A common misconception is that all nonprofits are automatically tax-exempt. This article outlines nonprofit and tax-exempt status and whether both are needed.
We have outlined in other posts the difference between nonprofit corporations and tax-exempt organizations. Many nonprofits are organized as both a nonprofit corporation and a tax-exempt entity. In short, nonprofit status refers to state-law status; tax-exempt status refers to state and federal tax exemption under tax regulations.
A nonprofit organization, whether incorporated or not, can decide whether or not it wants to apply for tax-exempt status.
What does tax-exempt mean?
Tax-exempt status means that your organization is exempt from paying certain taxes.
Tax-exempt status from the IRS exempts a nonprofit from paying corporate federal income tax on income generated from activities that are substantially related to the purposes for which the group was organized.
The organization will owe corporate federal income tax on income unrelated to its tax-exempt purposes, called unrelated business income (UBI). UBI is income generated from routine business activities not substantially related to the entity’s tax-exempt purposes. Learn more about UBI here.
Different state laws may allow various types of organizations to be exempt from paying sales tax, hotel occupancy tax, and, if incorporated, franchise tax.
What are some examples of taxes that a tax-exempt organization may be required to pay?
Tax-exempt organizations may still responsible for federal payroll (Social Security, Medicare, and unemployment) taxes, unemployment taxes, real estate taxes, personal property taxes, sales and use taxes, franchise taxes, and taxes on lobbying activities, among others.
What types of organizations qualify for tax-exempt status?
To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual. In addition, it may not be an action organization, i.e., it may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.
States have different requirements for whether unincorporated associations can be tax exempt. For example, both Texas nonprofit corporation and an unincorporated nonprofit association can receive state tax exemptions.
To receive a state tax exemption in Texas as an unincorporated nonprofit association, the organization must devote all or substantially all of its activities to the alleviation of poverty, disease, pain and suffering by providing food, drugs (medicine), medical treatment, shelter, clothing or psychological counseling directly to indigent or similarly deserving individuals for little or no fee. The organization’s funds must be derived primarily from sources other than fees or charges for its services.
To receive state tax-exemption in Texas as a nonprofit corporation, the organization can request tax-exempt status from the Texas Comptroller.
Why would an organization want to obtain tax-exempt status?
Tax-exempt status from the IRS will allow contributions made to charitable organizations by individuals and corporations to be deductible under Code section 170.
Additionally, state tax-exempt status will save money when purchasing goods and services for use by the organization.
How does a nonprofit apply for tax-exempt status?
Nonprofits must apply at both the federal and state level for tax-exempt status.
To apply for federal tax-exempt status, a nonprofit goes through several steps, including applying to the IRS using Form 1023, 1023EZ, or 1024, depending on the type of work and budget projections.
In Texas, an organization must submit an application to the Texas State Comptroller of Public Accounts.
Can organizations lose tax-exempt status?
Yes, tax-exempt status can be revoked by the state and the IRS.
Loss of federal exemption:
The IRS can revoke a nonprofit’s tax-exempt status as well. Some common reasons are as follows:
- Change in activities/purpose: Similar to state tax-exempt requirements, the IRS can revoke an organization’s status if the majority of its activities is different from what was in the original application for tax-exempt status. Inform the state and IRS if your organization’s purpose/activities change considerably to ensure that they fall under an exempt purpose.
- Failure to file annual returns: Tax-exempt organizations have annual filing requirements. An organization will automatically lose tax-exempt status for failure to file certain returns. Check with the IRS on specifics for your organization.
- Private Benefit: No part of the organization’s net earnings can inure to the benefit of private shareholders or individuals.
- Lobbying: Tax-exempt organizations are allowed to lobby, but lobbying cannot comprise a substantial part of its activities.
- Political Activity: Tax-exempt organizations are prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate running for public office. Organizations can promote and encourage voter participation, registration, and education.
- Unrelated Business Income: UBI may jeopardize status. Using the three-prong test, any income that passes the test must be taxed accordingly.
Loss of state exemption:
An organization that applied for state exemption based on federal exemption can lose their status if their federal exemption is revoked. Additionally, if the purpose or activities of the organization change considerably from the original purpose or activities, an organization can lose their exemption if the changes no longer fit the requirements for a tax-exempt organization.