1. Alternatives to Forming a Charitable Nonprofit
A Start-Up May Not Be in Your Client’s Best Interests
By Gene Takagi and Emily Chan
L
awyers retained to assist in the for- may present little challenge for a law- Before a decision is made to form a
mation of a charitable nonprofit yer or a sophisticated client. Howev- nonprofit, lawyers should ensure that
should consider whether forming er, funding, compliance with myriad the founders understand the funda-
a nonprofit is in the client’s best inter- requirements, and operating a viable mentals of operating as an organiza-
ests. Absent sufficient research by the nonprofit can be exceptionally difficult, tion exempt under section 501(c)(3) of
client and a good plan for continued even with the best of intentions and ini- the Internal Revenue Code (the Code),
viability, the lawyer may best serve tial seed capital. Typically, when the including the prohibitions against pri-
the client by introducing alternatives economy is not strong, the competition vate inurement and private benefit. Too
to forming a nonprofit, which may for funds and other resources can be many founders believe that they are enti-
include (1) an alliance with an existing fierce due to an increasing pool of non- tled to control the nonprofits they create
nonprofit, (2) fiscal sponsorship, or (3) profits, the growing need for services, and can leverage such control to their
a donor-advised fund. and diminishing resources. If a nonprof- personal advantage with little restriction.
Prior to forming a nonprofit, lawyers it is insufficiently prepared to compete Under the private inurement doc-
and their clients should consider the and operate in such an environment, trine, a nonprofit may not permit any
extremely competitive landscape—the the end product may be gross inefficien- part of its net earnings to inure to the
vast majority of new nonprofits will cies, frustrated founders, disillusioned benefit of a person having a personal
fail, become dormant, or operate in donors, and fewer resources ultimately and private interest in the organiza-
financial distress. Stan Madden, direc- reaching its intended beneficiaries. tion’s activities (i.e., an insider such as
tor of the Center for Nonprofit Studies a director, officer, or key employee).
at the Hankamer School of Business at Sufficient Research An organization that engages in an
Baylor University, estimated that only Individuals considering forming a inurement transaction may face revo-
one-third of nonprofits survive beyond charitable nonprofit should research cation of its exempt status. Under the
five years. Ron Mattocks, author of not only how to start a nonprofit but similar, but broader, private benefit
Zone of Insolvency: How Nonprofits Avoid also whether a new nonprofit would be doctrine, a nonprofit may not confer
Hidden Liabilities and Build Financial the best vehicle to further their chari- nonincidental benefits on individu-
Strength, asserts that as many as one- table objectives from the public’s per- als for the benefit of private interests.
third of the nation’s 1.4 million regis- spective. Researching and writing a Accordingly, any benefit conferred
tered nonprofits operate in the zone of business plan is a prudent early step. upon an individual must be incidental,
insolvency. The plan should define the nonprofit’s quantitatively and qualitatively, to the
The mechanics of forming a non- mission and identify its core activi- furthering of the organization’s exempt
profit and obtaining tax-exempt status ties, potential supporters, and targeted purposes. Where an excess benefit is
beneficiaries. It also should contain an conferred upon a person who is in a
Takagi is principal of the law office of assessment of the nonprofit’s environ- position to exercise substantial influ-
Gene Takagi in San Francisco and editor ment, including its potential allies and ence over the affairs of the organization
of the Nonprofit Law Blog. Chan is a competitors, and a projected multiyear (e.g., a director, officer, or other dis-
member of the Class of 2010, University budget. The exercise of preparing a qualified person), the transaction may
of California, Hastings College of the plan will likely require market research be subject to excise taxes under section
Law. Their respective e-mails are gene@ and help determine whether or not 4958 of the Code.
attorneyfornonprofits.com and there are already one or more nonprof- Founders also should be cogni-
emilynicolechan@gmail.com. its with similar goals. zant of the ongoing obligations of a
Published in Business Law Today, Volume 18, Number 6, July/August 2009. © 2009 by the American Bar Association. Reproduced with permission. All rights reserved. 1
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without
the express written consent of the American Bar Association.

