Nikki Semanchik: Hello, my name is Nikki Semanchik and I am an attorney in San Diego, California. My firm is Semanchik Law Group, and one of our primary practice areas is nonprofit law. Today I'm going to talk to you about how to represent nonprofits, volunteer as a board member, or start your own nonprofit. So before I get started with today's topic, I kind of wanted to introduce you to the idea of nonprofit law as a practice area. So for many business attorneys, nonprofit formations probably come up quite a bit. You probably have clients asking about them, or if you're in the state planning arena, that's also a common thing that might come up with private foundations. Then as an attorney, I'm sure that you get asked to sit on a lot of boards, or possibly you've thought about adding that to something that you'd like to do with your volunteer time.
So the idea of how a nonprofit runs and some of the legal aspects of a nonprofit are something that I think a lot of attorneys come across in their practice in one way or another. So as a nonprofit attorney specifically, my job really involves a variety of things. So part of it is the formation of nonprofits and what that means is that someone will come to me with the idea to form a nonprofit, and I will take them through that formation process and form their nonprofit for them so that they have a distinct legal entity that is 501(c)(3) tax-exempt. So we'll talk a little bit today about what that looks like to form a nonprofit and how that process works, but that's a big part of my job. So that's a task that is pretty streamlined and is really not dissimilar to forming any other type of business entity, just a lot more steps and compliance involved.
So that's one aspect and when somebody comes to me and they say that they want to form a nonprofit, they often say that they've had this idea for years, they've been sitting on it and they just want to help someone. So part of my job in forming the nonprofit really is to have a very candid discussion with them about what it means to have a nonprofit because there are a lot of misconceptions which we'll go through a little bit more today, but some of the misconceptions involve the idea that nobody owns a nonprofit. So before we get through that formation process, I just like my clients to understand that they're going to be creating an entity that they actually don't have ownership in and that means they won't be able to profit off the entity or share in any proceeds. You can't sell a nonprofit.
So I really like them to have that understanding in advance. So that is one big part of the job is forming the nonprofit and again, we'll go through those steps. Another big job as a nonprofit attorney is what I call outside general counsel work. So this is the type of work that any inside general counsel would be doing for a nonprofit if the nonprofit had the budget to have a general council, which most of them don't. So this is just really anything that might come up for the nonprofit. So a lot of the times it might be reviewing bylaws, and this is tricky for nonprofits because nonprofits often have the idea that they should do everything on their own, on a shoestring budget. So once they actually do start bringing in revenue through donations or services, and they have money to hire an attorney, they often have bylaws that they possibly pulled offline or the board compiled on their own.
So typically a bylaw review, the bylaws are in pretty rough shape and they often are not in compliance with the law. And bylaws are a lot more, I would say, important with a nonprofit, which we'll talk about just because the governance aspects of nonprofits are just so essential. Another thing that I'll do as outside general counsel is I'll deal with board disputes. So you may think this doesn't happen often with nonprofits unless you happen to be on a PTA and you see how those work, but they often do have board disputes. It's a power struggle or it's maybe a dispute among just board members or among the membership and the board. Oftentimes I will come in to educate the board on their fiduciary duties, to educate them on what the rights of the members are, and to just navigate that dispute with them and make sure that everyone is really protected with the real idea, being that my job always is to represent the nonprofit and not any individual board member.
Another part of my job as outside general counsel is often compliance. So unlike a regular for-profit entity, nonprofits actually have a lot of compliance that they need to do. So that's on an annual basis. They need to typically have a filing with the local secretary of state. They need to do their tax returns of course, with the local tax board and then the IRS. But they often also have an attorney general compliance requirement. So they have to file something with the state attorney general and that often involves giving that attorney general a copy of their tax returns. Of course, they have a minute meeting requirement, which should have annual meeting minutes associated with it. So while those compliance requirements are not difficult, when you're looking at an organization where the majority of the people involved are volunteers, the compliance can be really tricky, whether it's just not having an understanding of what the requirements are or having a board that may have turned over.
I see this often with any school-based nonprofits. So for PTAs or little leagues or anything, or like that, where the parents are involved while their children are in school, as soon as those parents leave, you often have a situation where the new board has no idea what was done or what needs to be done. So compliance is a big problem. For nonprofits, if they fail to file their IRS tax return for three consecutive years, they'll lose their tax-exempt status automatically. So it's very important that those filings are done and so that's something that we'll often step in and assist with and educate on. Another thing that comes up quite a bit is employment matters. So when nonprofits want to hire employees, how they navigate a lot of those employment rules. We also talk to nonprofits a lot about their internal policies and contracts.
