Musicians and the Law

Business forms

There are two broad categories of business entities: for profit and non-profit (tax exempt)

First, for-profit business forms.

When considering a business entity, most lay people immediately think corporation; but
there are several alternatives to the corporation that may be more appropriate, depending
upon the type and size of business being considered. When deciding which form of
business ownership to use, there are two main factors to consider: liability exposure and
tax ramifications.

Liability is the monetary risk that the business will have for mistakes made under the
auspices of the business or for debts that the business itself cannot pay. To whom would
you be liable and what is the possible scope of that liability (how much might it cost you
to cure the mistake or pay the bill) can get very complicated, but generally can be divided
into two categories: contractual liabilities and tort liabilities. Contract liability as
previously discussed come from various contract obligations. As stated earlier1, a tort is a
breach of the duty of care that all of us are expected to exercise in society. When looking
at it from the standpoint of liability, it can be said that a tort is any civil wrong - other
than a breach of contract - for which the law provides a remedy.

There are three categories of torts: Intentional torts, negligence, and strict liability.
Intentional torts are – just as it sounds – intentional harms caused to others. The classic
example is someone is shot in anger. Obviously, there may be some criminal liability to
the shooter, but criminal liability will not monetarily compensate the victim. For that we
look to the intentional torts (most likely battery in this case). Negligence suits are
probably the most common type of personal injury lawsuits. They range from medical
malpractice to car accidents to the famous MacDonald’s scalding coffee lawsuit.2 With

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Class 1, The US Legal System, page 9.
2 Liebeck v. McDonald's Restaurants, also known as the McDonald's coffee case and the

hot coffee lawsuit, was a 1994 product liability lawsuit that became a flashpoint in the
debate in the United States over tort reform. Although a New Mexico civil jury awarded
$2.86 million to plaintiff Stella Liebeck, a 79-year-old woman who suffered third-degree
burns in her pelvic region when she accidentally spilled hot coffee in her lap after
purchasing it from a McDonald's restaurant, ultimately Liebeck was only awarded

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strict liability, liability is found, even where the person found strictly liable was not at
fault or negligent. Today it strict liability most commonly associated with defectively
manufactured products, under the theory that the party who profited from the product
should be responsible for its harm not the innocent purchaser. Another example of strict
liability is that under certain circumstances, an owner may be held strictly liable for
damage caused by ones trespassing animals.

Corporations, limited partnerships, and limited liability companies, if properly constituted

and maintained, provide the owners with a shield from personal liability, so that only the
business assets (and not the owner’s personal assets) can be reached if there is a judgment
against the business due to a mistake. There are requirements that must regularly be met
to keep that shield in place however, and those requirements, along with the costs of
forming and maintaining one of those business entities, may be more than the business
can afford. As a result, some businesses prefer to operate as a sole proprietorship or
general partnership.

A sole proprietorship, as the name implies, is a business that has only one owner – only
one person makes decisions and shares in the profits. A general partnership is a business
in which several owners share management decisions, and share in the profits (according
to their ownership interests). The start-up costs for these business forms are generally less
than for a corporation, limited partnership, or limited liability company.

If you chose to operate as a Sole Proprietorship or Partnership, and your business has a
name other than your given name, you should (and in some states, may be required to)
file a fictitious name registration sometimes called a DBA registration (doing business
as). Depending on the State, this is filed with the Attorney General or County Clerk of the
home state or county of the business. (Because of the formalities of the other types
business formations (Corp, LLC, etc.), the name will be filed with the paperwork forming
the business.) Filing the name of your business protects your rights to the name, and
creates a record of your business name. If you have any level of success, the name will be
a very valuable commodity to you, and in the case of liability, registration may be
important for others to know the responsible party. (see Appendix 1)

$640,000. Liebeck was hospitalized for eight days while she underwent skin grafting,
followed by two years of medical treatment. Wikipedia has an excellent article
summarizing this case and the controversy surrounding it.
https://en.wikipedia.org/wiki/Liebeck_v._McDonald%27s_Restaurants

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In a sole proprietorship, no management document is required, but in a general
partnership, you may want to consider having an agreement among the general partners
that provides: 1) how decisions will be made; 2) how profits will be shared; 3) whether
interests can be transferred to outsiders; and 4) what happens if a partner dies or becomes
disabled and cannot participate in the business.

Note: courts consider the general partnership as the default business form when more
than one person(s) are in business together. This means that if you are operating as a
partnership and a dispute among the partners arises without such an agreement in place,
the court may impose restrictions to which you may not agree. (Like dividing assets up in
equal share upon insolvency)

In a General Partnership, each is liable for any debts or judgments taken on by the
business. There is no limited liability, which means all the partners’ assets can be taken in
a lawsuit or be targeted to settle debts should the partnership become insolvent. Any
partner can be sued for the full amount of business debts. Note that assets in a General
Partnership can be divided according to agreement, and liabilities can too, up to a point.
Ultimately though, liabilities are Joint and Several, meaning that each individual is liable
for any debt incurred by the partnership.

Taxes are payable by the owner or general partners on their individual tax returns. In
corporations (unless special “S” status is sought), the corporation itself pays income tax,
and then the profits distributed to shareholders in the form of dividends are taxed again.

This cannot be stressed enough: with a sole proprietorship or general partnership, you can
be fully liable, and your personal assets seized, to satisfy the liability or debts of the
business if the assets of the business are not enough to pay those debts or satisfy the
liability.

Again note: a general partnership is the default business form when you are operating
with more than one person and no agreement to the contrary in place.

That does not necessarily mean that you should never operate a business as a sole
proprietorship or general partnership. You need to evaluate how much potential liability
there is, and whether you can protect against that liability, either because the business
will not enter into contracts beyond its ability to pay, or because you can buy insurance
against the liability.

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For example, consider where your business will operate. If you are leasing office space,
and the business defaults under the lease, the sole proprietor or general partners could be
fully liable for all damages under the lease. The same is true if you buy an expensive
piece of equipment over time, and then can’t make the payments. But, if you are
operating out of your home, and your business does not involve substantial inventory or
equipment, the risk for contractual liability may not be significant. As to other liability,
you can obtain general liability insurance to protect you against liability for anyone
getting hurt on the business property. As to the business you do, and the mistakes that can
occur, consider the worst mistake you could make, and what it would cost you to fix it. If
you are an antique restorer, or jewelry repairperson, the cost of repairing your mistakes
will differ from those of the operator of a catering service, or the owner of a business
specializing in cleaning houses.

You need to evaluate your risks, and determine if you can obtain sufficient insurance to
protect you against them. There are many insurance products available to protect against
various risks – some you may never have considered. The issue then becomes whether
the cost of the insurance is greater than the cost of forming a business entity that will
provide a liability shield. In many cases, you will get the same insurance coverage
regardless of the business form, so a liability shield may be superfluous. If you are
comfortable that you can make all your expenses, and insure against all potential risks at
an affordable cost, then you might want to consider operating as a sole proprietorship or
general partnership. Otherwise, you may need to consider a corporation, limited
partnership, or limited liability company, where your personal assets can be shielded
against business liability.

The Limited Partnership (LP) combines corporate and partnership features most often for
use as a tax shelter, but does not create a legal entity separate and distinct from its
owners. The LP usually formed by at least one general partner (or full partner) and at
least one limited partner (or nominal partner). General partners are the operators who
control and manage the partnership, and are jointly and severally liable for all its debts
and obligations. The limited partners (1) cannot, in any way, control or participate in the
management of the partnership (otherwise they will lose their limited liability protection),
(2) are liable only up to the sums invested by them, and (3) cannot withdraw their
investments without the consent of the general partners.

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Both types of partners benefit from the firm's profits, capital gains, accelerated
depreciation, and investment credits, but the general partners are paid management fees
as well. Limited partnerships can be formed for any type of business but they are most
popular in equipment-leasing, movie making, oil and gas exploration, and real estate
development industries. When the business begins to show taxable profits, a limited
partnership is often terminated and reorganized as a regular limited company.

