Summary. Forming a nonprofit and obtaining tax-exempt status are two separate projects, and confusing them is the most common early error. Incorporation happens at the state level and creates the entity. Exemption is a federal determination requiring specific language in the articles that a standard incorporation service will not include. This article walks the whole process: entity choice and governance, the organizational and operational tests, the purpose and dissolution clauses, the Form 1023 and 1023-EZ application, the determination letter and retroactivity, and the public charity versus private foundation classification. A long section addresses ongoing compliance: private inurement and excess benefit transactions, unrelated business income tax, the Form 990 series and automatic revocation, state charitable solicitation registration, lobbying limits and the § 501(h) election, the political campaign prohibition, and donor substantiation. It closes with fiscal sponsorship, a formation checklist, a worked example, an FAQ, and related reading.

Four people decide to start a nonprofit. They use an online service to incorporate, open a bank account, print business cards, and begin fundraising. Eight months later a major donor's advisor asks for the determination letter.

There is no determination letter. Nobody filed Form 1023. The articles of incorporation, produced from a generic template, contain no purpose clause limiting the organization to exempt purposes and no dissolution clause dedicating assets to charity — so the organization does not satisfy the organizational test and cannot be approved without amending the articles in every state where it has registered.

Meanwhile it has solicited donations in six states without registering under any of their charitable solicitation statutes, and it has told donors their gifts were tax-deductible.

Every one of those problems is fixable. All of them were avoidable with a two-page checklist at the start.

The short answer

Two separate steps:

  1. Form the entity under state law — usually a nonprofit corporation, by filing articles of incorporation with the Secretary of State. This creates the organization and gives its directors limited liability. It confers no tax exemption.
  2. Apply for federal tax exemption by filing Form 1023 (or the streamlined Form 1023-EZ) with the IRS, which issues a determination letter recognizing exemption under § 501(c)(3).

Section 501(c)(3) exempts organizations "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition ..., or for the prevention of cruelty to children or animals," provided that:

  • no part of the net earnings inures to the benefit of any private shareholder or individual;
  • no substantial part of the activities is carrying on propaganda or otherwise attempting to influence legislation; and
  • the organization does not participate in, or intervene in, any political campaign on behalf of or in opposition to any candidate for public office.

Two exemption consequences that matter:

  • The organization does not pay federal income tax on exempt-function income.
  • Donors may deduct contributions under § 170, which is usually the practical reason to seek exemption.

Classification matters as much as exemption. Every § 501(c)(3) is presumed a private foundation unless it qualifies as a public charity under § 509(a). Public charity status brings better deduction limits for donors, no excise tax on investment income, and freedom from the private foundation restrictions.

Part I: Forming the entity

Choosing the form

Nonprofit corporation is the standard choice: it provides limited liability for directors and officers, a familiar governance structure, and a body of state law. Most states have adopted a version of the Model Nonprofit Corporation Act.

Alternatives and when they fit:

  • Charitable trust — used where a donor is funding a defined purpose and prefers trustee governance to a board; common for private foundations.
  • Unincorporated association — free and immediate, with no liability shield. Suitable only for very small, short-lived groups.
  • Nonprofit LLC — possible, but for exemption the IRS applies particular requirements, and the members generally must themselves be § 501(c)(3) organizations or governmental units. Rarely the right vehicle for a startup charity.

Where to incorporate. Usually the state where the organization will actually operate. Delaware offers no meaningful advantage for a typical charity, and incorporating out of state means registering as a foreign corporation where you operate, plus two sets of filings.

The articles of incorporation

This is where the fatal error occurs, because the state does not require what the IRS does. Two clauses must appear:

Purpose clause — limiting the organization's purposes to one or more exempt purposes:

The Corporation is organized exclusively for charitable, educational, religious, or scientific purposes within the meaning of Section 501(c)(3) of the Internal Revenue Code, or the corresponding section of any future federal tax code.

Dissolution clause — permanently dedicating assets to exempt purposes:

Upon the dissolution of the Corporation, assets shall be distributed for one or more exempt purposes within the meaning of Section 501(c)(3), or shall be distributed to the federal government, or to a state or local government, for a public purpose.

