This article highlights the key characteristics of different M&A transaction options, outlines strategic questions to ask to help identify the best transactional structure for your nonprofit, and reviews essential due diligence steps to follow. 

Structural Options
Mergers and acquisitions often appear similar because both are frequently announced as the combination of two organizations. However, the differences in these transaction structures carry significant legal implications, so understanding those distinctions is essential for deciding which is best for your nonprofit. A subsidiary restructuring is another frequently used option.

Merger
A merger is a legal combination of two or more entities into one. In a merger, the surviving corporation assumes all the non-surviving entity’s rights, assets, and liabilities. A nonprofit merger offers the advantage that any bequests or future gifts will go to the surviving organization. While this could be a significant benefit for organizations with a history of regularly receiving such planned gifts, many nonprofits do not have a history of receiving such gifts. Additionally, mergers come with the notable downside that all potential future claims and liabilities will persist within the merged entity. 

Acquisition (or Asset Transfer)
Unlike a merger, in an asset transfer acquisition, there is no automatic legal succession to all rights and obligations. Instead, only the transferor’s specifically identified assets and liabilities are transferred. The actual legal nature of the transaction is often a dissolution under applicable state law, where the asset transfer occurs as part of a dissolution proceeding. Acquisitions or asset transfer transactions are popular choices for organizations looking to expand their programs and assets but want to avoid the risk of taking on another organization’s liabilities. However, a nonprofit must take reasonable steps to address known and unknown liabilities before dissolving. 

Subsidiary Restructuring
Some organizations opt to bring another organization under its control through a subsidiary restructuring while continuing to operate as separate tax-exempt nonprofits. This structure might be chosen to keep the liabilities of different programs separate or to maintain distinct brand identities, while also benefiting from the cost efficiencies of a combined legal structure that often includes a cost-sharing or shared services arrangement. A subsidiary restructuring can be achieved by making one entity the sole member of the other. The “parent” nonprofit, as the sole member of the subsidiary, would have specific statutory rights regarding the “subsidiary” nonprofit, such as the right to elect the subsidiary’s directors and approve certain key corporate actions or transactions (e.g., mergers, asset transfers, dissolutions, and amendments to the certificate of incorporation). Additional rights may be granted to the member through the subsidiary’s certificate of incorporation or bylaws. However, the subsidiary’s board of directors is the legal fiduciary body responsible for overseeing the activities of the subsidiary, and appropriate corporate formalities must be maintained to ensure separation of liability between the parent and subsidiary. 

Strategic Questions
Deciding if a merger or acquisition is the right next step for your organization involves asking specific key questions.

• Will the transaction allow us to accomplish our mission better?
  Consider whether the transaction will help the organization enhance its services and program offerings or expand the reach of its programs.
• Will the transaction improve our operational and financial efficiency?
  Combining two smaller organizations or bringing a smaller organization’s programs into the operational framework of a larger organization can reduce the administrative costs necessary to support the combined programs.
• Do the organizations have sufficiently compatible organizational cultures and values?
  This question is particularly relevant if certain staff members or board members will move from one organization to the other as part of the transaction, which is often — though not always — the case.
• How much would the transaction cost in legal and other fees?
  For smaller organizations, complex transactions may not be practical or cost-effective. In addition to internal approvals, which may include approval by the board of directors and any voting members, some states also require Attorney General or court approval. Additional regulatory approvals may also be needed, depending on the organizations involved (e.g., state and federal education agencies for schools). That said, combining two organizations’ programs under one legal entity (or other unified structure) could be a worthwhile upfront investment for long-term savings and mission optimization.

Key Due Diligence Considerations
Nonprofits considering a merger or acquisition should thoroughly review key risk areas before moving forward. Although the due diligence process will differ based on the nature of the transaction and your nonprofit’s role in it, the following are important issues a nonprofit should examine regarding its counterparty. 

Financial Health
Look for fiscal stability, donor concentration risks, and hidden liabilities.

Tax and Regulatory Compliance
Make sure the other organization has historically fulfilled its tax and compliance obligations. 

Governance and Operational Health
Confirm whether the other organization followed good governance (e.g., annual conflict of interest disclosures, maintaining minutes of Board meetings) and operational practices (e.g., proper management of HR matters, internal financial controls, and data security).

Contracts
Determine which agreements require affirmative consent to be transferred and which should and can be terminated, versus those that would be critical or beneficial to continue. 

