Setting up a non-profit organization can be advantageous because of the tax breaks, but it isn't easy. In order to benefit from the advantages of a non-profit organization, you must closely adhere to government regulations. There are in fact several different types of non-profit organizations, categorized based on who sets up the organization, its purpose, donation methods, etc., and they each receive different tax benefits and have different requirements. Read on to learn more about how to set up a non-profit properly, so that your organization can be successful in the long term.

1. What is a 501(c)(3) organization?

Section 501(c) of the Internal Revenue Code specifies a number of different organizations that can qualify as tax-exempt non-profit organizations. These include charities, social welfare organizations, business leagues, labor organizations, civic leagues, social and recreational clubs, and many others. 501(c)(3) organizations are those founded for religious, educational, charitable, scientific, or literary purposes, for testing for public safety, to foster national or international amateur sports competition, or prevent cruelty to children or animals. In order to qualify as tax-exempt organizations, they also must not distribute profits to shareholders.

When applying for 501(c)(3) status, unless you can show that your organization is a public charity or a private operating foundation, the Internal Revenue Service (IRS) will assume that the organization is a private foundation. The tax deductions for donations to these types of organizations differ, so it's important to pay attention to this point during the application process.

2. Why set up a non-profit organization?

Some of the benefits enjoyed by 501(c)(3) non-profit organizations that have been approved by the IRS include:

• They can collect donations from the public. The donations should be used for purposes such as cultural, scientific, educational or charitable programs.
• They are tax-exempt; they do not need to pay Federal or state business income taxes. However, if the organization does any commercial activity not related to its tax-exempt programs, then it must pay business taxes on that income.
• Benefactors can deduct their contributions from their taxable income. As much as 50% of contributions to charitable organizations and private operating foundations can be deducted, and up to 30% of contributions to private foundations.
• Non-profit organizations receive a discount on postage rates.
• The organizations and their employees get discounted premiums for group life insurance and health insurance.

3. Requirements for setting up a 501(c)(3) organization

In order to receive the tax benefits of a 501(c)(3) organization, you must be approved for tax-exempt status by the IRS as a charitable organization or private operating foundation. For that you will need to meet the following conditions/requirements:

1. The organization must be founded for religious, educational, charitable, scientific, or literary purposes, for testing for public safety, to foster national or international amateur sports competition, or prevent cruelty to children or animals.
2. The organization's operation must not serve the founder's or shareholders' private interests.
3. The organization must not undertake activities to influence legislation or political elections.
4. The organization must be considered a public charity or private operating foundation.

4. Limitations on non-profit organizations

Since 501(c)(3) non-profit organizations enjoy significant tax benefits compared to corporations, these organizations are somewhat limited in how they must operate:

1. They must pay taxes on income that is not related to their tax-exempt purpose. If this kind of income makes up a disproportionate amount of the organization's overall income, the IRS may reconsider the organization's 501(c)(3) tax-exempt status.
2. The organization's assets must be used for its tax-exempt purpose; the shareholders cannot derive any benefit from an increase in assets. If the non-profit disbands, it must distribute its assets to other 501(c)(3) organizations.
3. The organization cannot distribute profits to shareholders or pay them to board members, executives or employees outside of their normal salaries.

5. Types of non-profit organizations

There are three main types of 501(c)(3) organizations: Public Charities, Private Foundations and Private Operating Foundations.

Public charities receive a large amount of funding either directly or indirectly from the public and the government. Their public funding base must be broad; it cannot be limited to a few individuals, families or companies. Public charities are usually further categorized into three types: The first consists of churches, schools and hospitals. The second type consists of charities whose financial backing comes mainly from government funding and donations from the public or from other charities. The third type consists of charities that support one or more other charities; these are usually called Supporting Organizations.

Private foundations, also called non-operating foundations, usually have a particular source of funds and distribute their funds to other charitable organizations, rather than spending them directly on their own charitable programs. These foundations often invest their main capital, and then use the income from investment for philanthropic purposes.

Private operating foundations, meanwhile, use their income and assets to run their own tax-exempt charitable programs, and usually don't contribute to other organizations. They generally don't seek donations from the public, either.

6. Preparing to apply for non-profit status

After establishing a non-profit organization, you have 15 months to apply to the IRS for tax-exempt status, and this period can usually be extended for another 12 months, meaning you have up to 27 months to complete the process. The effective date of tax-exempt status can be retroactively set as the date the organization was established. The application process usually takes 3 to 6 months, and there are a number of documents that must be submitted. The documents must be approved by the organization's Board of Directors, and should be drafted by an attorney who is familiar with non-profit organizations.