Also standard: a prohibition on inurement, a limit on legislative activity, and an absolute prohibition on political campaign intervention.

These clauses satisfy the organizational test, Treas. Reg. § 1.501(c)(3)-1(b). Without them the application is rejected, and amending articles after the fact is possible but requires board and sometimes member approval, a state filing, and updates to every registration.

Bylaws and governance

Bylaws govern internal operation: board size, terms, election, officers, meetings, quorum, committees, and amendment procedures.

Directors owe fiduciary duties, generally stated as:

  • Duty of care — act in good faith, with the care an ordinarily prudent person would use, in a manner reasonably believed to be in the organization's best interests. Attend meetings, read the materials, ask questions.
  • Duty of loyalty — no self-dealing; disclose and manage conflicts.
  • Duty of obedience — act consistently with the organization's stated mission and governing documents.

Enforcement usually runs through the state attorney general, who has standing to enforce charitable trusts and to remove directors; private parties generally lack standing absent a special interest.

Adopt at the first meeting:

  • Bylaws.
  • A conflict of interest policy (the IRS asks about it on Form 1023 and effectively expects one; a sample appears in the Form 1023 instructions).
  • A document retention and destruction policy — note that destroying documents relevant to a federal investigation is a crime under 18 U.S.C. § 1519, which was enacted after Sarbanes-Oxley and applies to nonprofits.
  • A whistleblower policy — the other Sarbanes-Oxley provision that applies to nonprofits is the anti-retaliation rule, 18 U.S.C. § 1513(e).
  • Compensation approval procedures using the rebuttable presumption process described below.
  • Gift acceptance policy for non-cash gifts.

Board composition. The IRS looks for a board that is not controlled by a single family or by compensated individuals. A majority of independent directors is the practical standard for public charities, and a board of three related people invites scrutiny at application and at audit.

Insurance. Directors and officers coverage is inexpensive for a nonprofit and is usually a condition of recruiting good board members. Volunteer director immunity statutes and the federal Volunteer Protection Act, 42 U.S.C. §§ 14501-14505, provide partial protection for uncompensated directors but do not cover willful misconduct and do not pay defense costs. See Business Insurance and Coverage Disputes.

Part II: Obtaining exemption

The two tests

Organizational test. The articles must limit purposes to exempt purposes, must not expressly empower the organization to engage more than insubstantially in non-exempt activities, and must dedicate assets on dissolution.

Operational test. The organization must be operated exclusively for exempt purposes, which the regulations construe as primarily. An insubstantial non-exempt purpose is tolerated; a substantial one is fatal. Two absolute limits apply regardless of substantiality: no private inurement and no political campaign intervention.

The operational test also embeds the private benefit doctrine, which is broader than inurement: the organization must serve public rather than private interests, and more than incidental private benefit to any person — insider or not — jeopardizes exemption.

Form 1023 versus Form 1023-EZ

Form 1023 is the full application: a detailed narrative of activities, three years of actual or projected financials, governance documents, compensation arrangements, conflict of interest policy, and specific schedules for churches, schools, hospitals, supporting organizations, and others. The user fee is several hundred dollars, and processing commonly takes three to nine months, longer if the application is assigned for development.

Form 1023-EZ is a three-page online eligibility-attestation form available to organizations that project annual gross receipts of $50,000 or less for three years and have total assets of $250,000 or less, subject to a list of disqualifying characteristics (foreign organizations, churches, schools, hospitals, supporting organizations, and others). The fee is lower and processing is fast, frequently a few weeks.

A candid note on 1023-EZ. It is attractive and it has been criticized, including by the Taxpayer Advocate and in IRS studies, because it approves organizations on attestation without reviewing governing documents. Organizations that file it still must actually satisfy the organizational test, and many do not — their articles lack the required clauses even though they attested otherwise. If you file 1023-EZ, have someone confirm the articles first, because an exemption obtained on a false attestation is revocable retroactively.

Timing and retroactivity

File within 27 months of the end of the month in which the organization was formed, and exemption is retroactive to the date of formation. File later, and exemption generally runs only from the postmark date, leaving a gap during which contributions were not deductible and income was taxable.