2. an organization with substantially
10 Questions Your Clients Should Answer Before Forming a Nonprofit similar goals to the one contemplated
1. What will be the nonprofit’s charitable purposes? already exists. Working or collabo-
rating with an existing nonprofit can
2. What will be its core activities?
leverage significant advantages while
3. Who are its intended beneficiaries? mitigating many of the risks that can
4. Are there existing nonprofits with a similar mission, and, if so, have you be a fatal blow to the survival of a new
discussed your ideas with them? nonprofit.
Working with an existing nonprofit
5. Can your mission be furthered more effectively and efficiently by an as an employee or volunteer may be
existing nonprofit? especially valuable to an individual
6. Can you attract sufficient resources to start and operate a new who lacks experience, nonprofit busi-
nonprofit? ness sophistication, and/or resources.
When appropriate, lawyers should
7. Have you drafted a business plan (including a three-year projected make their clients aware of the follow-
budget)? ing benefits of working with an exist-
8. Are you familiar with what it takes to start and run a nonprofit in ing nonprofit:
compliance with the laws and best practices? • Avoidance of start-up costs and
administrative burdens of a new
9. Have you considered alternatives to forming a new nonprofit, such as
nonprofit.
fiscal sponsorship and donor advised funds?
• Increased efficiency in further-
10. Whose help will you need to form the nonprofit and get it running? ing the charitable mission by using an
established infrastructure.
nonprofit, including periodic filings governing body, marketing strategies, • Opportunity to gain experience
with the Internal Revenue Service (IRS) and targets for ongoing support and and expertise in running a nonprofit.
and various state authorities. Those some long-range ideas. • Development of connections in
who will serve on the board of a non- While it may not be the lawyer’s the nonprofit community.
profit corporation should know the role to judge the relative viability of Collaborating with an existing non-
basics of nonprofit corporate gover- a contemplated nonprofit, it is usu- profit is an alternative that may be
nance. In addition, if there are to be ally clear when a client is relying on considered even where the contem-
employees, the nonprofit must be pre- an unrealistic expectation that donors plated charitable idea is not currently
pared to meet the obligations of a new and funders will find and support the being implemented by an existing
employer. new nonprofit with little effort or plan- nonprofit. A nonprofit with a com-
Well-prepared founders increase ning. Generally, in such case, the law- patible mission may be receptive to
their chances of creating a sustainable yer should recommend that the client implementing and operating a new
nonprofit organization. Lawyers advis- either postpone forming a nonprofit program, particularly if a volunteer is
ing ill-prepared, would-be founders or consider one of the alternatives out- willing to bring resources to the table.
may do a great service to their clients lined below. Alternatively, the nonprofit may have
and to the broader public by educat- institutional knowledge relating to
ing them and sending them back to Use of an Existing Nonprofit the charitable idea and its implemen-
do their homework before they decide According to the National Center tation. Moreover, the nonprofit may
whether to proceed with the formation for Charitable Statistics, the number of open doors and leverage assets that
of a nonprofit. 501(c)(3) organizations has increased might not be otherwise readily avail-
by over 70 percent between 1996 and able, such as
Plan for Viability 2006. In the one-year period from • Existing resources, including
A great plan for providing services October 1, 2006, through September staff, volunteers, infrastructure, and
to members of a charitable class is rea- 30, 2007, the IRS received over 85,000 systems.
son for excitement, but in and of itself, applications for recognition of exemp- • In-house experience and exper-
it is not a sufficient reason to form a tion under section 501(c)(3). tise, which may allow the contem-
nonprofit. There also needs to be an A critical mistake made by many plated program to be launched and
achievable plan for acquiring resources founders of charitable nonprofits is operated efficiently and in compliance
(human, financial, and other) required their failure to communicate with, with the law.
to provide those services and operate and examine, the existing nonprofits • Donor and business relationships,
the nonprofit over a period of time. in their space. With roughly 1.8 mil- including with institutional funders,
Such plan should include sources of lion domestic nonprofits (IRS 2008 nonprofit leaders, allied organizations,
adequate start-up capital, an initial Annual Report), chances are high that and the media.
Published in Business Law Today, Volume 18, Number 6, July/August 2009. © 2009 by the American Bar Association. Reproduced with permission. All rights reserved. 2
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without
the express written consent of the American Bar Association.

