California Nonprofit Organizations

  1. Basics.

    1. A nonprofit organization (generally) pays no federal or state taxes but must meet certain requirements.

    2. A charitable organization is a type of nonprofit that has qualified to have donations that are made to it be tax deductible as charitable donations.

    3. Not all nonprofits are charitable organizations.

  2. Types of California Organizations That Can Be Nonprofits

    1. Unincorporated Associations

      1. The advantage is that you don’t have to form an entity.

      2. The disadvantages are:

        1. Each member is personally liable for the obligations and misdeeds of the association.

        2. The law regarding unincorporated associations is unclear.

    2. Charitable Trusts

      1. These are basically good only for holding, managing or distributing property.

    3. Nonprofit corporations

      1. The vast majority of nonprofit organizations are nonprofit corporations.

      2. As with owners of for-profit corporations, the participants are shielded from personal liability unless they do something illegal, fraudulent, etc.

    4. As a result, nonprofits almost always want to be nonprofit corporations.

  3. Types of California Nonprofit Corporations

    1. If you want to be able to get distributions of profits from the entity or sell the entity, it cannot be a nonprofit. (Salaries, though, can be OK.)

    2. Public Benefit

      1. Must be formed for public or charitable purposes.

      2. May not make any distribution of assets to members at any time. On dissolution, the assets must go to another nonprofit.

      3. May be charitable.

      4. Self-Dealing. Interested directors may be liable for a "self-dealing" transaction unless it is approved in advance by the disinterested directors, who must find that it is fair and reasonable to – and for the benefit of – the corporation and that no better arrangement is available.

        1. A self-dealing transaction is one where the director has a material financial interest.

        2. If a majority of the directors then in office are involved, then the transaction can only be approved by the court or the Attorney General’s office.

        3. Actions of the board in setting compensation for the officers or directors are exempt from this requirement.

      5. Interlocking Directorships. Transactions between a nonprofit corporation and another corporation with interlocking directorships may be void unless material facts as to the interlocking directorship are fully disclosed to the board and transaction is approved by sufficient number of directors without the common directors or the transaction just and reasonable as to the corporation.

        1. The nonprofit and the other corporation have an interlocking directorship if at least one person is a director on both boards.

        2. Query whether this also applies to limited liability companies, since the statute does not mention them.

      6. Interested Persons. No more than 49% of the directors may be "interested persons".

        1. An "interested person" is any person compensated for services rendered to the corporation (other than as a director) during the previous 12 months and brothers, sisters, spouses, parents, descendants and in-laws of interested persons.

      7. A special standard of care applies to investments.

      8. Public benefit corporations are subject to more government regulation and supervision than the other two types.

    3. Mutual Benefit

      1. May be formed for any nonprofit purpose.

      2. May make distributions of assets to members on dissolution (but not before).

      3. Cannot be charitable.

      4. Self-Dealing. A "self-dealing" transaction is not voidable if it is approved (at any time) by the remainder of the directors (they do not have to be a majority of the directors then in office), who must also be disinterested and find that it is just and reasonable to the corporation. Alternatively, the interested director must prove that the transaction is just and reasonable to the corporation.

        1. Again, actions of the board in setting compensation for the officers or directors are exempt from this requirement.

      5. Interlocking Directors. Transactions between a nonprofit corporation and another corporation with interlocking directorships may be void unless material facts as to the interlocking directorship are fully disclosed to the board and the transaction is approved by sufficient number of directors without the common directors or the transaction is just and reasonable as to the corporation.

      6. One problem with mutual benefit corporations is that they cannot qualify for charitable status.

    4. Religious

      1. Must be formed primarily for religious purposes.

      2. May not make any distribution of assets to members at any time.

      3. May be charitable.

      4. Because these are specialized, they will not be addressed here.

  4. Voting Members.

    1. If there are members with voting power, they elect the board of directors.

    2. A nonprofit can have members without voting rights, or different classes of membership, some with voting rights and some without.

    3. Having voting members requires a membership meeting or ballots mailed to all members. If the voting membership is large, this can be expensive and time-consuming.

    4. Alternatively, the incorporator can appoint the initial board members and the board can be self-perpetuating, meaning that whenever there is a vacancy the remaining board members choose a replacement director.

    5. Some or all of the directors can also be chosen by persons (including entities) specified in the articles or bylaws. (If there are voting members, only one-third of the directors may be chosen this way.)