The determination letter is what donors, grantmakers, and state regulators ask for. Until it issues, an organization may operate and may describe itself as having an application pending, but it must be accurate: telling donors gifts are deductible before a determination is a misrepresentation, though if the determination later issues retroactively the deduction is preserved.

Public charity or private foundation

Every § 501(c)(3) is a private foundation unless it establishes public charity status under § 509(a):

  • § 509(a)(1) — churches, schools, hospitals, governmental units, and organizations receiving a substantial part of support from the general public or government, tested under the one-third public support test of § 170(b)(1)(A)(vi) (with a 10 percent facts-and-circumstances alternative).
  • § 509(a)(2) — organizations receiving more than one-third of support from gifts, grants, and gross receipts from exempt-function activities, and not more than one-third from investment income.
  • § 509(a)(3) — supporting organizations, which support another public charity; heavily regulated in Types I, II, and III.
  • § 509(a)(4) — public safety testing organizations.

The public support test is computed over a five-year period on Schedule A to the Form 990, and it is where organizations quietly fail: a charity funded almost entirely by one family or one donor will not meet it, and a single very large gift can distort the ratio (the 2 percent limitation counts only a limited portion of any one donor's contribution toward public support for § 170(b)(1)(A)(vi) organizations).

Why classification matters:

Public charity Private foundation
Donor deduction limit (cash) Higher percentage of AGI Lower
Deduction for appreciated property Generally fair market value Often limited to basis for non-publicly traded property
Excise tax on net investment income None Yes, § 4940
Minimum distribution requirement None 5 percent of assets annually, § 4942
Self-dealing rules § 4958 excess benefit Absolute prohibition, § 4941
Excess business holdings, jeopardizing investments, taxable expenditures Not applicable §§ 4943, 4944, 4945
Annual return Form 990 or 990-EZ Form 990-PF

Private foundation status is not fatal, and it is the right structure for many donor-funded organizations. But it is a materially different regulatory regime, and an organization that intended to be a public charity and drifts into foundation status by concentrating its funding has a problem worth catching early.

Part III: Staying exempt

Obtaining exemption is a project. Keeping it is a practice, and these are the obligations that actually generate problems.

Private inurement and excess benefit transactions

Inurement is absolute: no part of net earnings may benefit an insider. There is no de minimis exception, and a violation can cost exemption entirely.

Because revocation is a blunt instrument, Congress added intermediate sanctions in § 4958: excise taxes on excess benefit transactions between an applicable tax-exempt organization and a disqualified person (a person in a position to exercise substantial influence over the organization, including officers, directors, key employees, substantial contributors, and their families and controlled entities).

An excess benefit transaction is one in which the economic benefit provided exceeds the value of the consideration received. The tax is 25 percent of the excess benefit on the disqualified person, rising to 200 percent if not corrected within the taxable period, plus 10 percent on any organization manager who knowingly participated (capped per transaction).

The rebuttable presumption of reasonableness is the practical protection. Compensation and property transactions are presumed reasonable if:

  1. approved in advance by an authorized body composed entirely of individuals without a conflict of interest as to the transaction;
  2. the body obtained and relied upon appropriate comparability data before making its determination; and
  3. the body adequately documented the basis for the determination contemporaneously — in the minutes, at the meeting or by the next meeting.

Every organization paying compensation to an insider should follow this process for every compensation decision, and record it in the minutes. It costs one agenda item and it shifts the burden to the IRS.

Unrelated business income tax

Exempt organizations pay tax at corporate rates on income from an unrelated trade or business, §§ 511-514. Three elements: a trade or business, regularly carried on, and not substantially related to the exempt purpose (aside from the need for funds).

Statutory exclusions matter enormously and are where most activities land: dividends, interest, royalties, and (with conditions) rents from real property; income from a business where substantially all the work is performed by volunteers; a business carried on for the convenience of members, students, patients, officers, or employees; the sale of donated merchandise (which is why thrift stores are not taxed); qualified sponsorship payments; and certain convention and trade show activity.