Most business commonly considered corporations are organized as C Corporations. A C

Corp. is owned by any number of stockholders (whether publicly or privately traded,
nationally or internationally), and is its own separate legal entity for taxation and liability
purposes. Long ago, to promote small business entrepreneurship, the S Corporation was
created. (Like the C Corp., it is named after the IRS Code section that defines it) The S
Corporation has the tax and liability advantages as the C corp., along with the same
required formalities of articles of incorporation, stock ownership and regular meetings
(with recorded minutes). Unlike the C Corp., the S Corp. is limited to a maximum of 100
stockholders (all must be US citizens) and has a pass-through provision to avoid the
double taxation problem of C Corporations. (the business income "passes through" the
business to the owners' tax returns) The S Corp is not required to file with the Securities
& Exchange Commission (SEC) an important advantage over the C Corp which is
required to make extensive SEC filings when it has over 2,000 shareholders.

Because of the added requirements of SEC filings and all of the other formalities required
of C Corps., along with double taxation, only fairly large corporations are C Corps. All of
the companies listed on the Stock exchanges in the US are C Corps., but many are not
listed and are “closely held.” (Less than 5 shareholders own 50% of the stock) Double
taxation alone is reason enough that C Corp. status is only for the very largest companies.

Double taxation refers to the fact that profits are taxed at both the corporate and personal
levels. The corporation must pay income tax at the corporate rate before any profits can
be paid to shareholders. Then any profits that are distributed to shareholders through
dividends are subject to income tax again at the recipient's individual rate. In this way,
the corporate profits are subject to income taxes twice. Double taxation does not affect S
corporations, which are able to "pass through" earnings directly to shareholders without
the intermediate step of paying dividends. In addition, many smaller corporations avoid
double taxation by distributing earnings to employee/shareholders as wages. Still, double
taxation has long been subject to criticism from accountants, lawyers, and economists.

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Critics of double taxation would prefer to integrate the corporate and personal tax
systems, arguing that taxes should not affect business and investment decisions. They
claim that double taxation places corporations at a disadvantage in comparison with
unincorporated businesses, influences corporations to use debt financing rather than
equity financing (because interest payments can be deducted and dividend payments
cannot), and provides incentives for corporations to retain earnings rather than
distributing them to shareholders. Note: the 2017 tax law did limit to an extent the
deductibility of corporate debt. Time will tell if it has a significant influence on corporate
behavior.

Proponents counter that the corporate tax is a fair price for limited individual liability; an
argument that is losing ground with the advent of the LLC as we will soon learn. Perhaps
the biggest reason to retain double taxation on corporations is that no one can agree on an
alternative way to raise that amount of government revenue.

Why is it worth is for so many companies to be C Corporations given double taxation?

(Hint… remember, many are listed on stock exchanges)

The Limited Liability Company or Limited Liability Partnership (LLC/LLP – recently

I’ve even seen PLLC – Professional Limited Liability Corporation) are the newest and
most popular business forms for new business ventures. (The first LLC was in Wyoming
in 1977, and most other states had them by the 90’s) The LLC evolved to promote
business incorporation and entrepreneurship within the state. (remember that the S corp.
formed under federal tax law and the LLC are a state-by-state invention) Generally,
LLC’s combine the best qualities of sole proprietorship and partnership (less formality
and flexible day to day operations), with the tax and liability advantages of the S
corporation – including the option of pass-through taxation. Generally (state laws vary)
LLP’s and PLLC’s are formed by professionals (doctors, lawyers) and LLC are the more
generalized business form.

Pass through entities and the 2017 tax law changes.

One of the hallmarks of the 2017 tax legislation was a reduction of the top corporate tax
rate. Not all business forms are organized as corporations however; and more
importantly, some business entities are allowed to elect either pass-through taxation or
conventional corporate taxation. With pass-through taxation owners pay taxes on all
business profits on their individual tax returns. In contrast, a corporation, or a business
that elects corporate-style taxation, is taxed directly on all business profits.

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Under the new tax law the corporate rate changes from a progressive 15% to 39% to a
flat 21%. The personal rates changed to a progressive 0% to 37%. Clearly the pass-
through scheme meant to favor small business no longer works with this disparity. The
solution that congress came up with is that business income that passes through to an
individual from a pass-through entity and income attributable to a sole proprietorship will
be taxed at individual tax rates less a deduction of up to 20% to bring the rate lower. The
details of how this will work gets a bit complicated, and awaits the rulemaking process of
the IRS. Many tax experts opine that this provision has the potential for abuse. We will
talk more about this later in the course.

Liability limits
The shield from liability created by certain business forms can be complicated. A
business form will not shield one from personal liability, (Wrongful acts by an
individual) only liability associated with the business. For instance, in an accident
involving a delivery truck driver, whether and how much liability is found for the driver
and/or the company will depend on many factors such as: the employment status of the
driver (More on that in our unit on employment law), the laws regarding comparative
negligence in the state of the suit (how to apportion the claim among multiple wrong-
doers), and insurance coverage. Remember though, the liability shield is for the
protection of the owners of the company, not the employees, but in some cases, can
extend to the employees.

If a Doctor forms an LLP and performs all of her work under the umbrella of the LLP,
and is paid by the LLP, and then is sued for malpractice, will the liability shield protect
her personally from liability? No, a business form will not protect one in cases of
professional malpractice – a form of personal liability. (Lawyers, architects, and
accountants are other similarly situated professionals) What if that same doctor is driving
from her office to the hospital during the work day, and has a car accident in which she is
at fault? Here too, the businesses liability shield is not likely to help her. What if she is in
a group practice and one of her fellow doctors loses a malpractice suit, will an LLP
protect the business and/or her personal assets from the suit? In many states yes, but in
some states no. Some states consider that professionals in a professional corporation have
joint and several liability. (When multiple parties can be held liable for the same event or
act and be responsible for all restitution required.)

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Now, let’s consider the same group medical practice and someone visiting their offices
slips and falls on the stairs leading up to the front door. Will the LLP protect the doctor’s
personal assets in this case? Most likely yes, as it will protect her personal assets if the
partnership suddenly dissolves and they default on the lease on the building they occupy.
(Unless she personally guaranteed the lease)

Now consider a scenario where the injured party had some amount of responsibility in the
causing the injury. A classic example is a passenger in a car who doesn’t wear a seat belt.
The driver is at fault in an accident and the passenger is injured. This is called:
contributory negligence. The injured party “contributed” to the injury. It is an issue
related to the amount of compensation, not a defense against finding fault. Again, this is
handled differently in different states, but generally some amount of the injury can be
assigned to the passenger reducing the monetary award in a successful suit. Are you
beginning to see how complicated Tort law can be?

Notice
When having dealings with a company, wouldn’t the information that the owners of the
company are shielded from liability be important to know? Let’s say that you are renting
a building to the Stephen Jones Company, and you know Stephen Jones as a very wealthy
local business person but you’d never heard of his company. (It turns out that it’s a new
venture for him) Wouldn’t you want to know that you were renting to his LLC or to his
Sole Proprietorship? Well, whenever you do business as a company, if that company
takes a form other than a sole proprietorship or a general partnership, state law will
require the inclusion of certain required words as part of a business name. (“Corp.,”
“Inc.,” “LLC,” “Limited,” etc.) This is a form of notice which alerts everyone who and
what they are doing business with.

Additionally, there will be a list of restricted words which not be permitted to use the
name unless the business fit into the named category. Commonly restricted words include
"bank" and "insurance". These words are restricted because their - use or misuse - could
be misleading for the general public.

The law of agency and liability

You may have noticed that people sometimes sign agreements as individuals, and other
times on behalf of companies that they work for.

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When you sign an agreement as an individual, you are personally vouching for the
fulfillment of that agreement, and are personally liable for the consequences of failing to
fulfill it. For example, suppose things don’t work out as planned in an agreement you
signed in your own name. Let’s say the other party sues you and wins. You now must
personally fulfill whatever obligation the judge imposes upon you, whether it’s to pay the
other party or perform on the agreement.

It’s different when you sign on behalf of a company. A company is a legal entity separate
from the people behind it. When you sign for a company, the company is liable, not you.
The company is party to the agreement. Thus, if the court decides in the other party’s
favor, the entirety of that money must come from the company’s assets, not directly from
the personal accounts of the people behind the company. Therefore, some people choose
to form a company for their business even though they are only one person — they don’t
want to risk losing everything in the off chance that a big judgment is entered against
them.

