California Law
California Associations & Nonprofit Corporations Law
- Associations & Nonprofit Corporations Law
Associations & Nonprofit Corporations Law
Most people recognize the value of associating with others who have similar interests, concerns, occupations, or professions. Historically, people have formed associations in order to share interests or further common goals. Associations have ancient roots: during medieval times, and even earlier, merchants formed trade guilds. Today, associations and nonprofit corporations continue to proliferate in occupations and professions, as well as in many other areas of people's lives. Associations and nonprofit corporations provide members with opportunities for education, information exchange, social activities, research sources, and political power. Not only do businesspeople benefit from their membership in such groups, their organizations may become members of associations made up of businesses, commonly known as federations. Some businesspeople may find themselves organizing or directing associations or nonprofit corporations. For these reasons, it is helpful for business leaders to understand the structural options available to nonprofit groups. An organization will need professional advice from an attorney to establish the business, and from an accountant to oversee financial matters once the association is in operation. This chapter describes the benefits of cooperative, unincorporated associations as well as the benefits of nonprofit corporation status, and explores formation, organization, and tax issues.
Forming an Unincorporated Association
While many nonprofit associations benefit from forming nonprofit corporations, small, local, or labor organizations tend to prefer an unincorporated association format. Local musical, religious, or literary clubs, for example, may not have the financial or human resources to obtain and maintain nonprofit status. Nonprofit corporation status, discussed below, tends to be advantageous to larger groups with activities and relationships external to the organization. Small charitable organizations, such as family trusts, do not seek public funds or otherwise deal with people or organizations outside of the association. These organizations would not benefit from nonprofit corporation status, and incorporation would add additional and unnecessary legal requirements and possible liability.
Unincorporated Association Law
Just because an association takes a less formal approach to its formation does not mean that it should grow haphazardly. Members of unincorporated associations should be aware that without some formal planning, associations risk running afoul of the law. Early organization becomes particularly useful once an association starts to grow in membership and resources.
Most states do not have laws that govern unincorporated associations in general, although they may have statutes concerning specific types of associations. California law, however, does address both unincorporated associations generally and certain specific types of unincorporated associations, such as nonprofit associations and joint stock associations. The laws generally do not mandate registration or internal procedural requirements for associations, unless they become nonprofit corporations. Instead, the California laws primarily address liability and property ownership and conveyance issues. An attorney familiar with associations law can identify and explain any requirements. Labor organizations (unions) must follow strict federal laws governing their formation, their activities, and their relationships with management and employees. Labor unions are discussed in more detail in the Labor Law Chapter.
In addition to statutes dealing with unincorporated associations, some legal principles may be applicable to such groups. Associations may not be formed for illegal purposes. Gun clubs, for instance, are lawful as long as members comply with state and federal gun laws; anti-government groups may be prohibited by laws that outlaw treason, as well as bylaws that limit the type and number of firearms people may possess.
Historically, an unincorporated association was not liable for actions of its members because it was not a legal entity subject to suit. However, the trend in the law is to allow even unincorporated associations to sue and be sued. California generally allows such actions. Furthermore, in some states, individual association members may be liable for acts of other members under the traditional law of agency. A member of a musical society who contracts for a group performance may, even unintentionally, hold the other members responsible for upholding the contract. In effect, members of associations may act as agents for other association members. In California, however, some statutes specifically limit the liability of members of associations for the acts of other members. A manager of an association also may have a fiduciary duty, that is, the association has placed the person in a position of trust and confidence. He or she is required to act in good faith and in the best interests of the association. Similarly, the law of estate planning and probate, tort law, property law, criminal law, or even state anti-discrimination law, may apply to an unincorporated association.
Articles of Association
Every association should have articles of association. Sometimes referred to as the charter or the constitution, the articles of association is the document containing a statement of the association's purpose and an outline of the procedures it will follow. Some states require an unincorporated association to file its articles of association with the secretary of state, the county clerk, or another state or local agency. The charter should be tailored to the particular organization, but most articles of association contain the following:
- Organizational purpose
- Organizational structure
- Qualifications for membership
- Methods for appointing leaders
- Internal procedural guidelines, such as frequency of meetings and authority for handling finances
- Tax status
Any organization that solicits funding from the public, borrows money, is subject to insurance laws, is in a regulated industry, or has tax liability, must have articles of association. Even if not required, however, every association can benefit from the clarity of purpose and procedure that comes from creating a charter.