Legal Proceedings
Review for any active or potential lawsuits or legal proceedings and evaluate their possible impact after the transaction.

Staffing/HR Considerations
Assess potential retention risks, including any necessary adjustments to ensure equal treatment among similarly situated staff members after the transaction.

Assets & Liabilities
Make sure you understand the assets and liabilities of the other party, including whether it holds clear title to its key assets (such as real property and intellectual property).  

Reputation
Verify that the other organization has a trustworthy reputation among its stakeholders and the public. 

Whether your organization aims to enter a strategic growth phase or establish a home for your key programs before winding down, nonprofit mergers and acquisitions can be an effective tool to help you reach your goals. By understanding how different M&A options impact your ability to achieve your objectives, your nonprofit can confidently step into the next phase.

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Unsurprisingly, the IRS has not been immune to the recent churn within the federal government workforce. Over the past year, wait times for processing Form 1023 have been anywhere from 7.5 to 9 months. The IRS’s website states that applicants who submitted their applications after September 25, 2024, have not yet been assigned reviewers. This wait may increase in the coming months. Thus, you might wonder—are there faster options available?  

The IRS offers an option for organizations with a compelling reason to request faster, expedited processing. The IRS guidelines include the following examples of compelling reasons to approve expedited processing. 

• If the organization has a pending grant, not receiving it could adversely impact its ability to operate.
• If the organization is newly established and offers disaster relief to victims of emergencies. 
• If delays in issuing a determination letter are caused by errors made by the IRS. 

If your organization qualifies under one of those reasons, consider applying for expedited processing. To achieve this, we suggest closely following the IRS’s requirements.  Your organization must submit a letter to the IRS outlining the compelling reason(s) for the expedited processing request. As you prepare your request, we recommend considering and framing it with the following in mind.    What reasons justify your organization receiving its determination letter sooner than other organizations waiting in the processing queue for months? The IRS must understand why your organization must receive its determination letter quickly.    

Suppose your organization has a donor willing to give a vital grant. Still, the grant depends on the organization’s formal confirmation of its tax-exempt status by a specific deadline.  In that case, you can ask the donor if they are willing to send a letter to the IRS on behalf of the organization. If the donor agrees to write a letter, they should include the following information:  

• The committed donor’s name (the person or the organization)
• The amount of the donation (or value of the asset being donated)
• The date the donation will be forfeited or permanently redirected to another organization. 

In your organization’s letter to the IRS, it is important to explain the potential harm to the organization and/or its charitable class if there is a delay in receiving the IRS determination letter. For example, consider the following.   

Your organization is submitting an application to the IRS for tax exemption and plans to operate a drug and alcohol treatment center for teens. The previous center closed years ago, and no other similar center exists in the area. A donor has pledged a specific amount that will cover the center’s construction costs if your organization can provide proof of its tax-exempt status by a specific date. Your organization cannot open the treatment center without funding for the building.  

In this scenario, if your organization submitted an expedited request to the IRS, your letter should emphasize the impact of the donation on the organization. For example, without donations, your organization could not open a center. You might consider highlighting how long your organization would take to raise the same amount the donor is pledging and how many people your organization could assist if the center opened sooner with the donor’s contribution. Then, ask the donor to write a letter to the IRS on the organization’s behalf, providing the information listed above, which would accompany the expedited request.  

Even if your facts may not be as urgent or compelling as this example, conveying how a long delay will significantly hinder your ability to execute critical programming with real-world consequences might still make submitting an expedited review request worthwhile.

Given the staffing uncertainty at the IRS and throughout all federal agencies, predicting what will happen in the coming months is nearly impossible. If your situation fits the IRS’s stated criteria for expedited processing, it may be worth submitting an expedited review request, especially if you provide essential services to your community. And remember, if you have questions or need assistance, be sure to consult with legal counsel.  

The views expressed in this article reflect Perlman & Perlman’s experience with expedited processing.  While we have not heard of specific changes, it is uncertain if staffing reductions and changes in the administration’s priorities will impact on the IRS’s review of expedited processing requests. 

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Public Charity vs. Private Foundation

Every organization classified under section 501(c)(3) is categorized as either a private foundation or a public charity. The main distinction between the two lies in the level of public involvement in their activities.