Watch these:

  • Advertising income in a publication is unrelated business income; a qualified sponsorship acknowledgment (name, logo, locations, product listing, without comparative or qualitative language, price information, or an inducement to buy) is not, § 513(i). The line between an acknowledgment and an ad is a recurring audit issue.
  • Debt-financed income under § 514 can pull otherwise excluded passive income into UBIT.
  • Rent from real property is excluded, but rent attributable to personal property and rent based on net profits is not, and rent for services (parking, meeting support) may be.
  • Silo rules require computing UBTI separately for each unrelated trade or business, so losses from one cannot offset income from another.

File Form 990-T if gross unrelated business income is $1,000 or more. Substantial unrelated activity also threatens exemption itself under the operational test, quite apart from the tax.

The Form 990 series and automatic revocation

Annual information returns, due the 15th day of the fifth month after year end:

  • Form 990-N (e-Postcard) — gross receipts normally $50,000 or less.
  • Form 990-EZ — under the applicable receipts and asset thresholds.
  • Form 990 — larger organizations.
  • Form 990-PF — all private foundations, regardless of size.

Failure to file for three consecutive years results in automatic revocation of exempt status under § 6033(j), by operation of law, with no notice required. Reinstatement requires a new application and, for retroactive reinstatement, a showing of reasonable cause under published procedures. Automatic revocation is one of the most common ways small nonprofits lose exemption, and it is entirely a calendaring failure.

The 990 is public. It is disclosed by the IRS, published by aggregators, and read by grantmakers, journalists, and donors. Treat it as a communication document, not merely a filing: the program service accomplishments narrative, the governance section, and the compensation schedules are what people actually read.

State obligations

Federal exemption does not confer state exemption or the right to solicit.

  • State income and franchise tax exemption usually requires a separate application, though some states follow the federal determination automatically.
  • Sales and use tax exemption varies enormously; many states do not exempt nonprofits at all, and those that do often require a separate certificate.
  • Property tax exemption is a separate application to a local assessor, often with use-based requirements and annual filings.
  • Charitable solicitation registration is required in roughly forty states before soliciting in that state, with annual renewals and financial reporting. Online solicitation raises the question of where you are soliciting; the Charleston Principles, a set of non-binding NASCO guidelines, are the common reference point, and the conservative practice is to register where you actively target donors or receive substantial contributions. The Unified Registration Statement simplifies but does not eliminate the burden.
  • Professional fundraiser registration and contract requirements apply where an outside fundraiser is engaged.
  • Annual corporate reports with the Secretary of State.

Lobbying and political activity

Two different rules, and they are frequently confused.

Lobbying is permitted in limited amounts. The default standard is that no substantial part of activities may be attempting to influence legislation — a vague test measured on facts and circumstances.

The § 501(h) election replaces it with a mechanical expenditure test: an electing public charity may spend a defined percentage of exempt-purpose expenditures on lobbying on a sliding scale (20 percent of the first $500,000, declining, with an overall cap of $1,000,000), and no more than one-quarter of that on grassroots lobbying. Exceeding the limits triggers an excise tax; exceeding 150 percent of the limits on average over four years costs exemption.

Making the election, by filing Form 5768, is usually advisable for any organization that lobbies at all, because it converts an unpredictable standard into a number. Churches and private foundations cannot elect.

Political campaign intervention is absolutely prohibited. No support for or opposition to any candidate for public office, at any level. Violations can cost exemption and trigger excise taxes under § 4955.

Permitted, with care: genuinely nonpartisan voter education and registration; candidate forums open to all candidates on equal terms; issue advocacy that does not reference candidates or elections; and individual leaders speaking in their personal capacities, clearly outside the organization's name and resources. The line is fact-intensive and the IRS considers timing, targeting, and whether the message identifies candidates by position.

Donor substantiation and disclosure

  • $250 or more: the donor must obtain a contemporaneous written acknowledgment from the organization stating the amount, whether any goods or services were provided, and a description and good faith estimate of their value, § 170(f)(8). Without it, the donor's deduction fails, and the failure is the organization's fault in practice even though the burden is the donor's.
  • Quid pro quo contributions over $75: the organization must provide a written statement informing the donor that the deductible amount is limited to the excess over the value of goods or services received, § 6115.
  • Non-cash gifts over $5,000 generally require a qualified appraisal and the organization's acknowledgment on Form 8283; disposition within three years requires the organization to file Form 8282.
  • Vehicle donations have their own regime under § 170(f)(12) and Form 1098-C.
  • Public inspection. The organization must make its three most recent Forms 990 and its exemption application available for public inspection, § 6104(d), with penalties for refusal. The donor list on Schedule B is redacted from public copies for most organizations.

