It’s an old joke among farmers: “I should really form a nonprofit organization because I certainly don’t make any profit!” Although that might be true, the decision to form a nonprofit organization is a bit more complex than assessing whether the business generates a profit. This chapter will explore in detail what nonprofits are, how they are formed and the structures behind them.
|General Concept||Nonprofit Specific Terminology|
|Name||“Farm Organization, Inc.” for incorporated nonprofits|
|Owners/investors are called||None! A nonprofit has no owners|
|Persons who make management decisions are called||The “Board of Directors” is responsible for management of the nonprofit|
|Creation document is called||“Articles of Incorporation”|
|Organizing document is called||“Bylaws”|
|An owner’s investment is called||None–no owners|
|An ownership share is called||None–no owners|
|State and IRS interaction||A nonprofit is first formed at the state level as an incorporated nonstock/nonprofit entity. To earn tax-exempt status, the nonprofit must then apply to the IRS for recognition under the 501(c) code. If the organization also wishes to accept tax- deductible donations, it must be recognized as a 501(c)(3), specifically. Generally, the state will also recognize tax-exempt status after the IRS does.|
|How many participants can you have?||State law requires two to three people. IRS rules require a minimum of three people to serve on the board of directors|
|Is there personal liability?||No, if the nonprofit is incorporated. Yes, if the nonprofit is unincorporated.|
|Are annual meetings required?||Yes, most state nonprofit statutes require that the organization hold at least an annual meeting|
|Who files the tax return?||All nonprofits must file an annual tax return with the IRS or risk revocation of their status. The informational returns are known as the 990 series and the specific form depends on the organization’s size.|
State and IRS Classifications
Like all of the other business entities addressed in this Guide, the steps in forming a nonprofit organization are managed at both the state and the IRS level. The IRS classification of an entity as a tax-exempt charity that is eligible to receive tax-deductible donations is what most people mean when they use the phrase nonprofit organization. While this step is important, it is different than forming the entity itself. Forming the entity occurs at the state level and is the first subject we will explore. At the state level, an organization can utilize either the unincorporated or incorporated option.
Forming a Nonprofit at the State Level
Key characteristic of the nonprofit: no individual ownership
All 50 states have statutes that define how a nonprofit corporation is formed. Some states use the phrase “nonstock corporation” rather than nonprofit corporation. This phrase is perhaps the more accurate one as it illustrates the real distinction between a nonprofit and a for-profit entity at the state level. It’s not about profit, as a nonprofit can generate a profit. But, what a nonprofit cannot do is create stock. A nonprofit organization cannot be owned by anyone. It cannot be sold and its assets cannot be used for the benefit of one or a group of private individuals.
Many farmers would like a business that they can eventually sell to a new farmer or transition to the next generation. The business may also be the farmer’s retirement fund. After a lifetime of building a brand, a market and equity in the business, farmers often need to cash in on some of that equity for retirement. A farmer who chooses to form a nonprofit entity may work as an employee and then receive a retirement package at the end of their career. But, the farmer gives up a significant amount of control as the nonprofit’s board of directors sets compensation and retirement packages or otherwise maintains control over the farmer’s compensation. A nonprofit organization must be controlled by a board of directors that is charged with upholding certain legal duties to the public as a whole. As part of those legal duties, boards may be limited in how they compensate farmers or finance a retirement.
Incorporated nonprofit organization
The majority of nonprofit organizations choose to form an incorporated entity. Two main factors drive this decision. First, many organization participants want their personal assets to be insulated from the organization’s liabilities. As an example, a group of neighbors may gather every Saturday to tend an orchard in their neighborhood. The group may organize events such as apple tastings or classes in pruning and planting apple trees. Say one of the group members gives a child a pruning lesson and the child cuts himself in the process. The child’s parents could sue group members in their personal capacity because the orchard organization may not legally exist as an entity to be sued. Suing the individuals who participate within it may be the only option the child’s parents, or their insurance company, have to recover for damages incurred.
