Non Profit Tax Exempt: Everything You Need to Know
Nonprofits are created to advance ideas, beliefs, and initiatives, rather than being a single person or a group of individuals.8 min read
What is a Nonprofit Tax-Exempt Organization?
A nonprofit tax-exempt organization is a particular type of nonprofit organization that is immune from paying certain federal income taxes and specific state taxes, with the potential to also provide tax deductions on received donations. A 501(c)(3) organization is a particular type of nonprofit; the IRS may deem it tax-exempt because of its charitable offerings.
What Qualifies a Nonprofit for Tax Exemption?
Nonprofits are created to advance ideas, beliefs, and initiatives, rather than being a single person or a group of individuals. It is quite different than a corporation or several other business entities that pay out profits to shareholders or that are owned privately. Deciding which type of nonprofit you are is integral to determining tax exemption as well as defining the type of organization it is that your group is operating.
Some nonprofits are tax exempt from most federal income taxes and some state taxes, including sales taxes and property taxes. Also, some nonprofit organizations may offer their donors tax deductions on the money they offer. The American tax code has 29 types of nonprofit organizations, including:
- 501(k) – Such as a child’s daycare
- 501(c)(6) – Popular examples are chambers of commerce and real estate boards
- 501(c)(3) – Such as an anti-cruelty organization
- 501(c)(7) – One example may be a yacht club
One type of 501(c)(3) is a charitable nonprofit organization. It enjoys tax exemptions and tax deductions on donations. For a charitable nonprofit organization to become a tax-exempt 501(c)(3), it must pass 3 tests and also say clearly that they will not exist for the personal gain of its owners, staff, families, associates, or supporters.
The 3 tests are:
- Organizational Test
- The nonprofit is created for a lawful purpose in any one of the 7 categories.
- These categories are: religious, charitable, against animal or child cruelty, scientific, educational, public safety testing, or assist in advancing national or international sports competitions.
- The nonprofit is created for a lawful purpose in any one of the 7 categories.
- Political Test
- Organization must declare it will not participate in a political race for any candidate or spend money for political reasons.
- Charitable organizations cannot act in a biased manner toward politics or legislation.
- Asset Test
- Include in its charter that incomes cannot receive assets or income (except to compensate fairly for their services).
What Is the Difference between Nonprofit and Tax Exempt?
- Nonprofit means the state law has declared it as such.
- Tax-exempt is the federal income tax exemption, as per the IRS and certain state taxes.
To apply to be federally tax-exempt by the IRS, corporations must first have been given a nonprofit state through the state.
What Is a Nonprofit?
An organization that runs to provide a public purpose, instead of to provide personal monetary gain to its members is a nonprofit. But just because it is nonprofit does not mean that it cannot make a profit. In fact, it does make a profit as it offers goods and/or services. It may even invest in the stock market. But nonprofits are different than other institutions that make income because nonprofits do not have “profit sharing.”
The legal process in setting up a nonprofit varies significantly from one state to another. In many states, you must file Articles of Organization or a Certification of Formation, which states the day you created the corporation.
How Do You Apply for Nonprofit Status?
To apply for a nonprofit status, you will first want to decide which state to apply through. This would typically be the state where the organization is located. Contact the Secretary of State’s Office to learn the procedures required to follow. Remember to stay current on state reporting and renewal guidelines as well, so that you are completely up-to-date with your responsibilities when applying for a nonprofit status.
What Is Tax-Exempt?
This type of status refers to a nonprofit that is excluded from having to pay corporate income tax on any income related to the activities within the organization for which it was created. Certain stipulations must be met by both the IRS and the state to receive a tax-exempt status. The nonprofits that the U.S. government recognizes as tax exempt are:
- The most popular choice for a community group
- State law dictates its structure
- Personal liability protection
- Incorporated organizations
- Policies, such as the Constitution, may be in place, rather than Articles of Incorporation
- No personal liability safeguards
- More limited in its interests than the other two kinds
- A rare choice for a community organization
To file for a tax-exempt status, you will need to fill out a lengthy, 30-page application. Take note that 501(c)(3) organizations fill out Form 1023, while all other types fill out Form 1024.
Once granted the status, the IRS provides a 501(c)(3) Letter of Determination that the organization can use to show its tax-exempt status at any time. The letter says that your nonprofit “qualifies” for unique tax treatment. If you misplace your copy, simply call the U.S. Internal Revenue Service’s customer service number for nonprofits and provide your nonprofit’s name; having the EIN on hand is also helpful. But you do not have to necessarily file to receive the tax-exempt status; two alternatives are:
- Automatic recognition
- Examples are subordinate groups that have a group exemption or are run by parent groups, church groups, non-private foundations with gross receipts under $5,000.
- Fiscal conduit
- An incorporated organization that provides funds and other clerical-type tasks for the nonprofit.
How Do You Apply for Federal Tax-Exempt Status?
