that you took the time to think about what you want and to discuss it with them.

It is a good document to keep in an easy-to-find place. If you have a file cabinet in your home with other important papers, for example, that would be a good place. A safe-deposit box is not as it can be hard to access quickly. I often recommend that clients keep a copy in the glove box of their car(s) and in their suitcase pocket when traveling. Wherever you keep it, be sure that your agent, family, and close friends know where to find it.

Choosing Witnesses

For a will to be legally recognized in the State of Washington, it must be:

  1. In writing,

  2. Signed by the testator (or by someone at his/her direction and in his/her presence), and witnessed by two competent people, and

  3. Those witnesses must also sign the document (or sign a self-proving affidavit that is notarized) (emphasis added).

Witnesses are key. Without witnesses to testify that you did, in fact, intend to create a will and that you are competent and not creating it under duress, the court cannot be certain that your will is your will. The standard of practice today is for witnesses to sign a notarized self-proving affidavit, which states that he or she knows that you are 18 years of age or older, competent, not under duress; that you are intending to create a will, that you asked them to be there to witness the signing, and that you did, in fact, sign the will while they watched.

While anyone can serve as a witness, some people make better witnesses than others. A good witness is:

Someone who is not named in your will or who stands to inherit if you didn’t have a will. Why? The people who stand to inherit may present a conflict of interest — especially if any of your bequests may ruffle the feathers of your family. Avoiding controversy now by selecting neutral witnesses and you may curb will contests and litigation for your family in the long run.

Someone who knows you. While it is a common practice for attorneys to enlist their administrative support or paralegals to witness a signing, strangers are rarely the best option. Remember: it is the job of a witness to testify, if needed, that you were sane and signing your will without coercion or duress. In some firms, your first time meeting a witness might be 10 minutes before you sign. Compare that to a neighbor or coworker, who has known you (albeit superficially) for years. Who is the better judge of your competency? Remember: this person doesn’t need to read the contents of the will, they only need to sign a statement at the bottom of your will that they watched while you signed the will.

Do I need life insurance?

Life insurance can be an important part of an estate plan, but not for everyone. Many employers include a small life insurance policy for their employees, usually just enough to cover burial expenses. Additional life insurance can be useful, especially for the parents of young children or those who support a disabled spouse or child. However, you do not want to buy more insurance than you need. So how do you know whether you need it, and if you do, how much to buy?

Whether you and your family could benefit from life insurance depends on several long-term and short-term factors. The questions below can help you determine whether life insurance may help provide financial stability for your family. 

1. How many people depend on your earning capacity?
If the answer is "none," you probably don't need life insurance. 

2. How much money would your dependents need for living expenses?
There are several ways to determine this number. One is to take your annual salary and multiply it by 10. Why 10? Historically, the stock market has grown an average 10% every year since 1928. If your dependents invested the total life insurance, they should receive your annual salary in interest yearly. You may also want to take into account any property that would be inherited and deduct the value of its sale, as well as any other potential sources of income for your dependents (for example, gifts from grandparents who may step in if a disaster occurred). For many of my clients, $1-2 million per parent is a typical amount. 
It is also important to count the value of any stay-at-home parents in this equation. If that person suddenly passes away, there will be the additional costs of child care, home cleaning, meal preparation, and so forth. 

3. How long will it take for your dependents to become self-sufficient?
If your kids are young, you may need life insurance for 20 or 30 years, long enough to see the youngest through college. However, if your kids are already in high school, a 10-year policy should be sufficient to see them into adulthood.
Let me back up for a minute. I'm talking about term life insurance here, which expires after the term passes. Much like auto insurance, it is only in effect while you have the policy. After all, you don't need car insurance if you don't have a car. That's why it's important to figure out how long you will need insurance and to be covered only for the time in which it makes the most sense. Universal life insurance, on the other hand, is more like an investment or an enforced savings account -- you continue to pay into it throughout your life. When you pass, it passes to your designated beneficiary. It is a gamble whether you will end up paying more than the amount of the policy (if you live a long time) or less (if you die young), and it is debatable whether you would be better off investing that monthly premium in an investment account. For these reasons and more, most financial planners recommend against universal life insurance. If you're interested in learning more about universal life insurance, however, I encourage you to talk with your financial adviser. For most of my clients, term-life insurance is the best fit for safeguarding the future financial stability of their children. 

Now let's talk about your family's short-term needs.

