The process of creating a tax-exempt organization is generally viewed as a difficult process and while the individual steps can be daunting and time consuming, the differences between beginning a corporation and beginning a tax-exempt corporation are largely similar. This article will discuss the chief differences that should be noted when starting a tax-exempt corporation as well as briefly address liability issues with unincorporated organizations and LLCs. The focus of this article is on Nebraska and corporations being formed under its laws, however, because tax-exemption is largely a creature of federal law much of the article is applicable to corporations formed in other states as well so long as care is given to address differences in state corporate law.
Liability Associated With Unincorporated Organizations
It is not uncommon for an unincorporated organization to exist. The general perception of an unincorporated organization is that there is very little or nothing placed in writing. This is not necessarily true, though. Often times an unincorporated organization will take the form of a partnership which is governed heavily by statute and mutually agreed upon contract. The use of contractual relationships between members of an unincorporated organization is fairly common and often is effective at regulating the internal operation of an organization. Unfortunately such arrangements are oftentimes not of use when seeking to avoid personal liability arising from the actions of the unincorporated organization.
The two most common ways of avoiding personal liability arising from an organization are to create either a corporation or a limited liability corporation (LLC) for your business organization. Both of these forms can offer owners and operators the advantage of limited liability however in the tax-exempt arena the two differ from one another greatly. The use of LLCs as a tax-exempt business will be discussed later in the article, however, the LLC is less common in this area than the corporation. The most common form of tax-exemption for corporations can be found in §501(c) of the Tax Code. 26 U.S.C. §501(c). This section of the Code details the requirements for a corporation to be considered tax-exempt by the federal government. There are numerous forms that are available, some of the more commonly seen are: civic leagues/organizations under §501(c)(4); labor/agricultural/horticultural organizations under §501(c)(5); and fraternal benefit organizations under §501(c)(8). Id. The most important of these, and by far the most commonly used, is §501(c)(3). This section of the code allows a corporation to be tax exempt for the broadest number of purposes. These purposes will be laid out in full later in the article but a few of the most important purposes are: charitable; educational; scientific; and fostering amateur sports. 26 U.S.C. §501(c)(3). This article will focus on the basic requirements of §501(c)(3) that are different from how other corporations are created.
Articles of Incorporation
The articles of incorporation is the key document to creating a corporation of any kind. This document lays out much of the basic information about a company such as corporate name, address of the corporation, names and addresses of the people incorporating, and other important information. The articles of incorporation is the document that is filed with the Secretary of State as part of forming the corporation. In general the articles of incorporation for a tax-exempt corporation (S corp) are the same as those filed for a normal corporation (C corp). This follows from the idea that the S corp is, at its core, a corporation which has agreed to a few extra restrictions in order to meet an IRS standard. After seeking an Employer ID Number (EIN) from the IRS, one will have to draft the articles of incorporation. While the similarities between the two forms are greater than the differences, it is critical to have an understanding of what the differences are in order to properly file your corporation with the IRS as being tax-exempt.
One important difference arises in defining what the governing body of the corporation will consist of. In general the governance of an S corp is very similar to that of a C corp with a group of members, or shareholders, electing a board of directors to oversee the operation of the company and then the board of directors electing various officers to oversee the day-to-day running of the company. An important difference, though, is that Nebraska does not require a nonprofit corporation to have any members at all. Neb. Rev. Stat. §21-1940. Whether or not the corporation will have members must be stated within the articles of incorporation. Neb. Rev. Stat. §21-1921(a)(5). Whether there are members or not does not change the fact that the corporation must still have a board of directors. Neb. Rev. Stat. §21-1968. If the corporation does not have members then the corporate organizers will elect a board of directors of the corporation after creation of the company.
