Nonprofit Corporations Overview
§ 17.1Nonprofit Corporation Formation (State Level)
A nonprofit corporation is formed by filing a certificate of formation that conforms to Texas Business Organizations Code (TBOC) requirements with the secretary of state (SOS Form 202, form 17-1 in this manual). In particular, the certificate must be in writing, submitted by the duly authorized organizer(s), and signed by an organizer. The nonprofit corporation’s certificate of formation typically differs from those for LLCs and other entities by being customized to contain language relating to tax exemption issues. Once formed, the nonprofit corporation can begin transacting business in the state of Texas like any other entity (subject to obtaining a license to do business).
The name of the nonprofit corporation must appear on the certificate of formation. Texas law does not require nonprofits to include “corporation,” “incorporated,” or similar designations in their names, but some organizers prefer to include them or their abbreviations to show the incorporated nature of the entity. The certificate of formation must also include the purpose for which the corporation is organized; this language is scrutinized by the IRS during its tax exemption application process (detailed later in this chapter). In addition, for IRS satisfaction, the certificate of formation needs to include certain language limiting the rights of profits, prohibiting other actions by persons, or both. The final required language relates to dissolution and distribution of assets upon winding up and the permitted scope of such actions by a nonprofit corporation.
PRACTICE TIP: Search for similar entities on the secretary of state website. Their certificates of formation will contain language that has already been approved for tax exemption at the federal, state, and other levels of government. This language can be set out in your entity’s governing documents to ensure it is approved for tax exemption. In some instances, this language can also be found on the organization’s website or on third-party websites like Charity Navigator’s. It is important to use these precedents to draft the largely bespoke certificates of formation.
PRACTICE TIP: Have clients who want to establish a nonprofit corporation put together a business plan for their nonprofit so they can understand the goals and requirements of a nonprofit corporation. The founders of a nonprofit corporation should, at a minimum, think about what they want the nonprofit to accomplish, what actions can (and cannot) be taken by individuals, and where they ultimately want the nonprofit to rest upon termination. The business plan can also take into consideration some of the financial goals, which can be tied into the nonprofit corporation’s tax exemption application with the IRS.
The certificate of formation should include the names of at least three individuals who will serve as initial directors for the corporation. The initial directors will serve until the organizational meeting is held and permanent directors can be selected. There is no limit on how many directors can serve, but three to nine is the most common range of director seats on a nonprofit corporation. The certificate of formation should also specify if the corporation will have members. As with other entities, the rest of the required language in the certificate of formation for a nonprofit corporation sets out the registered agent’s name and address, the name and address of the organizer, and the effective date of incorporation.
PRACTICE TIP: The certificate of formation can include more detailed language governing the director election process, the directors’ indemnification or exculpation, methods of voting with or without a meeting, the qualifications and residency requirements for directors, the methods for removing or replacing a director, and other language as necessary.
After the certificate of formation is filed, it is important for the nonprofit corporation (or its advisors) to draft other governing documents in preparation for the organizational meeting. These documents include bylaws, meeting minutes (or unanimous written consent by directors in lieu of a meeting), consent and resignation of the organizer, a codification of the conflicts of interest, document retention and donation policies, and other documents as the initial board deems necessary. These documents will be submitted to the IRS as part of the tax exemption application process. Once they are prepared, and soon after the certificate of formation is filed with the secretary of state, a meeting should ideally be held in person or by remote means or, alternatively, via a detailed unanimous written consent circulated to every director of the corporation.
§ 17.2Federal Tax Exemption for Nonprofit Corporations
For the purpose of this discussion, we will focus on IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, required for the federal tax exemption for nonprofit corporations.
PRACTICE TIP: The IRS updates and amends forms often. Make sure that you obtain the latest versions of IRS Form 1023 and the Instructions for Form 1023.