So that might be through unrelated business income that they're taxed on or in situations where they might have private inurement or excess benefit transactions, kind of navigating those rules and counseling the nonprofit on how they need to treat those situations. Then a big part of my job really, as a nonprofit attorney is education. So a lot of these founders that decide to form a nonprofit, they might not come from the nonprofit space and they just don't understand some of the rules. There are a lot more rules when it comes to nonprofits, ensuring that there's no conflict of interest and all of the things that the nonprofit needs to do to protect that 501(c)(3) status. So really, it's I take it very seriously to make sure that the nonprofits that I form, that the founders feel like they really understand what they're getting themselves into.
Then my job really is to step in and educate them on some of those complexities within the law that certainly come up for them. Okay. So today, just to give you an overview of what the topics we're going to talk about, we're going to go pretty in-depth on the formation and exemption of nonprofits. So nonprofits that are taxed as 501(c)(3) tax-exempt entities. We'll really go into how we form the non-profit and how we get that exemption. We'll also talk about annual compliance requirements. So what are the compliance requirements? Who are they filing with? How do we make sure we keep track of those? We'll talk about common nonprofit governance issues. So what are the things that typically come up for a nonprofit in terms of governance and things that we need to watch for? We'll talk about fiduciary duties of the board.
So this is really important for those attorneys that are looking at serving on a board and certainly with the importance of indemnification and liability protection. We'll talk about that because if you are looking at serving on a board, you want to make sure that you are individually protected and that you understand what the fiduciary duties of the board are so that when you step into that role you know what you're responsible for. Then we will also talk a little bit more specifically, although it does deal with compliance, but we'll talk about the 990 informational return and audit requirements. So what do those look like for a nonprofit? Again, part of being a nonprofit attorney is quite a bit of tax and so unlike maybe with the business law where you don't think about or talk about much the tax returns that your client will file, the 990 return for a nonprofit is informational.
So it's really important to understand exactly what those requirements are and to have some conversations with your clients, if not actually review the returns yourself. Then we will talk about the importance of quality bylaws. So of course it's essential for a nonprofit to have bylaws, but nonprofits really do use their bylaws and they really should treat them like the rules for how the nonprofit should function. And because governance is so important, bylaws really are quite essential, and having good ones will make a difference for a nonprofit. So we'll kind of talk about what should be in those and how to navigate those from a legal perspective.
Then we'll go into some of the tax issues for tax-exempt entities. So some of the things that we see could be problematic for the nonprofit and how they will navigate those issues. Then just generally some of the tips that I have for representing nonprofits and some of the experiences I've had throughout the years that may be able to help you as you decide to potentially move into this field. Okay. So getting into nonprofit formation and exemption, and again, this is a big part of my job as a nonprofit attorney. What will often happen is someone will schedule a consultation with me and they'll have an idea for a non-profit profit that they've been thinking about for a long time and oftentimes it's quite a sad story. It's a mother that's lost her child to some illness or some tragedy or an individual who's really seen some type of hardship in their own life and they want to start a nonprofit to help other people in that situation.
I've seen that more and more this past year, as people individually have faced such hardships that what they want to do with their time and their money is to help others. That's certainly one of the things that I absolutely love about this practice area is you get to see all of the people that are really just trying to make a difference and impact change in the world. So when I get a call like that, and somebody wants to form a nonprofit, one of the preliminary considerations that I'm thinking about when they're talking to me is what are they trying to form? What type of nonprofit? So are they trying to form what we call a public charity or a private foundation? Now, these are two different legal classifications that the IRS will give to a nonprofit.
Before we even get into the nonprofit formation process, we need to have an understanding of which one they're going to fit under. Now, again, this is a status, really a tax status that the nonprofit gives that the IRS gives to a nonprofit. So before we get tax-exempt status, we need to understand which one they're likely to fit under and which one they're hoping to get. So the public charity is probably the most commonly understood. When you hear 501(c)(3) people often get those numbers mixed up 5013C. The idea is that it's a tax-exempt entity, right? It doesn't pay taxes for any of its income and any donations to it are able to be written off. So the donor is able to write off those donations on their tax return, right? So it's deductible and so when we look at a public charity and those are the most common that we think about those are entities that generally receive a greater portion of their financial support from the general public, rather than a private donor.
So what they typically need to do is meet a public support test and that public support test requires that they get at least 33 and a third of their donations from the general public. So what that means is that I am thinking about when someone is talking to me, are they looking at being a public charity? Do they plan on getting donations from the general public, or are they planning on funding this nonprofit on their own? So when I find that they are saying that they want to do this with their family, or that they have a significant amount of wealth that they want to pass on in some way. It's usually that they're looking at a private foundation rather than a public charity. So that is a situation where they're typically controlled the nonprofit by just a few members of a family or a small group of individuals.
So think like the Bill & Melinda Gates Foundation, right? They usually derive more of their support from just a small number of sources or even from investment income. So with private foundations there tends to be at least less public scrutiny about various operating restrictions and excised taxes for failure to comply with those restrictions because the funds are not coming from the general public. The idea is that they're just coming from a few individuals. So the public may be less concerned. Though I kind of question that in the last few years, it does seem that there has been more and more public scrutiny on how private foundations are utilizing that money, and certainly with both public charities and private foundations, the tax returns are completely public and anyone can view them.