Becoming a Tax-Exempt, Nonprofit Corporation
Forming a tax-exempt, nonprofit corporation is a fairly complex endeavor that requires time, money, and an understanding of legal and tax technicalities--all of which may be scarce in organizations that would most likely benefit from tax-exempt treatment and nonprofit status. Still, the benefits available to nonprofits are so great that it often is worth the time and energy to become familiar with the necessary steps. Some of the rules governing how a nonprofit corporation must be formed and operated are complex. The process of becoming a tax-exempt, nonprofit corporation actually has two distinct phases: (1) creating the nonprofit corporation, and (2) applying for tax-exempt status for the corporation once it has been created. The chronology of these two phases is important. The second phase--applying for tax-exempt status--will be far simpler for organizations that keep that goal in mind during the first phase.
Benefits of Tax-Exempt, Nonprofit Status
The primary benefits of tax-exempt, nonprofit status are financial. All or most of the money made by a tax-exempt, nonprofit corporation is free from federal, state, and local taxation, so the organization can devote a larger share of its funds to the purpose for which it was formed. Furthermore, nonprofit status is often a prerequisite to obtaining private grants or government funding. Donors are more likely to contribute financially to tax-exempt, nonprofit corporations than to non-exempt organizations because donors can write off the donations on their tax returns. In addition to tax benefits, there may be low-cost postage and advertising rates available to nonprofit organizations, and many retail stores offer reduced rates to nonprofits and their employees. As with all other businesses, nonprofits are open to lawsuits and liability for the way they conduct themselves. Organizing as a not-for-profit corporation can shield the individuals who run the organization from personal liability for organizational debts.
The often-overlooked advantages of forming a tax-exempt, nonprofit organization are the internal benefits that the organization gains when required to commit to writing its management structure and corporate purpose. Many nonprofits start out as a small group of committed persons working toward a definite goal. Having to think through the organization's purposes and management procedures can bring clarity, focus, commitment, and structure at an early stage in the organization's life. These qualities can be invaluable as the organization grows, takes on new projects, and adds new members, or if internal disputes arise.
Drawbacks of Tax-Exempt, Nonprofit Status
Just because an organization qualifies for tax-exempt, nonprofit status does not mean that seeking nonprofit status is the best plan. Tax-exempt, nonprofit status does have drawbacks:
- Profits of the organization cannot be divided among workers or directors (although workers and directors may be paid reasonable salaries)
- Only a small amount of the group's income can be earned from sources unrelated to the organization's reason for receiving tax-exempt status
- The assets of the group cannot go toward purposes other than those that warranted the tax-exempt status
Many businesses do not take advantage of tax-exempt, nonprofit status because they prefer the flexibility and the possibility of personal financial gain associated with for-profit status. Other organizational leaders opt not to incorporate in order to avoid the paperwork. For a very small organization that does not need donations or that has few tax obligations, forming a nonprofit corporation and seeking tax-exempt status may be more trouble than it is worth.
Nonprofit Corporations in California
Most nonprofit corporations in California are governed by the Nonprofit Corporation Law, with administrative authority granted to the Secretary of State. Under this law, a nonprofit corporation may be formed for a wide variety of purposes, but nonprofit corporations generally are divided into three categories: public benefit corporations, mutual benefit corporations, and religious corporations. Public benefit corporations may be formed for any public or charitable purpose. Mutual benefit corporations may be formed for any lawful purpose.
