When you start a nonprofit, it is necessary to select from numerous options for classification at both the state and federal level.  Each option can have very different consequences, and some of the choices can be difficult to reverse.

The most well known type of nonprofit is a public charity that conducts charitable and/or educational activities, is tax exempt, and is eligible to receive tax deductible donations.  If this is the type of nonprofit you wish to form, then your choices are straightforward – you would form a California nonprofit public benefit corporation (assuming you are forming it under California law) and apply for federal tax exemption under Internal Revenue Code Section 501(c)(3).  But if you want to form some other type of nonprofit, things can get a bit complicated.

California Classifications: Public Benefit versus Mutual Benefit

At the state level, it is necessary to choose from among several types of nonprofit corporation (there are other options as well such as unincorporated associations, but I will not cover those here).  The two most common types are the nonprofit public benefit corporation and the nonprofit mutual benefit corporation.

A public benefit corporation can be either one of the following:

(1)    organized primarily for religious (however, it is also possible to form a religious organization as a California nonprofit religious corporation), charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals; OR

(2)    a civic league or social welfare organization.

A public benefit corporation may be tax exempt under one of two sections of the California Revenue and Taxation Code: 23701d or 23701f (these sections correspond with the two types described above).

California nonprofit public benefit corporations exempt under 23701d must meet the following requirements:

• no part of the net earnings may benefit any private shareholder or individual
• no substantial part of the organization’s activities may include influencing legislation
• the organization may not participate in political campaigns of candidates for public office
• upon dissolution, the organization’s assets must be donated to another nonprofit charity or government agency.

California nonprofit public benefit corporations exempt under 23701f must meet the requirements of an organization exempt from taxation under Section 501(c)(4) of the Internal Revenue Code (described below).  Its assets must be irrevocably dedicated to 501(c)(4) compliant purposes – this means that upon dissolution, the assets cannot be distributed to anyone for any other purpose.

Note that if you choose to form as a nonprofit public benefit corporation, you cannot easily convert to a mutual benefit corporation.  The only way to do such a conversion is to first ensure that all of the assets of the organization are donated to another nonprofit or government agency with exempt purposes.

California nonprofit mutual benefit corporations can be many types of organizations such as labor, agricultural, or horticultural organizations; fraternal orders; business leagues; chambers of commerce; social or recreational clubs; voluntary employees’ beneficiary associations; teachers’ retirement fund associations, homeowners associations, etc.

Federal Classifications: 501(c)(3) versus exemption under other sections of the Internal Revenue Code

Once you have chosen from among the options at the state level, you will need to decide under what federal code section you will apply for tax exemption.  Note that you do not need to apply for state or federal tax exemption.  Some organizations choose not to for various reasons.  For example, many medical marijuana collectives are formed as California mutual benefit corporations.  They do not apply for federal tax exemption because trafficking in marijuana is not legal under federal law.  Often they choose not to apply for tax exemption under state law either because they want to give back to the state by paying taxes.

If you do choose to apply for federal tax exemption, you have more than 25 classifications to choose from.  As noted above, the most well known federal classification is 501(c)(3) – a charitable or educational organization.  In this post I will describe two of the other most common options: 501(c)(4) and 501(c)(6).

An organization exempt under 501(c)(4) is known as a civic league  or social welfare organization.

It operates primarily to further the common good and general welfare of the people of the community.  Here are some examples from the IRS web site:

• An organization operating an airport that is on land owned by a local government, which supervises the airport’s operation, and that serves the general public in an area with no other airport,
• A community association that works to improve public services, housing and resi­dential parking, publishes a free commu­nity newspaper, sponsors a community sports league, holiday programs and meetings, and contracts with a private se­curity service to patrol the community,
• A community association devoted to preserving the community’s traditions, ar­chitecture, and appearance by represent­ing it before the local legislature and administrative agencies in zoning, traffic, and parking matters,
• An organization that tries to encourage in­dustrial development and relieve unem­ployment in an area by making loans to businesses so they will relocate to the area, and
• An organization that holds an annual festi­val of regional customs and traditions.

An organization exempt under 501(c)(6) is known as a business league or chamber of commerce.  The purpose of the organization must be to promote the common business interest of a group of persons.  It may not engage in a regular business of a kind ordinarily carried on for profit.  The organization must receive support from its members.

An organization does not qualify for exemption under section 501(c)(6) if any of its net earnings inures to the benefit of any member.  Members may nevertheless receive some kinds of benefits from the organization, such as newsletters and similar material.  Moreover, the profitability of the members’ individual enterprises may be enhanced by the successful promotion of the common business interest.

Both Section 501(c)(4) and (6) organizations may engage in political campaign activities on behalf of or in opposition to candidates for public office but the organization must ensure that its political campaign activities do not constitute the organization’s primary activity.  Also such activities are subject to a tax.

In general, section 501(c)(4) and(6) organizations may engage in an unlimited amount of lobbying, provided that the lobbying is related to the organization’s exempt purpose.

Both types of organizations must ensure that no part of its net earnings benefit private individuals or businesses.  For example, the organization should never pay more than fair market value for any goods or services it receives from an individual or business.

In general, contributions to 501(c) organizations other than organizations described in section 501(c)(3) of the Code are NOT deductible as charitable contributions for federal income tax purposes.

Related posts:

1. Setting compensation for a nonprofit executive director
2. High level employees of nonprofit organizations that receive non-monetary compensation could be subject to sanctions!
3. Nonprofit Governance Tune Up
4. Hiring a fundraiser for your nonprofit? Be aware of California requirements
5. Securities Law Exemptions – First in a Series

Comments RSS