So there is certainly a great amount of transparency there. So the big difference is that with a public charity, donors can deduct contributions of up to 50% of the adjusted gross income. Whereas with a private foundation, they can generally only deduct up to 30% of their adjusted gross income. There are also rules that private foundations must expend at least 5% of their asset value. So they actually need to have money go out on an annual basis and there's various other differences, but really what I'm thinking about when somebody says that they want to form a nonprofit, where is the money coming from? Do they want to be a public charity or a private foundation? So the default is really private foundation and so this is where actually I see a lot of nonprofits that didn't hire an attorney that get themselves into hot water when they try to do the application themselves and they don't understand these differences. They often get classified as a private foundation and the private foundation tax return is much more complicated.
It's not easy to do on your own, like a public charity's tax return is if you have a low amount of gross receipts and it's really often not what they're intending. So what I really ask myself when I'm trying to classify them is what is the nonprofit intending to do? Do they want to support other organizations or are they going to have their own programs? So think about this, if you're speaking to a client and they say, "I really feel like I want to put my money somewhere where it's going to make a difference and I want to support pediatric cancer. There's some organizations that I'd really love to give grants to." Okay. Then they're probably going to be a private foundation.
So you ask them questions. Is it just you that are planning on funding this? Are you planning on holding fundraisers or do you plan on having any of your own programs? If in the contrast you hear a client and this is more common that they say, I want to help, I want to educate the public about this cause, I want to run a clinic, or I want to have a dog rescue and they actually want to run the programs themselves. Then they either want to charge for the services or they want to get donations. Then they're going to be more of a public charity. So really the question is where are they getting their funding? And that's how they'll be classified. Okay. So we'll talk about more when we get into the actual tax-exempt, how we get tax-exempt status, how that looks on the 1023 application.
But that's really a big preliminary consideration that I go into. Now, the formation process involves really four distinct steps. First is incorporation, which looks not dissimilar to the formation and incorporation of any corporation or LLC that a business attorney may do. Next is getting the federal tax-exemption. So that's the 501(c)(3) status and that's done with the IRS and then you get state tax-exemption. Now, this is not required for every single state, typically states where you actually pay some state income tax, it is required. So you need to actually get exemption with the state, as well as the IRS in those states. This is particularly important in states like California, where we have a minimum franchise tax fee for all entities. Now we don't want our client to have to pay that $800 annual fee and so we make sure to get them exemption.
Then there is attorney general registration requirements, which we'll talk about and that's very, very common and most states have that requirement. Now, incorporation as any business attorney knows incorporation starts by filing articles of incorporation with a secretary of state. They might be called something different in your particular state, but they all have the same bits of information. Sometimes there is a form available on your secretary of state's website, which you can use. I recommend having your own version that you use, like a Word document because you might want to have additional information. I find that the form version just doesn't include everything that really should be in there. Now, what needs to be in there from a legal perspective, obviously is the name of the entity and then a general-purpose statement and a specific purpose statement.
So the general purpose statement might be really what is the organization charitable or educational or religious or scientific? That would be the general purpose and that's going to be a state general-purpose, not to be confused necessarily with the IRS purpose. So you'll see two different areas typically on the articles where it says the general purpose for the state versus the IRS purpose, which can be a bit confusing. So then there's this specific purpose statement, and that's really similar to a mission where I do counsel clients is to not have the specific purpose statement be too specific.
You want it to have some flexibility because you don't want the client to have to go and amend their articles, anytime that their mission shifts and changes, and it really will. They're going to grow and they're going to probably do things that they don't anticipate in the beginning. So having that, even though it's called a specific purpose statement, having it fairly broad is usually a better way to go and then there should be a dedication clause and that's a line in there that's going to say that the assets of the nonprofit are specifically dedicated toward this nonprofit purpose. A dissolution clause which says that upon dissolution, the assets of the nonprofit will go to another nonprofit and so that they can specify exactly which nonprofit or which type of nonprofit, but the IRS does require that those four bits of information are in the articles.
So we know once we file the articles, we have a distinct legal entity, right? The next thing that we need to do is draft bylaws. So we'll talk a little bit later about what some things that need to be in those bylaws, but essentially bylaws are the rules for how a nonprofit should function and so they're really important. We want to make sure that they're very clear that they comply with the state nonprofit corporation act, and that they're a useful tool for the nonprofit. After we have filed the articles, we'll get an employee identification number, which is important for nonprofits. Most donors will want to know that number. I tell clients it's like the social security number for their business and for our clients, we will complete initial meeting minutes, and this will identify the board of directors and the officers and authorize all the initial corporate action, like filing the articles and appointing the registered agent, opening a bank account and obtaining an EIN. Then if required in your state, you'll file an initial report or statement of information. So that's the incorporation process which we really tell clients is step one.
