INTRODUCTION:
One increasingly large part of the economy is composed of not for profit entities that engage in a variety of charitable, educational, religious or other public purpose in which the goal is not to make money but to help or educate a segment of our society. These entities can be created by anyone who learns the unique methods of formation and operation the law imposes and is willing to forgo profit in order to help others. While a reasonable salary can be paid to the persons running the entity, any money made by the entity must be used for the underlying purpose for which it was created. There are a large variety of structures and methods available and the fact that tens of thousands of such entities exist in California alone should indicate how effective and useful they can be.
A California nonprofit corporation allows you to create an entity with limited liability, like a corporation, but to have no taxes payable on its income and to allow other persons to deduct from their income tax contributions to it. Named at times, "foundation," or "nonprofit corporation" or "501 C 3 Corporation" it is all the same thing: an entity created under the laws of the state of California which engages in specified activities only and which enjoys the tax benefits if and only if operated in strict conformity to the tax law.
To those used to a typical private corporation, or those unused to the concept of creating a legal entity at all, the unique characteristics of a foundation may seem quite difficult to comprehend at first, but in reality the requirements are relatively easy to master and such structures have become increasingly prevalent in the United States. Many tax experts consider such entities one of the most valuable tools that can be used to accomplish charitable or educational goals.
It is important to note that this entity is not a charitable trust or family foundation, both of which are often used for family or estate planning and have even more restrictive rules that apply to them if one is to enjoy tax benefits. While foundations are often integrated into family estate planning goals, their primary purpose must be to serve the public good in various specified ways that the government has determined are allowed.
The key is that the government is granting to you unique tax privileges but in return expects that you will only utilize the structure for those limited purposes that the government allows. Unlike a typical private corporation which may engage in any legal business at all, the foundation is restricted to the activities approved by the government and failure to strictly comply with those restrictions can have disastrous consequences for the tax status and survivability of the foundation.
It is vital to note that the foundation ultimately belongs to the people of the State of California and if you fail to comply with the law, the government will retrieve it and assume total control. If you abandon the foundation, the assets in it are reclaimed by the State. The government has the continuing right to audit and review all records and activities of the corporation to ensure that it is not a private company inuring to the personal benefit of the people running the company rather than the public good.
All employees of the entity, including the founders, can be paid a reasonable salary and, so long as one operates in the area allowed under the law, the founders can maintain total control of the assets in the foundation and enjoy the deductibility of monies contributed and lack of the requirement to pay income taxes. For the cost of adherence to rules and oversight, one receives better tax treatment than any other entity in our country.
This article will give a brief overview of the essential steps and requirements necessary for the creation and basic running of a foundation but the reader is advised to obtain competent legal and tax advice from both attorneys and accountants not only in the creation but in the operation of the company.
The Basic Structure of the Entity
The reader may wish to review our various web articles on the corporate structure in California, including Limited Liability Entities and Corporate Structures and Formalities in an American Non Public Corporation . The Foundation is simply a corporation that is granted tax exempt status if it engages in certain specified areas of activity and does not make a profit that is distributed to its owners. Indeed, technically, the owner is the State of California which is allowing you to run the entity so long as you comply with the requirements to do the specified acts.
What activities are allowed? Essentially, they come down to charitable, religious, educational, scientific and those types of activities which are dedicated to the public good and not to the benefit of the operators of the entity. Additionally, mutual benefit organizations dedicated to helping or educating its members such as trade associations, but not those whose purpose is merely lobbying or indirectly distributing profit to its members . The key is always the purpose and the money: is the purpose to make a profit either directly or indirectly or to help others in a nonprofit manner?
Thus, setting up a school which helps educate and does not make the owners wealthy would possibly be allowed but not a school in which the operator took out the profits it generated. Thus, conducting medical research in which the result is given gratis to the public or to doctors for treating people might qualify but not medical research in which the product is used to sell for a profit that goes to an individual.
In short it is precisely what the name implies: a corporation set up not to make a profit for the owners but to generate good for the public or a group of the public. The government sets the categories of "good" that can be done (education, medical research, charitable giving, arts, and other types of public good) and so long as you restrict yourself to those activities, you can remain tax exempt.
Essentially, there are three categories of allowed purposes : "Public Benefit Corporations;" "Religious Corporations;" and "Mutual Benefit Corporations."
The law is not precise since it seeks to apply to a world in change and the IRS and Franchise Tax Board decide on a case by case basis if an entity qualifies, but the general categories can be considered as follows:
Public Benefit Corporations are those entities organized for scientific, literary or educational purposes which benefit the public or for charitable purposes. Civil leagues and social welfare groups are also considered public benefit corporations.
Examples are nonprofit school, a medical research laboratory whose results are given to hospitals for free, a publishing company whose books are donated to the poor, etc, etc.
Religious Corporations are exactly what they sound like: churches, religious schools, religious study groups, etc.