Keep in mind, though, you can’t sign on behalf of a company that is not validly formed
and registered. And simply signing under an assumed name (e.g., “Jim Jones d/b/a Jim’s
Auto Shop”) does not make your company validly formed and registered. In such case,
your liability would not be limited in any way. You must take the proper steps to
incorporate, including registering with the state and filing appropriate documents.

There are other things to keep in mind when signing on behalf of a company. First, you
must have the authority to bind the company to an agreement. This is called being an
agent of the company. The company can directly give you authority as an agent in
writing, or it can imply such authority by acting in a way indicating that you have it.

Second, there are limits on the extent to which a company will limit your personal
liability. In cases of fraud, other intentional wrongdoing, or egregious illegality, a court
may still find you personally liable.

Another important concept is apparent authority. Apparent authority refers to a situation

where a reasonable third party (OPP) would understand that a party had the authority to
act as the agent of the company. This means a principal is bound by the agent's actions,
even if the agent had no actual authority, whether express or implied. For example, a
customer may believe that an employee who presents a contract on company stationery is
authorized to sign that contract on behalf of the company. Even if the employee does not

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have the authority to enter into contracts, the company will be legally bound by the
signed agreement. This is another example of the objective theory of contract formation
asking: would a reasonable and objective 3rd party (read: OPP) viewing the situation
from the reasonably understand the person to be an agent of the company?

How to sign as an agent

In each case of a signature for a separate legal entity, the signature line should include the
word “By.” Obviously, a business entity cannot itself sign, so a human on behalf of
company must acknowledge an obligation. This one word can be the source of confusion
and potentially litigation when omitted. Even in case where the “by” was written in
longhand by the signer (as opposed to typed in like the rest of the document) questions
could come up as to whether you have signed for yourself or on behalf of a company. It is
not automatic that you will be personally liable if the word “by” is omitted, but it is
simply good practice to always include the word by whenever you are signing on behalf
of anyone or anything other than yourself.

Dates
When you sign an agreement, include the date and make sure the other party does, too.
You and the other party don’t have to sign on the same day. (The signature date can
especially important when you’re first forming a company and need to be sure that your
liability protection will attach.) In any case, it is good practice because you simply don’t
know what may come in the future.

Final Changes to the Agreement.

Sometimes it’s necessary to make last minute changes to an agreement just before it’s
signed. If you use a computer to prepare the agreement, it’s best to make the changes on
the computer and print out a new agreement. However, it’s not legally necessary to
prepare a new agreement. Instead, the changes may be handwritten or typed onto all
existing copies of the agreement. If you use this approach, be sure that all those signing
the agreement also sign their initials as close as possible to the place where the change is
made. If both people who sign the entire document don’t also initial each change,
questions might arise as to whether the change was part of the agreement.

Copies of the Agreement.

Each party should retain a signed copy – if signing by ink, prepare at least two copies of
your agreement. Make sure that each copy contains all the needed exhibits and

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attachments. Both you and the other party should sign both copies -- and each should
keep your signed original.

Faxing Agreements.
It is not uncommon for businesses to communicate by fax machine. One party signs a
copy of the agreement and faxes it to the other who signs it and faxes it back. A faxed
signature is legally sufficient if neither party disputes that it is a fax of an original
signature. However, if the other party claims that a faxed signature was forged, it could
be difficult or impossible to prove it’s genuine, since it is very easy to forge a faxed
signature with modern computer technology. Forgery claims are rare, however, so this is
usually not a problem. Even so, it’s a good practice for you and the other party to follow
up the fax with signed originals exchanged by mail or air express.

Electronic Signatures.
Electronic contracts and electronic signatures are just as legal and enforceable as
traditional paper contracts signed in ink. Federal legislation enacted in 2000, known as
the Electronic Signatures in Global and International Commerce act (ESGICA), removed
the uncertainty that previously plagued e-contracts. An electronic contract is an
agreement created and "signed" in electronic form -- in other words, no paper or other
hard copies are used. For example, you write a contract on your computer and email it to
a business associate, and the business associate emails it back with an electronic signature
indicating acceptance. Since a traditional ink signature isn't possible on an electronic
contract, people use different ways to indicate their electronic signatures, including
typing the signer's name into the signature area (often with some grammatical
“bookends” – for example /Robert Smith/ or “Robert Smith”), pasting in a scanned
version of the signer's signature, clicking an "I accept" button, or using cryptographic
"scrambling" technology. There are various ways to create an electronically "signed
PDF" document and you can research current methods via your Internet search engine.
Electronic signatures can also be created using coded cryptographic signature method.

Changing the Agreement After It’s Signed.

No contract is engraved in stone. You and the other party can always modify or amend
your agreement if circumstances change and you both agree to the changes. It’s advisable
that an agreement be changed only by a written amendment signed by both parties. The
amendment should set forth all the changes and state that the amendment takes
precedence over the original contract. This amendment is then effectively a new contract

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 requiring all the elements of any contract. (remember, this is sometimes where the
preexisting duty rule of contracts comes up)

Will a business form always shield you from liability?

A key reason that business owners and managers choose to form a corporation or limited
liability company is so that they won't be held personally liable for debts should the
business be unable to pay its creditors. But sometimes courts will hold an LLC or
corporation's owners, members, and shareholders personally liable for business debts.
When this happens, it's called: piercing the corporate veil.

"Piercing the corporate veil" is a legal phrase that describes the owners of a corporation
losing the limited liability that having a corporation provides them. When this happens,
the owners’ personal assets can be used to satisfy business debts and liabilities. This
concept doesn’t apply only to corporations, however. Any business type that provides
limited liability to its owners is at risk of piercing the corporate veil if the owners don’t
take the steps necessary to ensure this protection remains intact. This is a very unusual
step by courts and rarely happens, but the most common reason for piercing the veil is
when a business entity and a person become so entwined as to make them
indistinguishable, either through a lack of capitalization (not funding the company
adequately) or through a lack of following required formalities.

Here are 5 steps for maintaining personal asset protection and avoiding piercing the
corporate veil by clearly delineating that the business exists separately from the owner.

1. Undertaking necessary formalities. Corporations have strict formalities they must follow,
and while LLCs do not face the same requirements, many of the same steps are advisable.
a. (for corporations like S corps) Create and regularly update bylaws, issue
shares of stock to owners (shareholders) and maintain a stock transfer
ledger, hold both initial and then annual meetings of both directors and
shareholders, undertake any annual filings required by the state of
incorporation in a timely manner and pay the necessary filing fees, and pay
corporate taxes.
b. (for LLCs) Undertake any annual filings required by the state of
incorporation in a timely manner and pay the necessary filing fees.
Recommended formalities include creating and regularly updating an
operating agreement, issuing membership certificates to owners, keeping a

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 membership transfer ledger, and holding both initial and annual meetings of
the members (and managers, if your LLC is manager-managed).
2. Documenting your business actions. Document the major business decisions and the
major meetings you hold. For example, sign and keep contracts your company enters.
Document that you held the initial and annual meetings of directors and shareholders
(corporations) or members/managers (LLCs) and keep the meeting minutes from each of
these meetings. Keep formal business documents for at least seven years.
3. Don’t comingle business and personal assets. Keep business assets separate from the
assets of the owner(s). Have a business checking account and business credit card and
only use these for business expenses. Also keep assets such as equipment and property
separate.
4. Ensure adequate business capitalization. Your business will need money and the
equipment and items necessary both to start and continue operations. There are many
ways to do this: through your own money, accepting money from others and making
them business owners, or through a business loan. Whatever your approach, without
adequate capital, your business will not survive. Keep in mind, this capital needs to be
designated to your business and not to you.
5. Make your corporate or LLC status known. Create business cards that display the name
of your corporation and LLC. Make purchases and pay invoices via a business checking
account or credit card. Create invoices in the company name to send to your clients. Also,
any contracts, leases and/or documents you sign should be in the company name.

Remember: if a judge cannot distinguish between what belongs to the business and what
belongs to the owner—and the owners cannot provide proof that all formalities have been
followed—it may be deemed that you’re acting more like a sole proprietorship or general
partnership than a corporation or LLC. The judge can then "pierce the corporate veil" and
award your personal assets to any plaintiff.

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Non-profit and tax-exempt organizations

Needless to say, tax exempt organizations have a very large footprint in the arts, so an
understanding of their formation and maintenance is an important aspect of this class.

