Tuesday, September 27, 2011

“Non-Profit” Does Not Equal “Tax-Exempt”: Applying for Federal Tax-Exempt Status

Many individuals who start a “non-profit” organization incorrectly assume that setting up a “non-profit” entity (i.e. a “non-stock corporation” in Virginia) will automatically make that entity exempt from federal, state and local taxes, and will permit donors to take a charitable deduction on their individual tax statements. A full discussion of tax law applicable to non-profit organization is beyond the scope of this article. However, we want to impart some general knowledge regarding how to set up a non-profit organization in Virginia and some general information regarding applying for tax-exempt status with the Internal Revenue Service.

In Virginia, a non-profit organization is usually a non-stock corporation, which is a form of entity that does not issue stock and is governed by the by-laws adopted by the members of the organization. There are many ways to organize the governance of the corporation, but generally, it is run by a board of directors that is elected by members of the organization. How a person becomes a member of the organization is determined in accordance with the rules set out in the by-laws. Of course, the members or the board of directors can elect a CEO or President to run the day to day operations of the organization.   
Becoming a non-profit entity under Virginia state law permits certain exemption from various state and local taxes, but does not automatically result in exemption from federal income tax. The first step to gaining federal tax-exempt status is to determine which type of tax-exempt organization the entity is. The most common categories of tax-exempt entities are: (1) Charitable and religious organizations; (2) Business leagues; (3) Labor organizations; (4) Social welfare organizations; and (5) Agricultural/horticultural organizations. The two most common types of tax-exempt organizations that Gross & Romanick helps to establish are charitable/religious organizations and business leagues.

Withdrawal Provisions in Organizational Documents

One important issue that individuals organizing a new business entity must consider is what will happen in the event one of the owners wants to voluntarily withdraw from ownership in the entity. By “withdraw”, we mean that the owner wishes to return the ownership interest (stock for a corporation or membership interest for a limited liability company) to the company or to the other owners in exchange for some form of compensation. This issue is commonly overlooked in the organizing process, perhaps because the ambitious and optimistic organizer is not mindful of the fact that one day he/she may want to leave. As a result, many new entities do not enter into written agreements dealing with this important issue.
It is essential that the owners consider this issue as part of the organizing process. Some common reasons for an owner wanting to withdraw are the following:

1. Disagreement with the business direction of the entity;
2. A falling out with the other owner(s);
3. Relocation, medical problems or other personal reasons;
4. Desire to cash in the investment or the need for money.

The place to insert a withdrawal provision for a limited liability company is the company’s operating agreement. For a corporation, it is a shareholder agreement. Here are a few common ways to handle a voluntary withdrawal:


In Virginia, it is very difficult to enforce a covenant not to compete against an ex-employee. The Virginia Courts will only enforce a covenant not to compete if: (a) it is narrowly drawn to protect the employer's legitimate business interest, (b) it is not unduly burdensome on the employee's ability to earn a living, and (c) it is not against public policy. In each case, the Court will evaluate the covenant not to compete on its own merits, balancing the terms of the covenant with the circumstances of the businesses and employees involved. 
In a recent case before the Fairfax County Circuit Court, Daston Corp. v. MiCore Solutions, Inc., et al., the Court declined to enforce a covenant not to compete which, on its face, appeared to be reasonable. 
In that case, two employees (with identical employment agreements) of Daston Corp., a business that develops, markets, sells and manages applications for Google pursuant to a nationwide license, left their employment and accepted employment with MiCore Solutions, Inc., a business which provides a range of consulting and information technology services based on Google applications. 
The covenant not to compete in each employee’s employment agreement with Daston read as follows: