Nonprofit organizations are exempt from federal income taxes under subsection 501(c) of the Internal Revenue Service (IRS) tax code. A nonprofit organization is an organization that engages in activities for both public and private interest without pursuing the goal of commercial or monetary profit. To be exempt from federal taxes, nonprofit organizations have to meet certain rules.
Key criteria that nonprofits must meet to be tax exempt include:
- Be organized and operated exclusively for charitable, scientific, religious, or public safety purposes.
- Collect income and turn over the entire amount (minus expenses) to organizations or individuals who are lawfully recognized as legitimate charities.
Non-profit status may entitle an organization to certain benefits, such as state sales, property, and income tax exemptions; but, this corporate status does not automatically give federal income tax exemption. To be tax exempt, most organizations must apply to the Internal Revenue Service for recognition of exemption in order to get a ruling or determination letter recognizing tax exemption.
Certain requirements must be included in your articles of incorporation if you want to apply to the IRS for recognition of federal tax-exempt status as a charitable organization under Section 501(c)(3) of the Internal Revenue Code.
To be exempt under section 501(c)(3) from the date of formation, an organization must file an application within 27 months of the end of the month in which it was formed.
Although certain organizations are not required to apply for recognition of exemption, many do so to clarify their tax status. An exemption application must be accompanied by a user fee. The IRS will not process your application until you have paid the user fee.
The Internal Revenue Service (IRS) defines one as an organization that operates for at least one of the following tax-exempt purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering natural or international sports competition, or preventing cruelty to children or animals. The goal of establishing charitable 501(c)(3) organizations is to feed, educate, heal, shelter, inspire, and nurture individuals of all ages, races, genders, and socioeconomic backgrounds across the United States and beyond.
These great goals provide nonprofit organizations with tax benefits, but they also necessitate a number of measures that will be detailed in the sections that follow.
Creating a nonprofit organization is analogous to establishing a normal corporation. This comprises selecting an available business name, filing articles of incorporation, drafting corporate bylaws, appointing initial directors, having the first board of directors’ meeting, and getting any licenses or permits that the corporation may require.
However, in addition to these standard company creation stages, nonprofit organizations must also seek for federal and state tax exemptions. Obtaining tax-exempt status is a critical step in establishing a nonprofit organization in order to reap benefits such as tax-deductible donations, grant funding, and income and property tax deductions.
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A nonprofit organization must complete IRS Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, to apply for tax-exempt status. To get the most out of the nonprofit’s 501(c)(3) tax-exempt status, this should be done within 27 months of filing the articles of incorporation. If an application is filed within this time limit, the tax-exempt status will be applied retroactively to the day the articles of confederation were filed.
Filing Form 1023 and applying for 501(c)(3) status can be done later than 27 months after filing the articles of incorporation, but the organization will have to show reasonable cause for the delay, and, upon approval, the tax-exempt status will begin as of the date the Form 1023 application was postmarked.
Form 1023-EZ: Streamlined application. Form 1023-EZ, Streamlined Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, is available for smaller nonprofit organizations and can be completed online. It can be filed by nonprofits with less than $50,000 in annual receipts and less than $250,000 in total assets. The IRS has included an eligibility worksheet in the Form 1023-EZ Instructions to help determine eligibility before filing.
Form 1023: Long-form application. Form 1023, Application for Recognition of Exemption under Section 501(c)(3) of the Internal Revenue Code, is the more complicated long-form application for all organizations that do not meet the requirements for the streamlined application. Form 1023 is broken up into 11 parts outlined in the following sections:
Identification of applicant. This tells the IRS about the organization, including the name of the proposed nonprofit, primary contact information, when the articles of incorporation were filed, etc. The organization must also have and include its federal employer identification number (EIN) before applying for tax-exempt status, even if it does not have any employees.
Organizational structure. This tells the IRS what type of organization the proposed nonprofit is and attaches the proposed nonprofit organization’s articles of incorporation and bylaws to the application form.
Required provisions. This ensures that the prospective nonprofit organization has included provisions in its organizing documents indicating that it was formed for a recognized 501(c)(3) purpose. It must also indicate that any assets of the organization that remain after it’s dissolved will be distributed to another 501(c)(3) tax-exempt nonprofit organization or to a government entity for a public purpose.
Narrative description of activities. This section provides a detailed narrative of the organization’s past, present, and future activities. Details that are encouraged are a description of how the activities further the 501(c)(3) purpose of the organization when the activity began or will begin, how and who will conduct the activity, where the activity will be conducted, and how it will be funded. Applicants are encouraged to be as specific as possible and reminded that, upon approval, their application will be accessible to the public.
Compensation and financial arrangements. In order to deter operating a nonprofit for the sole benefit of its founders and major contributors, this section requires organizations to report the total or proposed compensation for its officers, directors, trustees, employees, and independent contractors.
Members (and others) receiving benefits from the organization. This section outlines if the organization provides goods, services, or funds to other individuals and organizations as part of its activities.