Second, the majority of nonprofit organizations intend to seek IRS tax-exempt status as a nonprofit. Although an unincorporated entity may still apply for nonprofit status with the IRS, the organization will need to draft many of the same documents required to form a nonprofit corporation. At that point, it seems logical to file the paperwork at the state level so participants may receive personal liability protection as well.
Incorporated nonprofit: The formation process
Forming a nonstock or nonprofit corporation is generally quite simple. The organization will prepare and file articles of incorporation, along with bylaws that outline the entity’s operating rules and board of directors, for example. Broadly speaking, a nonprofit organization is governed by a board of directors. The board is elected or appointed according to the organization’s bylaws. The board must then elect or appoint officers from among its members. State law may dictate specific procedures for election or appointment of officers as well as the number and type of officers or directors. Bylaws may need to be filed with the state to demonstrate that the organization is complying with state rules. In addition, nonprofit corporations may choose to be membership organizations or not. Membership organizations often have additional rules in state laws for how members may participate in the organization governance. Of course, the state-level formation process is usually accompanied by a fee or two. On the plus side, the fees for forming a nonstock or nonprofit corporation are generally low compared to a for- profit entity.
Is membership right for your organization?
Choosing to become a membership organization is a serious decision. If the organization elects to be classified as a nonprofit corporation with members, members have specific legal rights to elect the board of directors and make other decisions for the organization. The members can exert a lot of power over the board. This can certainly be a good thing for cultivating shared responsibility for the organization’s mission. Yet, if the organization isn’t prepared to explore and satisfy the laws for membership, it may be easier to create shared responsibility in other ways. A non-member organization can still have supporters, sponsors and volunteers who have significant responsibility for the organization.
Incorporation grants personal asset protection for participants
The directors, officers and members of the board of directors of a nonstock or nonprofit corporation receive personal liability protection from organizational responsibilities, provided the organization has followed its legal obligations. Of course, officers and directors can still be sued by individuals asserting that legal obligations were not followed and thus personal protection doesn’t attach to directors and officers. Many nonstock or nonprofit corporations will carry what is called directors and officers insurance so they can afford to defend themselves and their directors or officers from any claims or lawsuits that may be filed.
Unincorporated nonprofit association
Individuals familiar with the sole proprietorship and a general partnership understand that sometimes a person doesn’t have to actually file any paperwork to form a business entity. Simply acting in a certain manner is enough to qualify as a business. This is possible when forming a nonprofit organization as well. When a group of people get together to undertake an activity for mutual or public benefit that is not meant to generate a profit, they may be forming an unincorporated nonprofit organization (UNA). UNAs are very diverse and may focus on educational, scientific, sports, community, health or other interests. A UNA may be comprised of as few as two people, although some states require three people to participate before the group will be deemed a UNA.
A group of individuals might form a farm-related UNA for many purposes. Let’s return to our community orchard example. The group may charge for apple tastings or classes and use the revenue to purchase additional apple trees. The group is acting together to achieve a common mutual purpose and isn’t intending to engage in business or make a profit. Given this, they may have formed a UNA.
Forming a UNA is simple. The group doesn’t have to do anything except act together for a common mutual or public purpose. Organization and governance is quite simple–state laws requiring UNAs to take specific actions are uncommon. That isn’t to say no laws apply to UNAs. To the contrary, organizations that solicit for donations must register with the state, and organizations that take in money are responsible for tax filings, which would apply to UNAs as much as to any organization.
The UNA: Simplicity has trade-offs
Unincorporated nonprofit associations carry the same trade-offs as general partnerships. Members find it easy to form an unincorporated association as there is no need to file paperwork or have a board of directors. On the other hand, the personal assets of the people participating in the UNA may be accessed to satisfy liabilities that the organization as a whole might incur. Because the UNA does not need to draft any bylaws or assign responsibility to specific individuals as incorporated nonprofits must, it can be difficult to efficiently manage the organization’s obligations. For example, responsibility to comply with the laws described above regarding donations and taxes might fall through the cracks in an overly simplified UNA.