When filing the certification of formation (even when using the state of Texas forms) practitioners must consider and meet the requirements of IRS Form 1023 to obtain exemption. The certificate of formation requires a purpose, and if the entity is to be tax-exempt, that purpose must be deemed acceptable by the IRS. Acceptable purposes for IRS Form 1023 are “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.” Internal Revenue Serv., Dep’t. of the Treasury, Instructions for Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code 7 (2020).
In addition, the certificate of formation must state how the assets of the organization will be distributed upon dissolution. If using the state of Texas forms, this should be listed in the “additional language” area. The IRS approves the following language:
Upon the dissolution of this organization, assets shall be distributed for one or more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or shall be distributed to the federal government, or to a state or local government, for a public purpose.
Instructions for Form 1023 8.
PRACTICE TIP: Do not deviate from the simple language provided by the IRS in the certificate of formation. In addition, use the IRS Sample Conflict of Interest Policy for the organization bylaws, which can be found in appendix A of the Instructions for Form 1023. This language is acceptable to the IRS and will not be questioned by revenue agents. Bylaws can always be amended after the application for tax exemption is accepted.
For the organization’s exempt status to be effective as of the date of the approved certificate of formation, IRS Form 1023 should be filed within twenty-seven months of the secretary of state’s approval. If the application is filed after that twenty-seven month period, however, the exemption date will be effective as of the date IRS Form 1023 is filed.
IRS Form 1023 requires a narrative description of the organization’s activities and the organization’s financial data. If the organization is new and has not conducted activities or does not have financial data, that should be noted on the application, and the answers to these questions should outline the planned activities and the anticipated revenues and expenses. The level of detail depends on whether the organization uses IRS Form 1023 or IRS Form 1023-EZ. Each question should be answered in detail but as succinctly as possible.
PRACTICE TIP: If the application is not complete or the narrative and financial data are not clear, the application will be sent to a revenue agent, which will delay the application process by several months. The trick is being clear without being overly wordy.
The IRS considers any organization applying for exempt status using IRS Form 1023 to be a private foundation unless the organization meets certain criteria, which generally amount to a determination of whether the organization is a public charity. A public charity receives a significant amount of its funds through public support. To gain this public charity status, the entity must meet both the “one-third public support test” and the “not-more-than-one-third investment income and net unrelated business income test.” Instructions for Form 1023 14.
Every organization that qualifies for tax exemption as an organization described in section 501(c)(3) is a private foundation unless it falls into one of the categories specifically excluded from the definition of that term (referred to in section 509(a)). In addition, certain nonexempt charitable trusts are also treated as private foundations. Organizations that fall into the excluded categories are institutions such as hospitals or universities and those that generally have broad public support or actively function in a supporting relationship to such organizations.
Internal Revenue Serv., Dep’t. of Treasury, Private Foundations, IRS (Dec. 20, 2019), www.irs.gov/charities-non-profits/charitable-organizations/private-foundations.
PRACTICE TIP: It is important to understand where an organization plans to obtain its funding. If you are unsure if the organization truly qualifies for public charity status or private foundation status, let the IRS choose. This will prevent the application from being held up by a revenue agent.
§ 17.3Governance of Nonprofit Corporations
A nonprofit corporation’s certificate of formation should clearly state who is authorized to manage the organization and the specific acts they are authorized to perform.
A nonprofit corporation may be managed by members if that is plainly set out in the certificate of formation. See Tex. Bus. Orgs. Code § 22.202(a). It is important, however, to consider the practicality of having members manage corporate affairs, given, for example, frequent changes in membership status. If the organization has various levels of membership, the certificate of formation should be clear on which levels have voting privileges.
§ 17.3:2Management by Board of Directors
Absent a designation in the certificate of formation, management of a nonprofit corporation will be vested in the board of directors. Tex. Bus. Orgs. Code § 22.202(b). The board must consist of at least three directors. Tex. Bus. Orgs. Code § 22.204. Any organization that operates with fewer than three directors is not in compliance with the TBOC. Maintaining an odd number of directors is best to establish a clear majority when voting.