Organization’s history. This section reports whether the prospective nonprofit has taken over the activities of a prior organization or the assets of a preexisting nonprofit organization or if it has been legally converted from a previous association to a nonprofit.
Details of specific activities. There are certain activities a nonprofit organization is not permitted to participate in, and in this section, the organization affirms that it will not engage in such activities. Some of these activities include certain political campaign activities and gambling as part of fundraising activities. This section also requires more detailed information on the type of fundraising the organization does or is planning on doing and where that fundraising is to take place.
Financial data. This section requires prospective nonprofit organizations to provide a statement of revenues and expenses and a balance sheet. For organizations that have existed less than five years, this statement is completed for each year in existence, with projections for likely revenue and expenses. For organizations that have existed five years or more, the statement is completed for the most recent five tax years.
Public charity or private foundation. This section classifies the organization as a private foundation or public charity. Private foundations have strict operating rules and regulations, whereas public charities receive more favorable tax benefits. Public charities receive most of their support from the public or receive a majority of their revenue from activities specifically related to their tax-exempt purposes. All new 501(c)(3) organizations are automatically classified as public charities for the first five years as long as they demonstrate on Form 1023 that they reasonably expect to receive qualified public support regardless of the amount.
Fee information. The IRS website posts the current fee required when submitting Form 1023, and that information is included in this section.
Additional attachment schedules. Some prospective nonprofits will also be required to submit additional schedules to their Form 1023 application. The purpose of these schedules is to ask for additional, more specific information directed to specific types of nonprofits, such as those for low-income housing (Schedule F). A full list of additional attachment schedules can be found on the IRS website.
Once a Form 1023-EZ or 1023 is filed, the IRS will either grant the organization federal tax-exempt status, request further information before it decides, or issue an adverse determination. An adverse determination means that the IRS has denied tax exemption, and that determination becomes effective 30 days from the date it is issued. However, an adverse determination can be appealed; the organization can also submit a new Form 1023-EZ or 1023 application for review.
Tax Implications for Nonprofit Organizations
As mentioned, obtaining tax-exempt status offers nonprofit organizations numerous tax benefits to help further their charitable purpose. Below are the reasons many organizations seek to obtain 501(c)(3) nonprofit status:
Tax-exempt status. One of the most important and best-known benefits of forming a nonprofit is exemption from federal and state income and real estate taxes. This article has outlined the steps for obtaining federal income tax exemption. Rules and procedures vary by state for state tax-exempt status.
Limited liability. Forming a nonprofit protects individual directors, officers, and members from personal liability for the organization’s debt and liability, similar to regular corporations.
Entity status. A nonprofit organization exists on its own, giving it the opportunity to enter into its own contracts and litigate in its own name.
Perpetual existence. Like normal corporations, nonprofit organizations can exist indefinitely until dissolved.
Access to grants. Obtaining 501(c)(3) status makes some organizations eligible to receive grants as a means of gaining revenue. It also makes donations by other individuals tax-deductible.
Disadvantages of nonprofit status. There are also disadvantages to forming a nonprofit organization that should be considered before moving forward with attempting to form one.
Expense. Filing the required documents with the IRS and states means there will be filing fees to be paid. Some states also require nonprofit organizations to pay annual dues.
Compliance obligations. As part of ensuring the nonprofit continues to operate under the provisions required, it may be required to file an annual report, retain certain records, or file documents upon implementing certain changes to the organization.
Management. Nonprofit organizations are closely regulated because of the tax benefits offered and to ensure that the organization truly operates under the 501(c)(3) status applied for.
One of the ways a 501(c)(3) nonprofit organization can lose its tax-exempt status is by conducting activities that are not aimed at the exempt purpose it qualified for and beginning instead to serve private interests or private benefits of any individual members. It can also lose its tax-exempt status by lobbying for the purpose of proposing, supporting, or opposing legislation in a way that becomes more substantial than its overall activities.
Along those lines, a 501(c)(3) organization can lose its tax-exempt status by participating in a political campaign on behalf of or in opposition to any candidate running for public office. It can also lose its tax-exempt status by generating excessive income in areas unrelated to its exempt activities. 501(c)(3) organizations are required to report certain information to the IRS annually even though they are generally exempt from federal income tax; failure to meet these reporting requirements can jeopardize their nonprofit status.
While the purpose of a nonprofit organization is not to make a profit, a nonprofit must generate enough revenue to make itself a sustainable organization, just as a for-profit organization must do. This includes making enough for overhead expenses, compensation for employees, and costs as part of furthering its exempt mission. One of the ways it can do this is by applying for public and private grants that are usually dispersed for specific projects or purposes. Donations and fundraisers are among the top sources of funding for nonprofits. A nonprofit can also generate revenue through the sale of goods, even if the aim is not to make a profit.
When founding and running a nonprofit organization, there are several factors to consider and measures to follow. There are numerous tax advantages available to nonprofit organizations, but the intricacies can be difficult to manage and comprehend. More information on federal and state nonprofit creation and tax requirements can be found on the IRS website as well as state revenue departments’ websites.
