FREQUENTLY ASKED QUESTIONS: How do I start a nonprofit?

The rules governing nonprofit organizations are created by the federal Internal Revenue Service (IRS), the various States, and local Municipalities. They are complicated and they are volatile in that they can change, frequently as a result of economic, political, and social pressures.

Before you start

There are five steps to follow in establishing a nonprofit organization in Arizona and there are several very good resources that will help you. But before you take any of these steps you must ask yourself two questions:

"Why do I want to start a nonprofit organization rather than a for-profit organization?"

Functions	Nonprofit	For-profit
Purpose	Social Good	Profit-making
Form of organization	Incorporation or informal	Incorporation, sole proprietorship, partnership
Governance	Board of Directors	Board of Directors, owners
Taxes	Federal Exemption for income to the nonprofit; State & local exemptions vary	Taxable
Profits	Non-distributable	Distributed to owners
Staffing	Paid & non-paid (volunteer)	Paid

"Are there other organizations in the community that do what it is I propose to do?" If so: Is what I propose different than what any of them already do? Can I become a program of one of them rather than start a new business?

In the United States there are approximately 1,600,000 nonprofit organizations of which about 800,000 are charities. In Arizona, there are more than 29,000 registered nonprofits of which about 19,000 are currently operating. It is reported that approximately 1500 new nonprofits are started in Arizona each year. Thus there are many others working to make our community a better place for all who live here.

Each of these nonprofit organizations serves a perceived need. In some cases, they are the sole providers of a service; in others, they are among several. It is important to determine whether your proposed program fills a specific niche or whether it may be a duplication. If it is the latter, the chances of developing financial support and clientele may be limited.

It is entirely feasible that your proposed program can be part of an existing nonprofit organization. Such might fill your desire to provide a needed service and it might expand the reach of the existing nonprofit in fulfilling its mission. Your market research should inform you of those potential organizations. Should such a partnership be successful, it is entirely possible that sometime in the future it might serve the purposes of all involved to spin off your program into a separate nonprofit organization. It is worth a serious conversation with those nonprofits to determine what is your best course of action.

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What is a nonprofit organization?

Before you go further, you are encouraged to download from the IRS site both Publication 557 and the Instructions and form for Form 1023.¹ Please read these. The information in them is extremely valuable and will help you make more informed decisions.

Nonprofit organizations represent individual or collective action to address a problem or enhance society in ways other than that provided through governments (federal, state, local) or for individual profit (corporate stockholders, partners, sole proprietors).

Bruce Hopkins, in his book, "Starting and Managing a Nonprofit Organization: A Legal Guide" quotes the 1973 congressional testimony of then Secretary of the Treasury, George P. Shultz, who said that charitable organizations "are an important influence for diversity and a bulwark against overreliance on big government."²

Thus nonprofits are voluntary organizations with a primary purpose of serving the public good. They are exempt from federal taxes and many state and local taxes. This tax-exempt status is supported by a U.S. Supreme Court decision in which the following appears: "The State has an affirmative policy that considers these groups as beneficial and stabilizing influences in community life and finds this classification [tax exemption] useful, desirable, and in the public interest."³

Additional rationale for tax benefits is found in a federal court of appeals decision: "[O]ne stated reason for a deduction or exemption of this kind is that the favored entity performs a public service and benefits the public or relieves it of a burden which otherwise belongs to it."⁴

Some types of nonprofit organizations must evidence that they are publicly supported by proving they "regularly solicit funds from the general community." Public support may include government funds. The IRS has developed various tests to help determine if one meets these requirements. These are known as the "public support tests."⁵

Tax-exempt classifications are determined by the federal IRS. There are 32 different classifications of nonprofit organizations that receive exemptions from various taxes. Only 9 of these classifications may offer those who support it with grants and/or donations the right to declare their contributions as tax deductible. Charities with a 501 (c)(3) IRS classification comprise the bulk of those that can offer tax deductibility.⁶

Nonprofit organizations are not "owned" by anyone. The responsibility for legal and financial matters rests with its board of directors which is responsible for overall governance and stewardship. In some cases, the organization’s membership may "control" it by virtue of its power of vote for those who serve on the board of directors.

