Incorporation and Dissolution of Nonprofits - Module 2 of 5
Module 2: Incorporation and Dissolution of Nonprofits
In this module we will cover the business forms available to nonprofits, reasons for nonprofits to incorporate, steps for incorporation, typical state law requirements to maintain incorporation and federal tax status and dissolution of nonprofits.
Choosing a Business Form
Nonprofit corporations are distinct from traditional business corporations in their purpose, which is not to maximize and distribute profits, but for some designated public purpose. This “non-distribution constraint” is the common link between all nonprofits. Under state and federal law, they are prohibited from distributing profits to private individuals. If the nonprofit intends to file as an exempt organization, a threshold matter prior to incorporation is for the nonprofit to choose a business form based on its purpose, such as a charitable purpose, as defined by Section 501(c)(3) of the Internal Revenue Code.
There are a limited number of choices of business forms for nonprofits. Nonprofit organization may choose between nonprofit corporations, charitable trusts, unincorporated associations and limited liability companies. In all cases, the entity must inure to the benefit solely of the public purpose and nothing can inure to the benefit of any stakeholder or private individual or entity.
Nonprofit corporations are sometimes referred to as “non-stock corporations,” because they share the same characteristics as other corporations, except that they do not generate and distribute profits.
A trust is a division of property rights in which property is held by a “trustee” (which can be private people or entities) for the benefit of the beneficiaries, which must represent public purposes. The concept of a trust is an ancient one that tends to be favored for its stringent application of rules related to a trust’s purpose and administration. Public charitable trusts have no defined beneficiaries and are their provisions can be enforced by the attorney general of a state.
Limited liabilities companies, like corporations, limit personal liability for their operators, called members. They are separate legal entities with all the benefits of corporations that do business, purchase property, and pay taxes as individuals, separate from their owners and operators.
Factors that the organizers of a nonprofit may consider in choosing a business form relate to both tax and nontax considerations. Tax considerations may include the mission and purpose of the organization, whether the nonprofit will be a public charity or a private foundation, and similar considerations. Other practical considerations include the goals and sophistication of the organizers, the resources and governance capabilities available, how long the organization is meant to last and concerns about limiting liability to third parties.
Incorporating a Non-Profit
An unincorporated association can be as simple as two or more people organized around a common purpose that is not for profit. This might be appropriate for an association that is speculative, or of a limited duration, like a small school fundraising event, or a short-term, project-based cooperative. An unincorporated association is a flexible form of doing business that can begin and end when the members decide and may even apply for tax exempt status. However, if the nonprofit intends to function indefinitely, some states require registration and the organization may be required to file tax returns For serious ventures, there are many disadvantages to being unincorporated, that make incorporation necessary or even required by state law.
For example, unincorporated associations have no separate existence or status, and therefore cannot hold property, sue or be sued. As a result, financial institutions may be reluctant to do business with the association. There is also very little case law regarding unincorporated associations and it is governed not under the well-established law of corporations, but under the laws of agency. In addition, individual members of the association may be held personally liable for both debts and any wrongful acts by the association and its members.
By contrast, there are many benefits to incorporation for nonprofits. A corporation is a legal person that is perpetual, can hold property, can assert rights and offers a limitation of liability to its members. Whether a charitable trust, a nonprofit corporation or an LLC (under very limited circumstances), incorporation is a process most nonprofits will undertake before opening their doors.
Once a business form has been chosen, to properly incorporate, a nonprofit must register with a state and is subject to its laws. The organizers must draft articles of incorporation and file them with the state business registrar or secretary of state. The articles of incorporation are also sometimes referred to as a charter, or certificate of incorporation.
Though state requirements vary, typically, the articles of incorporation include the organization name, a description of its valid organizational purpose, the name of the registered agent and the names and addresses of the original incorporators or directors of the organization. An agent for service of process, referred to as a “registered agent,” is a person designated by a business entity to receive legal correspondence on its behalf. The agent may be an officer of the corporation, or a third party.
The organization files the required articles with the state, along with the payment of any fees associated with the registration, and, unless there are special requirements based on the business form chosen (such as publication requirements), formation of the organization is complete.
State Law Requirements
In addition to filing articles of incorporation with the secretary of state, there are other governing documents and requirements required of a nonprofit to maintain its status.
