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January 22, 2013

Understanding Tax Status Is Important in Nonprofit Formation, Lawyers Say

With more than 1.5 million nonprofit entities in the United States, lawyers who specialize in nonprofit formation are essential. Understanding the tax status of the organization is the key to creating a nonprofit, experts said during an _ webinar titled “Nonprofit Issues for the ‘Non’ Nonprofit Lawyer.”

There is a clear distinction between being a nonprofit and being tax exempt that must be conveyed to clients, the experts said. An entity can be a nonprofit and still be taxable.

“You want to consider if exemption is available … does the purpose of the entity sit within the definition of a 501 (c) (3) criteria?” asked Ingrid Mittermaier, principal at Adler & Colvin in San Francisco.

The program, sponsored by the ABA Business Law Section Nonprofit Organizations Committee, Section of Taxation Exempt Organizations Committee, Commission on Law and Aging, and Center for Professional Development, sought to educate lawyers on the basics of nonprofit formation.

Nonprofits include entities such as public charities, private foundations and churches. Experts agreed that a popular misconception of nonprofit entities is that they are unable to make a profit.

“A nonprofit organization is certainly permitted to conduct sales or other types of revenue-generating activities and have net income at the end of the year,” Mittermaier said.

Nonprofits, however, cannot have shareholders or owners who receive equity distributions from the corporation.

“Just the fact that you set up your legal entity as a nonprofit corporation does not mean that it is tax exempt,” Mittermaier added, emphasizing that it is important that clients file for tax exemption after the nonprofit is established.

Generally, nonprofits with 501(c) (3) tax status are exempt from state and federal income and franchise taxes.

Many states divide their nonprofit entities into groups: public, mutual or religious benefit. Public benefit institutions include hospitals, museums or schools. Homeowner associations are an example of mutual benefit entities, and churches are designated as entities for a religious benefit.

“The public benefit and the religious benefit organizations are the only ones that get to be 501 (c) (3) organizations where contributions are deductible. Mutual benefits may be exempt, but they are not going to have contributions that are deductible as charitable contributions,” said Lisa A. Runquist, transactional lawyer at Runquist & Associates.

Lawyers should provide clients with alternatives to starting a new nonprofit, such as linking up with existing nonprofits, garnering fiscal sponsorship or becoming a business with charitable causes, experts said.

“With regard to alternatives, if you are talking to a group of people who are raising money to distribute for a charitable cause and would not have significant operations, you might consider the use of a community foundation,” said Willard L. Boyd III, an attorney at Nyemaster Goode P.C. “By doing this, you do not need to set up a separate nonprofit.”

A community foundation has accounts where charitable donations can be made.