Non-Profit Formation & Law

The defining characteristic of a non-profit is that it is organized for the benefit of the public and cannot operate for profit. Additionally, they hold a certain tax-exempt status, which will be discussed further below.

Non-profits are formed under state law and can be organized as corporations, unincorporated associations, trusts, and under some circumstances as limited liability companies (LLCs). As with for-profit businesses, the choice of entity has corporate and tax law implications. In addition, certain types of entities offer protection from personal liability for directors, officers, and members of the non-profit. An attorney can provide guidance on which entity would be best for the non-profit as well as handle preparing and filing the documents required under state law.

Depending on the choice of entity, there are different legal documents which may be needed, including the non-profit charter, operating agreement, by-laws, and others. These agreements set forth the roles, rights, and obligations of those involved in the non-profit and the rules and procedures governing its operations. Experienced legal counsel is essential in drafting these documents so that they comply with the applicable laws, but also avoid future internal disputes and liability to third parties.

Generally, the state law where the non-profit is formed also governs some of its internal affairs.

Along with selecting an entity, non-profits must decide whether to have members. State or local law may require members. Absent that, the organization should determine if it wants to have all decision-making with the board or permit members to have that power. While the initial decision is made at the time the non-profit is formed, the structure can be changed to either add or delete members at a later time.

The non-profit’s by-laws should set forth the rules that apply to the members of the Board. These include elections, terms, powers, rights, responsibilities, liability, indemnification, removal, compensation, and other provisions.

In addition, requirements for board meetings must also be indicated, such as notice, conduct, procedures, quorum needed to transact business, and location.

Where the organization has members, the by-laws must state the classes and qualifications of membership, the rights, and duties of members, notice and conduct of meetings, dues, disciplinary actions, and other pertinent information.

Legal counsel can advise regarding best practices for non-profit governance as well as draft appropriate policies and procedures to protect the non-profit and minimize problems.

Section 501(c)(3) of the Internal Revenue Code provides tax-exempt status to organizations that are organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals. Once the non-profit is formed, the IRS Form 1023 (“Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code”) can be prepared and filed. This form must detail the organization’s funding, activities, management, and compensation.

In order to qualify as a 501(c)(3) eligible tax-exempt organization, any income that is generated must be used to pay for the reasonable operational expenses and activities of the non-profit. Paying employee salaries is permissible but the amount must be reasonable. Organizations are also subject to various restrictions on lobbying, political contributions, and campaigning, and expending time or money on activities unrelated to the organization’s purpose.

Under state and local laws, organizations may need to file an application for exemption from state sales tax, property tax, franchise tax, and other taxes. Further, non-profits may be required to register as a 501(c)(3) in order to solicit charitable contributions.

Non-profit laws are complex so the best way to avoid legal problems is to consult an attorney for assistance developing and implementing appropriate policies and procedures. However, organizations must also comply with their own rules. To minimize liability, non-profits must take these steps:

• Maintain good records. Corporate books, meeting minutes, and other financial and legal records should be kept, demonstrating compliance with the organization’s by-laws and applicable state and federal laws. These records can also help directors, officers, and members avoid personal liability.
• Hold board meetings. Meetings should be conducted at least annually, but more often is recommended.
• Comply with the by-laws. The by-laws establish specific formalities in how the board operates, how decisions are made and other governance matters. Non-profits should follow these procedures to avoid potential lawsuits.
• Avoid conflicts of interest. Non-profits should have a conflict-of-interest policy drafted by an attorney and signed by all board members.
• File informational tax returns. In order to preserve tax-exempt status, the non-profit must timely file a 990 informational return with the IRS.
• Regular legal review. It is a good practice to have legal counsel regularly review the non-profit’s compliance with its own procedures as well as any applicable laws.

Non-profits are subject to a wide array of federal, state, and local laws. Experienced legal guidance can help ensure the organization.