Many nonprofit leaders endeavor to prepare and file their own legal documents to save a little money. There is nothing wrong with this – it can certainly be done – but there are several rookie mistakes we see again and again.
1. Using the State’s Form Nonprofit Articles of Incorporation. This would seem like a no brainer. The Arizona Corporation Commission provides a pre-printed form and instructions to incorporate a nonprofit. Why not use it? It’s free and blessed by the state. Unfortunately, if you also want tax-exempt status for your corporation, you also have to satisfy the IRS. The state form does not include the tax provisions that the IRS requires tax-exempt organizations to have. Would be founders that file using the state’s form Articles of Incorporation without including an attachment with the appropriate tax provisions will end up with a taxable nonprofit – a result almost no one intends. To add insult to injury, once the IRS grants a determination letter (assuming the application was timely filed), it will only be retroactive to the date the of the correction and not the original incorporation date.
2. Forming a LLC. Consumers love LLCs because they are simple to form and maintain. However, a LLC with or other private interests as members generally cannot qualify for tax-exempt status. The only time a LLC will qualify for tax-exemption is when it members are exempt entities. This is because a membership interest is an ownership interest and the IRS will not view an entity with private owners as operating for exclusively tax-exempt purposes. Further, starting off as a LLC will disqualify an organization from filing the new 1023-EZ because entities organized as LLCs or successors to for-profits are not eligible.
3. Pulling Bylaws off of the Internet. We often see bylaws that are clearly meant for a different type of organization or that reference another state’s laws. For example, whenever we see Arizona bylaws that refer to “public benefit corporations” we know the bylaws were most likely co-opted from a California organization, as Arizona does not recognize public benefit corporations. Similarly, documents that require compliance with open meeting law, require third-party approvals, or contain complex voting member provisions are further evidence that organization needs customized bylaws.
4. Failing to File 990s for Start-up Period. Sometimes nonprofit founders don’t realize that to gain tax-exempt status, they have to act like a nonprofit from the day they incorporate. This means they must file a Form 990 for the start-up year even if it’s a short year and even if there is zero revenue. Most start-ups will be able to file the simplified 990-N their first year if they have brought in revenue of $50,000 or less. Failure to file 990s for three years will result in automatic revocation of tax-exempt status. This means if you don’t file 990s while you are waiting for tax-exempt status, the IRS may revoke an exemption immediately upon granting it.
5. Misclassifying Employees. This is still one of the biggest problem areas for both start-up and existing organizations. Misclassification can result in penalties and back taxes; however, we are aware of one organization that hired a worker as an independent contractor and then ended up being sued when that worker was injured in an accident while on an arguably work related errand. Since the worker was hired as an independent contractor the nonprofit did not purchase worker’s compensation insurance. The nonprofit was ultimately sued for the worker’s medical costs. Moral of this story? Whenever the correct classification is not crystal clear, the prudent approach is to treat the worker as an employee.
With a little advance planning and research, nonprofit founders can avoid these common mistakes and set their new organization up for success.