Nonprofit organizations — charities, foundations, educational institutions, religious organizations, and civic groups — play a vital role in American civil society. But operating a nonprofit involves a web of legal obligations that many founders and board members do not fully understand. From the moment you file for tax-exempt status to the ongoing compliance requirements that come with it, nonprofit law demands careful attention.
What Makes an Organization “Nonprofit”?
A nonprofit is an organization formed for a purpose other than generating profit for its owners or shareholders. In the nonprofit sector, any surplus revenue is reinvested in the organization’s mission, not distributed to individuals. This is distinct from a for-profit business, where profits can be distributed as dividends or owner draws.
Nonprofit status is a state law concept — states grant nonprofit corporate charters. Tax-exempt status (the ability to avoid paying federal income tax and to receive tax-deductible donations) is a federal concept governed by the Internal Revenue Code and administered by the IRS.
Not all nonprofits are the same under tax law. The most familiar category — 501(c)(3) public charities and private foundations — is just one of many. Other tax-exempt categories include 501(c)(4) social welfare organizations (which can engage in political activity that 501(c)(3)s cannot), 501(c)(6) business leagues (trade associations), and dozens of others.
Forming a 501(c)(3): The Process
To form a 501(c)(3) organization, you must:
Step 1: Incorporate Under State Law
Choose a state, draft articles of incorporation that include required provisions (including a statement of purpose limited to 501(c)(3) purposes and a dissolution clause directing remaining assets to other nonprofits or government upon dissolution), and file with the state.
Step 2: Draft Bylaws
Bylaws govern the organization’s internal operations — how the board is structured, how it makes decisions, meeting requirements, officer roles, conflict of interest procedures, and how bylaws can be amended.
Step 3: Recruit a Board of Directors
Nonprofits are governed by a board of directors. The board has fiduciary responsibility for the organization and must be structured to comply with state nonprofit law and IRS requirements. Boards should generally have at least three independent directors.
Step 4: Apply for Federal Tax-Exempt Status
File Form 1023 (or 1023-EZ for smaller organizations) with the IRS. This application describes the organization’s mission, activities, governance, and finances. The IRS reviews the application to confirm that the organization qualifies for 501(c)(3) status.
Step 5: Obtain State and Local Registrations
Most states require charitable organizations to register before soliciting charitable contributions. Registration requirements vary by state and may require annual renewals and financial reporting.
Governance: The Board’s Legal Duties
Nonprofit board members have three fiduciary duties that govern their obligations to the organization:
Duty of Care: Board members must act with the care that an ordinarily prudent person would exercise in similar circumstances. This means being informed, attending meetings, reviewing financial statements, and exercising independent judgment.
Duty of Loyalty: Board members must act in the best interests of the nonprofit, not in their own personal interests or the interests of any other organization. Conflicts of interest must be disclosed and managed.
Duty of Obedience: Board members must ensure the organization acts in accordance with its stated mission and complies with applicable laws and regulations.
The Conflict of Interest Policy
IRS Form 1023 asks whether the organization has adopted a conflict of interest policy — and virtually all should. A conflict of interest policy:
- Requires board members, officers, and key employees to disclose potential conflicts
- Establishes a process for the board to evaluate whether a conflict exists
- Prohibits interested parties from voting on or otherwise participating in decisions about transactions in which they have a personal interest
- Documents all of the above in board minutes
Without robust conflict of interest procedures, a board member who has a financial interest in a transaction approved by the board could expose the organization (and potentially themselves) to IRS scrutiny and legal liability.
Annual Compliance: Form 990
Most tax-exempt organizations must file an annual information return with the IRS — Form 990 (or 990-EZ or 990-N for smaller organizations). Form 990 is a public document — anyone can request a copy, and most Form 990s are posted publicly on ProPublica’s Nonprofit Explorer and Guidestar.
Form 990 requires detailed disclosure of the organization’s finances, governance, programs, compensation paid to officers and directors, and transactions with interested persons. Errors, omissions, or inconsistencies in Form 990 can attract IRS scrutiny and undermine donor confidence.
Failing to file a required Form 990 for three consecutive years results in automatic revocation of tax-exempt status — a serious consequence that requires a formal reinstatement process to reverse.
Fundraising Compliance: Charitable Solicitation Laws
Most states regulate charitable fundraising. Organizations that solicit charitable contributions in a state (including online solicitation that reaches residents of the state) are typically required to register with the state’s charity registration office before soliciting and to renew annually.
Registration requirements vary widely by state — some have no requirements; others require detailed financial statements and audits. The Unified Registration Statement (URS) streamlines the multi-state registration process for organizations soliciting in many states simultaneously.
Additionally, most states require charitable organizations to disclose their registration status and a specified statement in fundraising solicitations.
Lobbying and Political Activity Restrictions
One of the most significant constraints on 501(c)(3) organizations is the prohibition on political activity. 501(c)(3) organizations are absolutely prohibited from participating or intervening in political campaigns on behalf of or in opposition to any candidate for public office. Violation of this rule — sometimes called the “Johnson Amendment” prohibition — can result in loss of tax-exempt status.
Lobbying — attempting to influence legislation — is not absolutely prohibited for 501(c)(3)s, but it must be insubstantial relative to the organization’s overall activities. A 501(c)(3) can engage in some lobbying; it simply cannot make it a substantial part of its activities.
Protecting the Organization: Insurance and Liability
Nonprofits should carry appropriate insurance coverage:
Directors and Officers (D&O) Insurance: Protects board members and officers against personal liability for decisions made in their capacity as nonprofit leaders. Many qualified individuals will not serve on a nonprofit board without adequate D&O coverage.
General Liability Insurance: Protects against claims of bodily injury or property damage arising from the organization’s activities.
Employment Practices Liability Insurance (EPLI): Protects against employment claims — harassment, discrimination, wrongful termination.
Working with legal counsel experienced in nonprofit law — from formation through ongoing compliance — is one of the most valuable investments a nonprofit can make.