The application process would benefit from your seeking out a lawyer to help you make correct decisions and take you through the process with ease. The next steps are:
- Determine if the organization can obtain tax-exempt status by filing or is exempt without filing
- First apply to be a nonprofit and then apply for tax-exempt status
- Select the appropriate tax-exempt category, such as 501(c)(3)
- Approach the IRS for tax-exemption status
- Understand the requirements you must keep up, from reporting to renewal
What Are the Advantages of Nonprofit and Tax-Exempt Status?
- Fiduciary responsibility for the total funds
- Contract is directly with state
- Less postal rates in many cases
- Application for a federal tax-exempt status
- Provides many additional benefits
- Fewer taxes (state and federal), donors may get donation deductions, and separation or freedom from possible authority of fiscal agents
What Are the Disadvantages of Nonprofits and Tax-Exempt Status?
- Complex rules and responsibilities for both nonprofits and tax-exempt status
- One example is the yearly IRS tax form
- Funds, time, and energy spent seeking incorporation and tax-exempt status
- There are filing and accountant fees, to name just two
- Small groupings may find filing processes for incorporation and tax-exemption, using legal counsel, to be burdensome when first starting out
- There are limits to lobbying and advocacy actions
- Such as political support for election candidates
- Nonprofits are seen by the community as bureaucratic
When Should You Consider Applying for Nonprofit and Tax-Exempt Status?
- Community goals have been reached, giving the organization credibility
- The leading figures in the organization plan to:
- Keep it going a long time
- Apply for grants continually
- There is no appropriate fiscal agent or fiscal conduit in the local area
When You Might Not Want to Apply for Nonprofit and Tax-Exempt Status?
- The organization’s future is unstable
- No grants or outside funds are required for smooth operation
- There is a fiscal conduit open to taking on grant applications or other fiscal matters
When to File for 501(c)(3) Status
Obtain the most from tax-exempt status by filing Form 1023 within 27 months of when the organization filed the nonprofit Articles of Incorporation. This results in the tax-exempt status starting on the same date as the filing of the Articles of Incorporation. Thus, any donations given to the organization from that date on are tax deductible.
If the filing for 501(c)(3) status is after the 27-month period, then the tax-exempt status starts on the date postmarked on Form 1023 for the IRS.
Form 1023: The Federal Tax Exemption Application
Form 1023 is called the Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. It has 11 sections. An alternative for smaller nonprofits to fill out may be Form 1023-EZ, titled the Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. To fill out Form 1023-EZ, refer to the IRS site online, where you will find an Eligibility Worksheet to determine if your nonprofit meets the requirements for this smaller form.
For Form 1023, the lengthier version, it is ideal to consult an attorney specializing in nonprofit tax law to ensure that you fill out the form correctly. The form’s sections are:
1. Provide the basics of the organization
iii.Date the Articles of Incorporation was filed
iv.Note: The nonprofit must already have an EIN (Employer Identification Number)
2. Supply duplicate of Articles of Incorporation and relevant bylaws
i.Certain clauses are required to get 501(c)(3) status:
a.State corporation formed for a recognized 501(c)(3) tax-exempt purpose, such as educational, scientific, or educational
b.Dissolution clause that leftover property of nonprofit after dissolved be distributed to a different 501(c)(3) entity or federal/state/local government for public use
3. Describe organization’s history, present activities, and future goals
i.List in order of significance
ii.For each activity, explain:
a.How it relates to the nonprofit’s overall purpose and amount of time members spend on it
b. When the activity started or if it has yet to start then when this will occur
c.Who carries out each activity and its location
4. Agreements regarding compensation and money
i.To prevent nonprofits from being created only for self-serving interests
ii.Explain how the nonprofit will tell the original directors about the suggested compensation and who are the original officers, from CEO to CFO (list all)
iii.List the top five highest paid employees earning +$50,000/year
iv.List the top five independent contractors who make +$50,000/year
5. The organization must disclose if it will provide products and services within its exempt purpose arrangements
6. If your nonprofit is coming after an incorporated or previous organization then you must state the history of it
i.Whether it has taken over 25 percent or more of a pre-existing organization’s property or is the new legal form of a previous nonprofit
7. Answer questions pertaining to politics and fundraisers
i.The IRS is screening for fundraising activities such as bingo and gaming, as well as political campaign-related actions
8. Provide revenues, financial costs, and a balance sheet
i.If your nonprofit has been around for five years, it must provide monetary details for all of those years
9. Provide details to determine the classification code, as private foundation or public charity. Common examples of public charities are schools, churches, and hospitals. They primarily get their funding from the public or receive a lot of their funds from tax-exempt related activities. Many groups seek the public charity classification because they have more flexible rules and guidelines for operation than private foundations. As of September 9, 2008, any newly created 501(c)(3) group is right away classified as a public charity for its first five years, provided they prove on the specific Form 1023 that they plan to get public support to qualify.
If you wonder whether a nonprofit tax-exempt status is right for your organization, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.