Introduction
New non-profit organizations often find that the world is not a hospitable place. While
innovation, entrepreneurship, and risk-taking by new for-profit companies are lauded,
fledgling non-profits typically struggle to gain the acceptance and support of private
foundations, donors and others in the non-profit community because they tend to be risk
averse. There is, after all, only a limited supply of grants and donations to fund
charitable, artistic, and educational endeavors. Furthermore, the administrative burden of
forming and administering a non-profit can be staggering. New non-profits are therefore
often advised to pair up with an existing organization, use a for-profit structure, or
explore other alternatives before forming a new entity and applying to qualify under
section 501(c)(3) of the Internal Revenue Code (the “Code”).

Since the inception of the Federal income tax, the Congress has exempted certain types of
entities from income taxation. Many exempt entities, such as charitable organizations
(our focus), are familiar. Yet charitable organizations are but one type of exempt entity.
The benefit of tax exemption is extended to groups as diverse as social welfare
organizations, title holding companies, fraternal organizations, small insurance
companies, credit unions, cooperative organizations, and cemetery companies, and
religious organizations (including churches). There are now 28 different types of
organizations listed in the main exemption section of the Code (section 501), and
numerous other exemptions provided elsewhere. The number and financial holdings of
these organizations are large and have grown significantly since record- keeping began in
1975.

Size and growth of the charitable sector

Charitable organizations described in section 501(c)(3) represent by far the largest
category of exempt organizations, comprising about two-thirds of all exempt
organizations. In terms of asset size and revenues, the share of charitable organizations in
the exempt sector is similar. In 2001, the total revenue of charitable organizations
(including private foundations but not including churches and other organizations not
required to file) was about 9.3 percent of gross domestic product.

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Among charitable organizations not including churches, the largest categories of
organizations are hospitals and post-secondary educational organizations. In 2001,
hospitals held 29 percent of total assets and collected 42 percent of total revenues in the
charitable sector. Colleges and universities held 21 percent of the total assets and
collected 11 percent of total revenue.

The growth in the number and size of charitable organizations has been accompanied by
growth in the amount of charitable deductions.

The meaning of charity

In general, there are two approaches to the meaning of the term charitable -- the legal
sense and the ordinary and popular sense. The legal definition is derived from the law of
charitable trusts and is broader than the ordinary sense of the term, which generally
means the relief of the poor and distressed. Since 1959, Treasury regulations have
defined the term “charitable” in the legal sense, to include: Relief of the poor and
distressed or of the underprivileged; advancement of religion; advancement of education
or science; erection or maintenance of public buildings, monuments, or works; lessening
of the burdens of Government; and promotion of social welfare by organizations
designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions;
(ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights
secured by law; or (iv) to combat community deterioration and juvenile delinquency.
This definition is broad, encompassing several ideas that would not generally be
considered as charitable in the ordinary sense. In addition to meeting the regulatory
definition of charitable, an organization described in section 501(c)(3) is not organized
and operated for exempt purposes if a purpose of the organization is against public policy
or is illegal.

In addition to the public policy requirement, certain common law principles inform the
Federal tax law definition of charity. The charitable class requirement provides that an
organization be organized to benefit a sufficiently large or indefinite class of people. The
community benefit doctrine permits exemption as a charitable organization if the result of
an activity inures to the benefit of the community, even though a private person is the
immediate beneficiary of the activity.

The rationale for tax exemption and charitable deductions

There is no agreed upon explanation of the rationale behind the charitable tax exemption

15
and tax deduction. Some of the basic rationales that have been offered, may be
summarized as follows: (1) charitable organizations serve the public and therefore should
be supported through provision of tax benefits; (2) charitable organizations provide goods
and services that otherwise would have to be provided by the Government and therefore
should be supported by the Government; (3) it is difficult to measure the net income of
charitable organizations, and therefore they should be exempt from tax; (4) charitable
organizations promote pluralism; (5) charitable organizations are efficient providers of
services but have inherent limits on their ability to raise capital compared to for- profit
entities and therefore need government support in the form of tax exemption (and
charitable contributions); and (6) exemption is afforded to those organizations that can
prove their worth through sustained donations.

Public Charity or Private Foundation

Once an organization qualifies for tax-exempt status under section 501(c)(3), the
organization must be classified as either a public charity or a private foundation. An
organization may qualify as a public charity in several ways. For example, it may be a
specified type of organization, such as a church, educational institution, hospital and
certain other organizations; it may qualify as a publicly supported public charity; it may
qualify as a “supporting organization.” An organization that does not qualify as a public
charity is a private foundation.

Educational purposes
Tax exemption for educational organizations was provided in the Tariff Act of 1894, and
has been replicated in each subsequent income tax act. Educational organizations have
been eligible to receive tax deductible contributions since 1917. Like the term charitable,
the term educational has no precise meaning. The Treasury regulations set forth the basic
definition as relating to the “instruction or training of the individual for the purpose of
improving or developing his capabilities.” This definition is consistent with provision of
exemption for organizations that fit within the common conception of an educational
organization, such as schools, colleges, and universities. Yet educational organizations
are not limited to such traditional forms. The “instruction of the individual standard” may
be met by many other types of organization. The Treasury regulations also provide that
educational means the “instruction of the public on subjects useful to the individual and
beneficial to the community.” The IRS and the courts have permitted a broad array of
organizations to be considered educational under this standard.
A primary issue in determining whether something is educational is to determine whether
an organization’s presentation of information is objective and balanced, or whether the

16
organization instead is an advocate or a mouthpiece for propaganda.

Religious purposes
The Federal tax exemption for organizations operated for religious purposes was, along
with charitable and educational purposes, provided for originally in the Tariff Act of
1894, and religious organizations were designated as eligible for charitable contributions
in 1917. There is no definition of “religious” provided by regulation. The manifest reason
is the constitutional law framework that limits Federal involvement in religion. The IRS
has developed a multi-factor list of characteristics that inform whether an organization
may be considered a church (which is a kind of religious organization), and the IRS is
careful to point out that this list is not comprehensive and that in each case, the facts and
circumstances will be considered. In many cases in which a religious organization’s
claim to exempt status is questioned, the issue of whether the organization serves
religious purposes often is not addressed because exempt status may be denied on other
grounds, for example, private benefit or private inurement, commerciality, or violation of
the political activities prohibition.

The Constitutional concerns regarding Federal involvement in religious organizations

extend to the application of regulatory requirements. For example, certain religious
organizations are exempted from the requirement to apply for tax-exempt status, from
annual information return requirements, and special audit procedures apply to churches.
As a result, although religious organizations, particularly churches, constitute a
significant part of the charitable sector, information about such organizations is scarce.

501(c)(3) Arts Organizations

Despite these challenges, arts organizations share certain traits that can help them thrive
as non-profit 501(c)(3) organizations, with fewer of the hurdles faced by other kinds of
non-profits. First, while many organizations rely largely on foundation grants and private
donations, arts organizations can raise funds from ticket sales to performances, exhibits,
and other events. For many kinds of organizations, these “fee-for-service” revenue
sources can trigger “unrelated business income tax” or endanger 501(c)(3) status under
the “commerciality doctrine” applied by the Internal Revenue Service (“IRS”) and the
courts. However, these revenue sources are generally consistent with the tax-exempt
status of arts organizations. Additionally, these types of revenue sources can more easily
satisfy the “public support” tests that enable an organization to qualify as a public charity,
and thereby avoid classification as a private foundation and the stringent oversight to
which private foundations are subjected.

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HOW TO FORM AN ILLINOIS NONPROFIT CORPORATION

Most nonprofits are 501(c)(3) corporations, which means they are formed for religious,
charitable, scientific, literary, or educational purposes and are eligible for federal and
state tax exemptions. To create a 501(c)(3) tax-exempt organization, first you need to
create the appropriate business form in . Then you apply for tax-exempt status from the
IRS.

1. Choose who will be on the initial board of directors.

In Illinois, your nonprofit corporation must have three or more directors. You must have
at least one incorporator and the incorporator can be an individual (age 18 or older) or a
corporation (domestic or foreign).