Public charities typically receive a larger portion of their funding from the general public or government entities and engage more actively with the community. In contrast, a private foundation is usually overseen by family members or a small group of individuals, relying heavily on limited funding sources and investment income. Due to their lower level of public transparency, private foundations are subject to various operational restrictions and may incur excise taxes if they do not comply with these regulations.

Under tax law, an organization categorized under section 501(c)(3) is generally assumed to be a private foundation unless it formally requests and obtains a ruling to be recognized as a public charity. Organizations that qualify as public charities include schools, hospitals, churches, publicly supported organizations (which receive a specified portion of their total support from public sources), and certain supporting organizations. Churches, along with their integrated auxiliaries and conventions or associations, that fulfill the requirements of section 501(c)(3) of the Internal Revenue Code are automatically recognized as tax-exempt and do not need to apply for or obtain recognition of their exempt status from the IRS. 

Private foundations are categorized into two types: private non-operating foundations and private operating foundations, which are discussed and distinguished further below.

Public Charity

Public charities hold the most advantages among the three primary types of 501(c)(3) organizations. This is why many organizations aim to qualify as public charities to access the full benefits of this designation. These organizations typically engage in direct service or other tax-exempt activities but can also participate in grant-making initiatives. Their funding is obtained from diverse sources, including individual donations, government contributions, and private foundations.

An organization must meet one of three “public support” tests to obtain and maintain public charity status. The IRS considers an organization to have met the “public support” test if it satisfies either the (1) one-third (1/3) support test or the (2) ten percent (10%) facts and circumstances test.

One-Third Public Support Tests
To meet one of the two “one-third public support tests,” an organization must fulfill one of the following criteria: 

1. It must receive at least one-third of its support through contributions from other public charities, governmental agencies, and/or the general public. 
2. Alternatively, it can receive no more than one-third of its support from gross investment income while obtaining more than one-third of its support from contributions, membership fees, and gross receipts from tax-exempt activities.

It is important to note that any grant or contribution received from sources other than governmental entities or another public charity—provided that they meet the “one-third” test—counts as public support only up to a limit of 2% of the total support received over a five-year assessment period. 

For example, if an organization receives a total support of $100,000 over five years and obtains a grant of $40,000 from a private foundation, the entire $40,000 will count towards total support. However, only $2,000 (which is 2% of $100,000) of that grant will be counted as public support.

This limitation can create what is known as a “tipping” problem. A large contribution from a private foundation or an individual is capped at the 2% limit, which can increase the overall total support figure without a corresponding increase in the public support amount. As a result, this may lead the organization to fail the “one-third” test.

Ten-Percent Facts and Circumstances Test
If an organization cannot demonstrate that it is likely to meet the one-third support test, it can still qualify as a public charity by meeting the following criteria: (1) at least ten percent (10%) of its total support must come from a variety of public sources, (2) there must be widespread public interest in its programs, (3) it should have a continuous fundraising program aimed at reaching a diverse segment of the public, and (4) its board of directors must represent public interests effectively.

Advantages of Public Charity Status

Higher Tax-Deductibility Limits
One of the biggest advantages of being a public charity is that donors can deduct cash contributions in full up to 60% of their adjusted gross income.  This advantage means that individual donors have a greater tax benefit from contributing to public charities than private foundations (as further explained below).

Easier to Receive Grants from Private Non-Operating Foundations
Due to specific tax regulations, private foundations typically prefer to grant funds to public charities instead of other private foundations. As a result, if your organization is set up as a public charity, it is likely to receive more grants from private foundations compared to being structured as a private foundation.

Not Subject to Stricter Regulations Applicable to Private Foundations
Public charities have several advantages over private foundations, primarily because they are exempt from many of the stringent requirements that private foundations face. For example, public charities are not required to spend a specific minimum amount of their funds each year, known as “qualifying distributions,” which is mandatory for private foundations. However, in practice, most public charities tend to spend more than the minimum required to support their charitable activities. Public charities are not subject to the strict self-dealing rules that apply to private foundations; they do not have to pay a tax on their net investment income.

Ability to Engage in Limited Lobbying Activities
Public charities may also engage in a certain limited number of lobbying activities, as compared to private foundations and private operating foundations, which are completely prohibited from engaging in any lobbying activities.² 

Disadvantages of Public Charity Status

There are technically no disadvantages to public charity status, except for the requirement that the organization meet the IRS’s public support test. This means the organization needs to receive funding from a diverse range of sources. However, organizations that secure sufficient funding from limited sources—such as a small group of dedicated donors or an endowment—may not find it necessary or beneficial to focus on continuous fundraising efforts. Consequently, public charity status might not be the best tax-exempt option for organizations that prefer to avoid ongoing fundraising activities.