Bylaws are the internal rules and procedures that the nonprofit organization lives by. These must typically be drafted and maintained according to state law. The bylaws usually include notice requirements for meetings, structure of the board of directors and officers of the board, what constitutes a quorum, voting and other procedural rights of members, definitions of members or membership categories, procedures for election of officers and other business matters that relate to governance of the organization. The bylaws must not contain provisions that are inconsistent with state law, so review by counsel in the state of incorporation is prudent.
Annual meetings are typically required under state law so that members and stakeholders of the organization are made aware in a timely manner of any proposed changes or important events in the life of the organization. Annual meetings offer an opportunity for stakeholders to influence the direction of the organization. Annual meetings must be held according to time, notice, and quorum requirements established under state law or by the bylaws. Timing of annual meetings is usually based on the fiscal year chosen by the organization.
Nonprofits that plan to solicit and collect funds for charitable purposes are usually required to register with the state agency that enforces statutory rules governing charitable fundraising activities. Depending on the state, there may be additional rules related to the employment of solicitors and attorneys that provide advice on fundraising, referred to as “Professional Fundraising Counsel,” who may be required to register with the state. When working across state lines, a nonprofit will likely be required to register in multiple states and stay apprised of special rules related to soliciting donations from outside a state. Local governments and municipalities may also require registration and reporting of nonprofits engaged in soliciting activities. Organizations governed by charitable trusts usually have special financial reporting requirements. States impose fees, civil and sometimes criminal penalties for lateness or failure to adhere to reporting requirements.
States typically require nonprofit corporations to file reports that describe important information and financial activities. This ensures the state that the nonprofit is operating lawfully under its designated purpose. States almost always set forth record retention policies for registered businesses, including nonprofit organizations.
State corporate reports that must be filed periodically updating or confirming basic contact information with the secretary of state, along with the names of officers and registered agent. Financial disclosure requirements vary from state to state, and some states accept federal forms, such as exempt entity tax return (Form 990), in place of a state-generated form. States that have income tax require nonprofits with employees to file withholding forms. States may also require nonprofits that collect charitable donations to file sales, use, or property tax exemption forms, and to periodically make reports related to fundraising activities.
Failure to file corporate reports or financial disclosures to the appropriate state agency may result in fines and penalties, including the loss of “good standing” to do business in the state. Finally, to maintain state tax exempt status in a state, nonprofits may be required to periodically renew a tax-exempt certificate related to sales and use tax, or comply with other special state requirements.
Maintaining Tax Exempt Status
Diligent Record-keeping, filing timely exempt organization returns, and notifying the IRS of any major changes to the organization are everyday considerations for maintaining federal tax-exempt status. However, there are a number of additional considerations, depending on the organization’s classification. Primarily, the organization must always be mindful of its valid purpose, and if it strays from that purpose, it may face sanctions or loss of exempt status. Using 501(c)(3) organizations as an example, the purpose of the organization may not be directed toward private inurement, which occurs when nonprofit funds are diverted to benefit private individuals rather than the charitable purpose of the organization. Another IRS rule prohibits 501(c)(3) organizations from lobbying, or from making donations to political campaigns (unlike 501(c)(6) organizations, who may do so). Finally, the organization must not generate too much income unrelated to its exempt purpose.
Most exempt organizations are required to file annual returns on IRS Form 990. There are exceptions, such as churches, some educational organizations affiliated with churches and certain state and local political organizations. Organizations that do not file a Form 990 may still have required employment-related filings.
Some nonprofits are required to file paperwork with government agencies other than the IRS. For example, political organizations who collect campaign contributions may be required to file reports on amounts collected, and if engaged in legislative activity, regular lobbying disclosure forms reported to the Federal Election Commission, which regulates federal campaign finance and lobbying.
Section 6113 of the Internal Revenue Code also requires certain tax-exempt organizations that are not eligible to receive tax-deductible charitable contributions to disclose, in a conspicuous, express statement, that contributions made to the organization are not deductible from federal income taxes as charitable contributions.
Nonprofit returns must be filed with the IRS according to a schedule based on its chosen fiscal year, typically by the 15th day of the 5th month after the close of its year. The IRS may impose penalties for failure to file or for filing late. If an organization fails to file a return for three consecutive years, it will lose its exempt status.
While some states require independent audits of nonprofits, independent audits may also be required of organizations that receive federal funding. The IRS is authorized to periodically conduct direct audits of exempt organizations to ensure they are complying with the requirements for exempt status and paying any required taxes. This process may involve both on-location and offsite meetings at IRS offices.