It is important that any organization has a process to elect or appoint the board of directors. These acts should be completed during the annual meeting. If the board is large (seven or more directors), using alternate term years is preferable. For example, three board positions may be up for election or appointment during even-numbered years and four during odd-numbered years. This ensures the continuity of the board.
Directors must perform their duties “in good faith, with ordinary care, and in a manner the director reasonably believes to be in the best interest of the corporation.” Tex. Bus. Orgs. Code § 22.221(a).
Good Faith: Directors must act honestly and trustworthily in their duties and obligations. The directors should not attempt to take advantage of the corporation and should avoid self-dealing.
Care: Directors must be vigilant when conducting the affairs of the organization. This means that they have to monitor the finances of the organization, attend regular meetings, evaluate the records of staff, and operate in accordance with the organization’s bylaws.
Best Interests of Corporation: Directors must act reasonably based on the objective facts available to them at the time a decision is made. Objective facts include what the directors know and what they should have known. When acting in the best interest of the corporation, directors should consider both the short-term and long-term interests of the organization.
Many organizations have nonvoting advisory boards. This is acceptable if the bylaws clearly state that an advisory board is allowed. If so, the bylaws must also include the advisory board’s roles and responsibilities. The advisory board should have a clear appointment or designation process that is consistently followed and approved by the board of directors.
PRACTICE TIP: Many nonprofit organizations are started by people who want to do good, but who are ill-equipped to handle the responsibilities of running a public organization. It is important to express to your clients the importance of documenting and maintaining proper board responsibilities. Many founding organizers want to control their organizations. This is not possible through charitable nonprofit organizations that seek tax exemption. Making the distinction between what is allowed in a for-profit organization versus a nonprofit organization can help keep the directors on track.
§ 17.4Annual Meetings and Recordkeeping for Nonprofit Corporations
Nonprofit organizations must hold an initial meeting to adopt bylaws and to elect officers. Tex. Bus. Orgs. Code § 22.104(a). It is recommended that a business attorney attend this meeting to explain organizational documents to the board of directors. Meeting minutes should document the election process and the vote.
PRACTICE TIP: Meeting minutes are important to any organization. The minutes should be detailed enough to assist the board in deciding significant issues.
In addition to documenting adopting bylaws and electing officers, the initial meeting minutes should reflect an authorization to open a bank account and to file a tax exemption application (if applicable) and should indicate an acknowledgment of any members and of any other initial acts by the board of directors.
If the organization is member-managed, a separate meeting should be held to allow the members to vote in accordance with the bylaws.
The organization should establish a specific date and time each year that it will hold an annual meeting of the board of directors and, if applicable, members. If the organization has regularly set meetings outside of the annual meeting, the board and any members should receive timely notice providing the time and place of the meetings.
PRACTICE TIP: Meeting minutes can be discovered as legal evidence. Minutes should detail the discussions and resulting votes from any action, should be kept in the regular course of business, and should be stored accordingly.
Members have the right to inspect the books and records of a nonprofit corporation. Tex. Bus. Orgs. Code § 22.351. If a member issues a written demand for the books and records, the organization must comply and provide a time and place for inspection.
The organization must maintain current and accurate financial records. Tex. Bus. Orgs. Code § 22.352(a). The board of directors must ensure that annual reports are produced each year. Tex. Bus. Orgs. Code § 22.352(b). This financial report is public information. See Tex. Bus. Orgs. Code § 22.353(b). Failure to maintain financial records, prepare an annual report, or make the report available to the public is a class B misdemeanor. Tex. Bus. Orgs. Code § 22.354. Exemptions to this requirement are listed in TBOC section 22.355.
PRACTICE TIP: Each organization should have a written document management policy that states the length of time and manner in which documents should be held and when and how they should be destroyed. This policy should be provided to staff and volunteers and should become a regular business practice of the organization.
§ 17.5Periodic Reports for Nonprofit Corporations
Domestic and foreign nonprofit corporations are subject to periodic reporting requirements with the secretary of state.