What's important to remember is what the IRS does is they actually give retroactive tax-exempt status to nonprofits back to the date of formation. So from that date, from when we get our articles filed the nonprofit will actually be considered tax-exempt by the IRS back to that date, as long as they file their 1023 application within 27 months of formation. So step two is applying for tax-exempt status from the Internal Revenue Service. So this is we have our entity and now we need it to be a 501(c)(3). So there are many different purposes under 501(c)(3), the common ones are charitable, religious, educational, and scientific, but there are several others which I have listed. How we apply for this status is we do it through what's called the 1023 application and there are now two forms of the 1023 application.
There is the full application or what they call the 1023-EZ. Now there are the two paths is how I kind of describe it to clients when they come to me and I'm explaining the formation process. I say that there are two paths to getting 501(c)(3)status, the full 1023 application, or the 1023-EZ. So they call it the 1023-EZ because it certainly is easier. It's shorter, and the filing fee is less. So where we can get clients, when we have clients that are small and who are interested in doing the 1023-EZ, we will have them apply through that route. Now the 1023-EZ, which I'll explain a little bit more later, it was created to fill a backlog. So they were just taking a really long time the IRS to look at these 1023 applications.
So they created an easier form for clients. So we'll go into what those qualification are to do that form, but the full 1023 application, which we most commonly do for clients, it involves an application that you now do online. So it used to be a PDF form that you had to fill out. It's now done online through pay.gov. So you create an account and you fill out the form on there and it's made the process much easier. So it consists of a narrative application aspect where you're going to really describe what the programs are and the activities of the nonprofit, and they want the past, present, and future activities. You'll also provide the financials for the nonprofit so this is going to be a budget for if you're just starting out for the first three years and the profit and loss budget, and then a balance sheet.
Then there might be various schedules that you will complete based on your answers to the application. So those schedules are for things like schools or hospitals, or if you're giving scholarships. Then there will be things that you attach to the online application. So if you are an attorney completing the application for a client, you'll want to attach the 2848 Power of Attorney form signed by the client and you, which allows you to speak with the IRS on the client's behalf and to submit the application and the filing fee is currently $600. So you'll pay that through the online process and it says in my presentation notes that it's three to six months. Now, that is what it has been historically. The six months being the longer timeframe. Usually, it was rare that we ever saw it go over six months, but we are in a post or current pandemic time.
The IRS is just taking much longer to review these applications. So thankfully what they have actually done is they have gone and put a more accurate timeline on their website, which you can actually search, and you can see what applications they're currently reviewing. So applications submitted in December and you can see how far back they're going. So that's really helpful for managing client expectations, but it does. It takes a long time for them to review this full application and I just tell clients, this should not stop you from running your programs. You should feel free from the moment that you have that formation or your articles are filed to open your bank account and to collect donations and to run your nonprofit because your tax-exempt status is going to be retroactive. So that's just a really important thing that I make sure the client understands because otherwise, they get very, very antsy.
So just breaking down the form 23, to understand the various parts and what the IRS is really looking for. They kind of break it down. They want governance information, operational information, financial fundraising, and then specific activities. So within governance, they're really asking, do you have articles? When were they filed? Do you have bylaws? They want a copy of those. Do you have a conflict of interest policy? Which you should definitely make sure the client has, and they want to know who your officers and directors are. They're very concerned about, what is the compensation for those officers and directors and how often are they working? They used to ask for the bios of the officers and directors, but they actually removed that from the application. So clients always want to know, should they pay their board of directors?
Certainly not in the capacity as directors, they should not be paid. That should be a volunteer position. There's a lot of conflict of interest associated with being a director and the IRS just feels strongly that in order to fulfill their fiduciary duties, they should not be paid in that capacity. However, that is not to say that a nonprofit should not have someone who is a director and also is paid in another capacity. So they could be paid in the capacity of officer or executive director or some other role within the nonprofit. So the operational part of the 1023 application is that's where you have that narrative that really describes all the past, present, and future programmatic activities. So this is where there's a bit of creative writing on the part of your attorney to really explain to the IRS, what is the nonprofit planning on doing?
Often I get situations where a client gives me two or three sentences about their activities and part of this is really getting a bit more information out of them. So you can really understand what they're doing, looking at what other similar types of nonprofits are doing. So you can really understand the space and just really trying to put as much detail in so that the IRS really gets a grasp of what they're doing. This is also a public application. So though it's filed with the IRS, it's going to be available on the attorney general's website. Anyone who asks the nonprofit for it can request a copy of the 1023 application and so I do tell clients this is a place to really describe what you're doing to the public. So we take that seriously and make sure that all of the future activities and things that they plan on doing are described.
