Tax Exempt Status: Everything You Need to Know
For tax exempt status, there are a variety of important rules and procedures.8 min read
Tax Exempt Status
For tax exempt status, there are a variety of important rules and procedures. You will need decide what kind of nonprofit structure is best for your organization, become a non-profit, decide when to apply for tax exemption, and then bring together the professional guidance and resources to apply. You also must meet reporting and filing requirements.
Importance of rules in society
In every society, regulations exist for various reasons. Regulations set the ground rules and make things less chaotic. Generally, society gains from having stable rules. As people grow up, friends and family teach one important rules to follow.
An example rule is curfews. Families put curfews on their kids to protect them.
Society also consists of many organizations. They are also controlled by rules. Rules impact organizations and it is important for organizations to understand and follow them. Following rules helps the entire society function.
It can be difficult at times to understand all the regulations one needs to follow. Even a community association must understand therefore its legal status.
Nonprofit status vs. Tax Exemption Status
Tax exempt status and nonprofit status are similar but different. Many nonprofits want to also be tax-exempt.
Charities usually are nonprofits and thus considered to be tax-exempt by the federal regulators. However being tax-exempt does not use the same processes or regulators as being tax exempt.
When applying to be tax-exempt federally, you need to first be a nonprofit. However not every nonprofit can be tax-exempt.
Getting government nonprofit status is an initial key step. Tax-exempt statuses such as 501(c)3’s are given by the IRS.
Definition of Nonprofit Status
A nonprofit is a group where the owners do not get profits. The nonprofit can provide services and products, make a profit doing it, and can invest. Many nonprofits have significant investments.
However in the end the profits must return to the nonprofit itself. There can be no sharing of profits between owners. The nonprofit does not have true owners.
Nonprofits are frequently called “not-for-profits” groups. Their profits are just to keep them existing, rather than being a purpose of the group.
Nonprofit status isn’t given by federal regulators but instead specific state governments. However the federal government still has an impact on the nonprofit process and is able to recognize the designation. When applying for tax-exempt status, the federal government must recognize the nonprofit status.
You can get nonprofit status quite easily, without complicated filings or structures. Neighborhood groups, for example, exist as nonprofits without many formalities.
Kinds of nonprofits federally recognized: Corporations
The federal regulators recognize corporations as a form of nonprofits. For many community groups, this is a reasonable choice. You need to follow certain state regulations to form a corporation, including documents such as incorporation articles and operating rules (bylaws).
Normally a corporation has a board and officers. Liability for participants is limited too usually. For many community groups, becoming a corporation is a good choice because it is a straightforward organization form many are comfortable with.
- Corporations are a familiar form that are seen as serious and trustworthy.
- Members are also protected from personal liability, meaning the organization is suable but not them themselves. For example, if a person sues the group for disability discrimination, they can’t sue their interviewer but only the group. As another example, if an employee hurts someone in the course of their duties, the group can be sued but not the person.
- The strength of liability protection varies by state.
- Liability protection varies depending on situation as well.
- There is liability insurance for many nonprofit directors.
Kinds of nonprofits federally recognized: Unincorporated Organization
An unincorporated group is also one class of nonprofit the federal regulators recognize. Unincorporated groups are similar to corporations functionally and structurally. Unincorporated groups do have a formal and official composition.
Documents such as a constitution may exist instead of incorporation articles. However there is no personal liability protection.
Kinds of nonprofits federally recognized: Trust
The federal regulators also recognize trusts as a nonprofit. Trusts usually have a narrower scope of interests than corporations or unincorporated groups. Charitable trusts are especially common. However trusts are rarely used for community associations.
Definition of Federal Tax Exempt Status
The US Tax Code defines which groups are tax-exempt. The most common form are 501(c)3’s, also called charitable tax-exempt groups. 501(c)3’s have tax-exemption for most kinds of revenue for income and corporate taxes. Individuals also can deduct their contributions to the group from their personal taxes. For many groups, it is useful being a 501(c)3.
Including 501(c)3s, there are 26 total tax-exempt categories. Some groups may find one of these better for their purposes.
- If you are a group that is heavily involved in politics, you won’t be allowed to be a 501(c)3.
- A group that lobbies for political candidates might want to be a 501(c)4 if it primarily does social welfare.
- Before applying to be a 501(c)3, you should get expert advice.
- The best kind of tax exempt category varies significantly depending on your group.
- The IRS says Form 1023 takes about 8-hours to finish.
- It usually will take a few months to get approval.
- After completing the application, the IRS needs to affirmatively look at and approve it.
- While the application is pending, that often can be sufficient for financial contributors.
- After tax-exempt status is given, the IRS will send a determination letter. The letter can be used to prove it is tax-exempt. The letter also is required for foundations and when look for state government tax-exemptions and grants.