A second important difference comes in the requirement of a purpose clause. A C corp may contain a clause in its articles of incorporation that describes the purpose of the corporation. Neb. Rev. Stat. §21-220(5)(b)(2)(i). A nonprofit corporation, though, must state in its articles of incorporation that it is one of three types of corporation: (1) a public benefit corporation; (2) a mutual benefit corporation; or (3) a religious corporation. Neb. Rev. Stat. §21-1921(a)(2). Of these three, the most common to file will be the first, a public benefit corporation. This is because in order to gain tax-exempt status under §501(c)(3) of the Tax Code the corporation must be a for the public benefit. A religious corporation may also be able to attain tax-exempt status under §501(c)(3), though this is a less common filing than the category of public benefit corporation. The second of the three, a mutual benefit corporation, because this form of corporation will still have to file taxes because it is run for the mutual benefit of a specified group of people rather than proving benefits to the public. This also demonstrates that it is possible to be a nonprofit corporation but still be a taxable corporation. The terms have significant overlap but are not quite the same as one another.
The third major difference is the requirement for a dissolution clause. A nonprofit corporation must include in its articles of incorporation a provision to distribute and an all remaining assets once creditors have been paid. Neb. Rev. Stat. §21-1921(a)(6). This need not be an elaborate provision, all that is required by state law is that the provisions put forth here are not inconsistent with the law regarding distribution of assets upon dissolution. What can complicate this, however are additional requirements laid out by the IRS in addition to state requirements. So far the required additions to the articles of incorporation have all been additions required by state law. There are also provisions that must be added in order to be incompliance with the Tax Code.
The requirements laid out by the State of Nebraska for the required purpose clause in the articles of incorporation is quite straightforward, it is important to go a bit further in order to comply with IRS requirements, though. In order to qualify under 501(c)(3) the articles of incorporation must state that the purpose of the corporation are limited to one or more of the following: (1) charitable; (2) religious; (3) educational; (4) scientific; (5) literary; (6) testing for public safety; (7) fostering national or international amateur sports competition; and (8) preventing cruelty to children or animals. 26 U.S.C. §501(c)(3). The breadth of this list demonstrates why most S corps gain their status through §501(c)(3). On top of that list, though, the term “charitable” is also quite broad and encompasses the generally accepted legal definition of giving relief to the poor as well as other purposes such as the advancement of religion, the advancement of education or science, and the erection or maintaining of public buildings and works. The IRS also requires a statement in the articles that the assets of the corporation will be dedicated to whatever the exempt purpose is. This includes what will happen to the assets of the corporation upon dissolution.
These, then, are the basic additional requirements that must be included in the articles of incorporation for a corporation in Nebraska that is seeking to be considered tax-exempt under §501(c)(3): (1) state whether or not the corporation will have members; (2) identify the corporation as either a public benefit corporation or as a religious corporation; (3) state that the purpose of the corporation is limited to the exempt purposes laid out above; and (4) state that the assets of the corporation will be used exclusively for an exempt purpose and that upon dissolution the assets will be disposed of for the exempt purpose in a manner which is not inconsistent with the law.
Bylaws
When forming a corporation the bylaws are generally not filed along with the articles of incorporation, however they are also a crucial aspect to creating a corporation. The bylaws of a corporation are essentially the rules by which the corporation agrees to govern itself and are set at the outset. Bylaws are very mutable and can be adjusted in any number of ways to best fit the needs of the corporation. That being said, though, in order to form a nonprofit corporation in Nebraska it is necessary to create bylaws for the corporation. Neb. Rev. Stat. §21-1925. Furthermore, there are certain requirements for bylaws in order for them to comply with the statutory requirements placed upon nonprofit organizations.
One of the most critical areas which bylaws address is defining the number, powers, duties, and other aspects of the role that directors and officers play. There are limitations that must be allowed for in defining a nonprofit corporation’s board of directors that are very important to observe. First, in Nebraska all directors must be an individual. Neb. Rev. Stat. §21-1969. This means that all of the directors must be human beings. You cannot have a corporation, LLC, or any other business entity as a director for a nonprofit corporation. Also, the board of your nonprofit corporation must consist of at least three directors. Neb. Rev. Stat. §21-1970. Finally, the terms for any director cannot exceed five years and, unless the bylaws say differently, will be set at one year. Neb. Rev. Stat §21-1972. Of note when setting terms for directors is that it is common practice when determining the terms and elections of the board to stagger the election of board members. The staggering of board members is not a requirement but it is often a good idea to include in order to ensure continuity of the board. There are not only requirements for the board of directors, though, but also a requirement that must be met for officers of the corporation. The choice of what officers a corporation will have or not have is largely a matter left to the discretion of the board of directors, there are some officers that are required in order to be a nonprofit corporation, though. Neb. Rev. Stat. §21-1990. These required officers are: (1) a president; (2) a secretary; and (3) a treasurer. Id. Each of these officers must exist, however it is possible for all of these officers to be the same person.