Certainly, if they plan on doing, or if they end up doing more, that's not a problem. You don't need to ask permission from the IRS just to naturally expand as long as it fits within what you told them you would be doing generally. Then the financials, which we talked about, the detailed profit and loss for three years, and the balance sheet and clients get nervous about this and say, "Well, how am I supposed to know? And what if things change?" I just tell them that the IRS doesn't expect them to have a crystal ball and know these numbers are absolutely going to be what they are. Of course not. They want to know that you've thought it through and that you have a plan for where the money is going to come from and how you're going to spend it, and then fundraising.
So they really want to, this is where they're really trying to decide if you're the public charity or private foundation. So how are you going to fundraise or are you going to fundraise? Where's the money coming from? That's where they want to know that and then they have a bunch of questions where they have questions about your specific activities. I call these the red flag boxes because the IRS really wants to know if you do check, yes, they want an additional explanation often. So that's where us having done so many applications, we can preemptively give the IRS information that they want because when you submit this application, it does take a long time to get reviewed. And sort of the last thing that you want is a situation where the IRS is coming back for additional information. So to the extent that you can just provide it to them in advance, it's incredibly helpful.
Okay. So you can go online and look at the 1023 application. You can look at the PDF form or now it's online. So it just takes you by and asks you all the questions. Okay. So now the 1023-EZ. So again, when a client calls me, I'll talk to them about if they want to do the 1023-EZ or the full. If they're in a situation where I think that they're eligible for the 1023-EZ, I will encourage them to do this application. When the IRS first came up with this 1023-EZ, I think a lot of us nonprofit practitioners were a little bit skeptical. We were worried that it would increase the likelihood that the IRS would audit the nonprofit. We just felt that it was good practice for a nonprofit to put time into figuring out their budget and their programmatic activities, and really pull all of that together.
I don't disagree with the latter. I do think it's important for a nonprofit in order to be successful they need to have an understanding of what their budget is and to put some time into the application is like a business plan. It really forces them to go through that exercise. But I haven't seen the audits and I think that the 1023-EZ for my clients who really fit the eligibility criteria, which you can go through the worksheet, which is attached to the end of the 1023-EZ to see if they meet the criteria. I think it's a great option for those clients and so really the biggest criteria point that I bring up to clients is do they think that they'll have less than $50,000 in gross receipts for any of the next three years. Well, really it's for all of the next three years.
So are they going to have more than 50,000 in any of the next three years? So what the IRS is looking for is, are you going to be small? Do you think you're only going to have 50,000? If so you're eligible. Now, this always leads to every single client that asks, "Well, what if we get a huge grant or some unexpected donation that we weren't anticipating?" Now, of course, that's always a possibility and the IRS doesn't expect you to decline those funds. When they give you tax-exempt status as a 501(c)(3) after you file the 1023-EZ you have the exact same tax-exempt status as a nonprofit that filed through the full 1023 application. So they're not going to require you to reapply or take away your status. You just need to be able to say within good faith, that you don't anticipate getting more than 50,000, and then you are able to use this application. So for clients who are budget conscious, I think that this is a really good option, and I lean more toward it now than I did when it first came out.
Okay. I guess to go back on that 1023-EZ a little bit, the filing fee is $250, and it's also done online. It used to be about a two to four-week timeline to get an approval, which was very attractive for a lot of clients, but this is actually taking a lot longer too. So you can now look on the IRS website and see what the current processing times are for the EZ. Now, after we get the 1023 approval letter, it's called a determination letter. Once we get that back from the IRS, they will let you know whether or not you have public charity or private foundation tax-exempt status and that is really what we think of as the golden ticket. Now, you are a tax-exempt, nonprofit and donors will often request that or private foundations giving grants will request a copy of that determination letter.
So that's very important. So it takes us to the next step. If your nonprofit is in a state where you pay state taxes, you may need to seek state tax-exemption. So it's typically done with the local franchise tax board or state taxing agency. In almost every state, the application can be streamlined after you have already received the IRS exemption. So once you've already gotten that determination letter, so I wait to apply for state tax-exemption until the nonprofit has already received the federal determination letter, because it's much easier and usually the state will just follow suit with what the IRS has determined.
So this avoids state income tax, and then any other annual minimum taxes that may be imposed on an entity in the state. There also are opportunities sometimes for property tax-exemption or sales tax-exemption, or other tax-exemptions in a particular state. So you're free to look at those for your particular state. They kind of vary. Okay. Now the final step in a nonprofit formation is attorney general registration. So the attorney general's job is to keep track of nonprofits and the charitable assets they have and provide oversight. So if you think about this, right, it makes sense. The public is typically donating their funds to a nonprofit, and there needs to be some type of oversight to make sure that the nonprofit is doing what they say they're going to do with those funds. They're not misappropriating it or mismanaging it and that they provide oversight so that consumers can be protected.