Necessary Documents
At the very beginning of the process of forming a nonprofit corporation, a group should file articles of incorporation--the charter document of the corporation--with the Secretary of State's Office. The articles of incorporation must include:
- The name of the corporation
- A statement of the specific purpose for which the corporation is organized
- The name and address of the corporation's agent for service of process
- The name and address of each incorporator
Although the list of required items is short, the articles of incorporation may set forth additional information about the corporation. Most articles of incorporation documents are complex, because incorporators want to craft an organization uniquely suited to the people who form it and the purposes for which it is formed. The Nonprofit Corporation Law contains numerous "fallback" provisions detailing how the corporation operates. Some provisions automatically apply unless they are specifically modified in the articles of incorporation or bylaws. Other provisions can be modified only in the articles of incorporation. An attorney experienced in advising nonprofits can help an organization decide how much it wants to alter the "fallback" provisions of the Law and whether it is best to do so in the articles of incorporation or bylaws. Incorporators are charged with signing and delivering the articles of incorporation to the Secretary of State's Office.
The nonprofit corporation must hold meetings of the board of directors. At the first such meeting, the board must adopt bylaws, which define the rules and procedures under which the corporation will operate. The bylaws may not be inconsistent with the articles of incorporation. Bylaws typically include:
- The number, qualifications, manner of election, powers, duties, and compensation of directors
- Qualifications for membership
- Different classifications for members
- The manner of admission, withdrawal, suspension, and expulsion of members
- Property, voting, and other rights and privileges of members
- Appointment and authority of committees
- Appointment or election, duties, compensation, and tenure of officers
- Time, place, and manner of calling, conducting, and giving notice of member, board, and committee meetings or of conducting mail ballots
- Making of reports and financial statements to members
- The numbers required to establish a quorum for meetings of members, committees and the board
A California nonprofit corporation should file articles of incorporation, the minimum franchise tax, and appropriate fees with the Secretary of State. All nonprofit corporations in the state are required to file an annual report of officers and directors with the Secretary of State's Office. The organization must file the articles of incorporation with the recorder of deeds in the county in which the registered office of the corporation is located. Certain charitable organizations may face additional requirements.
Later, the articles of incorporation and bylaws must be submitted to the Internal Revenue Service (IRS) when filing for federal tax-exempt status under section 501(c)(3) of the Internal Revenue Code, discussed below.
Officers and Directors
Every corporation governed by the Nonprofit Corporation Law must set forth the number of directors in its bylaws. The bylaws also may describe the titles and duties of the officers. The same person may perform functions of more than one office.
Incorporating means that a business is considered a legal entity separate from its employees and directors; thus, it is able to make contracts and incur liability in its own right. But the employees and directors may be legally responsible for actions taken on behalf of the corporation. California statutes require that the director of a nonprofit corporation discharge his or her duties in good faith, in a manner he or she reasonably believes to be in the best interest of the corporation, and with reasonable care. A director who performed his or her duties in accordance with this standard is not liable simply by reason of his or her position as a director. Directors and officers who serve without compensation are not liable for acts of the corporation unless the acts are intentional.
Getting Tax-Exempt Status for a Nonprofit
Many kinds of businesses and groups qualify for federal tax-exemption. Some groups, such as chambers of commerce, social clubs, and credit unions, may be entitled to federal tax-exempt status under very narrowly drawn statutes not discussed here. A common form of tax-exempt status is found in section 501(c)(3) of the Internal Revenue Code. This is the most desirable form of tax-exemption not only because 501(c)(3) corporations are exempt from federal, state, and local taxes, but also because donors to the organization can qualify for tax write-offs for their contributions to the organization. Failure to qualify for tax-exempt status subjects an organization to federal taxation. An association may be subject to taxation as a corporation if it meets three of the four following factors:
- Central management
- Continuity beyond the lives of individual members
- Limited liability of shareholders
- Freely alienable shares
Nonprofits that Qualify for Federal 501(c)(3) Status
There are five different purposes for which the IRS allows organizations to file for tax-exempt status as nonprofit corporations under section 501(c)(3) of the tax code.
Charitable Purpose
The term "charitable" in section 501(c)(3) has a broader definition than in common usage. It refers to anything that has benefit for the public. Organizations established for a charitable purpose may intend to benefit only a relatively small group of people, but may not be so small that the actual beneficiaries are specifically listed. Examples of charitable purposes include the maintenance of public buildings and relief for the poor.