Members of nonprofit boards of directors serve without compensation except that they may be reimbursed for expenses incurred as part of their voluntary service. Boards of directors are responsible for assuring that the organization adheres to the principles of "no private inurement", and the avoidance of "private gain" and "conflicts of interest."

These important principles are explained in the resources listed in this FAQ.

Nonprofit organizations may make a profit – as long as that excess of income over expenses is returned to the organization in pursuit of its mission. The expenses may include compensation paid to employees – as long as it is in accordance with community standards for the same work, thus avoiding issues of "private inurement" and "private gain."

Nonprofit organizations must file annual federal tax information reports, called Form 990. The exceptions to this are churches and nonprofits that do not generate $25,000 or more income. It should be noted that Forms 990 that have been filed with the IRS are made available to anyone over the Internet and a copy of such must be provided anyone who asks.⁷ Additionally, Arizona – and most states – requires annual registration as a charity along with a financial statement.

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There are certain precepts that a nonprofit organization must maintain in order to assure its tax-exempt status and the ability to offer tax deductibility to its donors. A nonprofit organization may not distribute profit to individuals in their private capacity. Charities must be organized and operated so that “no part of…[its] net earnings…inures to the benefit of any private shareholder of individual."⁸ They may not solicit or receive contributions directly for specifically named individuals. They may not offer opportunities for private gain to any of its directors, trustees, officers, or key employees. As an organization governed by a board of directors, no one person may hold control. Nonprofits are held to the highest standards of public trust; they may not keep secret their standard annual tax information reports (IRS Form 990). Compliance with IRS Intermediate Sanctions is an imperative; IRS sanctions may be applied in the event of non-compliance.⁹

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Thoroughly researched business plan with market analysis. See www.boardsource.org for information on governance and strategic planning. A basic plan will consist of, minimally, the following components:

• Mission of potential organization
• Description of service or product
• Need or marketability of service or product
• Analysis of marketplace including full descriptions of real or potential competition
• Cost projections over 5 year period
• Income projections over 5 year period
• Expertise needed to perform service or product projections
• Board of directors
• Biographies of you, the board of directors, and other key people. Be sure to note expertise in service, program, management, and governance.

Financial support in the forms of grants and donations can be very difficult to obtain in the first few years. In addition to keen competition from well-established nonprofits, new organizations must prove their market niche, expertise, and stewardship of resources before many funders and donors will help support them. Therefore, a thoroughly researched business plan is essential.

State Incorporation (fee is charged)¹⁰

Register with the Arizona Corporation Commission. This incorporates your organization as a nonprofit. You do not need to incorporate but there are multiple reasons to do so including protection from personal liability.¹¹ You may access the information and the forms you need via Internet: http://www.cc.state.az.us A similar process will be required in any other state; information is available via each state’s website or Mancuso’s "How to Form a Nonprofit Corporation in all 50 States."

Note: In Arizona while you are preparing to start a nonprofit, you may – in advance – reserve the name you have created for your organization. The Secretary of State and the Corporation Commission offices have registration of trade name forms.

Obtain EIN

The Employer Identification Number (EIN) is the equivalent of your corporation’s federal ID number, similar to your own social security number. The form for obtaining this number is SS-4, available over the Internet at www.irs.gov. The fastest way to obtain the number is to call the number on the form and follow the instructions.¹² You will need this number for banking and for the next step.

File IRS Form 1023

This is the final step in obtaining your tax-exempt status; it can take up to 6 months depending upon the IRS office through which you must file. This form requires considerable attention. Each time the form is returned to you for further information or clarifications, the time for receiving your exemption is extended thus it is advisable to ask legal counsel versed in nonprofit law to review the form after you complete it but before you send it in.

BEFORE you complete this form, you are urged to review any of the following references and/or to read carefully Publication 557 and the Instructions for completing Form 1023 available over the Internet from the IRS site www.irs.gov. Look for information on Tax-Exempt Organizations. Your business plan will provide you valuable information for completing the form; part of the requirements are your income projections over the next 4 years. (Remember to familiarize yourself with the Public Support requirements.) Upon acceptance you will receive a Letter of Determination. Be sure to permanently file the original; copies will be requested by various agencies and funders.