So it's really the attorney general's job and typically they're, it's a separate branch, called the registry of charitable trusts or something to that effect. So really what triggers a filing registration requirement with them is that you have begun to solicit donations in that state. Now, what can be tricky is that you may be incorporated in one state, in California, for example, and also soliciting donations in another state. So it may actually be required that you file in multiple states and so this becomes very tricky for clients and it's a tricky area truthfully. The question is what necessitates registration in a state? Now, some states have adopted, what's called the Charleston Principle and that idea essentially boils down to you need to be specifically targeting a person in that state and engaging in passive solicitation that has an ongoing and repeated contact with the state residents.
So for example, if a nonprofit has a donate here button and someone is donating in multiple states, that is not going to trigger a registration requirement in various states, most likely because that is not an ongoing and repeated targeted interaction with individuals in that state, it's very passive. But if you went into that state and had a fundraiser where you were actually soliciting with donors there, and you continued that or repeated that solicitation, then that might trigger a register requirement. So it's different for every single state and not all of them have adopted this Charleston Principle, but it's something that we really think about and counsel nonprofits through. Typically when you're filing with the attorney general, you have that initial filing and then you usually have an annual filing requirement. So the annual filing requirement is often going to ask for a copy of the tax returns and that just makes it easier for individuals to go and look at the tax return for a nonprofit. So that's the role of the attorney general and what those filing requirements are.
Now, we talked a little bit about this in the start of the presentation, but nonprofits do have quite a bit of ongoing annual compliance. So things that they need to do really on an annual basis to keep their tax-exempt status. So some of the things they need to do are typically they will have some type of annual or bi-annual filing with the secretary of state. So it might be called an annual report or a statement of information. Typically, what they're asking for is just an updated address and the names of the officers and directors. So you want to make sure that you do this. If you failed to do this, you often can trigger the nonprofit losing number one, its good standing in the state so that they might not be protected from lawsuits or contract disputes in that state. Then it could also trigger losing tax-exempt status on a state level as well.
So while it seems like a small thing it can be very, very important. Now the IRS has annual tax returns and so there are three types of tax returns for a nonprofit public charity. Public charities will do either 990, a 990-EZ, or a 990-N. Private foundations, which we're not talking about a lot here, but they do the 990-PF private foundation so it's a separate return, which I mentioned can be a little longer and harder. So with these different types of tax returns, they're graduated returns with the idea being that really small nonprofits that are bringing in $50,000 are less, should not have to do a really complicated tax return and expend funds on that. So they will file what's called a 990-N and it's really an electronic postcard. So it's done online.
It asks really just eight bits of information. It's quite simple. I tell clients they can easily do it themselves, or I'll do it for them and that's due each year by May 15th. Now, if they are above 50,000 in gross receipts and gross receipts is really any income. So anything coming from donations or service revenue or anything coming in. So if they have more than 50,000, but less than 200,000 then they're going to do a 990-EZ, which has a bit more information that's required than the 990-N. So certainly they are really going into more some of their activities and it's an informational return, which is important. It's not just the numbers, it's really they're seeking out information about the nonprofit and how it's running. So there is a bit more in that 990-EZ.
Often I tell clients when you get to that point where you're doing the EZ that's when you really want a CPA involved. Then finally for over 200,000 or 200,000 and over, it's the 990 full. So again, this is an informational return. It's a very, very long tax return. It requires a lot of information and honestly, I don't think it's something that just the CPA should be involved in. The board should have some hand at reviewing it because they are asking for information about the activities of the nonprofit and how the nonprofit is running from a governance perspective, an operational perspective. These are not just things that every CPA may know about the nonprofit and so there should be some collaboration between the board and the CPA to make sure that the 990 is correct and accurate. And really this is the only place where you can communicate to the IRS how you've expanded your programs or what you are doing.
Again, it's public. So this is also where you're communicating to your donors, what you're doing with the money and what your programs are and what your governance looks like. So it's very important that the 990 is accurate. Now, as I mentioned before, if a nonprofit fails to file their tax return for three consecutive years, they will be automatically revoked. So what that means is they'll lose their tax-exempt status. They can apply for reinstatement of that tax-exempt status through various avenues. So it's not completely the end of the world, but it's certainly not something a nonprofit wants to deal with losing that tax-exempt status. So we try to make sure they understand that it's due every May 15th. They can get an extension if they need to.
There will be no penalties for failing to file the 990-N on time, but for the 990-EZ and 990, there are penalties. So it is very important. You may also have a state tax board annual filing requirement. Sometimes they're similar to the IRS filings in that they might be asking for more information if the nonprofit brings in more revenue. Then as I mentioned, you might have an attorney general filing requirement, and then, of course, every nonprofit typically will need to do an annual meeting and have minutes associated with that meeting. So that might be where they are electing their officers and directors or approving the major actions of the nonprofit. It's also important a lot of states have an audit requirement in California. The audit requirement is once you get to over $2 million, you have a requirement to get audited financial statements.