1. What assets will be available to help with your families immediate financial needs?
Do you have a joint checking account? Can your spouse or the guardians for your kids access your bank accounts? Are most of your assets liquid (meaning they can be converted to cash easily) or not (like real estate, coin collections, etc)? 

2. After you die, how long will it take for your assets to transfer to your heirs?
While probate is not expensive, it can take months before payments can be made out of your estate. While there are court orders that can release family expenses early, life insurance can also help with immediate expenses. 

3. Will your estate owe substantial debts and taxes after your death?
This is also mostly an issue if there are not sufficient liquid assets to deal with immediate financial needs. If your estate is mostly non-liquid (real estate, business ownership, jewelry), they may be sold off quickly but for less than they are worth in order to cover those immediate financial needs.  While debt may not be a significant concern for your estate, it is worth thinking about now. 

Lastly, let's talk a bit about the impact of life insurance on your estate. The reason why life insurance can help with immediate financial needs is because it transfers to your beneficiary outside of the probate process. While your real estate and bank accounts are subject to probate proceedings that can take months, your life insurance will pay out to your beneficiaries within weeks (sometimes within days). 

However, for the purposes of estate taxes, life insurance is included. As I've said before, if you own a home in King County and have life insurance, you will probably exceed the estate tax exemption. The exemption amount changes every year -- for 2018, it's $2.129 million. If you're in this boat, I recommend consulting with an estate planning attorney. 

How to write your own will

Truth: not everyone needs an lawyer to help them write a will. 

How do you know if you should hire an estate planning attorney?

The American Bar Association recommends hiring an attorney if any of the following circumstances are true for you:
1. Complications with previous marriages, divorce, or blended families.
2. You, your spouse, or children have international citizenship.
3. You own or have interest in property in another state.
4. Your assets exceed a certain amount (this varies state-to-state and changes each year. In Washington, right now, it's $2.129 million, and that includes real estate and life insurance. Hint: if you own a home in King County and have life insurance, your estate will probably be higher than $2.129 million). 
5. You or your spouse are getting (re)married and could have complications with trusts, property ownership, or guardianship for your minor children.

None of those apply to you? Great! You probably don't need an attorney to help you write your will.

So what are the common pitfalls that people make when writing their own wills?
1. Not doing one at all. (Hint: you're probably already here!)
2. Not completing the process.
3. Doing one incorrectly, which can result in the will not being legally binding.
4. Leaving stuff out. It's amazing how often people forget about pets, businesses, or *how* to split assets among children. 
5. How and when assets and money are given. Some financial planners recommend spacing out payments instead of lump sums.
6. Not updating your will when you have kids, remarry, acquire new assets, or have other life changes. 

If you're serious about writing a will yourself, and none of those situations above apply to you, I highly recommend GYST. It is an informative site with links to free templates and a lot of well-researched state-specific information on wills, powers of attorney, living wills, and life insurance. 

If you have more questions, let me know. 

How to Choose a Personal Representative

One of the most important parts of your will is the appointment of your Personal Representative (aka PR). This is the person who will make sure that your wishes in your will are followed, and will settle all of your final bills and make distributions from your estate to your heirs. 

So how do you pick someone?

First, resist the temptation to name more than one person. While some of my clients don't want to pick between their kids or siblings, this is a job best done by one person. It saves time and energy to only require one signature, where as joint PRs may have to both sign. 

Second, this person will need to stay on top of deadlines and keep detailed records. He or she will talk to banks, insurance companies, realtors, and more. I recommend choosing someone who is good with details and known for being fair.

Third, I always recommend picking someone who will be aligned with your wishes. This could either be someone who stands to inherit from your estate, or someone who would support the person who will inherit (for example, your child's grandparent or favorite aunt). The Personal Representative is entitled to reasonable compensation for their work on your estate. However, if he or she draws a salary from your estate, then he or she will pay income taxes on that money. If he or she stands to inherit money from the estate (or supports that all of it is going to your kids), then he or she may opt not to be paid since the taxes on inheritance will be less (possibly even nothing). 

Lastly, always, always, always name back-up personal representatives. Most of my clients name their spouse as their first-choice personal representative, which makes the most sense as spouses have an unlimited exemption to inherit free from estate taxes and are likely to be the person most invested in carrying out your wishes. However, your spouse may not be able to serve for whatever reason. I recommend including a second and third choice, and then allowing for a professional fiduciary to serve just in case.