A nonprofit corporation is required by TBOC section 22.357 to file a periodic report that lists the names and addresses of its current registered agent and office and its current officers and directors. The Texas secretary of state is authorized to require a nonprofit corporation to file the report (SOS Form 802, form 17-3 in this manual) not more than once every four years. See Tex. Bus. Orgs. Code § 22.357.
The report is due no later than the thirtieth day after the date the secretary of state sends notice to the corporation that the report is due. See Tex. Bus. Orgs. Code § 22.359. The secretary of state sends all notices relating to the filing of the periodic report, including any notice of forfeiture or delinquency, to the designated registered agent at the registered office address on file. See Tex. Bus. Orgs. Code § 22.358.
The notice sent by the secretary includes a preprinted periodic report form that includes the current information of record.
PRACTICE TIP: There is no “anniversary date” for the filing of a nonprofit periodic report. A nonprofit corporation may avoid the consequences of noncompliance, however, by voluntarily submitting a periodic report to the secretary of state on a routine basis on an “anniversary date” of its own choosing. Periodic reports also may be filed electronically through the secretary of state’s online access system, SOSDirect.
Certain restrictions and limitations apply to mergers involving Texas nonprofit corporations.
Pursuant to TBOC section 10.010(a), a nonprofit corporation may not merge into another entity if the nonprofit corporation would lose or impair its charitable status because of the merger. Tex. Bus. Orgs. Code § 10.010(a). Note, however, that the secretary of state does not determine whether a proposed merger will affect a nonprofit corporation’s charitable status.
One or more domestic or foreign for-profit entities or non-code organizations may merge into one or more domestic nonprofit corporations if the nonprofit corporations continue as the surviving entity or entities. Tex. Bus. Orgs. Code § 10.010(b). A nonprofit corporation may merge with a foreign for-profit entity, but only if the nonprofit corporation continues as the surviving entity. Tex. Bus. Orgs. Code § 10.010(c). One or more nonprofit corporations and non-code organizations may merge into one or more foreign nonprofit entities that continue as the surviving entity or entities. Tex. Bus. Orgs. Code § 10.010(d).
Although an unincorporated nonprofit association is a TBOC entity, it is not authorized to engage in a statutory merger under chapter 10 of the code. Section 252.017 specifically provides that the only provisions of the TBOC that apply to an unincorporated nonprofit association are chapters 1 and 4 and, if a nonprofit association has designated an agent for service of process, the provisions of subchapter E of chapter 5. Pursuant to section 1.106(c), this specific provision of chapter 252 would supersede the provisions of chapter 10. See Tex. Bus. Orgs. Code § 1.106(c).
The fee for filing a merger transaction of a nonprofit corporation with a for-profit entity is $300. The fee for filing a merger transaction where the only parties to the merger are nonprofit corporations is $50.
§ 17.7Conversion of Nonprofit Corporations
§ 17.7:1Conversion of Nonprofit into For-Profit Entity Prohibited
TBOC section 10.108 specifically prohibits the conversion of a nonprofit corporation to a for-profit entity. See Tex. Bus. Orgs. Code § 10.108.
§ 17.7:2Conversion of Nonprofit Corporations into Other Entities
While section 10.108 prohibits a nonprofit corporation from converting into a for-profit entity, the secretary of state will accept a certificate of conversion that converts a domestic nonprofit corporation to a nonprofit limited liability company, a nonprofit corporation created under another Texas statute, or a foreign nonprofit corporation.
§ 17.8Failure to File Periodic Report—Chapter 22 TBOC Involuntary Terminations
§ 17.8:1Effect of Failure to File Periodic Report
Failure to file the nonprofit periodic report when due results in the forfeiture of the corporation’s right to conduct its affairs in Texas. See Tex. Bus. Orgs. Code § 22.360(a). Notice of forfeiture is mailed to the corporation’s registered agent at the registered office address. See Tex. Bus. Orgs. Code § 22.361.