Obtaining Nonprofit Tax Status with the IRS
Preparing the tax-exempt application
Forming a nonstock or a nonprofit corporation at the state level is quite easy and is the first step in forming a nonprofit organization. But, it is generally not the last step. As explained earlier, most people who form a nonstock or nonprofit corporation actually have an additional goal in mind. They would like the organization’s income to be tax exempt and would like the opportunity to receive tax-deductible donations. This is a separate matter and generally handled first at the federal IRS level.
A nonprofit entity that wants to be recognized as federally tax exempt or to receive federal tax-deductible donations must apply for these classifications with the IRS. Technically, these are two different procedures. Organizations that fall under the 501(c) section of the tax code are considered tax exempt. This means that if the organization brings in revenue and generates a profit above and beyond its expenses, those monies are not taxed. The ability to accept tax-deductible donations is reserved for organizations that qualify under the 501(c)(3) section of the tax code. These organizations are considered charities. The tax code has several other classifications (such as 501(c)(5) for farm advocacy organizations), which are tax exempt but may not accept tax-deductible donations. Many farms and farm- related entities want both tax-exempt status and the ability to accept tax-deductible donations, so this resource focuses on the obligations of 501(c)(3) organizations.
To form a 501(c)(3), the entity completes and submits IRS Form 1023, “Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code” or its shorter version, IRS Form 1023-EZ. The application is designed to illustrate to the IRS whether the organization meets the obligations contained within the federal tax code for a 501(c)(3) organization. For example, the application contains questions meant to show whether the entity is formed as a nonstock or nonprofit corporation at the state level (or that it has equivalent paperwork in place); the organization is formed for specific purposes; the bylaws contain specific clauses such as those relating to conflicts of interest; and other details. Of course, the IRS isn’t merely curious–it’s checking to see if the entity passes the test. Before dedicating the effort to completing a potentially lengthy IRS Form 1023, an organization should verify that it will pass a few additional tests to become a 501(c)(3) organization. The rest of this chapter explores those tests.
What is your nonprofit’s purpose?
A nonprofit organization must be exclusively dedicated to one or more qualifying purposes before it will receive 501(c)(3) status. These purposes include religious, charitable, scientific, public safety testing, literary, educational, national or amateur sports competition, or the prevention of cruelty to children or animals.
Farms seeking 501(c)(3) status organizations are most likely to qualify for either an educational or a charitable purpose. Beginning with educational purposes, farms operated as part of a school program may find easy opportunity here. Fortunately for everyone else, an educational purpose doesn’t require a formal school environment. Organizations can satisfy an educational purpose when they are dedicated to producing educational materials and doing broader outreach on educational subjects. For example, one tax-exempt farm uses ecological techniques to repair land depleted from years of monoculture farming. Because the farm is exclusively dedicated to demonstrating techniques and advancing awareness of the scientific principles behind the farm, the IRS found that it satisfied an educational purpose. The IRS also pointed out that this farm is open to the public, publishes articles widely on its results and does not make a substantial profit.
Some farms may earn 501(c)(3) status under a charitable purpose. The IRS’ definition of a charitable purpose is broad. To summarize the elements most potentially relevant to farming, charity includes combating poverty, alleviating discrimination and stimulating economic development in economically depressed communities. Farms dedicated to providing job training and skills development in regions that suffer from a lack of opportunity might qualify as charitable. There also may be opportunity to use farming to alleviate discrimination or to ease neighborhood relations.
Is your farm exclusively dedicated to a qualifying purpose?