An important step in the preparation for setting up a non-profit organization is convening a meeting of the Board of Directors, which will officially establish the organization. During this meeting, the following items should be decided:

1. Discuss and approve the organization’s Articles of Organization and By-Laws;
2. Pass a resolution to establish the non-profit organization;
3. Select board members;
4. Approve a schedule for future Board meetings;
5. Establish committees, such as administrative, audit, and program committees;
6. Appoint Board members to each of the committees.

When discussing the Articles of Organization and By-Laws, the Board of Directors should consider the organization's mission; the Board members' qualifications; the number and term of service of Board members; the meeting schedule; the quorum required for a meeting; the responsibilities, powers and term of service of executives; rules for amending the By-Laws; and the procedure for dissolving the non-profit. The responsibilities of the Board of Directors primarily include the following:

• Plan and decide the non-profit organization's mission and purpose;
• Recruit and appoint executives to carry out the Board's management obligations;
• Oversee the organization's operation and evaluate its programs in order to ensure it reaches its objectives;
• Participate in fund-raising activities;
• Draw up an annual budget and internal work standards to ensure that funds are effectively used for the appropriate programs;
• Strengthen the organization's public image.

7. Steps for applying for non-profit status

The basic procedure for setting up a non-profit organization is as follows, but it is far from simple. There are many legal requirements which must be met, and many details that should be discussed and decided together with your attorney and accountant.

1. Discuss the process with an attorney and other professionals;
2. Draft the organizing documents to establish the organization;
3. Convene a Board meeting to approve the organizing documents and any other resolutions;
4. Register and incorporate the organization with your state government;
5. Order the organization certificates and seals;
6. Apply for an Employer Identification Number (EIN) from the IRS;
7. Draft a plan for the organization's development over the next several years (including funds to be collected, target donors, and uses for donation funds);
8. Discuss and prepare the application materials to the IRS;
9. Apply for tax-exempt status from the IRS;
10. Apply for tax-exempt status from your state government.

8. State requirements for non-profit organizations

State governments also perform a regulating role for some non-profit organizations. They primarily concern themselves with two types of organizations: First, organizations that have their offices or property in the state; and second, organizations that conduct fundraising activities in the state. State governments generally require non-profit organizations located in or fundraising in the state to register, that is, to report the organization's operations. There are primarily two parts to this requirement: 1) submit reports on the organization's finances and internal management; and 2) submit an Annual Report, with an emphasis on fundraising activities.

In Maryland, for example, non-profit organizations must send an annual audit report, signed by the organization's Director and Chairman of the Board, to the state government within 6 months of the end of each fiscal year. The following categories of organizations, however, are not required to submit an annual report: 1) religious organizations or schools that do not have specified fundraising personnel; 2) organizations that only collect funds from their members; 3) organizations whose annual donations from the public total less than $25,000. These organizations do need to submit the "Exempt Organization Fund-Raising Notice," however.

9. IRS reporting requirements for non-profit organizations

After your non-profit organization is established, you will need to continue to pay attention to Federal and state laws and regulations in order to operate the organization according to their requirements, so as not to lose tax-exempt status.

Non-profit organizations must keep careful track of their finances, prepare financial reports, and hold onto documents that verify their income and expenses. They should also have detailed records to show the sources of income and donations.

Most 501(c)(3) organizations must submit Form 990, Return of Organization Exempt from Income Tax, to the IRS to report the organization's income, expenses and activities. Organizations whose annual income is less than $100,000 and total assets are less than $250,000 can used the simplified form (990-EZ). Private foundations, including private operating foundations, should submit Form 990-PF. And no matter whether you submit Form 990, Form 990-EZ or Form 990-PF, if the 501(c)(3) organization's income from activities not related to the tax-exempt purpose is $1,000 or more, then you will need to submit Form 990-T.

The following types of 501(c)(3) organizations do not need to submit Form 990 or Form 990-EZ:

• Churches and organizations affiliated with churches;
• Organizations affiliated with government agencies;
• Subsidiary organizations of larger organizations.

In the past, non-profit organizations whose annual income was less than $25,000 did not need to submit an annual report, but since 2006, these organizations also need to submit this information through an electronic reporting form.