    6. Public benefit corporations frequently do not have voting members. Mutual benefit corporations usually do have voting members. Still, strongly consider having non-voting members. Not only is this easier to administer, the nonprofit does not run the risk of having outsiders try to hijack the organization.

  5. Gaining Tax-Exempt Status

    1. To be tax-exempt, an organization must state a tax-exempt purpose in its articles of incorporation, which are primarily identified in Internal Revenue Code Section 501(c). It is crucial to state the tax-exempt purpose properly to obtain tax-exempt and charitable status.

    2. There are 30 categories of tax-exempt organizations. Some of the most popular are:

      1. 501(c)(3): organizations organized and operated exclusively for purposes that are charitable, religious, scientific, testing for public safety, literary, educational, fostering amateur sports competition, or preventing cruelty to children or animals.

        1. These are the charitable nonprofits, meaning that donations to them can be deducted from the donors’ tax returns as charitable donations.

        2. Generally, if the organization wants to be charitable, it must have one or more of these purposes (and only these purposes) in its articles of incorporation.

        3. The downside of being charitable are that you have to provide much more information in the application (for example, projected budgets) and the entity has more restrictions placed upon it.

      2. 501(c)(4): Social welfare organizations, including those that lobby substantially.

      3. 501(c)(6): business leagues, chambers of commerce, real estate boards, trade associations, and professional football leagues.

      4. 527: political organizations.

    3. For a 501(c)(3) to become tax-exempt (and to be designated charitable), the organization must file applications with the IRS (Form 1024) and the State (FTB 3500). Tax-exempt status is NOT automatic for 501(c)(3) entities.

      1. It takes an average of 120 days to process the application. Roughly one-quarter to one-third of the applications are processed in 6 to 10 weeks.

    4. For other nonprofits, assuming the articles state an appropriate purpose, an application to the IRS is not technically required – but it is strongly advised. (A State application is still required.)

    5. Before the IRS approves the application, a 501(c)(3) can solicit donations, but it must tell the donor in advance that deductibility as a charitable donation is contingent on the IRS approving charitable status.

  6. Gaining Charitable Status

    1. There are two types of charitable entities: public charities and private foundations.

    2. Ordinarily a charitable entity is assigned to one of these two classes when it applies for tax-exempt status.

    3. The typical private foundation is a family or company foundation that receives most of its money from an endowment or the family or company – and which therefore cannot meet the "public support" test for public charities.

    4. Because private foundations are subject to extensive regulation and public charities are not, and because donors to public charities have more generous tax deductions, the last thing most charities want is to be classified as a private foundation rather than a public charity.

    5. Certain charitable entities automatically qualify for public charity status:

      1. churches/synagogues/mosques;

      2. schools with a regular faculty and curriculum and a regularly enrolled student body;

      3. hospitals and medical research organizations.

    6. Other charitable organizations have to meet one of the "public support" tests: the 509(a)(1) test, the 509(a)(2) test or the "facts and circumstances" test.

      1. 509(a)(1) test (small donors)

        1. One-third or more of the entity’s total support must come from government grants, other 509(a)(1) charities, membership fees or – to the extent the money from any one person does not exceed 2% of the total support – other gifts, grants and contributions.

          1. Exempt-function activities are not counted in total support.

          2. Unusual grants may be excluded from the calculation. To qualify as an unusual grant, the contribution must come from a disinterested party who is attracted by the publicly supported nature of the non-profit, and the contribution must be unusual (meaning the non-profit does not regularly rely on the grant) or unexpected.

      2. 509(a)(2) test (exempt-function income but not disqualified contributors)

        1. One-third or more of the entity’s total support must come from government grants, 509(a)(1) charities, 509(a)(2) charities, membership fees, other gifts, grants or contributions or – to the extent that the money from any one person does not exceed the greater of $5,000 or 1% of the total support – fees for services or products from the performance of its exempt functions.

          1. Exempt-function activities ARE counted in total support.

          2. Money from "disqualified persons" does not count toward the one-third. This includes:

            1. the board of directors;

            2. officers;

            3. founders;

            4. a person whose compensation is based on revenues derived from organization activities that the person controls;

            5. a person who has or shares authority to determine the a substantial part of the budget;

            6. a person who manages an activity of the organization that represents a substantial portion of the organization’s income.

            7. a person who owns a controlling interest in an entity that is a disqualified person.

      3. "Facts and Circumstances" test

        1. Basic requirements

          1. At least 10% of the organization's total support meets the 509(a)(1) tests for public support; this means that contributions from contributors other than government entities and charitable organizations are counted only up to the 2 percent limit.

