Home ==> Best Practices Manual ==> Becoming a Nonprofit

Becoming a Nonprofit and Becoming Tax Exempt

This chapter describes the basic steps taken in order to form a charitable nonprofit corporation and receive tax exempt status. The title 501(c)(3) refers to the section of the Internal Revenue Code under which public benefit corporations may be organized. The 501(c)(3) designation is required for most Community Development funds. Some states and most federal programs require any applicant for grants and other funds to function as a freestanding nonprofit legal entity. Religious institutions are frequently already recognized as some kind of tax-exempt organization. Even so, it is advisable for religious institutions interested in community development work to set up a separate nonprofit organization to engage in development activities, to ensure accurate accounting and to avoid placing the religious institution at any financial risk. Sample corporations include programs dedicated to promoting community development, social welfare, education, the arts, public health, and affordable housing. Once your newly formed corporation acquires tax-exempt status, the IRS imposes specific accounting requirements and guidelines on business activities.

Filing articles of incorporation create a nonprofit corporation with the secretary of state in accordance with the Texas Nonprofit Corporation Act ("TNPCA"), articles 1396-3.02 and 1396-3.03. "Nonprofit Corporation" means a corporation no part of the income is distributable to members, directors, or officers [TNPCA, article 1396-1.092A(3)]. A nonprofit corporation may be created for any lawful purposes, which purposes must be fully stated in the articles of incorporation. Not all nonprofit corporations are entitled to exemption from state or federal taxes.

Exemption from federal and state taxation is not automatic and eligible corporations must apply with the Internal Revenue Service ("IRS") and the State Comptroller to obtain an exemption. There are a variety of fees associated with applications for these various procedures. Therefore, this is a three-step process:

1. State of Texas Incorporation - Articles of Incorporation must be filed with the Secretary of State of Texas. A certificate of Incorporation is then issued for the organization. This must be done before the IRS can begin to evaluate an organization. The Secretary of State Office is also the place to have the availability of a proposed name of an organization checked. This check makes sure that the name of the organization is not being used by another organization.
2. IRS Recognition of Exemption for an Organization - Application for this recognition must be made to the IRS who will determine whether an organization is exempt from certain kinds of federal taxes.
3. State of Texas Exemption Certificate - After receiving a determination from the IRS, these papers are filed with the Comptroller of Public Accounts, State of Texas. The Comptroller's office recognizes the exemption from franchise tax and also sales tax. An exemption certificate can be used in lieu of the sales tax on taxable items if they relate to the purpose of the exempt organization.

Some organizations hire an attorney or another person who specializes in filing these applications, but all of the necessary paperwork can be done by an organization itself.

State of Texas Incorporation

The Texas Business Corporation Act and The Texas Nonprofit Act do not distinguish between corporations using these designations. When articles of incorporation are filed with the secretary of state pursuant to one of those statutes, either a business corporation or a nonprofit corporation is created. Designations such as S.C. or 501©(3) relate only to federal tax provisions.

The State of Texas provides assistance in filling out the Articles of Incorporation. The best way to access these instructions and forms is through the Secretary of State website. [www.sos.state.tx.us]. At this website, you can find Form 202, which will be the form that an organization needs for this application.

In order to find this form, you will need to click on the following sequence of links:

• Functions of the Office
• Organization and Nonprofit Associations
• Business Organization Forms
• Formation of Business Entities & Nonprofit Corporations
• Form 202

This website also contains answers to many questions that an organization has about registered agents, trade names, etc. Additional questions can be answered by calling: (512) 463-5555.

Please note: It is essential that you notice the suggested wording on the "IRS Recognition of Exemption under Section 501" when you write the articles of Incorporation. The IRS will determine that your articles do not meet their standards if your wording does not comply. You will be required to amend your articles with the state before you can complete the IRS process. This will mean a significant delay in the process.

IRS Recognition of Exemption for an Organization

The IRS determines exemption from federal taxes. Always consult with the IRS prior to filing the articles of incorporation to determine what provisions should be included in the articles for the corporation to be exempt from federal taxes.

