Selecting the State of Incorporation

Founders of to-be-formed nonprofit corporations may be confused about selecting an appropriate state of incorporation.  The general rule of thumb is to incorporate in the state in which the nonprofit will operate.  This may substantially reduce the nonprofit’s reporting requirements and associated burdens.  If the nonprofit is incorporated elsewhere, it may be required to qualify to do business as a foreign corporation in the state in which it is operating.  In addition, the nonprofit may need to register to engage in charitable solicitations, obtain state tax exemption, file several regular information returns, and maintain an agent for service of process, in both the state of incorporation and the state of operations. 
 
However, there are other factors to consider in deciding on the state of incorporation, particularly if the nonprofit will be operating in multiple states.  State corporation and tax laws may be more favorable in some states than in others.  For example, nonprofits may be concerned about the presence or absence of state income taxes, the amount and types of regulations that would impact their operations, restrictions on compensated directors, and filing burdens.
 
The following are some of the considerations for groups considering incorporating in California:
 
Form FTB 3500A. California has a state tax exemption application separate from the 501(c)(3) tax-exempt status process with the IRS. Prior to 2008, there was only one option: a multi-page form FTB 3500. As a result, states without taxes, such as Nevada, could leverage the appeal of no such additional filing requirement. However, beginning January 1, 2008, the California tax exemption process was streamlined for organizations that have already received federal 501(c)(3) determination with the introduction of form FTB 3500A, Submission of Exemption Request. Form FTB 3500A is only a one page form submitted with a copy of the 501(c)(3) determination letter, thereby greatly diminishing the effort involved to obtain California tax exemption.
 
Default Rules. The California Corporations Code has a section specifically dedicated to nonprofits that also contains a myriad of default rules. Not every state shares these characteristics. For example, Delaware has a much less comprehensive code dedicated to nonprofit corporation law. States such as Delaware that allow great flexibility in constructing bylaws may be more desirable for nonprofits that intend to or already have comprehensive bylaws. California, on the other hand, is better able to “fill-in” the gaps for more simple bylaws due to its default rules. California’s default rules should not, however, deter nonprofit corporations with detailed bylaws as many of the default rules only apply if not otherwise indicated in the organization’s articles or bylaws.
 
49% Limitation on Interested Directors. California imposes a 49% limitation on interested directors. Calif. Corp. Code § 5227. Other states, such as Delaware, have no such limitation. In one respect, no limitation on the number of interested directors makes it easier for a nonprofit to incorporate simply because it is one less rule to follow. However, the 49% limitation rule is considered a best practice in the nonprofit sector and therefore, it may be a beneficial rule the nonprofit wants to have in place.
 
Agent for service of process. A nonprofit must have an agent for service of process with a physical address located in the state of incorporation. The government may send official documents (e.g., tax notices and annual reports) to the agent’s address and the agent is also responsible for accepting lawsuit papers on behalf of the nonprofit. Therefore, a nonprofit that operates and is incorporated in California will benefit from having a domestic agent for service of process, which may be more readily accessible and available, such as an officer of the nonprofit. If a nonprofit operating in California incorporates in a foreign jurisdiction, it will have to appoint an agent for service of process in that foreign jurisdiction of incorporation as well as qualify to operate in California with the California Secretary of State.
 
Lawsuits in Court. A nonprofit risks the possibility of being hailed into a court in the state of its incorporation. Therefore, incorporating in the same state of the nonprofit’s operation may present fewer hurdles for individual(s) required to appear in a court in the state of incorporation.
 
California Nonprofit Integrity Act 2004. The California Nonprofit Integrity Act applies to most nonprofits operating in California. The Act requires compliance with provisions such as an annual financial statements audit by an independent certified public accountant for charitable corporations with gross revenues of $2 million or more. Therefore, even if a nonprofit is incorporated in another state, it cannot evade these requirements if it is operating in California.
 
A previous post on Form 3500A, “Form 3500A – Affirmation of 501(c)(3)” is viewable here. California’s Franchise Tax Board also has a frequently asked questions section regarding the differences between form FTB 3500 and form FTB 3500A as well as tax news section discussing the updated process. 
 
A summary of the key provisions of the California Nonprofit Integrity Act 2004 is available here.
 
- Emily Chan