Mutual Benefit Corporations are entities organized for the mutual benefit of the members and do not exist for a profit. They cover the range from trade groups and associations to tennis and golf clubs, hobby clubs, yacht clubs, etc, etc.
There are no "owners" of the entity since the State owns it and all its assets. However, the entity is controlled by the members (if they exist) and/or the Board of Trustees or Directors. Great latitude is given in the organization so long as the operations are correct. Thus, one can have members who pay dues; members who do not pay dues; no members at all but a Board. The Board can be created and maintained by the Founder; it can be elected by the members; it can be elected in whole or part by the members, etc. etc.
The Board of Trustees act in most structures just as a Board of Directors in a standard corporation and normally appoint the officers who run the day to day operations of the foundation. Officer and employees can be hired at prevailing wages, though, of course, no ownership interest or options are available since there are no private owners. There are limits to salary and benefits that can be paid to the employees and officers of a public benefit nonprofit so as to avoid defacto profit going to the founders but so long as the salary and benefits are reasonable, the taxing authorities will allow such salaries to be paid.
The nonprofit has strict reporting requirements to both the State and the Federal government to assure each that its activities remain nonprofit. Failure to comply can result in loss of nonprofit status and even seizure of all remaining assets.
Once created, the corporation provides limited liability to the members, a tax-deductible entity that will not pay taxes on its income with some exceptions. And once you determine to close the doors, any remaining assets are transferred to the State, not to the contributors.
Meetings of the Board may be as frequent as one wishes but usually are quarterly and at least annually. Meetings of members, if they exist, are also usually annually.
If there are no members, the Board makes all strategic decisions and the officers carry them out. If there are members, either they or the Board will determine strategic decisions.
While the Board of Trustees have a fiduciary duty to the foundation and must not engage in self-dealing, their liability is more limited than a typical private corporation and minus gross negligence or intentional wrong doing, they are seldom found personally liable based on their duties to the foundation. Legal counsel should be retained by the entity to advise on decisions of the Board if there are any questions as to acting in an inappropriate manner.
Whether to have members and the size and makeup of the Board should be discussed with counsel and depends mostly on the nature of the activities being considered. Many foundations merely have nonvoting members with a board that elects one third of its members annually or has annual meetings of the members who elect the board. Board members may receive a stipend but usually do not.
Lastly, depending on the activities, other requirements may apply. Thus, Charter Schools have various requirements imposed by the State Board of Education that must be complied with and must be incorporated into the rules and methods of the foundation. Medical foundations often must conform to licensing requirements of the State and many trade associations are part of much larger organizations which have their own unique rules.
TAX ASPECTS OF THE STRUCTURE
There are two reasons to become nonprofit. First, obviously, is the tax benefit which allows the corporation to avoid having to pay income taxes on its activities and to receive tax deductible donations from third parties. Secondly, the entire ethos of the entity, for both its members and third parties is quite different than the standard profit making entity. Let us first discuss the former aspect.
The most time-consuming aspect of the initial set up of the entity is demonstrating to the taxing authorities that your proposed entity is to be appropriate for tax exemption. This requires filling in far more than the standard Articles of Incorporation which are typical for profit companies. One must fill in dozens of forms for both the Federal and State government including proposed budgets, your business plan, your proposed initial personnel structure, etc. and these documents ARE carefully reviewed by various persons in both the State and Federal government and it is quite usual to have the documents result in additional inquiries from the government before tax exempt status is granted.
This can be both a prolonged and exhausting procedure and since foundations with members often have complex and extensive rules for participation by the membership, one must spend the time before the documents are filed to ensure that there are no aspects of your submission that is likely to cause additional questions and delay.
A very large salary for the founder or self-dealing between the founder's private business and the foundation is a typical type of plan that causes concern for the taxing people. Loading the board of trustees with children of the founder or a travel budget to exotic places for the board or officers without very good foundation purposes is another typical "red flag" for the tax people.
They will read your plan and budget. Unlike most tax returns, this is a document that is going to be carefully reviewed by an individual within the IRS. They will be critical if you are seeking to make this a tax-free method of engaging in private business. You have the burden of demonstrating to them your intent since it is your request for unusual status that is causing the review.
How long will this take you to prepare the forms? The IRS has conducted a study and determined that the average person requires four hours and 41 minutes to learn their 501 (C) (3) application form and 9 hours and 22 minutes to prepare it for the IRS.
We think that is optimistic in terms of a lay person doing it the first time. Without legal counsel, you should plan on about five times that period since what the IRS fails to consider is need to create the business plan and budget (which requires a good week of intensive work) and the inevitable need to run it all by your tax expert.
Even with counsel, you must plan on it taking at least twice as long the IRS states since they do not include the business plan and budget preparation nor the need for the California forms to fill in.