Call the IRS (800/829-3676) to request the following forms:

• Form SS-4 Application for Employer Identification Number (EIN)
• Form 1023 Application for Recognition under 501©(3) of the Internal Revenue Code
• Form 8718 User Fee for Exempt Organization determination Letter Request
• Publication 557 Tax Exempt Status for Your Organization (This describes the rules and procedures for nonprofit organizations requesting exemption.)

Organizations should file these forms within 15 months of incorporation. Form 1023 requires a filing fee averaging $500. To file these forms, the organization must be able to provide description of exempt purpose and actual programs, who the organization is serving and why, where will the organization's funds originate, private vs. public support and a three year projected budget. Average processing of Form 1023 is 100 days. Processing for EIN number takes approximately 10 days. Banks require this number before an organizational account can be opened.

Questions concerning exempt status can be directed to:

IRS
Exempt Organizations
1100 Commerce
Dallas, Texas 75242
(214) 767-6023 [Customer Service]
(214) 767-0040

Application to the IRS requires detailed work about the nonprofit, but it does not require a professional to fill out the forms. It is important to complete the necessary forms completely and to follow through on any questions or requests for additional information from the IRS. The IRS frequently will ask for additional information. Do not get discouraged. Follow through because if the IRS timeline is not met, the nonprofit will have to start all over, including resubmitting all fees.

"Advance Rulings" are given to new nonprofits that do not have a past financial track record to supply to the IRS. Before the "Advance Ruling" expires, the nonprofit will be required to apply for a federal tax exemption. This exemption will last until the nonprofit dissolves or changes it purpose and intent.

The IRS will ask to see the organization's by-laws. Bylaws are easy to amend and do not have to be perfect in order to file for 501©(3) status. The following items should be addressed in the By-laws:

• Membership - its composition, how/when membership meetings occur, what notice is required for meetings, and criteria/process for calling special meetings, and voting.

• Board of Directors - number, election process, meetings, and length of term (can not be more than 10 years).

• Fiscal Management - fiscal year, and committee/officer responsibility

• Amendments - how to amend bylaws.

State of Texas Exemption Certificate

A nonprofit corporation may be exempt from the payment of state franchise taxes if its purposes fall within one of the exemptions listed in the Texas Tax Code, Chapter 171, Subchapter B.

The Comptroller's office will also determine whether the nonprofit qualifies for exemption from state and local sales taxes. The IRS ruling and a copy of the Certificate of Incorporation must be submitted to the Comptroller's office. If the nonprofit qualifies, then an exemption certificate will be issued. This certificate can be used in lieu of the sales tax on taxable items if they relate to the purpose of the exempt organization and are not used for the personal benefit of a private stakeholder or individual. The certificate does not require a number to be valid and may be reproduced in any quantity.

Questions on exemption procedures should be addressed to:

Comptroller of Public Accounts
Tax Assistance
Exempt Organizations Section
Austin, Texas 78774-0100
(512) 463-4600
(800) 252-1381
TDD: (800) 248-4099 or (512) 463-4621

Other Considerations when forming a Nonprofit Organization:

• Recruiting Board Members - How will the organization's constituency be represented?
• Board Meetings - How often and how long will the board meet?
• Fundraising Plan- What amount of funds is needed and where will they come from? What is the role of board or staff in fundraising? How much will come from foundation and corporate support, government grants, membership dues, and earned income?
• Accounting System - How will funds be tracked and reported?
• Staffing - What are the organization's personnel policies and payroll procedures?
• Community awareness - What is the plan for publicity, brochures, mailing lists, and outreach?
• Evaluation - How will the results of the organization's work be assessed and reported?
• Insurance - Obtain business insurance. Your members want some protection from legal liability (e.g. personal injury at workplace and property damage.)
• Legal needs - Check to see if any other government agency regulates the activity of the organization (e.g. childcare, health care, food service, etc.)

Back to Table of Contents