Starting a nonprofit organization can be both personally fulfilling and professionally challenging. While many nonprofit founders are motivated to do good in the world, forming and operating a successful nonprofit also requires business acumen and attention to complex state and federal laws. To ensure that your nonprofit starts with the proper legal foundation, it is important to take the right steps at the outset. Below are some essential legal issues to consider when forming a nonprofit.
A nonprofit can function as either an incorporated or an unincorporated organization. Incorporating may require additional filings, but both can qualify for tax-exempt status. To form an incorporated nonprofit, it is necessary to file incorporation paperwork with your state’s Secretary of State and pay a fee. There are legal protections to operating the nonprofit as a corporation, so most nonprofits choose to operate as a corporation. It is important to consult an attorney to prepare your incorporation documents, especially if you intend to qualify for 501(c)(3) status, as there are certain provisions the IRS requires to be included in the incorporation documents.
A nonprofit must create By-laws, which will govern how the organization operates. State requirements vary, but most By-laws provide for how the nonprofit can elect directors and officers, how many directors it should have, the length of a director’s term, quorum requirements, and how to hold meetings. Changing By-laws later will usually require approval by two-thirds of the directors.
Board of Directors
In a nonprofit, the board of directors is comprised of uncompensated volunteers who guide the mission, develop a strategy, set policies, oversee finances, and even fundraise. To the extent that the nonprofit wants to qualify as a 501(c)(3) public charity, having a majority of disinterested directors will be important to establishing tax exempt status.
Establishing a strong board of directors is critical to the success of every nonprofit organization. The best directors combine a passion for the mission with an ability to think strategically and provide proper oversight. Board composition will influence and direct the dynamics of the organization, so a team that brings a diversity of skills, perspectives and experiences is highly beneficial. With the right board members, a nonprofit can be successful in both good times and bad.
An executive director’s role is to oversee the nonprofit’s functions, including fundraising, program development, HR management and finances, and provide strategic guidance to board members on setting annual fundraising goals and standards for community outreach, grant-making, and more. However, a truly impactful executive director is dynamic, engaging and creative. He or she must embody the enthusiasm, passion, diversity and experience that is the model for all board members to follow. Particularly in a newly formed nonprofit, it will be up to the executive director to serve as the face and voice of the organization, and motivate board members to work as a team to advance the nonprofit’s mission. Part manager, part cheerleader, and part visionary, the executive director must be a strong leader who doesn’t mind getting his/her hands dirty in the day-to-day work.
Application for 501(c)(3) Tax Exempt Status
Most nonprofits that solicit funds will seek to qualify as 501(c)(3) tax exempt organizations with the IRS. To qualify, the nonprofit must fall into one of several IRS categories, including religious, charitable, scientific, educational or literary purposes. You should be sure to consult with an experienced attorney or accountant to assist in preparing the IRS forms. This is your opportunity to tell your story of why you should be granted tax exempt status with the IRS, and it is important to do it right to avoid delays or rejection with the IRS. An attorney can also help you best apposition the nonprofit to qualify for 501(c)(3) status.
Compliance with State Regulations
Most states require nonprofit charities that are organized in the state and/or solicit funds in their state to register with the charities division of the Attorney General’s office. Charities division registration is important, as many states require registration before you can solicit funds in that state. Depending on the nature of your fundraising and other activities, charities may have to register with the charities division in multiple states.
Operations – Special Rules for Charities
A nonprofit charitable organization must not only operate as a regular business (dealing with issues related to contracts, employees, leasing of space and the like), but must also deal with a series of special rules for charities. Generally, these can be broken into two categories – no self-dealing and following the donor’s intentions. These are the two most common areas where charities can get into trouble.
- No Self-Dealing. Generally this means that the charity must handle all business dealings with its officers, directors, donors and founders on an “arms-length” or for fair value, and any transactions with such parties must be disclosed to and approved by a majority of the disinterested directors (those not involved in this transaction). For example, if a charity leases space from a founder or director, the rent must be at no more than a fair market value rate. The IRS imposes penalties (known as “intermediate sanctions”) on the charity and its directors for above-market related party transactions, so it’s important to follow these rules closely.
- Following the Donor’s Intentions. This may sound obvious, but this is often where issues arise. For example, if you hold a fundraiser and your marketing materials provide that “all proceeds from the event will go to cancer research”, this means that the charity cannot later decide that some of the funds raised can be used for hiring a fundraiser, or for other programs not related to cancer research.
In addition, charities need to comply with all IRS laws regarding notices to donors for tax purposes.
The nonprofit leaders should not overlook their intellectual property (IP), which can be a valuable asset. If the organization generates ideas, images, marks, products, and reputations, it is important to protect these valuable assets. Trademarks, copyrights and patents can enhance the brand, generate support and drive growth. In addition to safeguarding the nonprofit’s own IP, nonprofit leaders should take care not to infringe upon another organization’s rights, as this can have costly consequences. The virtual world has added new twists on IP concerns and questions, so it is important to consult a lawyer to ensure proper procedures.
Nonprofits are not exempt from state and federal employment laws, so it is vitally important that the nonprofit leadership stays abreast of the employment laws that apply to employees in states where the nonprofit operates to ensure it is compliant. At a minimum, nonprofits need to:
- Formalize employment terms through formal employment contract, especially for senior management
- Understand the employee vs. independent contractor issues
- Develop an employee handbook
- Have written policies covering sexual harassment, social media and computer/internet use
Because employment laws are complex and ever-changing, it is advisable to have a professional resource available to consult when questions arise about employment issues. Relying on employment laws and HR management experts is much more prudent than trying to go it alone in this highly regulated area.
Like any business, a nonprofit needs to use a range of legal agreements to reduce its liability and avoid legal disputes. Some common agreements include:
- Confidentiality agreements to be used for suppliers, contract manufacturers, distributors, joint venture partners, prospective customers and other parties to whom confidential information may be disclosed
- General business contracts, such as office and equipment leases and contracts with major suppliers, distributor, contract manufacturers, brokers, joint venture partners, equipment vendors]
If you plan to form a nonprofit organization, being mindful of the above essentials will help put you on the path to success. Since the start-up process and ongoing compliance requirements can be complicated, you should be sure to consult an experienced nonprofit attorney and accountant.
C. Forbes Sargent III is a partner with Sherin and Lodgen LLP in Boston, and advises nonprofits on legal issues. Forbes is a former director of several nonprofit boards and served as fundraising chair of the American Cancer Society Massachusetts Division. Forbes can be reached at 617-646-2000 or firstname.lastname@example.org