Part IV: Fiscal sponsorship, and when not to form at all

Not every charitable project needs its own entity. Fiscal sponsorship lets an existing § 501(c)(3) receive tax-deductible contributions and carry out a project, either by taking the project in-house (Model A, comprehensive) or by making grants to a separate project entity subject to expenditure responsibility (Model C, pre-approved grant relationship).

When sponsorship is the better answer:

  • The project is time-limited (a documentary, a conference, a disaster response).
  • The founders want to test the concept before committing to formation and compliance.
  • Annual budget is small enough that the fixed compliance cost (accounting, Form 990, state registrations, audit) would consume a meaningful share of it.
  • Speed matters — sponsorship can begin immediately, while a determination letter takes months.

The trade-offs: the sponsor typically charges an administrative fee (commonly 5 to 15 percent), the sponsor has legal control over the funds and discretion over their use (which is what makes the deduction valid), and the project has no independent identity or governance.

A related caution: a "nonprofit" that will primarily sell goods or services at market rates to paying customers may be better structured as a for-profit, possibly a benefit corporation or a social enterprise, than as a charity whose activities will be substantially unrelated business.

A worked example

Harbor Reading Project (fictional) — four founders, a plan to run after-school literacy tutoring, a projected first-year budget of $120,000, mostly from two family foundations and one large individual gift.

Step 1: entity. Incorporate as a nonprofit corporation in the state of operation. Use articles containing the purpose and dissolution clauses, not a generic template.

Step 2: governance. Adopt bylaws; recruit a board of at least five with a majority independent (not compensated, not related to compensated staff); adopt conflict of interest, document retention, whistleblower, gift acceptance, and compensation approval policies at the first meeting.

Step 3: EIN and bank account. Obtain an EIN; open the account in the corporation's name; adopt dual-signature and reconciliation controls, because small nonprofits are disproportionately victims of embezzlement.

Step 4: exemption. Budget is above the 1023-EZ ceiling in year two under any realistic projection, so file the full Form 1023 within 27 months of formation for retroactive exemption. Prepare a clear narrative of activities and realistic three-year projections.

Step 5: the classification problem. With two foundations and one individual supplying nearly all support, Harbor may fail the public support test and be classified as a private foundation. It should model the § 170(b)(1)(A)(vi) computation now, applying the 2 percent limitation to each large donor, and build a diversification plan — small-donor campaigns, government grants (which count fully), and program fees — to reach the threshold within the five-year measurement window. Newly formed organizations get an advance ruling period, but the test bites eventually.

Step 6: state compliance. Apply for state income and, if available, sales and property tax exemption. Register for charitable solicitation in the home state before fundraising, and in any other state where it actively solicits.

Step 7: donor practice. Set up templated acknowledgments meeting the § 170(f)(8) content requirements, and a quid pro quo disclosure for any event ticket over $75.

Step 8: calendars. Form 990 due date, state registration renewals, corporate annual report, insurance renewal, and an annual board review of the conflict of interest disclosures.

What goes wrong if these steps are skipped: the articles fail the organizational test; the application is delayed or denied; solicitation occurs unregistered; the public support test fails and Harbor becomes a private foundation subject to excise tax and distribution requirements; and, most commonly of all, nobody files the Form 990 in year three and exemption is revoked automatically.

Formation checklist

Entity

  • Choose the state of incorporation (usually where you operate).
  • Articles with purpose and dissolution clauses satisfying the organizational test.
  • Bylaws adopted.
  • Initial board recruited, majority independent.
  • Conflict of interest, document retention, whistleblower, gift acceptance, and compensation policies adopted.
  • EIN obtained; bank account opened with financial controls.
  • D&O insurance placed; general liability considered.

Federal exemption

  • Determine 1023 versus 1023-EZ eligibility honestly.
  • File within 27 months of formation for retroactive exemption.
  • Prepare an activities narrative and realistic financial projections.
  • Model the public support test and plan for diversification.
  • Retain the determination letter where it can be produced on request.

