What is 501(c)(3) Status?

“501(c)(3)” status refers to a section of the Internal Revenue Code, the tax law for the United States, which allows organizations to operate exempt from paying federal income tax. There are several sections under the Internal Revenue Code, but section 501(c)(3) is specifically concerned with 27 types of non-profit organizations who have tax immunity. Administration of Section 501(c)(3) is by the Internal Revenue Service within the Department of the Treasury. Non-profit organizations are the predominant beneficiary of the 501(c)(3) designations and tax treatment, including private foundations, charitable organizations and private operating foundations. These tax exempt organizations are often referred to as “501(c)(3)s.” Because these organizations derive their tax exempt status from charitable and other activities that benefit society, these organizations must remain focused on this charitable intent or public benefit as reported in its application for 501(c)(3) status to the Internal Revenue Service.

What Are the Provisions Unique to 501(C)(3)?

Most people think of tax-deductible donations under 26 U.S.C. § 170 when they hear “501(c)(3).” However, there are other unique provisions under 501(c)(3) which should be kept in mind:

  • Discounts from the Postal Service for bulk mailing rates
  • USPS designation as Special Non-Profit
  • Many states allow exemption from state sales tax
  • Some states exempt 501(c)(3) entities from property taxes.
  • Most states also exempt 501(c)(3)s from paying state income taxes.

Some organizations are tax-exempt as nonprofit organizations but lack the 501(c)(3) status as a charitable organization. These differ from the unique provision of 501(c)(3) in that contributions to the organization would not be tax deductible to the giver.

Although many tax exemptions are available to the 501(c)(3) organization, these entities may still be responsible for state and local taxes, employment taxes, and excise taxes.

What Are the Restrictions On 501(C)(3) Activities?

In order to preserve the integrity of charitable and other non-profit organizations designated as 501(c)(3) entities and to prevent the government subsidizing private gain through tax breaks, there are strictly enforced limitations on the activities of 501(c)(3) organizations:

  • No part of the income and activities may unduly benefit a director of the organization or any other private individually in contrast to ethical standards.
  • Any lobbying activities must be insubstantial, representing less than 10 percent of the activities of the organization and consuming less than 10 percent of resources. (In the event the organization does engage in lobbying, Form 1023 should be filed rather than Form 1023-EZ).
  • Judicial activism and other propaganda should be restrained.
  • Political campaigning is not allowed. (Entities may file Form 5768 for a review of its activities regarding politics and lobbying to ensure compliance.)
  • Efforts to influence legislative activity may be allowed if expending less than a certain amount based on the size of the 501(c)(3) organization.
  • The organization may not endorse a candidate for public office or workplace nor contribute financially to any candidate or political organization.
  • The stated purpose of the organization must be followed at all times. For example, although it would also be a charitable endeavor, establishing a college scholarship fund for local students may endanger the 501(c)(3) status of an organization established with the purpose of feeding and clothing homeless women. Any changes in purposes would first need to be reported to the IRS.
  • Inurement, providing personal benefit to stakeholders or other insiders to the organization, is strictly prohibited. Examples are paying exorbitant salaries, selling property of the organization well below its fair market value or providing free services to stakeholders, directors, employees or other insiders.
  • If the 501(c)(3) entity dissolves, any assets remaining must be distributed to another non-profit, 501(c)(3) organization and may not be given to any director, officer, or employee of the closing entity.

The public policy underlying the allowance of a tax exempt organization under 501(c)(3) is to incentivize charitable activities and contributions to benefit the public and society at large. Therefore, to continue receiving the benefit of tax exemption, 501(c)(3) entities must be operated in an orderly manner and solely for the purposes stated in its organizational documents. No private interest should benefit from the organization’s activities. All profits derived from the organizations should only support charitable ventures.

Failure to adhere to these restrictions and strictly follow the rules and guidelines set forth in the Internal Revenue Code may result in fines and loss of tax exempt status. It is reported by the Nonprofit Risk Management Center that more than one hundred organizations forfeit their 501(c)(3) status each each year for failing to follow the rules.

Qualifying Entities That Can Seek 501(C)(3) Determination From the Internal Revenue Service

The following types of entities may apply for 501(c)(3) designation from the Internal Revenue Service:

  • Corporations
  • Trusts
  • Community Chests
  • Unincorporated associations
  • Churches
  • Limited Liability Companies (LLCs) so long as all the members of the LLC are entities with 501(c)(3) status.

Nonprofit corporations make up the vast majority of all 501(c)(3) entities. 

Types of 501(c)(3) Organizations

Entities with 501(c)(3) status fit mainly into one of three categories.

Types of 501(c)(3) Organizations: Public Charities

According to the Internal Revenue Code, any 501(c)(3) entity which is not a private foundation is a public charity. Common characteristics of a public charity are that:

  • Most revenue is received from the general public.
  • Public charities are nonprofit organizations
  • Government funding is a substantial part of income.
  • Public Charities must receive a minimum of 25 percent of its revenue from amongst a broad base of funding from the public at large, rather than a limited number of people or families. Sources of this broad support include individuals, companies and other public charities.
  • Members on the public charity’s board of directors should be unrelated.

Giving to a public charity is attractive to many donors because the gift is tax deductible to the donor. While other circumstances may alter these deductions on an individual basis, generally a single donor deduct from taxable income a gift of up to 50% of his or her income. A corporation is limited to deducting for tax purposes a gift of ten percent or less of its revenue.

The most recognizable public charities are those with lots of activities and programs.  Among these are:

  • Churches
  • Educational institutions
  • Animal welfare organizations
  • Benevolence organizations.