2. Choose a name for your corporation.

The name of your not-for-profit corporation must be distinguishable from the name of
any business entity on file with the Illinois Secretary of State. To see if your proposed
name is available, you can search Illinois's corporate name database on the Illinois
Secretary of State's website. You can also write or call the Secretary of Stateʼs office in
Springfield to find out if a name is available.

Although not required, the name may contain the words "corporation," "incorporated,"
"company," "limited," or an abbreviation of one of those. The name must end with the
letters "NFP" if the corporate name contains any word or phrase that indicates or implies
that the corporation is organized for any purpose other than a purpose authorized under
the Illinois General Not For Profit Corporation Act. The name may not contain the words
“regular democrat,” “regular democratic,” “regular republican,” “democrat,”
“democratic,” “republican,” or the name of any other established political party, unless
consent is given by the State Central Committee of the established political party.

3. Prepare and file your not-for-profit articles of incorporation.

You will need to create and file not-for-profit articles of incorporation with the Illinois
Secretary of State's office. The articles of incorporation must include basic information
about your corporation including: your corporation's purpose (as authorized under
Section 103.05 of the Illinois Not For Profit Act), the address of the corporation's initial

18
registered office in Illinois and the name of the initial registered agent at that office, the
name and address of each incorporator, and the name and address of each initial director.
The Illinois Secretary of State has a fill-in-able not-for-profit articles of
incorporation form on its website which you can use to form your not-for-profit Illinois
corporation. Complete and file your articles following the instructions provided on the
Secretary of State's website (adding the IRS-required language discussed below). Do not
use the online articles filing option unless it allows you to include provisions required for
tax exemption. (At the time this article was published, this was not allowed.)

The fill-in-able articles form on the Secretary of State’s website does not include certain
provisions required by the IRS to obtain tax-exempt status. To receive 501(c)(3) tax-
exempt status from the IRS, you'll need to add certain additional language to your
articles, including: a statement of purpose that meets IRS requirements, statements that
your nonprofit will not engage in prohibited political or legislative activity, and, a
dissolution of assets provision dedicating your assets to another 501(c)(3) organization
upon dissolution.

For information on IRS requirements for tax exemption including sample required
language, see IRS Publication 557, Tax-Exempt Status for Your Organization, available
on the IRS website. Be sure to include the tax-exempt required language in the articles
you prepare. For more information on preparing your Illinois not-for-profit articles, see A
Guide for Organizing Not-for Profit Corporations, available on the Illinois Secretary of
State's website.

4. Prepare bylaws for your Illinois nonprofit corporation

You'll need to prepare bylaws that comply with Illinois law and contain the rules and
procedures your corporation will follow for holding meetings, electing officers and
directors, and taking care of other corporate formalities required in Illinois. Your bylaws
do not need to be filed with the Illinois Secretary of State -- they are your internal
operating manual.

5. Hold a meeting of your board of directors

Your first board meeting is usually referred to as the organizational meeting of the board.
The board should take such actions as: approving the bylaws, appointing officers, setting
an accounting period and tax year, and, approving initial transactions of the corporation,
such as the opening of a corporate bank account. After the meeting is completed, minutes
of the meeting should be created.

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6. Set up a corporate records binder.
You should set up a corporate records binder for your nonprofit to hold important
documents such as articles of incorporation, bylaws, and minutes of meetings. For more
information, as well as minutes forms, consent forms, and other resolutions.

Obtain Your Federal and State Tax Exemptions

Now that you have created your nonprofit corporation, you can obtain your federal IRS
and Illinois state tax exemptions. Here are the steps you must take to obtain your tax-
exempt status:

1. File your Form 1023 federal tax exemption application.

To obtain federal tax-exempt status from the IRS, you will need to complete and file
IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of
the Internal Revenue Code. This long and detailed form asks for lots of information about
your organization, including its history, finances, organizational structure, governance
policies, operations, activities, and more.

Smaller nonprofits may be eligible to file Form 1023-EZ, Streamlined Application for
Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code. This is
a much simpler, shorter form that is filed online. Only smaller nonprofits--those with
projected annual gross receipts of less than $50,000 and total assets of less than
$250,000--are eligible to use the streamlined 1023-EZ application. (See the IRS website
for more information on the Form 1023 and Form 1023-EZ filing requirements)

2. Obtain your Illinois state tax exemption.

If your nonprofit receives a federal tax exemption from the IRS, it is exempt from Illinois
income tax. You do not need to file any documents to obtain the exemption. Some not-
for-profit corporations may qualify for an exemption from state sales tax. Check
the Illinois Department of Revenue website regarding what forms and documents you
need to file to apply for a sales tax and other state tax exemptions.

3. Other state reporting and registration requirements.

Depending on your activities and the size of your organization, you may need to register
with the Illinois Attorney General before doing any fundraising activities. Check the
Illinois Attorney General's website for rules and information about fundraising
registration requirements.

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THE BENEFITS AND BURDENS OF 501(C)(3) STATUS
501(c)(3) is a special tax status under federal law, generally available to organizations
formed and operated for a charitable, educational, scientific or religious purpose, and
promotion of the arts is recognized as a valid educational purpose.

Treas. Reg. § 1.501(c)(3)-1(d)(3)(ii), Example 4 (Educational organizations include

“[m]useums, zoos, planetariums, symphony orchestras, and other similar
organizations,” provided that the organizations otherwise satisfy the requirements
of section 501(c)(3) of the Code).

Before embarking on the 501(c)(3) qualification process, it is important to carefully

consider whether the benefits of 501(c)(3) status are worth the burdens.

There are three legal benefits to having 501(c)(3) status: (1) the organization’s net
revenue (after expenses) is generally not subject to tax; (2) contributions to the
organization are eligible for the charitable deduction (because of the interaction of
sections 170 and 501); and (3) the organization is eligible for grants from private
foundations. Also, don’t forget that, Federal recognition is a step toward State exempt
recognition which then may include exemption from State Property Taxes.

These benefits are not quite as advantageous as they may appear. Most non-profits
(including arts organizations) do not have large amounts of excess revenue – most
struggle to earn enough revenue to pay their expenses. Therefore, the tax exemption on
net revenue may not be crucial. Second, while the charitable deduction is a powerful
incentive for individuals inclined to give money to non-profit organizations, it is still a
difficult task to convince people to give. The charitable deduction tends to be important
only when an organization’s Board of Directors has a strong and committed network of
high-wealth individuals. Lastly, it can be difficult to get grants from private foundations.
Finding grant opportunities takes significant research, and the grant writing process
requires preparation, perseverance, and commitment.

Maintaining 501(c)(3) status can also be quite burdensome. A 501(c)(3) organization

must be run by a Board of Directors (generally 3 or more people) in accordance with
Articles of Incorporation, Bylaws, and various corporate policies that comply with
requirements set forth under federal tax law and state non-profit corporation law. Exempt
organizations are typically required to file an annual information return, stating
specifically the items of gross income, receipts, disbursements, and such other

21
information as the Secretary may prescribe. In addition, any compensation to Directors or
Officers must be closely scrutinized to ensure that such payments are reasonable.
Complex annual tax filings called the Form 990 (or Form 990-EZ) are generally required
for organizations with gross revenue exceeding $50,000 per year. (Organizations whose
annual gross receipts are normally $50,000 or less, file a much simpler electronic form
called the Form 990-N). These and other administrative difficulties are not typically
worth the trouble unless 501(c)(3) status would significantly enhance an organization’s
fundraising capabilities, or at least its image in the arts community.

The organization's Form 990 (or similar such public record as the Form 990-EZ or Form
990-PF) must be available for public inspection and photocopying at the offices of the
exempt organization, through a written request and payment for photocopies by mail
from the exempt organization, or through a direct Form 4506-A "Request for Public
Inspection or Copy or Political Organization IRS Form" request to the IRS of for the past
three tax years. Form 4506-A also allows the public inspection and/or photocopying
access to Form 1023 "Application for Recognition of Exemption" or Form 1024, Form
8871 "Political Organization Notice of Section 527 Status", and Form 8872 "Political
Organization Report of Contribution and Expenditures". Internet access to many
organizations' 990 and some other forms are available through GuideStar. Failure to file
such timely returns and to make other specific information available to the public also is
prohibited.

It is important to stress that the burden is on the exempt organization throughout its entire
life, to maintain records proving its exempt status. The IRS has no burden to prove a loss
of status.