Private Non-Operating Foundation

When an organization does not qualify as a public charity, the IRS automatically classifies it as a private non-operating foundation. Private foundations are usually funded by a small group of individuals, such as family members, or a single primary source, like a corporation. Most private non-operating foundations focus primarily on grantmaking to fulfill their charitable objectives and typically do not run their own charitable programs. However, it is important to note that non-operating foundations are not prohibited from conducting direct charitable activities if they choose to do so.

Advantages of Private Non-Operating Foundation Status

No Requirement to Fundraise
Private foundations do not need to ensure that they receive their funding from broad “public support.” This alleviates the administrative burden of making sure donations are not primarily from a limited number of donors.

Disadvantages of Private Non-Operating Foundation Status

Tax-Deductibility
Donors face a significant disadvantage in terms of tax deductibility when compared to public charities. Cash donations made to private foundations are only tax-deductible up to 30% of a donor’s adjusted gross income. As a result, many large donors tend to prefer donating to public charities instead.

Qualifying Distributions
The IRS mandates that private foundations adhere to several additional requirements that do not apply to public charities. One specific requirement is that private foundations must make “qualifying distributions” to eligible public charities or other tax-exempt organizations. These distributions must be equal to 5% of the average fair market value of their assets from the previous year.

Grantmaking Oversight
Private foundations that make grants to other private foundations, foreign organizations, or any entities that are not 501(c)(3) public charities must ensure proper oversight of these grants. This can be achieved through one of two methods: 

1. “Equivalency Determination” The foundation determines that the grantee organization is equivalent to a U.S. public charity. 
2. “Expenditure Responsibility” The foundation implements measures to ensure that the grant funds are used for charitable purposes.

The rules surrounding expenditure responsibility require detailed accounting and documentation to confirm that grants given to private foundations and other organizations not classified as public charities are spent appropriately—specifically, for charitable purposes rather than for private benefit or political gain. Due to these additional oversight requirements, private foundations may be discouraged from making grants to organizations that are not public charities. As a result, they typically concentrate their grantmaking efforts on supporting public charities.

Tax on Net Investment Income
Private foundations face additional taxes that public charities do not, including a 1.39% excise tax on their net investment income.

Prohibition on Self-Dealing Transactions
Private foundations are generally prohibited from engaging in financial transactions with insiders associated with the foundation. These transactions are referred to as “self-dealing transactions.” The following activities are typically considered self-dealing between a private foundation and a disqualified person: 

1. Sale, exchange, or leasing of property.
2. Leasing agreements.
3. Lending money or extending credit.
4. Providing goods, services, or facilities.
5. Paying compensation or reimbursing expenses to a disqualified person.
6. Transferring foundation income or assets to, or for the benefit of, a disqualified person.
7. Certain agreements to make payments of money or property to government officials.

The prohibition on self-dealing means that members of the foundation’s board and other disqualified persons, including significant contributors, are not allowed to personally benefit from any transactions that the foundation conducts. In contrast, public charities can engage in these types of transactions as long as the board determines that the transactions are in the charity’s best interest. The ban on self-dealing is quite extensive; even payments made to a disqualified person for goods or services rendered at or below fair market value are prohibited. Therefore, avoiding financial transactions between disqualified persons and the foundation is crucial.

Tax on Excess Business Holdings
Private foundations are subject to a tax on their excess business holdings. This tax effectively prohibits a foundation and its disqualified persons from owning more than 20% of the voting stock of a business enterprise in total.

Tax on Jeopardizing Investments
Private foundations are also subject to a punitive tax on certain risky investments, known as “jeopardizing investments.” Jeopardizing investments are those that generally show a lack of reasonable business care and prudence in providing for the foundation’s long- and short-term financial needs to carry out its exempt function. No single factor determines whether an investment should be deemed a jeopardizing investment; rather, the determination must be made on an investment-by-investment basis, taking into account the foundation’s portfolio as a whole. The foundation managers may consider expected returns, risks of rising and falling prices, and the need for diversification within the portfolio.

Private Operating Foundation

A private operating foundation is a special type of private foundation. It is typically established if an organization cannot achieve public charity status but can satisfy certain other criteria.