Types of 501(c)(3) Organizations: Private Foundations

Private foundations are a form of 501(c)(3) which is often further divided between operating foundations and non-operating foundations. As the name implies, non-operating private foundations do not actively engage in charitable activities or services. Rather, they raise money to distribute as grants to other non-profits and charitable organizations. Although not actively participating in activities, they must still define and state their charitable goals and then fund other organizations who engage in actions furthering those goals. As opposed to public charities, the private foundation may be funded by a small number of donors or even a single benefactor. The majority of the private foundation’s income derives from investments and endowments instead of broadly accepted donations from corporations and the public at large. Governance of a private foundation may be much more closely held than a public charity. Common example of private foundations are those established by wealthy families and those that provide assistance through scholarships; however most private foundations are not readily considered by most as non-profits. Like other 501(c)(3) organizations, contributions to private foundations may be deducted from the donor’s income in an amount not exceeding 30% of the donor’s income.

Types of 501(c)(3) Organizations: Private Operating Foundations

Another general type of 501(c)(3) organization is the private operating foundation. These are a hybrid between private foundations and public charities in that they share characteristics of both. Like the private foundation, the private operating foundation may have closely held ownership and control and may derive its income without the broad base of public support. However, it is most like the public charity in that it actively engages in activities for its stated charitable purpose instead of providing grants to other charitable organizations. Like other 501(c)(3) entities, the majority of income to the private operating foundation must be expended in furtherance of its charitable activities.

Obtaining 501(c)(3) Status

In order to qualify as a tax-exempt charitable organization under section 501(c)(3), the entity seeking this designation must apply to the Internal Revenue Service on a form provided. Depending on the specific characteristics of the organization, the applicable form will either be the Form 1023-EZ or Form 1023. Both forms entail a comprehensive review of how the entity is organized, how it is governed and the various programs it administers to further its charitable intent. Specifically the form asks for basic information such as:

  • Name of corporation or organization
  • Contact information
  • When the business was formed
  • The date of filing of any Articles of Incorporation
  • Employer Identification Number (This number must be obtained even if the entity will not have employees prior to completing the form 1023.  Also, a new EIN must be obtained for any organization that changes to an incorporated entity.)

The form 1023 is a detailed application containing 11 parts. The form 1023-EZ is the Streamlined Application for Recognition for Exemption Under Section 501(c)(3) of the Internal Revenue Code. This form is short and simple and may be filled and submitted online. Generally, smaller non-profit organizations and churches complete the form 1023-EZ. There is an eligibility worksheet which is used to indicate which form may be used by a specific entity. Regardless of size or other characteristics, a limited liability company must file the longer Form 1023.

In order for the 501(c)(3) status to be effective beginning on the date the organization was incorporated, the Form 1023 or Form 1023-EZ must be filed within 27 months of incorporation. The organization may file the Form 1023 or 1023-EZ later than 27 months, but if so, the tax exempt status begins on the date the form was postmarked. For a variety of reasons as set out on the form 1023, an extension of time to file beyond 27 months may be granted.

The organization’s articles of incorporation and by-laws must be attached to the Form 1023. In order to qualify for 501(c)(3) status, the articles of incorporation must state specifically that the organization was formed for charitable purposes and that upon dissolution of the organization, any assets remaining will be transferred to either another charitable organization or a local, state or federal government entity to be used for a public purpose.

Some groups may be considered tax exempt organizations under 501(c)(3) without having to file Form 1023. These include churches, public charities with less than $5,000 in receipts and organizations which are a subgroup of another organization that has exemption under a group IRS letter.

Before granting 501(c)(3) status, the IRS must approve an organization as a non-profit entity organized for charitable purposes. While most non-profits are considered charitable organizations, this is not always the case. To be considered a charitable institution, the organization must engage in activities that meet the statutory requirements of being “exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.” [26 U.S.C. § 501(c)(3)].

Generally charities are the organizations that we look to when we need some help and assistance. We further support charities with our donations.

Once approved by the IRS, this only means that the organization may be tax exempt. Going forward, the IRS will continue to monitor the organization to insure compliance with the requirements under 501(c)(3) and that the organization is performing the activities stated in its application for tax exempt status.

What Are the Compliance Requirements Of Having 501(C)(3) Status?

Filing the required application documents are necessary for obtaining 501(c)(3) status. Beyond that, organizations must insure that they comply with the restrictions on charitable organizations to maintain this tax-exempt status.

In addition, with the exception of churches and some small non-profit organizations, the IRS requires that 501(c)(3) entities file annual reports on Form 990.

Some states may also have additional requirements for 501(c)(3) organizations and require periodic reports from these entities.

Benefits of Having a 501(C)(3) Status

Some common benefits of obtaining tax-exempt status under section 501(c)(3) include:

  • Eligibility for grants and other gifts from government entities, private foundations and other charitable organizations.
  • Exemption from taxes imposed by federal, state and local governments.
  • Corporate protection from individual liability from lawsuits and other claims.
  • Increased donations for purposes of individual donor tax deductions.
  • Discounts on normal postage rates and rates for advertising.

Drawbacks of 501(c)(3) Status

Drawbacks to forming a 501(c)(3) organization include:

  • Directors, Officers, and Staff may not be able to be paid commensurate with their efforts or value to the company
  • Strict prohibitions on activities unrelated to the charitable purposes.
  • Close oversight by the Internal Revenue Service with risk of large penalties and taxes.
  • Assets of the organization must be distributed to another charitable entity upon dissolution.

For answers to your questions regarding charitable organizations or assistance in obtaining tax-exempt status under section 501(c)(3), visit UpCounsel’s marketplace and post your legal needs. Experienced lawyers are waiting to help you with your legal needs.