Religious Group
This term also is broadly interpreted. "Religious groups" include mainstream organizations such as churches or temples, as well as many other organizations of people with truly and sincerely held beliefs. The only necessary factor for qualifying as a religious group is that the group be pursuing the advancement of religion. It is more difficult to qualify as a "church" for tax-exempt purposes than it is to qualify as a religious group.
Scientific Organization
A group with the primary purpose of scientific research in the public interest is eligible for tax-exempt status. Research is considered to be in the public interest if the results eventually are made available to the public.
Educational Organization
"Educational organization" is another broadly defined filing category in which endeavors aimed at self-development as well as community benefit are allowed tax-free status for the purpose of education. A person or group may qualify under this purpose to espouse a point of view, provided it is not a political position. Parent-teacher organizations associated with schools generally fall into this category.
Literary Purpose
"Literary purpose" is a rarely used category for filing because most literary organizations that could fit this classification file as educational organizations instead. Generally, groups that sell books promoting the public interest, at or below cost, and available to the general public, qualify as groups organized for literary purposes.
Application for Federal Tax-Exemption
There are four publications and forms available from the IRS that should be used to apply for 501(c)(3) tax-exemption:
- Application for Recognition of Exemption (Form 1023)
- User Fee for Exempt Organization Determination Letter Request (Form 8718)
- Application for Employer Identification Number (Form SS-4)
- Tax-Exempt Status for Your Organization (Publication 557)
All of these publications are available free of charge and all come with detailed instructions or advice. The IRS will respond to the application in one of three ways: granting the exemption, requesting further information before making a final decision, or issuing a Notice of Proposed Adverse Determination. Form 1023 is the nucleus of the application. The Form 1023 packet includes instructions for responding to a request for further information or Notice of Proposed Adverse Determination. If the nonprofit corporation is granted tax-exempt status, the determination letter will summarize the basis for the decision and conditions that must be met to maintain it.
Qualifying for State Tax-Exempt Status
An organization that is exempt from federal income tax is not automatically exempt from California tax. It must apply separately for exemption from California tax. However, California and federal laws regarding tax-exempt status are similar, so organizations may want to complete the state and federal applications at the same time. In some cases, California may require that an organization obtain a federal determination of tax-exempt status before issuing a state exemption. California Form FTB 3500, the Exemption Application Booklet, provides application forms, instructions and other information.
Resources
For additional information on California associations and nonprofit corporations, contact the California Secretary of State, Corporate Division, 1500 11th Street, Sacramento, CA 95814, (916) 657-5448, or any local office of the California Franchise Tax Board.
Associations and nonprofits that are interested in additional information on the federal rules for tax exempt status should contact the Internal Revenue Service, 1111 Constitution Avenue N.W., Washington, DC 20224, (800) 829-3676.
Additional resources on associations and nonprofits generally can be found in:
- Hoyt L. Barber, How to Incorporate Your Business in Any State (Liberty House, Princeton, NJ 1989).
- Marcia L. Clifford, et al., Nonprofit Organizations: Forms for Creation, Operation and Dissolution (Callaghan & Company, Wilmette, IL 1987).
- John Cotton Howell, Forming Corporations and Partnerships (Liberty Hall Press, Blue Ridge Summit, PA, 2d ed. 1991).
- Anthony Mancuso, How to Form a Nonprofit Corporation (Nolo Press, Berkeley, CA, 2d ed. 1994).
- Barbara Singer, Nonprofit Organizations: Operations Handbook for Directors and Administrators (Callaghan & Company, Wilmette, IL 1987).
- Michael G. Trachtman, What Every Executive Better Know About the Law (Simon & Schuster, New York, NY 1987).
The Service Corps of Retired Executives (SCORE) also can be a useful resource. SCORE is a fraternity of retired business managers who volunteer to help new or existing businesses and nonprofit organizations. Information about the services offered by SCORE can be obtained by contacting one of the regional offices throughout the state.