Even with counsel, unless you wish to spend over five thousand dollars in fees, YOU must work to prepare the bulk of the business plan and budget and work closely with counsel to fill in the forms. Many firms, such as ours, create foundations for clients on a flat fee basis but only if the client participates closely in creating the documents and delivers to us good initial budgets and business plans.
And, of course, annually tax reporting forms must be filed with the IRS and State tax people and they may audit at any time. (Unlike a tax return, this is not to pay tax but to demonstrate that tax exempt activities are occurring as required.) We strongly recommend using good accountants to prepare the tax returns and can recommend several to you if you do not already have one.
It must be recalled that what is called "unrelated business income" may be taxable to the foundation. That essentially means engaging in a business that is unrelated to the underlying purpose of the foundation. (As an example, your medical foundation sells land in Arizona on a regular basis. That would almost certainly be a taxable event. However, a symphony gift shop to raise money for the symphony or occasional raising of money by an auction of donated items would not be.)
Is it worth it? Assuming you have a goal other than making money with your proposed activity, the few months dedicated for creating tax forms are not a major problem and much of the work-the budget and the business plan-is a good idea for you to create in any event.
The Ethos of the Non-Profit
There is a massive nonprofit economy in the United States, growing larger each year as more and more Americans conclude that they can do much of what matters to them, earn a good living, and enjoy the benefits of not paying corporate taxes. Many of our successful clients, who have made their fortune in various businesses but are not willing to spend their retirement on the golf course, begin a "new business" of a foundation and find that their past skills are entirely appropriate, that they meet wonderful new people and also "do good." Many of our clients see nonprofits as a way to link a family together on a common purpose.
But most people do nonprofits to accomplish a specific goal: setting up a school that "works," or saving a part of the community or environment or providing medical or charitable services, etc, etc. And once you launch your nonprofit you encounter an entire world of people like you and find, perhaps to your surprise, that not only are there a lot of "very nice" people out there, but they are talented, dedicated, supportive, and successful. One client, long the leader in his medical field, commented ruefully to the writer, " I thought that the best minds were in my department. Perhaps the best scientific minds were there - but the best minds in the sense of understanding life, our goals, how to be happy, are where I am now." When he wrote that he was in Micronesia delivering donated medical goods to remote islands, a project he began and which takes up three months of his life a year.
And that is the best part of foundations. They are tools, like corporations, and can be remarkably flexible and can pay you a living while you do things that matter to you.
If you are a group interested in mutual benefit (trade association) or better education (charter school) or a new church or a new way to interact and educate, provide medical services, provide food to the poor or aid to people around the world - all these can be accomplished in a nonprofit.
It is a different structure than a corporation that makes money and is subject to governmental oversight but once set up, it can provide limited liability, tremendous tax benefits, relative freedom of action, and entry into a world that can radically alter how you view yourself and your own life.
Raising Money
Once you file your application, it may take many months or even years before you receive your permanent tax exempt status but you normally receive a letter stating that your initial application appears appropriate and legally authorizing you to begin money raising efforts within a few months. You should note that if the exemption is later revoked, you will lose that status. Realistically, once you receive the preliminary letter you may assume that minus remarkable new events, you will be considered tax exempt and may begin your money raising efforts.
How to raise money and the politics of the nonpublic world are far too extensive a topic for this article, but it should be noted that both many books and many paid consultants exist who do nothing but explain how to raise money. It is never easy and all too many foundations end up spending most of their time not engaged in foundation purposes but in merely raising money. In your budget, you should carefully consider sources of income and the lag time inherent in seeking monetary funding.
And if all or the vast bulk of your funding is to come from you or your own family, you may have additional difficulties in achieving appropriate tax exempt status or deductions and should take the time before incorporating to consult with a good accountant and attorney on the matter.
This is particularly true if your family is to receive in salaries the bulk of the proceeds from the foundation. Put simply, the government does not want this to be a sham to allow your family to benefit from a tax-free structure that does not really engage actively in those true tax exempt activities. Salaries can certainly be paid, but it is far safer to have contributions derive from outside sources and salaries payable to more than just family members.
What Next?
There are various books that enable you to create your own nonprofit including an adequate one put out by Nolo Press which is available in most book stores and if you wish to put in the time necessary to read the sizable book and understand their contents, you can save two or three thousand dollars in fees and some accountant bills. Most people, stunned by the complexity of the matter, reluctantly go to professionals and you can expect the legal fees to be somewhere between two thousand dollars to four thousand dollars, costs to be about three hundred dollars, and accountant fees to be about one thousand to two thousand dollars for the initial set up.
Is it worth it? The first time you receive a donation and use it to further the cause that you are committed to not to make money but to do a project you consider “good,” the various technical requirements and hoops you jumped through will seem minor. Once established the annual reporting is routine and the credibility you gain from being a 501C3 corporation will be significant. One client who had run several for profit entities in his day put it well once he created his first nonprofit: “All my life I used my skills to beat out the competitors. Now I can use my skill to help others. I can’t tell you how pleasant that change is…”