So You Want To Start a Nonprofit – Part 4

By: Pete Kennedy, CPA

“How do I start a nonprofit?” is a question I get asked with some frequency and the answers might not be what you expect. If you are considering starting a nonprofit, there are a number of factors to consider. We’ve put together a four-part series of posts and accompanying videos to provide you with a baseline of information as it relates to key considerations to setting up a nonprofit, steps to setting up a nonprofit, selecting the appropriate tax exempt status, and, finally, obtaining exempt status.

Part 4: Obtaining Tax Exempt Status

Obtaining exempt status for 501c(3) organizations involves completing IRS Form 1023. The long form is for organizations expected to have estimated annual gross receipts exceeding $50,000 at any point in the next five years. Form 1023-EZ would be used if estimated annual gross receipts will be less than $50,000.

Form 1023 can be daunting. While the form itself is only 26 pages long, by the time you get done with the form and the attachments, you’re looking at 50 to 60 pages! The exercise of preparing this form forces an organization to think about where they want to be and how they’re going to get there. Be prepared to provide the following:

  • Financial projections
  • Sources of revenue and expense
  • Who will be paid – either as an employee or a vendor
  • Related party activity
  • Members of the Board – Note: If they will be paid, that is an automatic cause for added scrutiny of the application.

You may think you should simply give this form to your CPA or attorney to complete. This can be quite costly. My recommendation is that you try completing the form yourself first. The form is pretty straight forward and the information needs to come from you anyway. Then, if you have questions, call your CPA or attorney. Most nonprofits are cost conscious, especially when first starting out. This approach can save thousands of dollars.

Completing Form 1023-EZ is much easier, faster and cheaper. The filing fee is $275 versus $600 to file Form 1023. The approval process is quicker as well so if you meet the annual gross receipts requirement to file form 1023-EZ, do it!

You filed form 1023, what’s next?

Once you have filed form 1023, be prepared to wait. Wait time can vary dramatically. If you file form 1023-EZ, the wait time can be just a couple of weeks. On the other hand, the wait time for the long form can take a few months, which is the IRS standard, to up to two years (yes, we’ve seen this happen!). There are ways to get to the front of the line. For example, if you’re waiting for approval to receive a grant and it’s time sensitive, you can request expedited processing.

The next step is to respond to questions the IRS may have. IRS questions are fairly routine and easy.  I have never seen a well-thought out and legitimate1023 rejected. Although I should point out that the IRS is particularly sensitive to related party activity. Also, any time you may payments to Board Members, that’s a red flag.

The next step is approval – you’re getting closer! Approval should come in the form of a written letter, called a Determination Letter. Be sure to save the Determination Letter along with a copy of your 1023. Grantors may ask for a copy of your approval letter later. In addition, form 1023 is a public document, similar to the 990 tax return. Anyone can ask for a copy for any reason and you must comply, charging only a reasonable reproduction fee.

After you get your written approval, there’s one final step in the process. That is being listed in IRS official Pub 78 listing.  The reason you want to make sure you are listed is because Foundations have automated programs that check your organization’s EIN against Pub 78 and will not process grants if the organization does not appear in Pub 78.

Pub 78 is supposed to get updated monthly but there are times that doesn’t happen.  I’m on the board of an organization that got their approval letter and then applied for a number of grants. They got shot down saying that they were not on the Pub 78. At the time they were delayed by the government shutdown.

Unrelated business income

Now is a good time to bring up unrelated business income, or UBIT. This is a very complicated and broad topic. UBIT is income from an activity of a trade or business that is regularly carried on and is unrelated to the organization’s exempt purpose. For example, if your charitable plan is to buy a McDonald’s franchise and donate the profits to charity, in the IRS’s mind, that is not a valid exempt purpose. Nonprofit revenue sources need to be either either passive (think interest or investment gains), related to your exempt purpose (admission, program service fees) or contributions – other than that it’s probably taxable (exceptions for volunteer labor, donated merchandise, annual or irregular fundraisers).  The fact that 100% of the profits go to the charity is not a valid reason to avoid taxation.

You receive approval for exempt status, now what?

990 filing requirement is full 990; 990-EZ for those under $200,000 gross receipts; 990-N e-postcard for those under $50,000 gross receipts.  You may still need to file the long-form for another reason.  If you fail to file for three straight years, exempt status is revoked and you are right back to square one.

Generally due 15th of the 5th month after year end, 5/15 for calendar year ends.  Can be extended for 6 months without penalty or stigma (to 11/15)

Public support test on Schedule A – make sure it is being filled out correctly.  Designed to determine if the entity enjoys a broad base of support.  If all of your support comes from 3 or 4 donors, you are probably in trouble and if the preparer is not filling out the form correctly you might not even know it.

If you fail 2 years in a row, you get involuntarily converted to a PF – least favorable under 501c3 – not where you want to be and getting back is a difficult process.

If it looks like you will fail even one year, try the other tests out – ex. if you fail 509a1, try 509a2.

Other topics covered in this four-part series:

Part 1: Key Considerations to Setting Up a Nonprofit

Part 2: Steps to Setting up a Nonprofit

Part 3: Understanding Nonprofit Tax Exempt Status Types

Pete Kennedy is a Director at Cover & Rossiter and is one of the leaders of our Audit practice. He has developed an expertise in nonprofit accounting, auditing and tax issues and is privileged to work with many of the region’s leading institutions.

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