Switching to nonprofit status

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(FORTUNE Small Business) -- Dear FSB: I am in the process of creating a socially responsible business. It is currently a sole proprietorship. However, I would like to change it to a nonprofit with tax-deductible status. What is the best way to go about doing this with limited startup money?

- Keith, Monroe, Wash.

Dear Keith: According to Emily Campbell, attorney and managing member at New York City law firm The Campbell Firm PLLC, there are two big steps to this process. First, you must incorporate your business. After you've done that, you can file the appropriate IRS forms to turn your company into a non-profit, or a 501(c).

Depending on the state in which you wish to raise funds, you may also have to file paperwork at the state level. For example, Washington state has certain registration requirements for organizations that raise more than $25,000 from the public in any accounting year. You can find information on operating charities and trusts in Washington at the Secretary of State's website, which also provides a toll-free telephone number for more information.

At the federal level, there are more than two dozen types of 501(c) organization structures, each defined by purpose of the organization. The most common is 501(c)(3), which encompasses religious, charitable, scientific and educational organizations. You can decide which structure is most appropriate for you by going to the government's admirably jargon-free website, usa.gov/Business/Nonprofit.shtml. At the bottom of the page you will find an easy-to-read document with detailed information on choosing and filing for a 501(c) status. The paperwork is available at http://www.irs.gov/charities/.

Completing the forms is easier said than done - be prepared to thoroughly explain your projected budget and detail your sources of income. Because applications get rejected on technicalities, Campbell strongly recommends completing them with the help of an accountant and an attorney, who will also help you understand your responsibilities and obligations as a nonprofit.

While filing fees are unavoidable, you may be able to find accountants and attorneys that do pro bono or reduced-fee work for nonprofits. The best place to start looking is your local bar association, such as the King County Bar Association in Washington. Another tip: Keep in mind that if you qualify for nonprofit status, you will need to provide reports regularly to the IRS, so start to budget now for future legal and accounting work.

One other thing to consider is that your eligibility for state grants or tax incentives could be affected by the state in which you choose to form your entity.