There are also requirements placed on the meetings that need to be noted when creating the bylaws for a nonprofit corporation in Nebraska. Bylaws are capable of governing the procedure for calling and conducting meetings and are generally left to the discretion of the corporation to establish proper procedure. There are, however, a few requirements that must be met in this regard. First, it is necessary to establish that notice of meetings for members, if the corporation has members, is done in a fair and reasonable manner. Neb. Rev. Stat. §21-1955. This is not difficult to accomplish, and in general simply requires that the corporation give notification of the place, date and time of all meetings no more than sixty days before the meeting and include a description of what the meeting is about. Id. There are additional restrictions that must be observed when conducting meetings and voting in meetings; however, those need not be placed in the bylaws of the corporation.
Finally, it is important to be aware of some limitations on how the bylaws of a nonprofit corporation handle the liability of directors for their actions. In general directors and officers are indemnified for the actions taken in their role as a corporate agent. If seeking to change this through the use of bylaws, though, it is important to note that statue does have certain requirements that must be met. These rules establish minimum requirements for liability of directors and officers that cannot be avoided by the use of bylaws and are found in §21-1986, §21-1987, and §21-1989. These can be summarized as requiring directors and officers to follow the Business Judgment Rule, prohibit certain self-dealing transactions, and impose liability for unlawful distributions respectively.
Ultimately, then, it is important to place the following in a nonprofit corporation’s bylaws: (1) state that all directors must be individuals; (2) state the number of directors on your board and ensure that it is at least three; (3) be sure to at least create the offices of president, secretary, and treasurer; and (4) state the requirements placed on meetings of members that will ensure fair notification of place, date and time of meetings no more than sixty days before the meeting and that notification must include a description of what will be discussed.
Mission Statement
A mission statement can be an important document for a nonprofit organization to create. This is a short statement which looks to establish what the nonprofit organization is seeking to do and is often times used in promotional materials for the corporation. These documents can be critical when looking to attract funding and should be carefully considered. The idea behind creating a mission statement for a nonprofit organization is to create a concise overview of what the purpose of the organization is. This should be limited to no more than a few sentences and should cover your organization’s name, goals, who is to be served, how they are to be served, where you will serve, and how your organization is distinct from others. It can be a daunting task to fit so much information into such a short statement, however, it is made easier by being direct. An example of such a statement might be something like, “Healthy Eating Inc. is a group of dedicated individuals who are constantly striving to improve the diets of those living in the Omaha area. Healthy Eating Inc. works closely with other charitable organizations to bring healthy alternative to the underprivileged in our city by connecting those in need with local farmers who can provide healthy and inexpensive food.”
The Use of LLCs (and L3Cs) for Nonprofits
LLCs are currently the most popular form of business organization in general, however, for tax exempt and nonprofit purposes they can still be problematic. The issue arises largely from the fact that an LLC can act as a corporation or as a partnership. This ambiguity has led to the IRS treating LLCs warily when evaluating whether or not they should be allowed to seek tax-exemption when formed as a nonprofit. It is possible for LLCs to be a nonprofit and this can offer both protection from liability and, like other nonprofit organizations, can often be exempted from certain state taxes such as property taxes. The biggest issue with forming an LLC as a nonprofit is that it is very difficult to create an LLC that is capable of meeting the IRS’ requirements to be tax exempt under §501(c)(3). If you are seeking only to create a nonprofit organization then an LLC may be a good choice for the simplicity that it can offer; if, however, you would like to seek tax exemption under §501(c)(3) as well then it is not the best organizational form to use. When, then, can an LLC meet the requirements and be allowed to be tax-exempt under §501(c)(3)? It can occur, but generally such an LLC will have less in common with a nonprofit organization and more in common with a subsidiary or a holding company. This is because the IRS has created a set of twelve factors that must be met in order for an LLC to be considered tax-exempt under §501(c)(3). See I.R.S., U.S. Dep’t of the Treasury, Limited Liability Company reference Guide Sheet (2011), available at http://www.irs.gov/pub/irs-tege/llc_guide_sheet.pdf.