The primary distinction between private operating foundations and private non-operating foundations lies in their activities. Private operating foundations actively conduct their own charitable programs, whereas non-operating foundations do not. Because of this essential difference, private operating foundations must adhere to regulations similar to those governing public charities, which tend to be more favorable than those that apply to non-operating foundations.

Advantages of Private Operating Foundation Status

Grants from Private Non-Operating Foundations Count Towards the Grantor’s Qualifying Distributions
Private operating foundations are eligible to receive “qualifying distributions” from other private foundations in the same way that public charities are eligible to receive them for the conduct of their own charitable programs. This benefit makes it more likely that a private foundation would grant to a private operating foundation than to a private non-operating foundation.

Higher Tax-Deductibility than Contributions to Non-Operating Foundations
Private operating foundations are subject to the more generous donation deductibility limits applicable to public charities (whereas donations to non-operating foundations have lower deductibility limits). Because wealthier donors are sensitive to the deductibility cap, the more generous tax-deductibility limits available to private operating foundations is typically the primary motivation for founder-philanthropists to seek private operating foundation status over non-operating foundation status.

Cash contributions made to operating foundations are deductible for taxpayers up to 60% of their adjusted gross income (AGI), similar to the deduction limit for public charities. In contrast, for non-operating foundations, the limit is 30%. 

Donations of long-term capital gain property—such as artwork or real estate—are also deductible when given to operating foundations, with a limit of 30% of the taxpayer’s AGI, akin to donations made to public charities. However, this deduction is limited to 20% of the donor’s AGI for non-operating foundations. 

Additionally, the deduction for long-term capital gain property donated to an operating foundation is generally based on the property’s fair market value on the date of the contribution. Conversely, for non-operating foundations, the deduction for long-term capital gain property (excluding qualified appreciated stock) is limited to the donor’s tax basis in the property.

Disadvantages of Private Operating Foundation Status

Compliance with Strict Financial Tests
A private operating foundation must allocate most of its resources—either its earnings or assets—toward actively pursuing its tax-exempt activities. Specifically, it must spend at least 85 percent of its adjusted net income or its minimum investment return (whichever is less) directly on these exempt activities. This requirement is known as the income test. 

In addition to passing the income test, the foundation must also meet one of the following tests: (1) the assets test, (2) the endowment test, or (3) the support test. Together, these tests constitute the qualifying distribution requirement for private operating foundations. 

Private operating foundations must demonstrate compliance with these tests every year by providing information in the annual Form 990-PF filed with the IRS.

Restrictions applicable to non-operating foundations
Private operating foundations are also subject to taxes on self-dealing, excess business holdings, jeopardizing investments, and net investment income.

Conclusion

Choosing the right 501(c)(3) classification—whether as a public charity, a private non-operating foundation, or a private operating foundation—depends largely on the specific goals of the organization and its planned sources of funding. While it is relatively easy to switch from a public charity to a private non-operating foundation, it is a much more complex process to seek reclassification from a private foundation to a public charity. Therefore, it is crucial to understand the differences between these classifications in order to select the most suitable one for your goals from the start.

1   A 501(c)(3) refers to the federal tax code section granting tax-exempt status to certain organizations.

2  A narrow exception to the lobbying prohibition exists in connection with lobbying in “self-defense” on legislation that would affect the existence, powers, duties, or tax-exempt status of a private foundation or its ability to receive deductible contributions.

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When incorporating a new nonprofit, it’s important to consider some legal aspects. The first step is to choose the state where the nonprofit will be incorporated. It’s possible to incorporate a nonprofit in any state, regardless of where its activities will be carried out. Once the state of incorporation is chosen, the next step is to draft and file a certificate of incorporation to formally establish the organization. This article addresses the key issues to think about when incorporating a nonprofit.

Which state should we incorporate our nonprofit in?

When deciding where to incorporate, consider two main factors: (1) where the nonprofit will primarily operate and (2) the complexity or burden of complying with a state’s laws and regulations. Some nonprofits choose to incorporate in the state where they will primarily operate, while others choose a jurisdiction based on its flexibility in structuring internal governance.

Certain states, including New York, California, and Massachusetts, have corporate statutes that limit or dictate governance choices and require regulatory notification or approval for significant transactions, such as mergers, significant asset transfers, or dissolution. On the other hand, states like Delaware have fewer rules about how companies should be managed and approved by regulators. The Attorney General of Delaware doesn’t need to review or approve corporate transactions beforehand, and Delaware’s laws governing corporations are more flexible compared to laws in other states.