          2. The organization maintains a continuous and bona fide program of solicitation from public sources; and

          3. The organization demonstrates other factors as evidence of public support, which are discussed below.

        2. Factors

          1. The percentage of public support. The greater the percentage of public support is above the 10% limit, the less the following factors are important.

          2. The source of most of the support. There must be support from sources other than a single family. Support from government agencies or from people or entities that have no financial interests at stake in supporting the organization is a plus.

          3. The composition of the board of directors. It is better if the board of directors represents broad public interests rather than special interests.

          4. Whether public services are provided. If the organization provides services directly for the benefit of the general public, the non-profit is more likely to pass the test.

        3. Because this is a somewhat subjective test – meaning it gives the IRS a lot of leeway in deciding whether an entity meets it or not – it should be used only if one of the other two tests cannot be met.

      4. Note that unrelated income always counts against the organization.

    7. Even if an entity receives public-charity status, it may lose that status if it does not meet the required donation formulas.

  7. Donations.

    1. With a few rare exceptions, only donations to 501(c)(3) organizations are deductible on tax returns as charitable deductions.

    2. Payments to other nonprofits may be deductible in other ways, for example as a business expense. (Check with your CPA though.)

    3. California and many other states require that a potential donor be given a disclosure statement before the donor makes a contribution for charitable purposes.

      1. California basically requires the following:

        1. The name and address of the organization;

        2. The percentage of the gift or purchase price that will be used for charitable purposes OR the estimated total cost that will be used for direct fundraising expenses OR, if no sales solicitation is being made, a statement that audited financials of the organization’s expenses can be obtained by contacting the organization.

        3. Whether the organization is tax exempt under both federal and state law.

        4. The amount of the gift or purchase that can be deducted as a charitable contribution.

    4. When soliciting in another state, that state’s disclosure requirements (if any) must be met.

    5. When soliciting on a web site, all states’ disclosure requirements must be met (assuming the organization is accepting money from all states).

    6. The federal government requires that a donor making a charitable contribution must be given a receipt containing certain information before the earlier of when the donor’s income tax return is due or when the donor files the income tax return. Basically this requires the following information:

      1. The name of the donor and the date of the contribution.

      2. The amount of cash and a description (but not the value) of any property the donor has contributed.

      3. A statement of whether the organization has or will provide any goods or services in return for the contribution.

      4. A description and a good faith estimate of the value of any goods or services provided or to be provided by the organization.

  8. Lobbying

    1. Charities are absolutely prohibited from participating in any elections.

    2. A charity also may lose its tax-exempt status if a "substantial" part of its activities consists of lobbying.

    3. "Lobbying" is influencing legislation. Charities are free, though, to persuade administrative agencies and, of course, corporations.

    4. Because no one knows what "substantial" means – one court suggested that any lobbying is substantial – charities must avoid it.

    5. However, if certain charities make an IRC 501(h) election by filing IRS Form 5768, then they can spend the following amounts on lobbying:

      1. 20% of their first $500,000 in exempt-purpose expenditures;

      2. 15% of their next $500,000;

      3. 10% of their next $500,00;

      4. 5% of all exempt-purpose expenditures over $1.5 million up to a maximum limit of $1 million.

    6. Basically, the charities allowed to do this are:

      1. the 501(c)(4) organizations (civil leagues and social welfare organizations);

      2. the 501(c)(5) organizations (labor, agricultural and horticultural organizations); and

      3. the 501(c)(6) organizations (business leagues, chambers of commerce, real-estate boards, etc.).

  9. Unrelated Business Income

    1. A tax-exempt organization must pay income tax on net income realized from a regularly conducted trade or business that is not substantially related to the purpose or functions that qualify the organization for tax exemption.

      1. A fund-raising purpose by itself does not count as substantially related.

      2. Annual events are not considered to be regular.

      3. An activity is not considered a trade or business if unpaid volunteers perform substantially all the work without compensation.

      4. Selling donated merchandise is not considered a trade or business.

      5. Certain activities relating to trade shows are not considered a trade or business.

      6. Bingo games are not considered a trade or business.

    2. Often the purpose stated in the articles of incorporation is key in determining whether an activity is substantially related (although the purpose cannot exceed the limits set by the statute granting the tax exemption).

    3. If the unrelated income is too substantial, the organization will lose its tax-exempt status.