So that's just something to be conscious of for nonprofits and to advise them on. Okay, now what are some common nonprofit misconceptions? Well, there are quite a few, and I think it just really comes from maybe entrepreneurs going into the nonprofit world and just not really understanding the differences between a nonprofit and a for-profit, but really people just don't really understand some of these things. So part of my job is really to make sure that I educate them a bit on some of these common misconceptions. So one of them is that all nonprofits are tax-exempt. So a lot of people will assume because they have filed as a nonprofit with the secretary of state that they're automatically a tax-exempt entity, and they'll kind of stop there. That's where I often see with services like LegalZoom, or any of those online services.
Clients will often just pay for maybe the first step of getting the entity formed and they won't really grasp that they need to actually go and apply for tax-exempt status with the IRS and the state. So that's a common misconception. Another one is that all donations to nonprofits are tax-deductible. Now we talked about nonprofit 501(c)(3) entities, but there are actually many different 501(c) entities that are not under 501(c)(3). So there's a 501(c)(4) and a (c)(6) and (c)(7)s that I deal with commonly, and those entities are tax-exempt in that they don't pay income tax, but they are not an entity where donations to them are tax-deductible. That's a really important distinction, for example, a social club that might be a 501(c)(6) you can certainly donate to that entity, but you're not going to get a write-off for it. So that's just important for clients to understand. Another one is that nonprofits can't make a profit and so I think where I see this mostly is that people don't believe that nonprofits can charge for their services.
If you've ever been to a nonprofit hospital you know that they certainly can. And part of what you have to understand is that nonprofits need to always comply with their exempt purpose. So that purpose is going back to, in the formation, when we have that purpose, where we're listing, are they charitable? Are they educational? Are they religious? Are they scientific? So they always need to fulfill that exempt purpose, but they can certainly charge. So maybe they're charging below fair market value for their services or they're providing services to an underserved population. There's just nothing wrong with charging for their services. But I think it's just important to understand that there are limitations on what they're able to do. For example, they can't do something that is so commercial that it's competing with a for-profit entity, right?
It still needs to fit within that exempt purpose to some degree. Another common misconception is that the founder is the owner of a nonprofit and I hear this all the time. It's one of the first things that I make sure a client understands. Even when I tell them you're not going to own this, you're not going to be able to sell it or profit from it I still don't think that they really grasp it sometimes because it's a hard thing to get. You build something, you pay to get it formed, you're on the board and you feel like you own it, or you're entitled to something from it. So I see this more along the lines with years down the line, when a client who's already been formed will come back and say, but I gave everything to the nonprofit. I gave everything for years, my time, my money.
So they don't understand why now they can't start to put some of their personal expenses on the nonprofit or receive some type of benefit in some way. So it's a lot of counseling and just making sure that they understand that there are really important limitations on nonprofits in this way, and just counseling them to make sure that they understand just because you found a nonprofit, you don't own it. You may not always be able to serve on the board of that nonprofit. Another one is that nonprofits can't do business with for-profits.
People seem to be quite confused about nonprofits and for-profits doing business together. I think that's really common, but it happens all the time. We see it in buy one, give one campaigns. There's a whole cause marketing platform where nonprofits and for-profits work together or nonprofits are now making sure that they give back in some way and they want to be associated with a for-profit. So there are great opportunities for nonprofits to do business with for-profits and bring in a lot of revenue and donations. So I counsel clients all the time that that can be a really beneficial relationship.
Okay. So some of the common nonprofit governance issues that I see are failure to understand the role of the board of directors versus the officers. So I counsel clients often on who is the board versus who is the officers. Now, if you think about it from a top-down perspective, the top of the nonprofit is always going to be the board of directors and they are going to be in charge of the general oversight of the nonprofit. With that comes fiduciary duties of care and loyalty, good faith, and they need to make sure that the nonprofit is not mismanaging its assets and that it's always fulfilling its exempt purpose and those directors, they do not have individual power. Their power is in the collective body, meaning they get together, and assuming that they have quorum the appropriate number of directors are present.
They collectively will vote and majority vote will decide certain action and that's how a nonprofit will move and that's what makes it different than a for-profit. Those directors will then appoint officers, which sit under them and serve at the pleasure of the board. So they have oversight over the officers. So the officers are the president, secretary, and treasurer. So that's the difference in those two roles. Often another governance issue that we'll see is a breakdown between the executive director and the board of directors. So understanding what those separate rules are. So we'll just educate clients on what that looks like, that the executive director really serves under the board. Then just going back to that founder's dilemma, which I already touched on just this idea that a founder doesn't own the nonprofit and that they might put all of their heart and soul into it, but they can't personally reap any financial benefits.
