Introduction
This presentation summarizes the procedures to set up a tax-exempt organization and discusses some key concerns with respect to the organization’s by-laws, governance and insurance.

The term “tax-exempt organization” is derived from the federal income tax laws. The primary advantage of an organization’s qualification for exemption from federal income tax is that the organization’s income, other than income from an unrelated trade or business, will not be subject to federal income tax. A tax-exempt organization may also qualify for exemption from a variety of state and local taxes. Additionally, Section 170(c) of the Internal Revenue Code of 1986, as amended (the “Code”) allows individuals and corporations to deduct contributions to tax-exempt organizations, subject to certain limitations as provided in the Code.

Tax-exempt organizations can operate through vehicles such as nonprofit corporations, also referred to as not-for-profit corporations, subdivisions of a governmental entity or as trusts. The most common type of operational vehicle is a nonprofit corporation. It is important to note that if a tax-exempt organization is established as a nonprofit corporation that corporation is not tax-exempt by virtue of filing documents to create the corporation. You must comply with the Code’s requirements under Section 501(c)(3) and any other applicable sections to qualify as a tax-exempt organization. (There are other Code sections that may permit an organization to be tax-exempt, but for purposes of this presentation, we are only examining tax-exempt qualifications under Section 501(c)(3) of the Code.)

Forming a nonprofit corporation is much like creating a regular corporation, except that nonprofits have to take the extra steps of applying for tax-exempt status with the IRS. Here is what you need to do:

• Choose an available business name that meets the requirements of state law;
• Prepare and file articles of incorporation and other administrative documents to create nonprofit with the state;
• Draft corporate bylaws to govern the operations of the nonprofit organization and elect initial directors and officers;
• Address any best practices rules for the operation of the nonprofit corporation;
• Obtain insurance nonprofit business activities and director and officer activities; and
• Prepare IRS application for tax identification number and apply for your federal tax exemption and complete any necessary registration documents with the Illinois Attorney General.

Choose a Business Name
Before you form your nonprofit corporation, you need to decide on a name that complies with the rules of your state’s corporate filing office. The following guidelines commonly apply:

• The name of your nonprofit cannot be the same as the name of another corporation on file with the corporations division.
• The name must end with a corporation designator, such as Corporation, Incorporated, Limited, or Corp., Inc., or Ltd.  (This is required in only about half of the states.)
• The name cannot contain certain words prohibited by the state, such as Bank, Cooperative, Federal, National, United States, or Reserve.

In addition to confirming that another corporation in your state is not already using your proposed name, you must make sure your name will not violate a trademark owned by another company (in or out of your state).

Prepare and File Your Articles of Incorporation
After selecting a business name, you must prepare and file articles of incorporation with the Illinois Secretary of State. Although preparing this document isn’t difficult, you do need to include specific language to ensure that you’ll receive tax-exempt status. The purpose of your nonprofit corporation must state that it is organized and operated exclusively for certain enumerated public purposes, including religious, charitable, scientific, testing for public safety, literacy, or educational purposes. The articles of incorporation should also contain language as to whether your organization will operate as a public charity or a private foundation. 

All Section 501(c)(3) tax-exempt organizations are either public charities or private foundations. Generally, public charities include Section 501(c)(3) tax-exempt organizations that qualify as churches, educational institutions and hospitals, as well as those tax-exempt entities that normally receive one-third or more of their support from gifts, grants and contributions from a broad range of the general public. Tax-exempt supporting organizations affiliated with the foregoing public charities also qualify.

A private foundation, on the other hand, is a Section 501(c)(3) tax-exempt organization that does not qualify as a public charity, generally because it is supported by the founder. Whereas, public charities are theoretically accountable to their large and diverse contributor base, private foundations are not. As a substitute for this accountability to contributors, the Code imposes numerous statutory controls on private foundations such as the imposition of special taxes and limits how the private foundation may operate.

Draft Bylaws
The bylaws are the internal rules that govern your nonprofit corporation. Bylaws contain rules and procedures for holding meetings, voting on issues, and electing directors and officers. More specifically, the bylaws will address the following issues:

• Purpose of Nonprofit Corporation: While the purpose of the nonprofit corporation will be generally stated in the articles of incorporation, the bylaws may further clarify the corporation’s purpose and mission. In the bylaws, you can more broadly state what the organization hopes to accomplish.
• Organization Membership: You will need to consider whether the nonprofit corporation will require certain people, such as parents of students within a particular school district, to be members of the organization in order to participate in the organization’s governance and operations. This section should also specify whether dues will be paid.
• Board of Directors: Directors, who meet and make decisions collectively as the board of directors, have the authority (and responsibility) to manage and run the nonprofit corporation. Many states allow nonprofits to have just one director, but other states require at lease three. In the bylaws, you may permit that the board of directors create committees and subcommittees to help with certain functions of the corporation.
• Officers: In the bylaws, you will need to specify whether there will be officers. Officers typically perform the day-to-day functions of the corporation, while directors manage the affairs of the corporation on a more macro level.
• Organization Meetings and Voting: This section of the bylaws will specify when there are regular meetings and special meetings, how will agenda and notice of the meetings be prepared, who will proctor the meeting and how will order be maintained, and how voting on decisions will be made.
• Conflict of Interests Policy: The purpose of the corporation’s conflicts of interest policy is to protect the corporation’s interest when it is contemplating entering into a transaction or arrangement that might benefit the private interest of an officer or director of the corporation or might result in a possible excess benefit transaction. The policy is intended to supplement, but not replace, any applicable state and federal laws governing conflicts of interest applicable to nonprofit and charitable organizations. In connection with any actual or possible conflict of interest, an interested person must disclose the existence of the financial interest and be given the opportunity to disclose all material facts to the directors, officers, or members of committees established by the board of directors that possesses board-delegated powers, as the case may be, that are considering the proposed transaction or arrangement. After disclosure of the financial interest and all material facts, and after any discussion with the interested person, such interested person shall leave the meeting of the board of directors, or the committee established by the board of directors that possesses board-delegated powers, as the case may be, while the determination of a conflict of interest is discussed and voted upon. The remaining members of such board or such committee shall decide if a conflict of interest exists.