Designing a Program of Activities to Qualify under 501(c)(3)

An arts organization that has thoroughly considered the benefits and burdens of 501(c)(3)
status and wishes to move forward with the qualification process will need to design a
program of activities consistent with 501(c)(3) status. It is important to be aware of which
types of activities are acceptable and which activities raise suspicions at the IRS, and be
able to show the IRS several bona fide activities that fit squarely within the traditional
notions of a 501(c)(3) arts organization.

The exemption under section 501(c)(3) for arts organizations is based on the statutory
exemption for “educational” organizations, so educational activities carry significant
weight in the approval of 501(c)(3) status.

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Examples of educational arts organizations include:
An organization formed to promote the advancement of young musical artists by
conducting weekly workshops, and sponsoring public concerts by the artists. Rev.
Rul. 67-392, 1967-2 C.B. 191.
An organization formed to promote public appreciation of group harmony singing by
holding frequent meetings of members where they receive training and instruction
in vocal harmony and opportunities to practice under trained supervision. Rev.
Rul. 66-46, 1966-1 C.B. 133.
A dance school with a regular faculty, daily comprehensive curriculum, and a regularly
enrolled body of students. Rev. Rul. 65-270, 1965-2 C.B. 160.
Educational activities can also include individual instruction, or the dissemination of
instructional materials for free or for a nominal charge. See Rev. Rul. 68-71, 1968-
1 C.B. 249 (approving the 501(c)(3) status of an organization that provided career
education by distributing educational publications at a nominal charge and
providing free vocational counseling services).
Public exhibits or performances are also typically valid 501(c)(3) activities, if steps are
taken to ensure that the selection of artists is disinterested (i.e. the organization is
not merely a vehicle for showing the work of founders, directors or other insiders
of the organization), and provided that the artists or works are chosen for their
artistic merit rather than their ability to appeal to a mass audience. See Plumstead
Theatre Soc’y, Inc. v. Comm’r, 74 T.C. 1324, 1332-1333 (1980), aff’d 675 F.2d
244 (9th Cir. 1982) (contrasting commercial theaters, which “choose plays having
the greatest mass audience appeal … run the plays so long as they can attract a
crowd …[and] … set ticket prices to pay the total costs of production and to return
a profit,” with 501(c)(3) theaters, which “fulfill their artistic and community
obligations by focusing on the highest possible standards of performance; by
serving the community broadly; by developing new and original works; and by
providing educational programs and opportunities for new talent.”). It helps if at
least some of these exhibits or performances are open to the public for free.

For example, the IRS has approved the 501(c)(3) status of the following organizations:
An organization whose sole activity was sponsoring an annual art exhibit of artists
selected by a panel of qualified art experts. Rev. Rul. 66-178, 1966-1 C.B. 138.
A filmmaking organization that organized annual festivals to provide unknown
independent filmmakers with opportunities to display their films. Rev. Rul. 75-
471, 1975-2 C.B. 207.

23
An organization that presented public jazz concerts featuring aspiring jazz composers and
high school students performing alongside established jazz musicians. Rev. Rul.
65-271, 1965-2 C.B. 161.
A touring repertory theatre company that focused on works that were part of college
curricula. Rev. Rul. 64-175, 1964-1 C.B. 185.

Note that the IRS views the exhibition of art much differently than the sale of art,
especially with respect to the visual arts. The IRS typically denies 501(c)(3) status to art
galleries that engage in the sale of art for a commission. See Rev. Rul. 76-152, 1976-1
CB 151 (rejecting the 501(c)(3) status of a gallery formed to promote modern art trends
by exhibiting works of modern artists and selling the works on consignment basis with
the artist setting the selling price and the organization keeping a 10% commission, even
though this commission was lower than that charged by commercial entities and the
gallery planned to supplement its revenue through donations); Rev. Rul. 71-395, 1971-2
CB 228 (rejecting the 501(c)(3) status of a gallery formed and operated by approximately
50 artists for the purpose of exhibiting and selling the work of the founders).

Gallery sales activities are permitted only under very limited circumstances when sales
activities are sufficiently minor in comparison to educational and other valid 501(c)(3)
activities. Goldsboro Art League, Inc. v. Comm’r, 75 T.C. 337 (1980) (approving the
501(c)(3) status of a gallery that engaged in some sales for commissions in addition to
educational activities, based on the following factors: (1) there were no other museums or
galleries in the area, thus, the exhibition of art works showed a purpose primarily to
educate rather than to sell and the selling activity served merely as an incentive to attract
artists to exhibit their work; (2) works were selected by an independent jury for their
representation of modern trends rather than salability; (3) the organization demonstrated
that educational activities were its priority; (4) the art sales were not conducted at a
profit; and (5) of more than 100 works of arts exhibited in the organization’s galleries,
only 2 members of the organization had their art exhibited).

Most 501(c)(3) arts organizations focus predominantly on education and/or public

exhibits or performances, but other types of activities can be acceptable as well. For
example, the awarding of grants to aspiring artists and students is a permissible 501(c)(3)
activity, if procedures ensuring disinterested selection of winners are developed and
scrupulously followed. See Rev. Rul. 66-103, 1966-1 C.B. 134 (approving the 501(c)(3)
status of organization formed for the purpose of making grants available to writers,
composers, painters, sculptors, and scholars for projects in their respective fields which

24
they would not otherwise be able to undertake or finish due to the lack of funds. In
awarding grants, preference was given to persons showing distinction or promise in their
respective fields, and the recipients promised to make their work available for the benefit
of the public in ways customary and appropriate to the particular work. The organization
received no financial benefit from these grants).

The IRS has also approved of activities promoting the appreciation of art by less
traditional means, such as the recording and sale of obscure classical music pieces to
educational institutions, Rev. Rul. 79-369, 1979-2 C.B. 226, and a museum’s sale of
greeting cards displaying printed reproductions of selected works from the museum’s
collection and from other art collections. Rev. Rul. 73-104, 1973-1 C.B. 263. However,
these types of non-traditional promotional activities should be approached with caution,
as they implicate difficult issues that can lead to unpredictable results from the IRS. See
e.g. Rev. Rul. 76-206, 1976-1 C.B. 154 (rejecting the 501(c)(3) status of an organization
formed to generate community interest in classical music by urging the public to support
the classical music program of a for-profit radio station).

In summary, when applying for 501(c)(3) status, an arts organization should be prepared
to describe several activities similar to those approved by the IRS. There should be at
least some educational component, whether through workshops, classes, online
publications or tutorials, or other means. It is helpful to show engagement with the public
or local community through free exhibits or performances, and to focus on art that lacks
mainstream commercial viability. Lastly, an organization founded or run by artists should
make sure to focus on a wide variety of artists rather than just its founders or members.

Unrelated business income tax

In general, an exempt organization may have revenue from four sources: (1)
contributions, gifts, and grants; (2) trade or business income that is related to exempt
activities (e.g., program service revenue); (3) investment income; and (4) trade or
business income that is not related to exempt activities. In general, the Federal income tax
exemption extends to the first three categories, and does not extend to an organization’s
unrelated trade or business income.

The unrelated business income tax was introduced in 1950 to address the problem of
unfair competition between for profit companies and nonprofit organizations conducting
an unrelated for-profit activity.

25
Until the introduction of the unrelated business income tax in 1950, exempt organizations
enjoyed a full exemption from Federal income tax. If a charitable or other exempt
organization met the organizational and operational requirements of the statute, there was
no statutory limitation on the amount of business activity an exempt organization could
conduct so long as the earnings from the business were used for exempt purposes. Courts
extended this “destination of income test” to the exemption even of charitable
organizations that did not conduct any charitable programs, but rather operated
commercial businesses for the benefit of a charitable organization, so called “feeder”
organizations. In the years before 1950, charitable organizations also were acquiring real
estate with borrowed funds. In a typical transaction, a tax-exempt organization would
borrow money to acquire real estate, lease the property back to the seller under a long-
term lease, and service the loan with tax-free rental income from the lease. Under such
transactions, there was a concern that exempt organizations were in effect leveraging
their tax exemption and threatening the tax base by acquiring, through debt, income
producing assets that after the acquisition no longer generated revenue for the Federal
government.