Before selecting a state for incorporation, it’s important for the organizers to work closely with a qualified attorney to understand the available options. State nonprofit corporation laws govern many aspects of the governance structure, including the minimum size of the governing board, membership rights and procedures, board election and removal procedures, and processes for managing conflicts of interest or conducting an annual audit. Some state laws may also require regulatory or court approval for major transactions. These requirements can significantly impact the time and money needed for compliance as the nonprofit grows and evolves.  

Are there additional requirements when incorporating in a state where we have no operations? 

If a nonprofit is incorporated in a state where it is not primarily operating (known as the state of legal domicile), it must fulfill additional compliance requirements that would not apply if it were incorporated in its state of legal domicile. However, many nonprofits find these extra requirements manageable and worthwhile because of the advantages of incorporating in a state with a more flexible regulatory approach.

1. The nonprofit must have a registered agent in the state where it is incorporated. The registered agent is responsible for receiving legal mail on behalf of the nonprofit, such as service of process. There are corporate filing services that offer registered agent services for a reasonable annual fee.

2. The nonprofit is often required to file an annual report in its state of incorporation. For example, a nonprofit incorporated in Delaware must submit a Delaware Annual Report by March 1st each year, along with a $25.00 filing fee.

3. The nonprofit must also qualify to “do business” in the state where it primarily operates. This involves making an initial filing with the state and then filing annual reports to maintain its status. 

Nonprofit organizations, regardless of where they are incorporated, must register annually with state charity regulatory offices in order to solicit charitable contributions or hold charitable assets in all applicable states, including their state of legal domicile. For example, a nonprofit incorporated in Delaware, located in New York, and soliciting funds in New York is not subject to most of the governance requirements of the New York Not-for-Profit Corporation Law. However, in addition to registering to do business in New York with the New York Department of State, the nonprofit must also register annually with the New York Attorney General’s Charities Bureau, which regulates charitable solicitation and assets within the state. It’s important to note that many states’ laws exempt hospitals, educational institutions, and religious organizations from the charitable registration requirement. The scope of the exemption, as well as the manner of obtaining it, varies from state to state. 

What provisions are required to be included in our certificate of incorporation? 
What provisions are optional?

The certificate of incorporation is a crucial document that establishes a nonprofit organization’s legal and operational framework. Some states refer to this document as the Articles of Incorporation. It outlines the nonprofit’s purpose(s) and provides basic information about its structure and governance. Careful attention to several key issues is required when drafting the certificate to ensure that the nonprofit is formed correctly, eligible for federal tax-exempt status when sought, and compliant with relevant state and federal laws. 

When creating a certificate of incorporation, the required provisions may vary depending on the state’s laws. However, the following are the standard state-required clauses:

1. The legal name of the organization
2. The name and address of the incorporator
3. The purpose or purposes for which the corporation is formed
4. Designation of the secretary of state as an agent of the corporation for receiving legal documents
5. If the corporation must have a registered agent, the name and address of the corporation’s registered agent in the state
6. Whether the corporation will have members or a statement noting that provisions relating to membership will be in the corporation’s bylaws.

Several states also require the names and addresses of the initial directors to be included in the certificate of incorporation. 

When a nonprofit wants to apply for 501(c)(3) tax-exempt status, there are specific requirements to consider. While a corporation can generally be established for any legal purpose, for 501(c)(3) status, a nonprofit corporation must be organized and operated exclusively for one or more of the purposes described in section 501(c)(3) of the Internal Revenue Code. Meeting the first part of this requirement – the “organizational test” – typically requires a nonprofit to include language in its certificate of incorporation that explicitly limits its corporate purposes. The IRS Form 1023 (the application for 501(c)(3) status) states: Your organizing document must restrict your purposes to those described in section 501(c)(3). These purposes include charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.

The instructions for Form 1023 state that it is generally enough to limit a nonprofit’s purposes by referring to section 501(c)(3) to meet the organizational test under section 501(c)(3). The IRS gives an example of an acceptable purpose clause as follows: The organization is exclusively organized for charitable, religious, educational, and scientific purposes under section 501(c)(3) of the Internal Revenue Code or corresponding sections of any future federal tax code.            