The twelve factors all deal with the organizing documents of the LLC. The term “organizing documents” is used rather than articles of incorporation or operating agreement because of the variance that exists between the LLC laws of different states. For example, in Nebraska an operating agreement is not technically required and as such all of the twelve statements would need to be included in the articles of organization for the LLC. The twelve factors all require that something that must be included in the organizing documents in some way. First, the documents must include a specific statement which will limit the LLC’s activities to one or more exempt purposes. The exempt purposes for this are the same as were discussed earlier as the exempt purposes which a tax-exempt corporation must follow. Second, the documents must state that the LLC is operated exclusively to further a charitable purpose. Third, the documents must require that the LLC’s members are all 501(c)(3)s, government units, or wholly owned instrumentalities of a state. This requirement and the next two are the requirements that make a qualifying LLC more like a holding company or a subsidiary than a true nonprofit organization itself. The only entities that can ever be members of such an LLC are other tax-exempt organizations rather than individuals. Fourth, the documents must prohibit any transfer of any interest in the LLC to a transferee which would be prohibited from initial membership. Fifth, the documents must state that the LLC, any non-membership interests in the LLC, or any assets of the LLC can only be availed by, or transferred to, a non-member who would be prohibited from initial membership for a fair market value. Sixth, the documents must guarantee that, upon dissolution, the LLC and all the assets devoted to the LLC’s charitable purposes will continue to be so devoted. Seventh, the documents must require that any amendments to the articles of organization or the operating agreement are consistent with the language of §501(c)(3). Eighth, the organizational language must prohibit the LLC from merging with, or converting into, a for-profit entity. Ninth, the documents must require that no assets may be distributed to a member which ceases to be an S corp or a governmental unit. Tenth, There must be an acceptable contingency plan in place in the event that one or multiple member cease to be an S corp of governmental unit. This is fairly simple to accomplish because it would only require something along the lines of a forced sale to a still viable entity within a reasonable time such a 90 days. Eleventh, the documents must state that the LLC’s exempt members will expeditiously and vigorously enforce all of their rights in the LLC and will pursue all legal and equitable remedies to protect their interest in the LLC. Finally, the LLC must represent that all of its organizing document provisions are consistent with state LLC laws and are enforceable in both law and equity. That long list demonstrates why there are very few LLCs which seek, or are allowed, to be a tax-exempt entity under §501(c)(3). This leaves the LLC largely out of the discussion when trying to create a corporate form that will allow for tax-exemption.
Finally, of note is a currently small trend toward a new type of entity known as a Low-profit Limited Liability Company, or L3C. This type of organization is only currently available in a handful of states such as: Illinois; Louisiana; Maine; Michigan; North Carolina; Utah; Vermont; and Wyoming. The idea behind the L3C is to create an entity which is essentially the same as a nonprofit LLC but which can also allow for any profits which are earned to be distributed amongst the members rather than put back into the organization. States which allow this type of organization allow such distributions back to members while still granted protections and exemptions like those of a nonprofit LLC. It is critical when making an L3C to state that the mission of the organization is primarily charitable, and to name what the mission is. One of the major benefits associated with this form is the possibility of finding funding more easily due to the possibility of distributions. Currently there are very few places where such a form is used at all, and when comparing it to the twelve part test for tax-exemption of an LLC it is clear that there is no chance of the IRS allowing an L3C to be a 501(c)(3) organization in the near future. It is, however, an interesting form of nonprofit corporation which warrants keeping an eye on.