As a response to such practices and rulings, in 1950 Congress subjected charitable

organizations (not including churches), and certain other exempt organizations to tax on
their unrelated business income. The tax was intended to prevent unfair competition.
To address the issue of feeder organizations, the 1950 Act provided that, in general, an
organization that is operated primarily for the purpose of carrying on a trade or business
for profit may not be recognized as tax-exempt merely because all of the organization’s
profits are payable to tax-exempt organizations. To address the leveraging of exemption,
the 1950 Act also taxed certain rents received in connection with the leveraged sale and
leaseback of real estate.

Nineteen years later, in the Tax Reform Act of 1969, Congress made significant changes
to the unrelated business income tax rules, extending the tax to all exempt organizations
described in section 501(c). In order to prevent evasion of the unrelated business income
tax through the use of controlled subsidiaries, the Act also generally provided that
payments to a tax-exempt organization of interest, annuities, royalties, and rent from a
taxable or tax-exempt subsidiary of such organization may be subject to tax. These
provisions were intended to prevent tax-exempt organizations from “renting” assets to a
subsidiary for use in an unrelated business, thereby permitting the subsidiary to escape
income taxes through a large rent deduction. Since 1969, Congress has made a number of
changes to the unrelated business income tax rules, but the structure of the tax has

26
remained largely intact.

Contributions
Another feature of a minority of tax-exempt organizations is that contributions to such
organizations may be deductible by the donor as charitable contributions for income,
estate, and gift tax purposes under section 170 of the tax code. Contributions to charitable
organizations, for example, generally are deductible for income, estate, and gift tax
purposes, although the amount of deduction may be affected by such factors as the
recipient organization’s classification as a public charity or private foundation and the
type of property contributed. Other types of organizations that are eligible recipients of
charitable contributions include: certain Federal, State, and local government entities, if
the contribution is exclusively for public purposes; certain fraternal beneficiary societies,
if the contributions are used for charitable purposes; cemetery companies, if the
contributions are used for certain purposes; and certain organizations of war veterans.

Maintaining Exempt Status

The four IRS tests
To maintain tax exempt status, an organization must at all times during its existence,
affirmatively prove and pass these four tests if called on to do so by the IRS. Note: the
IRS has neither the desire nor the resources to ferret out nonconforming organizations.
Instead it depends mostly on the annual reporting of organizations and additionally on
community reporting (tattle tails) to police 501(c)3 compliance.

1. Organizational test – This is a test that looks squarely at the four corners of the
organizational document. It is in effect a “magic words” test, and the IRS tells you what
words to use!
The organizing documents must limit the organization's purposes to exempt
purposes in section 501(c)(3) and must not expressly empower it to engage, other
than as an insubstantial part of its activities, in activities that are not in furtherance
of one or more of those purposes. This requirement may be met if the purposes
stated in the organizing documents are limited by reference to section 501(c)(3).

See appendix A (page 34)

In short, the founding document must authorize only the exempt activities, prohibit
private inurement, limit the organizations political activities, and commit the
organizations assets irretrievably to exempt purposes.

27
2. Operational test – The organization must be operated “exclusively” for exempt
purposes. These are the factors that the IRS will look at:
Primary Purpose - In this context “exclusively” has been interpreted to mean
“primarily” by the IRS. So, if any none-exempt activities carried on by the
organization are found to be substantial, it will fail the operational test.
Commercial activities – Commercial (for profit) activities are not prohibited,
but the IRS will look to commercial activities to determine if they are in
furtherance of the tax-exempt purpose of the organization.
private benefit – Here the IRS will look to the public nature of the operation to
determine if the individuals benefiting are too narrow, too small or to limited a
group.

3. Private inurement test - The doctrine of private inurement generally prohibits an

exempt organization from using its assets for the benefit of a person or entity with a close
relationship to the organization. Inurement applies to transactions between applicable
exempt organizations and persons sometimes deemed “insiders” of the organization, such
as directors, officers, and key employees.
Overlap of Control and Benefit – those who control an organization cannot
benefit from its activities.
The issue of private inurement often arises where an organization pays unreasonable
compensation (i.e. more than the value of the services) to such an insider. However, the
inurement prohibition is designed to reach any transaction through which an insider is
unduly benefited by an organization, either directly or indirectly.

4. Political activities Test – both substantial lobbing and any electioneering are
prohibited by tax-exempt organizations.

SUMMARY
In general, the requirements for exempt status of an organization under section 501(c)(3)
of the Code are that (1) the organization must be organized and (2) operated exclusively
for certain purposes; (3) there must not be private inurement to organization insiders;
there must be no more than an incidental private benefit to private persons who are not
organization insiders; (4) no substantial part of the organization’s activities may be
lobbying; and the organization may not participate or intervene in political activities.
Permitted purposes are religious, charitable, scientific, testing for public safety, literary,
educational, the fostering of national or international amateur sports competition, or the

28
prevention of cruelty to children or animals. Failure to satisfy any of these requirements
should result in an organization not qualifying for exempt status under section 501(c)(3),
or should result in a loss of such status once a violation is detected by the IRS. Most of
the Federal law of charitable organizations is designed around ensuring that each of the
requirements is satisfied by an organization initially and on an ongoing basis. Each of the
requirements is simple to state, but none are simple, as each carries with it a significant
body of statutory, common, and administrative law.

WHAT ARE THE RESPONSIBILITIES, AND THE LEGAL DUTIES OF BOARD

MEMBERS?

Non-profit boards are generally self-perpetuating – meaning they elect new members
themselves. The board is legally responsible for the operation of the nonprofit
organization for which it serves – a fiduciary duty. In fact, individual members can even
be held personally liable for improper conduct if they breach their duties. So, pay careful
attention to the law and board duties. Doing so will help you minimize risk and ensure
your organization is the best it can be.

Board Responsibilities
In addition to standards of conduct, as a governing body, the board has a responsibility to
support management and staff, and ensure operations run smoothly and in accordance
with the law.

Legal Duties
Under state statutory and common law, officers and board members are fiduciaries and
must act in accordance with the fiduciary duties of care, loyalty, and obedience.

Duty of Care
A board member must exercise “reasonable care” when he or she makes a decision
for the organization. Here, “reasonable” is considered what a prudent person in a
similar situation might do. A director may rely on information from another
director, committee, or employee of the organization, as long as a prudent person
would believe the source to be reliable. Most states follow the Business Judgment
Rule, where a board member’s decision is presumed to be correct where the
judgment is rational, has no conflict of interest, and where the member acted in a
reasonably informed manner.

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 Duty of Loyalty
A board member must always act in the best interests of the organization, and not
in their own interest or in the interest of another person or entity. Duty of loyalty
questions are generally fact specific, and often dependent on factors such as timing
and disclosure. Conflict of interest falls under the duty of loyally, and may come
up directly or indirectly. When a case or potential case arises, the board member is
required to disclose the potential conflict before the board takes action, and to
have a disinterested board member(s) review the matter. The member may want to
recuse themselves for voting on matters that potentially could be viewed as a
conflict of interest.

Duty of Obedience
A board member must be faithful to the organization’s mission. This means he or
she cannot act in a way that is inconsistent with the organization’s goals.

The Possibilities of the L3C

By A. Nicole Campbell on November 10th, 2009 Posted in Formation

People have been whispering among themselves about the L3C, an emerging low-profit
limited liability company structure that aspires to link business methods with charitable
purposes and give socially oriented businesses greater access to investor capital. The
structure was created by Robert M. Lang, Jr., CEO of the Mary Elizabeth & Gordon B.
Mannweiler Foundation. Conceptually, the L3C is a hybrid not-for-profit/for-profit
entity: like a not-for-profit, it has a primary purpose of charity, but like an LLC, it can
have equity holders that have a right to distribution of profits. Notably, although profit is
allowed in an L3C, it cannot be a significant purpose of the organization. Vermont
passed the nation’s first L3C statute in April, 2008, effectively making the form legal in
every state since a Vermont L3C can technically do business nationally (even
internationally). Illinois, Michigan, the Crow Indian Nation in Montana, Utah, and
Wyoming have followed suit, and similar bills are currently pending in Arkansas,
Missouri, North Carolina, Oregon, and Tennessee.