A tax-exempt farm must be organized exclusively for an exempt purpose. The exclusivity of the qualifying purpose is an important note. If teaching and outreach are a side benefit of raising or selling crops and livestock, the educational purpose isn’t exclusive. A tax-exempt farm can make a profit, as long as the profit generation is in accordance with the purpose. For example, the farm above was allowed to make a profit so long as the generation of profit was for the purpose of educating the public that ecologically sound farming techniques can be profitable.
Some farmers might be disappointed to learn that adopting or promoting sustainable and environmentally friendly practices is not itself charitable or educational. Sustainable farms do improve the environment and offer many benefits to communities. When the food produced by these farms is marketed and consumed within communities, there is a potential to improve community health. People can learn more about their environment, neighbors and food production by buying from sustainable local farms. But, even if the farm loses money by adopting sustainable, environmentally friendly practices and selling locally, that doesn’t mean it qualifies for 501(c)(3) status. The IRS code and the cases that interpret it have set out very specific definitions for “charitable” and “educational” purposes, so farmers must be careful to see if they meet these definitions.
Two more tests to go!
If the farm is organized for a qualifying purpose, the organization should then ask if it passes the commerciality test and the public support test. These will also be required to qualify as a 501(c)(3) organization.
Pop quiz! 501(c)(3) organizations must answer “yes” to the following questions to receive the tax classification:
- Is the organization formed exclusively for a qualifying purpose as follows: religious, charitable, scientific, public safety testing, literary, educational, national or amateur sports competition, or the prevention of cruelty to children or animals?
- Is the organization not overly commercial in nature in that it does not unduly compete with for-profit businesses?
- Is the organization publically supported as demonstrated by its sources of revenue?
The commerciality test protects for-profit enterprises
Before getting into details on the commerciality test let’s talk about a scenario that’s playing out in communities across the United States. Nonprofit organizations are successfully establishing farms that meet charitable, poverty alleviation or educational purposes. For example, young people are learning how to grow food and build a sustainable business enterprises in their communities. Displaced workers are receiving job training skills by learning how to farm and how to sell those products at farmers’ markets. Church groups, schools and neighborhood organizations are all creating vibrant solutions to real needs within their communities through farming experience and knowledge.
As positive as they are, these programs don’t always work to everyone’s benefit. A farm organized as a 501(c)(3) may have a competitive advantage in the marketplace because it can accept tax-deductible donations and because it does not have to pay taxes on the profit it generates. This may influence the farm to sell its products at a lower cost compared to a for-profit business, expand sooner or capture market share earlier in the season. Understandably, this can create tension in communities where for-profit farms feel they are being undermined by well- meaning organizations.
No 501(c)(3) status for overly commercial organizations
The IRS has anticipated this scenario and the commerciality test is meant to prevent the benefits offered to tax-exempt organizations from becoming a threat to regular businesses. Under the commerciality test, an organization will not qualify for 501(c)(3) status if its operations are overly commercial in nature. This can happen when an organization directly competes with for-profit businesses. Assessing when an organization crosses the line into becoming “overly commercial” can be difficult. The IRS will apply several general factors to the specific situation. Generally speaking, a farm that does not advertise its products or does not make sales to the general public is less likely to be too commercial. Farms that have a low sales volume and depend primarily on charitable contributions for their revenue are likewise less likely to be too commercial. Of course, it can be difficult to satisfy these criteria if the farm exists to provide job or entrepreneurial training skills. Organizations in such a position may need to carefully scrutinize their programs and the IRS’ guidance material on this subject to avoid failing this test.
The public support test separates foundations from public entities
A 501(c)(3) organization must also pass the public support test. This test is designed to separate private foundations from public entities. Most organizations would like to be public entities since they enjoy fewer restrictions and greater tax benefits. Generally, this test focuses on identifying where the organization gets its money– if revenue is largely from the public as a whole, the organization meets the test. However, the details are a bit more complex.
