Not all nonprofit organizations are tax exempt. While many nonprofits benefit from tax-exempt status, receiving that status from the government doesn’t happen without some effort on the part of the organization. Therefore, it’s important to understand these details when creating your business entity. Tax-exempt nonprofits covered by Section 501(c) of the Internal Revenue Code most commonly file as 501(c)(3) organizations.
To receive tax-exempt status, nonprofits must apply and qualify for 501(c)(3) status.
What Is Tax Exemption?
An organization, such as a nonprofit, is tax exempt when they don’t have to pay federal corporate income taxes on income generated from the activities for which that entity was created, as well as some other taxes.
Organizations apply for tax-exempt status for a number of reasons. For one, tax exemption allows organizations to receive grants from private foundations and from the government. Additionally, they can provide tax deductions to individual donors, which makes them more attractive as charitable organizations. Tax-exempt status also makes organizations eligible for special postage rates, nonprofit advertising rates, and other discounts.
Tax-exempt status also provides some protection against lawsuits. Most charitable organizations incorporate before applying for tax exemption, so lawsuits would only apply to its corporate assets, while staff and board members have limited legal protection as members of the organization as well.
However, tax exemption doesn’t mean organizations don’t pay taxes at all. Exemption typically makes nonprofits exempt from paying federal income tax, sales tax, and property tax. They do, however, pay payroll taxes (social security and Medicare) just like for-profit corporations do.
What Is a 501(c)(3) Organization?
A 501(c)(3) organization is covered by Section 501(c)(3) of the U.S. Internal Revenue Code (IRC), making it exempt from the aforementioned taxes. The IRS recognizes more than 30 different types of nonprofit organizations, but 501(c)(3) organizations are the most common because donors can deduct their donations come tax season.
Broadly speaking, there are three types of organizations that are eligible for 501(c)(3) status: charitable organizations, churches and religious organizations, and private foundations. To qualify as a 501(c)(3) nonprofit, an organization must show it is any of the following:
- Committed to public safety
- Preventing cruelty to children or animals
- Promoting amateur sports
They also must explain how they serve the public good and demonstrate that they’re organized and operated for a specific purpose. But, again, they must not be committed to profit. A business that manufactures and distributes cheap water bottles to needy communities is admirable, but it wouldn’t qualify for tax-exempt status.
Some of the specific goals that 501(c)(3) organizations pursue include:
- Relief of the poor or underprivileged
- Advancement of religion
- Advancement of education or science
- Construction or maintenance of public works
- Pursuit of racial or economic justice
- Support of community development
- Improvement of public health
As you can see, 501(c)(3) organizations cast a wide net. Nursing homes, parent/teacher associations, some schools and hospitals, the Red Cross, and the Salvation Army all have also been known to qualify for tax-exempt status.
How Does a 501(c)(3) Organization Work?
Given the many accepted purposes of 501(c)(3) organizations, you’d be forgiven for thinking some of these organizations must be turning a profit. Of course, organizations need money to pursue their goals, pay their employees, and promote their work. As such, there are some additional regulations for 501(c)(3) organizations.
To achieve tax-exempt status, organizations must not serve any private interests, including those of the founders, the founders’ families, shareholders, or anyone else involved with the organization. Similarly, none of the organization’s net earnings can be used to enrich private shareholders or the founders. Any positive earnings must be used to advance the organization’s stated cause.
Some unrelated business income is allowed for a 501(c)(3) organization, but not a substantial amount. For instance, any unrelated business from sales of merchandise or rental properties must be limited and clearly delineated on the organization’s books.
501(c)(3) organizations are also forbidden from influencing legislation in a substantial way. That means they can’t participate in campaign activities to support or work against political candidates, and may not engage in lobbying except in some instances when its expenditures are below a certain amount. Additionally, employees must be paid solely based on the fair market value of their position, without “expectation” of bonuses or extra compensation.
If the IRS finds that tax-exempt organizations are not staying true to their stated purpose or violating any of these conditions, they may rescind the organization’s tax-exempt status. If organizations do change or adjust their purpose, they must notify the IRS.
Private vs. Public Charities
501(c)(3) organizations can be classified into public charities and private foundations. The main difference between the two is how they receive their financial support.
A public charity receives a substantial portion of its income or revenue from the general public or the government. At least one-third of donations must be received from the general public. Donors to public charities may qualify for certain tax deductions.
A private foundation is typically held by an individual, family, or corporation, and receives most of its income from just a few donors. They are subject to stricter rules and regulations than public charities, which is why all 501(c)(3) organizations are automatically classified as private foundations unless they prove they meet the IRS standards for public charity consideration. The deductibility of donations to private foundations is also more limited than public charity donations.
How Do You Obtain 501(c)(3) Status?
Forming a nonprofit organization is one step, but you won’t get the real benefits of being a nonprofit until you obtain 501(c)(3) status. We’ve already covered some of the high-level requirements, but how do you actually obtain tax exemption?
To apply for tax-exempt status, you must complete IRS Form 1023 within 27 months of your incorporation as a nonprofit. You must also include the articles of incorporation and documents that prove this organization is solely operating for exempt purposes. Fair warning: This form is complicated. In many cases, you’ll want to go through it with a dedicated nonprofit lawyer or use an online legal service, as there are many legal and tax technicalities that are important to understand.
For some nonprofits, however, there is a streamlined option available.
Smaller nonprofits may be eligible to use Form 1023-EZ. It’s shorter, simpler, and completely online. Nonprofits with less than $50,000 in annual receipts and $250,000 in total assets may use Form 1023-EZ. If you’re not sure if your nonprofit qualifies, use the Form 1023-EZ Eligibility worksheet contained in the Form 1023-EZ instructions. This form also carries a much smaller filing fee.
If your public charity earns less than $5,000 in annual revenues, you’re exempt from filing Form 1023. However, if you’d like your donors to be eligible for tax deductions, you should still file the form.
The Bottom Line
Nonprofits do valuable work, which is why they should be rewarded with tax-exempt status. However, tax exemption doesn’t happen overnight. Organizations must prove to the IRS that they are actively contributing to the public good and are not out for profit. Becoming a tax-exempt 501(c)(3) organization may take some time and effort, but if you qualify, the benefits make it worthwhile.