State

  • State income/franchise exemption applied for.
  • Sales and property tax exemption evaluated.
  • Charitable solicitation registration before soliciting, in every state where you solicit.
  • Professional fundraiser contracts reviewed and registered where required.
  • Annual corporate report calendared.

Ongoing

  • Form 990 series filed every year (three consecutive misses = automatic revocation).
  • Form 990-T if unrelated business income is $1,000 or more.
  • Compensation approved under the rebuttable presumption process and documented contemporaneously.
  • § 501(h) election filed if the organization lobbies at all.
  • Zero political campaign activity, verified.
  • Donor acknowledgments and quid pro quo disclosures issued.
  • Public inspection copies maintained.

Frequently asked questions

Is incorporating enough to be tax-exempt? No. Incorporation is a state filing that creates the entity. Exemption is a separate federal determination on Form 1023 or 1023-EZ.

Can we accept donations before the determination letter arrives? Yes, and if the application is filed within 27 months of formation and approved, exemption is retroactive, so the gifts are deductible. Be accurate with donors about the pending status.

Should we file the 1023-EZ? Only if you genuinely qualify and your articles actually satisfy the organizational test. The form is an attestation, not a review, and an exemption obtained on an inaccurate attestation is revocable.

Can our founders be paid? Yes, reasonable compensation for services actually rendered. Approve it through the rebuttable presumption process with comparability data and contemporaneous documentation, and keep conflicted individuals out of the vote.

Can we lobby? Yes, within limits. Make the § 501(h) election to convert a vague "substantial part" test into a mechanical expenditure limit.

Can we endorse a candidate? No. Never. The prohibition is absolute and violations can cost exemption.

Can we run a business? Yes, but unrelated business income is taxable and substantial unrelated activity threatens exemption. Check the statutory exclusions first — volunteer labor, donated merchandise, and convenience activities cover a great deal.

Do we have to register in every state where we fundraise? Roughly forty states require registration before soliciting. Online solicitation complicates the analysis; the conservative approach is to register where you actively target donors or receive substantial support.

What is the fastest way to lose exempt status? Not filing the Form 990 for three consecutive years. Revocation is automatic and requires no notice.

Do we need a lawyer? For articles that satisfy the organizational test, a governance structure that survives IRS review, and an honest read on public charity classification — the cost is modest and the errors are expensive to unwind. Many communities also have nonprofit legal assistance programs.

Can a nonprofit make a profit? Yes. "Nonprofit" describes the distribution constraint, not the income statement. A charity may and should run a surplus; what it cannot do is distribute earnings to insiders. Surpluses are retained for the mission, and operating reserves of several months are a mark of good stewardship rather than a compliance problem.

Can we pay a fundraiser a percentage of what they raise? Legally possible in most states, subject to registration and contract requirements, but it is disfavored by professional standards, draws regulator attention, and can support an excess benefit analysis if the fundraiser is a disqualified person. Flat fees or hourly arrangements are the safer structure.

What happens if we lose exemption? The organization becomes taxable as a corporation from the effective date, contributions cease to be deductible, and state exemptions dependent on federal status generally fall with it. Reinstatement after automatic revocation requires a new application, and retroactive reinstatement requires a reasonable cause showing under published procedures. Grantmakers will typically suspend payments until the letter is restored.

Closing thought

Nonprofit compliance is unforgiving in a particular way: the penalties for the boring failures are severe, and the penalties for the interesting ones are usually manageable. Nobody loses exemption for an ambitious program. Organizations lose it for not filing a form three years running, for articles that were never right, and for paying an insider without a documented process.

The founders who do this well spend one focused week at the start — correct articles, real bylaws, five policies, an honest public support model, and a compliance calendar — and then spend their attention on the mission. The ones who struggle skip that week, and spend the next three years discovering the requirements one letter at a time.

If the project is small, time-limited, or uncertain, consider fiscal sponsorship instead. The best structure is sometimes not to build one.

Related articles

This article is provided for general informational purposes and does not constitute legal advice. Nonprofit formation, exemption, and state solicitation requirements are technical and vary by jurisdiction. Consult qualified nonprofit counsel and a tax advisor before forming an organization or filing an exemption application.