Best Practices Guidelines
The best practices guidelines are designed to enhance and improve tax-exempt organization responsibility and governance. The guidelines do not in most instances reflect current legal requirements, but are intended to reduce a nonprofit corporation’s exposure to potential state and federal corporate, charitable trust and tax challenges. Also, the guidelines may improve the ability of corporations to attract charitable contributions and grants. Nonprofit corporations and tax-exempt organizations must strive for excellence in ethics in realizing their missions, managing resources effectively and governing well. All nonprofits must: (i) operate for the public good, (ii) comply with the law, especially in executing fiduciary responsibilities, (iii) uphold fundamental values including honesty, integrity, fairness and trust, (iv) observe articulated and rigorous ethical boundaries, including respect for all people’s race, religion, ethnicity, gender, age, socioeconomic status, sexual orientation and ability, (v) maintain complete and transparent financial accountability, and (vi) make appropriate information available to the public as required by law.

Insurance
This section aims to help you better understand the insurance risks that confront nonprofit corporations. In so doing, nonprofits can continue to provide client services without needlessly jeopardizing their organization's tax-exempt status or their consumers’/donors’ philanthropic assets.

• Myth: Nonprofits can't be sued because of charitable immunity.
  FACT: The concept of charitable immunity is based upon the notion that charitable organizations and individuals should be exempt from legal liability while giving selflessly to better their communities. Originally based upon an 1861 English court case, the doctrine of charitable immunity has faded over time and does not exist today.
• Myth: State laws protect charitable organizations against the threat of lawsuits.
  FACT: Today only three states (Alabama in 1991 and Delaware and Colorado in 1992) have adopted model statutes to provide liability protection to all volunteers (not just directors and officers) working for charitable organizations. Illinois has not adopted this model.
• Myth: The only insurance policy nonprofits need to purchase is a general liability policy.
  FACT: A general liability policy only covers basic exposures, such as premises and operations, even the organization's officers may not be protected under a stand-alone general liability policy.
• Myth: Directors & Officers (“D&O”) policy will protect us against any employment-related lawsuits.
  FACT: The coverage provided under many D&O policies can be very limited, with extensive lists of exclusions. D&O policies also do not protect against most employment-related lawsuits.
• Myth: If a charitable or nonprofit organization must purchase insurance, the organization should just try to purchase the lowest priced policy possible.
  FACT: An organization should determine its potential exposure to loss and then get coverage appropriate for that exposure. Buying a policy at a low price that doesn't fit your needs is no bargain.

The purpose of a risk management program is just that, to manage risk. A risk management program does not eliminate the need for insurance. Ideally, your organization only needs to purchase insurance protection against those risks that cannot be avoided through prudent risk management. A good risk management program will increase the likelihood your organization will be viewed as a "good risk " by insurers.

Apply for Your Federal 501(c)(3) Tax Exemption
A nonprofit corporation must qualify as a tax-exempt organization under Section 501(c)(3). In doing so, the organization must meet each of the following requirements in order to demonstrate that the organization serves a public rather than a private benefit and is not operated for the private or personal benefit of designated persons or its founders:

• The organization must be organized and operated exclusively for certain enumerated public purposes, including religious, charitable, scientific, testing for public safety, literacy, or educational purposes;
• No part of the organization’s net earnings may inure to the benefit of any private individuals or shareholders;
• No substantial part of the activities of the organization may be carrying on propaganda or otherwise attempting to influence legislation; and
• The organization must not participate or intervene in any political campaign.

To apply for your exemption, you must complete IRS Form 8718, User Fee for Exempt Organization Determination Letter Request, and IRS Package 1023, Application for Recognition of Exemption. For instructions on filling out these forms, read IRS Publication 557, Tax-Exempt Status for Your Organization. While you can’t actually file your exemption application until the Illinois Secretary of State has approved your articles of incorporation, before you file your articles, take a couple of hours to learn what it takes to qualify for the tax exemption. If you file your articles and then discover a problem as you begin working through the tax exemption application, you could be stuck paying taxes while you work through these issues – or even learn too late that your group isn’t eligible for an exemption.

After the IRS reviews your application, it will send you a letter indicating that it has approved your nonprofit status, or it might ask you for more information about your organization. The IRS can also deny your application outright.

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This publication has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.