Forfeiture of the corporation’s right to conduct its affairs does not impair the validity of a contract or act of the corporation or prevent the corporation from defending an action, suit, or proceeding in a court of this state, but the corporation may not maintain an action, suit, or proceeding in a court of this state. See Tex. Bus. Orgs. Code § 22.362(c).
A Texas nonprofit corporation that fails to file the delinquent periodic report and revive its right to conduct business within 120 days of the mailing of the notice of forfeiture is involuntarily terminated by the secretary of state. See Tex. Bus. Orgs. Code §§ 22.363, 22.364.
A nonprofit corporation that has involuntarily terminated its existence for its failure to file a periodic report is reinstated by following the specific reinstatement procedures set forth in TBOC section 22.365 and not the procedures established under section 11.253. See Tex. Bus. Orgs. Code § 22.365.
A nonprofit corporation involuntarily terminated under TBOC section 22.364 would file the delinquent report together with the maximum filing fee of $25. The corporation would not submit a certificate of reinstatement.
TBOC section 22.365 does not set forth a time frame within which the delinquent report must be filed and the corporation reinstated.
Section 22.365(a) requires the secretary of state to determine whether the corporation has paid all fees, taxes, penalties, and interest due and accruing before the termination and an amount equal to the total taxes from the date of termination to the date of reinstatement that would have been payable if the corporation had not been terminated. See Tex. Bus. Orgs. Code § 22.365(a). If the nonprofit corporation is not tax-exempt, a tax clearance letter issued by the comptroller of public accounts stating that the entity is in good standing for purposes of reinstatement fulfills this requirement. The tax clearance letter must accompany the delinquent report and must be valid through the date of filing of the report.
§ 17.9Dissolution of Nonprofit Corporations
TBOC chapters 11 and 22 state the procedures for winding up and terminating a nonprofit corporation. Section 22.302 of the TBOC provides details specific to nonprofits managed by members, managed by boards of directors with voting membership, managed by boards of directors with no members, and managed by memberships without voting rights. The appropriate notice provisions must be followed in each case. TBOC section 22.164 defines dissolution as a fundamental action and subsequently requires appropriate approvals to dissolve or terminate a nonprofit corporation.
In addition to following the procedural formalities, the nonprofit corporation must create a plan of distribution in accordance with TBOC section 22.304 and with the corporation’s dissolution clauses, whether in its certificate of formation, its bylaws, or both. All liabilities and obligations must be paid, satisfied, and discharged in accordance with TBOC section 11.053. Then any property held on a condition requiring return, transfer, or conveyance because of the termination of the corporation must be returned. The remainder of the property may then be distributed to other organizations that are exempt under section 501(c)(3) of the Internal Revenue Code (IRC) or that are described in IRC section 170(c)(1) or (c)(2). Lastly, a district court will distribute any remaining assets to organizations exempt under IRC section 501(c)(3) or described in section 170(1) or (2).
PRACTICE TIP: The certificate of formation must include how the assets of the organization will be distributed upon dissolution in order to obtain the federal tax exemption.
§ 17.9:1Filing Certificate of Termination with Secretary of State
When winding up activities are complete, the organization must file a certificate of termination (SOS Form 652, form 21-2 in this manual) with the secretary of state. The certificate of termination must be signed by an officer of the nonprofit corporation. The existence of the nonprofit ends upon filing the certificate of termination, unless a later date is given or the certificate states that it is effective when a stated event or fact takes place (the termination must be effective within ninety days of the date of signing).
Organizations recognized under IRC section 501(c)(3) that are required to file annual information returns must file the appropriate IRS Form 990, marked as a final return, to inform the IRS about its termination. The final IRS Form 990 must be filed within four months and fifteen days after the effective date of the nonprofit corporation’s termination. The corporation should then complete an IRS Form 990 or 990-EZ schedule N (Liquidation, Termination, Dissolution, or Significant Disposition of Assets) with the applicable information.