3. • Goodwill, which may provide the must weigh such benefits against a lack Donor-Advised Funds
program with name recognition and of autonomy; their limited control over A donor-advised fund, first defined
built-in public trust. the Project, which remains under the in the Internal Revenue Code as a
ultimate control of the Sponsor; and result of the Pension Protection Act of
Fiscal Sponsorship the sponsorship fees. 2006, is a fund or account (1) that is
Fiscal sponsorship is the term used It is likely that a great majority of separately identified by reference to
to describe the relationship between an individuals and groups interested in the contributions of a donor or donors;
individual or group of individuals who forming a nonprofit have never con- (2) that is owned and controlled by a
have initiated a charitable project (the sidered, nor even heard of, fiscal spon- sponsoring organization; and (3) with
Project) and an existing tax-exempt sorship. Yet, fiscal sponsorship may be respect to which the donor or person
organization that has agreed to support a very attractive alternative to forma- appointed or designated by the donor
the Project (the Sponsor). Typically, tion of a nonprofit, particularly where has, or reasonably expects to have,
the Sponsor confers upon the Project the sustainability of a separate entity advisory privileges with respect to dis-
the benefit of the Sponsor’s tax-exempt is highly questionable or the charita- tributions or investments. Individuals
status and certain administrative servic- ble endeavor has a relatively short life contemplating forming a grant-making
es. However, the precise nature of the span. Sponsors often serve as incuba- private foundation may find a donor-
relationship, the support provided by tors of Projects that later spin off upon advised fund to be a better alternative.
the Sponsor, and the rights of the Proj- a determination by their respective Founders of private foundations will
ect’s initiators (the Project Initiators) Project Initiators that they can govern face slightly different challenges from
may vary widely depending on the
agreement between the parties. A well-
drafted fiscal sponsorship agreement is Additional Resources
therefore imperative. Fiscal Sponsorship
Perhaps the most common model of • www.fiscalsponsorship.com (San Francisco Study Center)
fiscal sponsorship is one in which the
• http://foundationcenter.org/getstarted/tutorials/fiscal (Guide to Fiscal
Project is housed within the Sponsor,
Sponsorship)
has no separate legal existence, and is
operated by the Sponsor’s employees
and/or volunteers. Greg Colvin, author Donor-Advised Funds
of Fiscal Sponsorship: 6 Ways to Do It • www.guidestar.org/DisplayArticle.do?articleId=1092 (New Rules Affecting
Right, describes this model as the Direct Donor-Advised Funds)
Project Model. Contributors to the
• www.bostonfoundation.org/Giving/GivingDetail.aspx?id=194 (Donor-
Project make their gifts directly to the Advised Fund/Private Foundation Comparison)
Sponsor. The Sponsor usually retains
a portion of the gifts as a fee (5–10
percent is common) and allocates the and operate sustainable independent founders of public charities. Funding
rest to the Project. The Project Initia- organizations. Lawyers providing coun- may not be a critical issue, but direc-
tors may serve as employees or volun- sel to would-be founders of nonprof- tors, trustees, and managers must deal
teers of the Sponsor delegated with the its who appear inadequately prepared with additional laws and limitations
responsibility of operating the Project. to set up a sustainable organization associated with private foundations.
They also may retain the right to move should inform their clients of the fiscal For example, private foundations must
the Project to another Sponsor or to sponsorship alternative. (1) pay a 2 percent tax on their net
a new exempt organization created to Project Initiators that are consider- investment income; (2) refrain from
permanently house the Project. Any ing fiscal sponsorship should be very acts of self-dealing; (3) meet minimum
such rights should be precisely spelled selective in choosing a Sponsor. Spon- distribution requirements (generally
out in the fiscal sponsorship agreement. sors differ widely with respect to 5 percent of their investment assets);
Fiscal sponsorship may provide a charitable mission, services, manage- (4) abstain from excess business with-
Project with immediate tax-exempt sta- ment oversight, fees, experience, legal holdings; (5) abstain from jeopardiz-
tus, advantageous treatment as a pub- sophistication, and their own viabili- ing investments; and (6) refrain from
lic charity (i.e., nonprivate foundation) ty. Nonprofit support centers, commu- certain types of expenditures, such as
without independently passing a public nity foundations, and the online Fiscal those paid or incurred to lobby, make
support test, some degree of adminis- Sponsor Directory produced by the grants to individuals that do not sat-
trative support, and a governing body San Francisco Study Center (www. isfy certain criteria, or make grants to
that has a duty to ensure that the Proj- fiscalsponsordirectory.org) may be help- nonpublic charities other than oper-
ect is operating in compliance with ful resources for finding a qualified ating foundations without exercising
applicable laws. The Project Initiators Sponsor. expenditure responsibility. Moreover,
Published in Business Law Today, Volume 18, Number 6, July/August 2009. © 2009 by the American Bar Association. Reproduced with permission. All rights reserved. 3
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without
the express written consent of the American Bar Association.