Nonprofits, especially charitable organizations, sometimes elect to hold independent, voluntary audits to build a reputation for transparency and to highlight the integrity of the organization, often making the results open to stakeholders and to the public.
An IRS audit begins when the organization receives an initial contact letter from the IRS and continues until a closing letter is issued. A list of requested items will usually be issued, and interviews with financial officers of the organization may be held. The IRS can contact the organization if it needs further information or if the organization is unresponsive. The organization has a right to representation throughout the process, and a right to appeal. Negative findings are dealt with directly with the auditing agent, who can make agreements with the organization or bring further action against it. Sometimes, an instrument referred to as a “closing agreement” can stipulate next steps to bring the organization into compliance. A closing agreement gives the IRS the leeway to limit the penalty for past transgressions if the taxpayer will commit to future compliance. Where a final agreement is reached, the agreement is conclusive and the IRS cannot reopen its case against the entity on the same matter. Where no agreement is reached, or the agreement is set aside by the IRS for fraud, misrepresentation, or malfeasance, the case remains open until the entity pays its assessed penalties and fees, or until an appeal is resolved either internally through the IRS Office of Appeals, or in federal court.
Dissolution of a nonprofit
There are many reasons why a nonprofit organization may decide to dissolve, including that has reached a conclusion to is stated mission or that it is unable to maintain assets and resources necessary to operate. Nonprofit entities may also be terminated by a state government for several reasons.
An organization that chooses to dissolve must hold a meeting of its board of directors and vote to dissolve the organization. The process employed must be consistent with state law and with the organization’s bylaws and articles of incorporation. A certificate of dissolution must be filed and recorded by the secretary of state where the organization originally incorporated.
Exempt organizations must notify the IRS when they undergo changes in form, or when they undergo a liquidation, dissolution, termination or substantial contraction. Most organizations must notify the IRS when they terminate, which close the organizations’ IRS account records.
The board of directors must also handle the payment of outstanding liabilities to creditors and contractual obligations and distribute of the nonprofit’s remaining assets. The board of directors of the dissolving nonprofit must craft a plan for dissolution that includes payment of liabilities and distribution of assets. The plan should first address outstanding sums owed to third parties and identify other organizations capable of lawfully accepting assets from the dissolving organization. Charitable organizations are required by law to distribute all remaining assets only to other exempt organizations. The board of directors must thus identify other organizations to accept the remaining assets - including all cash and tangible property.
Involuntary dissolution of a nonprofit corporation may be forced by the state when the organization has abandoned its activities for a statutory time period, where a board is deadlocked and unable to conduct business for an extended period of time, where there is pervasive fraud, where liquidation is necessary because the corporation is failing and unable to conduct business under its stated purpose and for other reasons that vary state to state. A state’s attorney general may dissolve a nonprofit administratively if the nonprofit fails to comply with statutory administrative requirements such as periodic reports, or judicially where the attorney general files suit to dissolve the nonprofit for cause.
Such a lawsuit, depending on state law, may also be filed by the organization’s board members or by another proper plaintiff. The matter is then litigated by the parties, and a judge decides whether to dissolve the organization. The organization can appeal, but once appeals are exhausted, the dissolution is recorded by the secretary of state, upon which the organization will cease to exist.
In our next module, we will look more closely at a few of the state and federal statutes and regulations governing nonprofit organizations.
 Moore, Darren B., “Overview of Nonprofit Organizations: The Basic Framework,” presented to 29th Annual Nonprofit Organizations Conference, Austin, TX.
 Fishman, James J. and Schwarz, Stephen, Nonprofit Organizations, Cases and Materials, Fourth Edition, pp 50-52; https://www.law.cornell.edu/wex/charitable_trust
 Fishman, James J. and Schwarz, Stephen, Nonprofit Organizations, Cases and Materials, Fourth Edition, p 48.
 Fishman, James J. and Schwarz, Stephen, Nonprofit Organizations, Cases and Materials, Fourth Edition, pp 48-49.
 Fishman, James J. and Schwarz, Stephen, Nonprofit Organizations, Cases and Materials, Fourth Edition, p 55.
 Fishman, James J. and Schwarz, Stephen, Nonprofit Organizations, Cases and Materials, Fourth Edition, p 56.