The L3C is taxed like any other for-profit entity and is not eligible for tax exemption
under Section 501(c)(3) of the Internal Revenue Code. L3Cs hope to encourage an influx
of new capital into charitable causes that are too risky for for-profit ventures and that
nonprofit dollars alone cannot sustain. The L3C effectively creates a market for
investment in companies that offer low rates of return, but contribute to the community,

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unlike the non-profit, which offers no rate (and sometimes a negative rate) of return on
investment. Therefore, if an entity has a charitable mission, but does not believe it can be
profitable, or has a social mission, but probably could not secure program-related
investments (“PRIs”) from private foundations, it would be better off forming as a not-
for-profit or for-profit entity, respectively.

L3Cs envision a tiered investment structure. The first tier relies on PRIs to cover the
areas of highest risk. Under current law, private foundations are required to spend at
least 5% of their net asset value annually. PRIs essentially function as loans that will be,
at least theoretically, repaid. Even with no interest, the PRIs will still count as qualifying
distributions towards the 5% requirement. The L3C creators believe that private
foundations will make PRIs with L3Cs because the PRI requirements are incorporated
directly into the L3C structure itself, eliminating the need for private foundations to apply
for private letter rulings from the Internal Revenue Service (“IRS”), which can take up to
18 months to process and cost $50,000 or more in legal fees, plus a substantial fee to the
IRS.

Once PRI funding is in place, the thinking is that the L3C should then be on firmer
ground to attract investments from corporations and individuals and offer them a return
on their investment. This way, the PRI not only helps the L3C with its operating
expenses, but also creates a type of equity cushion that enables the L3C to receive
additional funds from more traditional funding sources. At that point, the L3C will likely
have some assets of value, so a third tier can involve investments with returns closer to
the market rate, can attract for-profit investors, and even enable the L3C to receive bank
loans at market rates. Basically, the L3C structure offers flexibility in terms of investors
and their expected returns. Still, whether L3Cs will be able to achieve this level of
success remains unclear.

If successful, however, L3Cs could allow organizations that rely heavily on donor
support, such as symphony orchestras, to become self-sufficient. They could also help
revitalize struggling, but vital industries, such as newspapers, and promote employment
in those areas. For example, North Carolina’s L3C bill envisioned collaboration between
local nonprofit organizations and failing furniture and textile businesses to help keep jobs
in local communities. The L3C model would also be especially helpful in the
microfinance industry, where receiving different tiers of investments, particularly at the
market level, would be integral to the success of microfinance institutions. Opponents of
the L3C are concerned that the creation of L3Cs will take away grant money that private

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foundations would have otherwise given to charities because the foundations will have
given the money to L3Cs in the form of low-yield PRIs, which would decrease the
amount of grants that the foundation could pay out. Proponents of the L3C say that
creation of the L3C does exactly the opposite and actually increases the amount of money
available for charities since the L3C will be able to accept so many different types of
investments.

The L3C is full of possibility, but whether that possibility will materialize is still up in the
air. For one thing, it is not clear how private foundations will react to the L3C structure,
or whether private foundations will make PRIs without first seeking private letter
rulings. And without the initial influx of PRI funding, L3Cs will find it difficult to attract
for-profit investors, which would affect the L3C model’s viability. But, if
foundations make PRI investments with L3Cs and if those investments are followed by
different conventional sources, the possibilities of a world with L3Cs may be realized.

Most importantly, the IRS has yet to really weigh in on whether private foundations
investing in L3Cs is safe. Ronald J. Schultz, senior technical advisor in the Tax-Exempt
and Government Entities Division, said that L3Cs raise a number of tax issues, including
PRI, private inurement, and private benefit. Schultz also mentioned that private
foundations that think that investing in an L3C was a “slam-dunk” on the jeopardy
investment issue (where a foundation is taxed on any jeopardizing investments it makes),
would be premature. He said that the IRS and Congress have not yet signed off on the
idea of L3Cs, and private foundations should consider whether investing in an L3C could
jeopardize the private foundation’s charitable activities. For a great article discussing the
response to Schultz’s statements, please visit The Nonprofit Times.

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Appendix A

COOK COUNTY CLERK'S OFFICE DAVID ORR, CLERK

ASSUMED BUSINESS NAME (DBA) APPLICATION

STATE OF ILLINOIS ) Registration Number: ______________

(For Office Use Only)
COUNTY OF COOK )

A. Is your business a Corporation (excluding Professional), LLC, LLP or a Non-Profit?

No - please complete the form below.

If yes, please register with the Secretary of State, Corporate Division. The Cook County Clerk's office does not file Corporations, LLC, LLP or Non-Profit organizations.
If registering your Assumed Business Name with the ending of PC, SC or LTD the entity must be a registered professional service corporation with the Illinois
Secretary of State’s Office and at the time of filing must provide the following:
1. Articles of Incorporation from the Illinois Secretary of State’s Office, if in business for less than a year
2. Certificate of Good Standing from the Illinois Secretary of State’s Office, if in business for more than a year

B. Contact Information (your application will not be processed if all fields required (*) below are not completed).
*Contact First Name *Address 1

*Contact Last Name Address 2

*Contact Email *City

*Contact Phone *State

*Zip

C. Assumed Business Name

The undersigned is/are conducting or transacting business under the
Assumed Business Name of:

D. Nature of Business
The nature of business conducted or transacted is (be descriptive):

E. Business Addresses within Cook County

Cook County Address 1 Address 2 (apt., suite, unit) City Zip

F. Business Owner(s)/Partner(s)
The true and real full names of all new person(s) owning, conducting or transacting the business are as follows (add notarized attachment for additional owners/partners):
Partner Type Trust/Company Title Complete Address
Owner/Partner Full Name (Individual, (include city, state, zip /
(If trust or company) (If company)
Company or Trust) if individual, list residential address)

Page 1 of 3

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 35
Appendix B (from the IRS website)

DRAFT A
Articles of Incorporation of ____________________
The undersigned, a majority of whom are citizens of the United States, desiring to form a
Non-Profit Corporation under the Non-Profit Corporation Law of
_______________________________, do hereby certify:
First: The name of the Corporation shall be _______________________________.
Second: The place in this state where the principal office of the Corporation is to be
located is the City of ____________________________________,
________________________ County.
Third: Said corporation is organized exclusively for charitable, religious, educational,
and scientific purposes, including, for such purposes, the making of distributions to
organizations that qualify as exempt organizations under section 501(c)(3) of the Internal
Revenue Code, or the corresponding section of any future federal tax code.
Fourth: The names and addresses of the persons who are the initial trustees of the
corporation are as follows:
Name ___________________________ Address_______________________
Fifth: No part of the net earnings of the corporation shall inure to the benefit of, or be
distributable to its members, trustees, officers, or other private persons, except that the
corporation shall be authorized and empowered to pay reasonable compensation for
services rendered and to make payments and distributions in furtherance of the purposes
set forth in Article Third hereof. No substantial part of the activities of the corporation
shall be the carrying on of propaganda, or otherwise attempting to influence legislation,
and the corporation shall not participate in, or intervene in (including the publishing or
distribution of statements) any political campaign on behalf of or in opposition to any
candidate for public office. Notwithstanding any other provision of these articles, the
corporation shall not carry on any other activities not permitted to be carried on (a) by a
corporation exempt from federal income tax under section 501(c)(3) of the Internal
Revenue Code, or the corresponding section of any future federal tax code, or (b) by a
corporation, contributions to which are deductible under section 170(c)(2) of the Internal
Revenue Code, or the corresponding section of any future federal tax code.

If reference to federal law in articles of incorporation imposes a limitation that is invalid

in your state, you may wish to substitute the following for the last sentence of the
preceding paragraph: "Notwithstanding any other provision of these articles, this
corporation shall not, except to an insubstantial degree, engage in any activities or

36
exercise any powers that are not in furtherance of the purposes of this corporation."

Sixth: Upon the dissolution of the corporation, assets shall be distributed for one or
more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue
Code, or the 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. Any
such assets not so disposed of shall be disposed of by a Court of Competent Jurisdiction
of the county in which the principal office of the corporation is then located, exclusively
for such purposes or to such organization or organizations, as said Court shall determine,
which are organized and operated exclusively for such purposes.

In witness whereof, we have hereunto subscribed our names this day of ______________
20_____.

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