Register with State (fees may be charged):

Before charities may solicit contributions they must file with the Arizona Secretary of State -- and annually in September thereafter. Your latest Form 990 must be attached. Most states require a similar process.¹³ Instructions and forms are available over the Internet www.azleg.state.az.us/ars/44/06552.htm There are additional requirements if you hire contract solicitors.

The Arizona Corporation Commission requires the filing of an annual report each year. The forms will be sent to you. Your latest Form 990 must be attached. Go to www.cc.state.az.us for information over the Internet.

Registration with the Arizona Department of Revenue is required to obtain tax exemption. Contact the Department to determine if you are exempt from sales tax. www.revenue.state.az.us

If you will be employing persons, register with the state unemployment insurance bureau. Information and forms are available at www.de.state.az.us/esa/uitax/emp.asp

Note: You will need to complete numerous forms for various regulatory agencies. It is your responsibility to research and know these. Some of these are referenced below:

1. You may also wish to apply for a nonprofit mailing permit from the US Postal Service. See www.nonprofitmailers.org/news.html for additional information.
2. Obtain directors and officers liability insurance. Go to www.nonprofitrisk.org for information about risk management and insurance.
3. Understand if you need special licenses or permits for your specific area of service. Professionals and accrediting agencies will be helpful.
4. Contact your county assessor to determine if you might qualify for property tax exemption. Most nonprofits do not qualify.
5. Seek assistance in establishing accounting processes and procedures. Understand the rules for filing the IRS Form 990 which is a public document.

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Five topics to know for your success

Each of the following topics is essential to your success. Information about them is available at the various resources listed below. In addition, the Center on Nonprofit Leadership & Management at ASU offers 10 – 15 hour courses through its Professional Development program. Please see the schedule posted on this site.

• Governance: what are legal responsibilities of boards of directors; how do they operate
• Financial Management: what are the basic accounting and audit requirements; how to develop and read nonprofit financial statements
• Program Knowledge: how to evaluate programming and evaluate for effectiveness.
• Resource Development: how to develop donor relationships that lead to effective fund raising; foundation and corporate fund raising.
• Nonprofit Law and Ethics: what specific laws to know and how to understand and make decisions that are ethical and sound.

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Notes

1. http://www.irs.gov.

2. Hopkins, Bruce, Starting and Managing a Nonprofit Organization: A Legal Guide, 3rd ed., Wiley Nonprofit Series, John Wiley & Sons. 2000. Chapter 2.

3. Hopkins, Bruce, Starting and Managing a Nonprofit Organization: A Legal Guide, 3rd ed., Wiley Nonprofit Series, John Wiley & Sons. 2000. Chapter 1.

4. Hopkins, Bruce, Starting and Managing a Nonprofit Organization: A Legal Guide, 3rd ed., Wiley Nonprofit Series, John Wiley & Sons. 2000. Chapter 1.

5. Mancuso, Anthony, How to Form a Nonprofit Corporation in All 50 States, 4th ed., NOLO Press. 2002. Chapter 4.

6. IRS, Publication 557.

7. http://www.guidestar.org.

8. Hopkins, Bruce, Starting and Managing a Nonprofit Organization: A Legal Guide, 3rd ed., Wiley Nonprofit Series, John Wiley & Sons. 2000. Chapter 5.

9. Miller, Steven T., “Easier Compliance is Goal of New Intermediate Sanction Regulations, IRS.

10. Some of the resources below are specific to Arizona. Visit your state website, usually www.state.xx.us (xx=postal abbreviation for your state), and search for similar departments and/or tax-exempt and/or nonprofit.

11. Hopkins, Bruce, Starting and Managing a Nonprofit Organization: A Legal Guide, 3rd ed., Wiley Nonprofit Series, John Wiley & Sons. 2000. Chapter 2; Mancuso, Anthony, How to Form a Nonprofit Corporation in All 50 States, 4th ed., NOLO Press. 2002. Chapter 2.

12. Mancuso, Anthony, How to Form a Nonprofit Corporation in All 50 States, 4th ed., NOLO Press. 2002. Chapter 8.

13. www.azleg.state.az.us/ars/44/06552.htm.

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