Alternatively, a nonprofit organization’s certificate of incorporation can fulfill the organizational test by specifying a particular charitable purpose. If this approach is chosen, nonprofits should be cautious in crafting a purpose description that does not overly restrict the organization’s ability to effectively pursue its broader charitable goals.

According to Form 1023 instructions, the nonprofit’s certificate of incorporation must ensure the permanent dedication of its assets to a section 501(c)(3) purpose. In the event of dissolution, a 501(c)(3) tax-exempt nonprofit must distribute its assets for an exempt purpose described in section 501(c)(3), or to the federal, state, or local government for a public purpose. In some states, nonprofits can rely on state law to establish the permanent dedication of assets for exempt purposes. 

Form 1023 instructions offer the following example of an acceptable dissolution clause: 

Upon the dissolution of this organization, assets shall be distributed for one or more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code or corresponding section of any future federal tax code or shall be distributed to the federal government, or a state or local government, for a public purpose.

Nonprofits may want to include a provision setting forth the statutory limitations or prohibitions applicable to 501(c)(3) nonprofits regarding lobbying and political campaign activities. 

How long does it take for the certificate of incorporation to be filed? 

States may take anywhere from a few days to a few weeks from the submission date to file the certificate of incorporation. The speed of incorporation is another factor that may influence the decision of where your nonprofit should incorporate. It is easier and faster to incorporate in some states than others. Many states offer expedited filing for an additional fee, including 24-hour, same-day, or even 2-hour expedited filing.

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501(c)(3) Charitable Organizations

Purposes
501(c)(3) organizations operate exclusively for charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.  For purposes of section 501(c)(3), the term charitable is used in its generally accepted legal sense and includes:

• Relief of the poor, the distressed, or the underprivileged
• Advancement of religion
• Advancement of education or science
• Erecting or maintaining public buildings, monuments, or works
• Lessening the burdens of government
• Lessening neighborhood tensions
• Eliminating prejudice and discrimination
• Defending human and civil rights secured by law
• Combating community deterioration and juvenile delinquency

Public Charity vs. Private Foundation
Every 501(c)(3) organization is classified as either a private foundation or a public charity. Private foundations and public charities are primarily distinguished by the level of public involvement in their activities. Public charities normally receive a significant portion of their financial support from the general public or governmental units and interact more with the public. 

A private foundation is typically funded by a single person, a family, or a company. Private foundations are subject to stricter operating restrictions because they are less open to public scrutiny than public charities. They are subject to certain excise taxes for failure to comply with those restrictions.  

Private foundations are further classified between private non-operating foundations and private operating foundations. The main difference is that private operating foundations actively “operate” or conduct their own charitable programs. Because of this major difference, private operating foundations are subject to the same regulations as public charities on a few key matters, which are generally more favorable than the rules applicable to non-operating foundations.

Lobbying
Lobbying is any attempt to influence legislation, including acts, bills, resolutions, or ballot initiatives by Congress, state legislatures, local councils, or similar governing bodies.

A public charity is not permitted to engage in substantial legislative activities. If lobbying activities are substantial, a 501(c)(3) organization may fail the operational test, risk losing its tax-exempt status, and, in certain cases, be liable for excise taxes.

Like public charities, private foundations will jeopardize their 501(c)(3) status if lobbying is a substantial part of their activities. However, private foundations are subject to a significant excise tax on their lobbying expenditures, such that the excise tax generally acts as a lobbying prohibition for private foundations.  A limited exception to this lobbying prohibition, known as the “self-defense” exception, applies if the communication addresses legislation that affects the foundation’s existence, powers and duties, tax-exempt status and/or deductibility of contributions.

Political Campaign Activities
All 501(c)(3) organizations are prohibited from directly or indirectly participating in or intervening in any political campaign on behalf of (or in opposition to) any candidate for elective public office.  Prohibited political campaign activities include any statements made by or on behalf of the organization in favor of or in opposition to any candidate for public office and contributions to political campaign funds.  Violating this prohibition may result in denial or revocation of tax-exempt status and the imposition of excise taxes on the organization.

Tax-Deductibility and other Characteristics 
Donations to 501(c)(3) organizations are tax-deductible, though the deductibility limits vary between public charities and private foundations (and generally are more generous for public charities). In addition, 501(c)(3) organizations are generally exempt from state income tax exemption and state sales tax exemption (although some states only grant sales tax exemption to a narrow subset of 501(c)(3) organizations).  501(c)(3) organizations are also generally eligible for the nonprofit mail rate, which provides a significant discount. 

