Many people mistakenly believe that all nonprofits automatically have IRS 501(c) tax-exempt status or state tax exemption. So, first, is important to note the distinction between “nonprofit” and “tax-exempt” status. In short,
- nonprofit status refers to state-law corporate (business) status
- tax-exempt status refers to state and federal tax exemption under tax regulations.
Nonprofit organizations are NOT automatically tax-exempt. A nonprofit organization, whether incorporated or not, can decide whether or not it wants to apply for tax-exempt status. It must go through a formal process of receiving tax exemption.
What does tax-exempt mean?
Tax-exempt status means that an organization is exempt from paying certain taxes.
- IRS tax-exempt status means an organization does not pay federal taxes on revenue generated from activities that are substantially related to the purposes for which the group was organized. Note that if that organization has revenue unrelated to its purpose (called unrelated business income), it may pay a separate unrelated business income tax.
- State tax-exempt means an organization does not pay certain state taxes. State laws differ on the types of tax breaks – possibly sales tax, hotel occupancy tax, and/or franchise tax.
As nonprofit organizations are still businesses like other businesses, they may still be responsible for other taxes like federal payroll, unemployment, real estate, property taxes, sales and use, franchise, and taxes on lobbying activities, among others. It is important to check with your state specific requirements.
What types of organizations qualify for federal IRS tax-exempt status?
There are dozens of IRS tax-exempt categories. The Internal Revenue Code outlines many types of 501(c) organizations. Each has different requirements and obligations. Some include:
- 501(c)(3) public charities, hospital and health care organizations, private foundations, community foundations, corporate foundations, religious organizations, churches, schools, supporting organizations.
- 501(c)(6) professional and trade associations, business leagues, chambers of commerce.
- 501(c)(7) fraternal and social groups.
- 501(c)(4) social welfare groups.
The type that most people are familiar with is the IRS Section 501(c)(3) organization.
What is an IRS 501(c)(3) Tax-Exempt Organization?
A 501(c)(3) tax-exempt organization is a nonprofit corporation, trust, or unincorporated association that is organized and operated for one or more exempt purposes described in Internal Revenue Code section 501(c)(3), such as:
- Charitable,
- Educational,
- Religious,
- Scientific,
- Literary,
- Testing for public safety,
- Fostering national or international amateur sports competition, and/or
- Preventing cruelty to children or animals.
In addition to being organized and operated exclusively for exempt purposes (charitable, religious, scientific, educational, and more), there are many other rules. For example, none of its earnings may inure to any individual, it is restricted on lobbying, and more.
Benefits of Tax-Exempt Status under IRC Section 501(c)(3)
There are numerous benefits of having Internal Revenue Code Section 501(c)(3) status:
- Exemption from federal income tax;
- Tax-deductible contributions;
- Possible exemption from state income, sales, and employment taxes;
- Reduced postal rates;
- Exemption from federal unemployment tax; and
- Tax-exempt financing.
501(c)(3) Status is Not Automatic for a Nonprofit Corporation
A nonprofit organization must apply for and receive the tax exemption. There are several steps to getting IRS 501(c)(3) status, including:
- forming a board of directors
- setting up a state nonprofit corporation
- getting an EIN
- preparing bylaws and conflict of interest policies
- completing IRS Form 1023 or IRS Form 1023 EZ to apply for IRS 501c3 status,
- applying for state tax exemptions and other permits and licenses, and more.
There are unique steps for churches, schools, and international organizations, so it is important to work with an attorney who can guide you on the distinctions of each.
Are there activities that a 501(c)(3) cannot do?
Yes. There are many types of activities that can risk your 501(c)(3)’s tax-exempt status: private benefit, lobbying, political activity, excessive unrelated business income (UBI), and not filing required annual tax reports.
1. 501(c)(3) Risk: Private Benefit
Nonprofit organizations with 501(c)(3) status must avoid all activities that will substantially benefit the private interest of any individual or organization.
Inurement: No part of an organization’s net earnings may inure to the benefit of an individual. This means that a 501(c)(3) organization is prohibited from allowing its income or assets to accrue to insiders. The prohibition of inurement is absolute. Any amount will jeopardize the organization’s 501(c)(3) status.
2. 501(c)(3) Risk: Lobbying
Lobbying is an activity designed to influence legislation. If its lobbying activities are substantial, a 501(c)(3) nonprofit may risk losing its tax-exempt status.
3. 501(c)(3) Risk: Political Campaign Activity
Political campaign activity involves directly or indirectly participating or intervening in any political campaign on behalf of or in opposition to any candidate for elective office. The prohibition of political campaign activity is absolute. Any violation may result in the loss of tax-exempt status and the imposition of excise taxes.
4. 501(c)(3) Risk: Excessive Unrelated Business Income (UBI)
If an exempt organization regularly carries on a trade or business that is not substantially related to its exempt purpose (except that it provides funds to carry out that purpose), then the organization is subject to tax on its income from that unrelated trade or business. Learn more about UBI and UBIT here.
5. 501(c)(3) Risk: Not Filing IRS Form 990
Most tax-exempt organizations must file annual informational returns with the IRS. This report is called the IRS Form 990. If an organization fails to file Form 990 three years in a row, the IRS will automatically revoke its tax-exempt status.
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This article and Cullinane Law are cited in the Marquette Sports Law Review. See Laurel C. Montag, It’s (Not) All Par for the Course: An In-Depth Analysis of the PGA’s Controversial Nonprofit Status, 32 Marq. Sports L. Rev. 569 (2022)