Organizations can pass the public support test in two ways. Both tests are measured over a five-year period. First, if an organization receives a substantial part (more than one-third) of its total income from government grants, grants from other charities, donations from the public, membership fees and mission-related revenue, it passes part of the first test. However, if more than 2 percent of the organization’s total support comes from a single individual, that portion should be excluded from the one-third calculation. If an organization fails this test, it may try for the “facts and circumstances” test, which it has two ways to pass. First, the organization’s percentage of income from public sources may be as low as 10 percent if other circumstances such as the makeup of the board of directors, its programming and its accessibility to the public all demonstrate that it is a public entity. The second way to pass the facts and circumstances test is different: Two elements must be met. The organization must receive more than one-third of its support in contributions from the general public or from sales directly related to its tax-exempt purpose. Then, the organization must also receive no more than one- third of its support from investment income and sales from purposes unrelated to its tax-exempt purpose.
This is confusing, so let’s explore a few basic situations where the various public support tests will NOT be passed. Let’s say a farm generates all its revenue from the sale of tickets to a haunted Halloween barn tour. Another farm might have a single benefactor that donates 95 percent of the organization’s revenue each year. A third farm might receive the bulk of its income from leasing property or facilities to unrelated entities–perhaps it owns several duplexes that are leased on the regular rental market. These farms would likely fail the public support test because their income doesn’t come from a spectrum of the public at large. Instead, it comes from unrelated sales, a single benefactor and investment or real estate ventures. These tests can be difficult and complex, especially for organizations that don’t yet know where their support will come from. Farms going down this path should seek information from the IRS and from organizations that support nonprofit entities.
Tax exemption can be a relatively expensive and long process
The process to receive 501(c)(3) status can be expensive and long. The fee for the IRS Form 1023-EZ is $400 for qualifying entities. For those that must complete the IRS Form 1023, entities with anticipated annual gross revenue over $10,000 averaged across four years pay a fee of $850. The IRS Form 1023 fee for entities with lower gross receipts is $400. Application processing times can be as quick as six months, but if the IRS has additional questions, it can take a year or longer to get an answer. The process is complete when the IRS issues a determination letter to the entity, which is the organization’s proof of status. Earlier, this Guide suggested that organizations fully explore their qualifications for 501(c)(3) status before completing the application. Not only will this save time, it will save money.
Implementing Best Business Practices for Your Nonprofit
Like all other business entities, the nonprofit will have to uphold certain formalities and best practices to maintain the entity’s integrity. This includes keeping the nonprofit’s financial affairs separate from the those of the nonprofit’s directors and officers, such as maintaining separate bank accounts and accounting systems. The board of directors and officers must also abide by the bylaws, as these are the ground rules for how the entity is to operate. This includes complying with a strict conflict of interest policy to ensure that directors and officers do not have a critical say in a matter that would benefit or harm their personal financial situation. In addition, annual maintenance obligations deserve close attention. A nonprofit organization will need to complete annual paperwork at both the state and federal levels. The state may require annual fees to maintain the nonstock or nonprofit corporation, as well as annual fundraising registrations and tax filings, which also take time to prepare and often involve fees. At the IRS level, an organization must complete an annual tax return, even if no tax is owed. Depending on the organization’s size, the form may be the IRS Form 990-N, 990- EZ, or 990. Failure to file annual tax returns with the IRS can result in revocation of tax-exempt status. If this happens to an organization, it may need to resubmit IRS Form 1023 all over again to reapply.
Find more guidance on forming nonprofit organizations
The Internal Revenue Service website (www.IRS.gov/charities-non-profits) is the most authoritative source of information. Don’t forget to review it.
The National Council of Nonprofits (www.councilofnonprofits.org) has a brief guide that addresses legal and non-legal considerations. Also, they can direct you to your state council of nonprofits organization, which can be a valuable resource for state-specific formation and tax information.
How to Form a Nonprofit Corporation (Nolo Publishing): This reliable publisher of legal information has some great, easy-to-read resources on the legal aspects of forming a nonprofit. Check your local library for copies. The Nolo website has some state-specific information as well.