Two methods to get tax-exemption with no filings: Automatic Recognition
You can also get tax-exempt status automatically with no filings. Many groups automatically get 501(c)3 classification with no filings. A sub-group of a larger group that has 501(c)3 status, either automatically or by application, also gets 501(c)3 status.
- Churches, their sub-parts, and church conglomerates get 501(c)3 status automatically.
- 501(c)3 status is automatically given also to non-private-foundations with less than $5000 in revenue. For example, a group trying to increase bicycling space might get this classification.
- Even though groups may be automatically tax-free status, they still might want to file to get a determination letter. The letter makes it easier to get donations and get state tax-free status.
Two methods to get tax-exemption with no filings: Fiscal Conduit
You can also get tax-exemption through a fiscal conduit. Also termed a lead agency, this is when an already-exempt group integrates with and another group to do a task.
This can be helpful in organizing groups, paying contractors, and sharing workroom. One example of a fiscal conduit is United Way. A Public Health department also is a group that is frequently a fiscal conduit.
You need a fiscal conduit initially, and a lead agency will do filings and other things that can you help you start off.
Definition of State Tax Exemption
Many state government exemptions have various exclusions such as from state, income, and property taxes. State exemption laws morph and vary, and so you should confer with a state’s Secretary of State for current laws.
Many states have similar requirements to federal regulators, making 501(c)3 status sufficient to be tax-exempt from state tax.
Advantages of having a Nonprofit Status
By having a non-profit, you can get state contracts and are a fiduciary for the non-profits funds. Non-profits will also often have lower postage rates.
As a nonprofit, you can get exemption from federal taxes which helps with other things too.
Advantages of having a Federal Tax Exempt Status
Being exempt from federal taxes, you avoid many taxes and your contributors are able to deduct their contributions. You can also directly apply for grants.
Many grants from foundations and the government need 501(c)3 status proof. If you don’t have federal exemption, you need to get a fiscal conduit. Getting federal exemption means you are freer from financial demands. It also helps your organization’s morale and independence.
Nonprofit Status and Tax Exemption Drawbacks
If you incorporate, there are many regulatory requirements that may prove tough for a volunteer group.
- You must send annual returns for taxes to the IRS.
- Applying for exemption costs money and takes time. It often takes $500, though instead $150 in some situations.
- Tax, legal, and accounting fees are often expensive.
- Therefore initially, incorporation may not need be needed, as these issues can be disruptive.
- Incorporating and becoming tax-exempt can also restrict political activities. For example, nonprofits can’t endorse public office candidates.
- Creating nonprofits also adds another layer of bureaucracy.
- If a tax-exempt group does certain non-exempt functions, it might be taxed on those.
When to apply Nonprofit and Tax Exempt Status?
A group that has determined to be worthwhile through notable achievements, where its people want to continue its operations and existence for at least the near-term. Other possible conditions:
- You also need to be selling services or products, or be applying for funds regularly.
- There also must be no fiscal conduit available nearby.
- The group must have a certain future existence.
- It can also not need outside funds to operate.
- A similar fiscal conduit is willing to help the group for money.
Groups will have to examine their details to choose the most sensible path. During the initial 15 months of creation, tax-exemption application can be retroactive to the group’s founding. There is also a 12-month extension on this federally. This means you must file within 27 months of creation to skip taxes during that time. If a group knows it wants to exist long-term, it’s a good idea to apply early on.
Obtaining Nonprofit Status
Getting nonprofit status varies by state. It’s a good idea to get legal advice during the process.
- First determine if now is the right time to apply for nonprofit status.
- Determine what legal form to use (trust, corporation, unincorporated, etc).
- Determine which state you will apply in. Some states are more open to nonprofits than others.
- Follow the state’s procedures for applying. Reach out to the Secretary of State to get more details on the procedure.
- When applying, you need to be very careful with the filings’ wording. Federal regulations require certain kinds of wording.
- Understand each state’s requirements for ongoing filing and renewal.
- The incorporation articles are needed when applying for tax exemption. The articles will need to specifically say what the nonprofit is being made to do. The IRS looks over this when it’s reviewing applications.
- Send Form 1023 to the IRS. It’s at least 30-pages, not including attachments. It will usually take 100 hours to finish and the IRS will take from a few months to a year to approve it. The IRS may send follow-up inquiries, which should be quickly answered.
- The IRS’s Form 1023 fee has two tiers. The normal fee is $750. If you expect less than $40K in revenues for the entire first four years, the fee is $350.
- Do the state-application too if needed. However many states don’t have such an application for tax-exemption. Some have a 1-2 page required filing though.
How to apply for federal tax exemption?
Getting federal tax exemption is similar to getting nonprofit classification. Get legal advice to assist in the process. Look to see if the group is able to apply for tax exemption or if it gets automatic exemption.
- Determine if now is the right time for your group to apply.
- Look to see which classification you can apply for.
- Apply for exemption.
- Understand filing requirements for renewing and reporting.
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