Okay. Something that is really important for protecting the officers and directors and for those looking at serving on a board is making sure that the bylaws have indemnification provisions in them. This is a provision that's going to say that the officers and directors of and profit will be indemnified if they're brought into a lawsuit. It happens all the time where a nonprofit is brought into a lawsuit and all of the officers and directors are named. So having this indemnification provision can be really, really important to making sure that the officers and directors are protected. Now, going hand in hand with the indemnification provisions are directors' and officers' insurance. So we call it D and O insurance and that is really important to make sure if there is a situation where the officers and directors are sued and there is indemnification procedures in the bylaw, provisions in the bylaw that we have insurance, that's going to come and fund that.
So I often recommend to anyone that you should not serve on a board unless the organization has D and O insurance. Board education is really important, just really making sure the board is educated about what their fiduciary duties are and before you serve on a board to understand that it can be easy to sit on a board and be a newcomer, and just go along with what's happening. But you have an individual fiduciary duty to make sure that you are protecting the organization. So asking questions, actually looking at the financials, paying attention, not just voting with the majority, you need to make sure that you take that job really seriously because you could be personally liable if you don't fulfill those duties, it's unlikely, but it's an important job. I think it should be taken quite seriously.
Especially if you are an attorney serving on a board I think that there is a duty there to understand if you do not understand nonprofit law, that maybe you're not going to delve into that and get involved in some of those legal aspects of the nonprofit and that you because I see it often that people will bring lawyers on their board to get legal services from them, instead of realizing that the attorney could provide value, just because of their experience, generally as a board member and not free legal services. So be cautious of getting in a situation where a board brings you on because that's what they're looking for because you might be in a situation where you're then practicing an area that's outside of your area of expertise, which is going to do no service to you or the nonprofit. Okay.
We talked a little bit about this, the importance of quality bylaws. I'll just touch on this a little bit more that again, governance issues are really common with nonprofits and they often have these power struggles. So what the bylaws are, is there a roadmap for how the organization will run procedurally. So it's going to clarify does the nonprofit have members and what are those members' rights? Do they vote out on the board? Do they vote on amendments to bylaws? What are the director's terms and how would we go about removing a director? When will we have meetings and what are the notice requirements? Notice means how do we provide the notice that a meeting is going and to occur and how much in advance of the meeting do we need to provide that?
What is quorum? Meaning how many directors need to be present for action to occur. Indemnification that we talked about, and is that going to be mandatory that the board is absolutely indemnified or permissive that will be voted on. Who are the officers of the nonprofit and what are their terms and roles and titles? Then an important one is how the bylaws could be amended. Some of the tax issues that we often see with nonprofits are really losing their tax-exempt status or the risk of losing their tax-exempt status. So are they operating in a way that they could risk their tax-exempt status? There are many ways they could do that.
990 issues and transparency and just really the nonprofit not understanding that their financials are open to public scrutiny and so that's an important one. Private inurement so is an insider benefiting unfairly financially from the nonprofit. We always say that a nonprofit is not meant to have any individual benefit from it. So private benefit, excess benefit these are all laws that nonprofits must deal with to make sure that nobody is receiving an unfair benefit and that all goes back to that conflict of interest policy, which creates a policy for how any potential conflict is dealt with in the nonprofit. Then a common tax issue is unrelated business income tax, which nonprofits are able to have a little bit of unrelated business income but if they get to an extent where they have too much, that could be an issue that would jeopardize their tax-exempt status.
Some of the tips that I have for representing nonprofits really it's education. So educate your clients as much as you are actually doing the tangible work, educate them on what it means to have a nonprofit. That's big part of the job and I think that what can really set you part apart as a really quality nonprofit attorney, and that requires you to understand the law. So not only the IRS provisions that relate to nonprofits but your local corporation's code. So you really need to have a very thorough understanding of those laws because governance is so important with nonprofits. So I'll get very intricate questions about how can we do this, or when do we need to provide this notice? And it all goes back to my local nonprofit corporation's code in California and so understanding that law or having some kind of treatise that can help you navigate that is really important.
Then obviously know your client, take the time to listen to them, and understand exactly what they're doing, what are their programs, and what is their mission. Then you can be a lot better advocate for them and provide them a lot more insight. So some of the key takeaways that I hope that you can take away from this presentation today is number one, nonprofit law is really an exciting and rewarding practice area. It's my favorite practice area. I get so much joy from helping individuals that are giving back and it's where I see the most innovation and really, really cool ideas that people are coming up with. It's been a tough couple years for people and so I think seeing that there are so many people that want to spend their time giving back to others is really rewarding. That there's a lot of nonprofit rules that are unique, conflict of interest rules, and compliance so understanding those.
I hope that you take away that those are important and you need to have a good grasp of those and that governance is key for nonprofits. So understanding some of those rules in the corporation's code and understanding the importance of bylaws. Then I hope that you understand that serving on a board of a nonprofit also comes with its serious legal obligations. And hopefully, after this presentation, you feel really like you're prepared to either take on this practice area or serve on a board and you feel like you have a little bit more knowledge there. It has been my absolute pleasure and I hope that if you have any questions that you feel free to reach out to me and thank you very much.