4. A Fourth Alternative? exempt purposes and in compliance
with the law. Sponsoring organizations
Lawyers may determine for certain clients that the laws applicable to non-
that regularly disregard their donors’
profits and tax-exempt entities are not compatible with the client’s plans.
wishes will soon lose goodwill in their
For example, the client may be seeking to secure investment capital or
communities and may no longer be
earned income from substantial unrelated business activities. Or the cli-
competitive as sponsors of donor-
ent may want rights and control more consistent with that of an owner
advised funds.
of a for-profit corporation than a director or officer of a nonprofit. In such
Lawyers asked to form private foun-
cases, a for-profit corporation or limited liability company may be a more
dations should generally ensure that
appropriate vehicle for the client. If the client desires to form an entity
their clients are aware of, and educated
that pursues social goals over maximization of its owners’ return on their
about, the donor-advised fund alter-
investments, the new low-profit limited liability company (L3C) may be a
native, particularly where the initial
viable alternative.
funding is modest. One rule of thumb
states that private foundations should
the charitable deduction limits for con- with a financial institution like Fidel- not be formed without funding of at
tributions to a private foundation are ity, Vanguard, or Schwab. Community least $2 million. However, this recom-
lower than those for comparable con- foundations offer valuable philanthrop- mendation presumes that such amount
tributions to a public charity (e.g., the ic guidance to donors and opportuni- will be a one-time contribution to an
charitable deduction for a contribu- ties to participate in community lead- endowment. It does not recognize the
tion of money to a private foundation ership initiatives and events. Financial plan of some clients to make regular
is generally limited to 30 percent of the institutions may offer lower administra- contributions to the foundation or to
donor’s adjusted gross income versus tive fees and costs. give the foundation a limited life span.
50 percent for a contribution of money Perhaps the most important limi- The better rule of thumb is that a pri-
to a public charity). tation of a donor-advised fund is the vate foundation should not be formed
The many benefits for the donor of a donor’s lack of legal control after mak- without a strong likelihood that it will
donor-advised fund include ing the contribution. Because the con- distribute at least $25,000 in annual
• No formation costs. tribution is considered a completed gift grants. Anything less may result in
• Possibility of making immediate at the time of contribution, the donor inefficient grant-making in light of the
deductible contributions. may be able to take a charitable deduc- costs associated with operating the
• More generous deduction limits tion in the year that the gift is made. foundation.
(because the sponsoring organization is However, the trade-off is that the donor
a public charity). may only provide recommendations Conclusion
• No administrative, investment, or or advice to the sponsoring organiza- Well-intentioned individuals form
governance responsibilities (and associ- tion about potential recipients of grants too many unsustainable and ineffi-
ated risks). from the donor-advised fund. While cient nonprofit organizations because
• No need to provide oversight over the donor may not have legal control of insufficient research or planning.
grants. over the fund, it is easy to understand Before routinely facilitating the for-
Additional benefits of a donor- why sponsoring organizations gener- mation of a nonprofit, in many cases,
advised fund may depend on the ally make a strong attempt to adhere lawyers may best serve their clients by
nature of the sponsoring organization, to their donors’ recommendations so advising them of possible alternatives.
which is typically either a community long as such grants would be consis-
foundation or a public charity affiliated tent with the sponsoring organization’s
Published in Business Law Today, Volume 18, Number 6, July/August 2009. © 2009 by the American Bar Association. Reproduced with permission. All rights reserved. 4
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without
the express written consent of the American Bar Association.