Applying for Tax-Exempt Status
Organizations seeking 501(c)(3) tax-exempt status must file the Form 1023 or Form 1023-EZ.  Churches that meet the requirements of IRC Section 501(c)(3) are automatically considered tax-exempt and are not required to apply for and obtain recognition of tax-exempt status from the IRS, although many churches choose to apply for tax-exempt status to obtain the certainty of the IRS’s determination. A written IRS determination can also simplify applying for other benefits, like state tax exemptions.

501(c)(4) Social Welfare Organizations

Purposes
501(c)(4) organizations must be operated exclusively for the promotion of social welfare.  The tax regulations specify that an organization operates exclusively to promote social welfare if it is primarily engaged in promoting the common good and general welfare of the people of the community.

Lobbying
501(c)(4) organizations may engage in unlimited lobbying related to their exempt purposes without jeopardizing their tax-exempt status.  This ability to engage significantly in lobbying activities is a key reason many organizations choose the 501(c)(4) designation.

Political Campaign Activities
501(c)(4) organizations can engage in political campaign activities if not the organization’s primary activity. 

Tax-Deductibility and other Characteristics
Donations to a 501(c)(4) organization are not tax-deductible. In addition, the names and addresses of donors do not need to be disclosed to the IRS in its annual Form 990 filing.  By contrast, all 501(c)(3) organizations must disclose their donors to the IRS in their Form 990 filings, and information about private foundation donors is made publicly available by the IRS.  Some organizations may also choose to seek 501(c)(4) status (especially as an alternative to 501(c)(3) private foundation status) if their donors do not need the benefit of tax-deductibility of their donations, and they would benefit from the more flexible rules applicable to 501(c)(4) organizations.

Applying for Tax-Exempt Status  
Organizations seeking 501(c)(4) tax-exempt status must file the Form 8976 Notice of Intent to Operate Under Section 501(c)(4), generally within 60 days of its formation. In addition to submitting Form 8976, organizations operating as 501(c)(4) organizations may also choose to file Form 1024-A to request recognition of tax-exempt status. Submitting Form 1024-A does not relieve an organization of the requirement to submit Form 8976.

501(c)(6) Business Leagues

Purposes
501(c)(6) organizations include business leagues, chambers of commerce, real-estate boards, and boards of trade.  A business league, which is perhaps the most common type of 501(c)(6) organization, is an association of persons having a common business interest, the purpose of which is to promote such common business interest and not to engage in a regular business of a kind ordinarily carried on for profit. Business leagues include trade associations and professional associations. To be considered exempt, a business league’s activities must be devoted to improving the business conditions of one or more lines of business as distinguished from performing particular services for individuals. 

Lobbying
501(c)(6) organizations may conduct unlimited lobbying to further their exempt purposes without jeopardizing their tax-exempt status.  An organization that engages in these activities must give its members notice of amounts of membership dues allocable to nondeductible lobbying expenditures; failure to provide such notice may subject the organization to a proxy tax on the amount of the expenditures.

Political Campaign Activities
501(c)(6) organizations are permitted to engage in political campaign activities if they are not the organization’s primary activity.

Tax-Deductibility and other Characteristics
Donations to a 501(c)(6) organization are not tax-deductible. 

Applying for Tax–Exempt Status
Organizations seeking 501(c)(6) tax-exempt status must file the Form 1024 with the IRS. 

Keep in mind that organizations engaging in lobbying and political campaign activities may also be subject to federal, state, and, in some cases, local lobbying registration and disclosure reports, depending on relevant factors, including the amount spent on the activities, whether lobbyists are retained, and the locations of such activities.  

Choosing the Classification of Your Organization

It is critical to correctly determine which tax-exempt status is most appropriate based on your organization’s key objectives.  Failure to apply for and obtain the correct tax-exempt status may subject an organization to unanticipated regulatory burdens and constraints and leave it unable to accomplish its essential goals.  While seeking reclassification of an organization’s tax-exempt status is possible, it can be a slow and complex process. As such, it is best to apply for the most strategically beneficial tax-exempt status from the outset.

The post Three Key Types of Federal Tax-Exempt Status[br] 501(c)(3), 501(c)(4), and 501(c)(6) appeared first on Perlman & Perlman.