A common misconception with charitable organizations is the notion that an organization is exempt from paying taxes because it has been organized as a nonprofit at the state level. Unfortunately this misunderstanding could leave an organization facing tax debt with both the IRS and their state franchise tax board and other government agencies.
Nonprofit status is a concept of state law. A nonprofit organization, in its simplest variation, is any organization for which those who control or support it do not earn a profit. Choosing to incorporate as a “nonprofit” or “nonstock” corporation may come with certain privileges, such as eligibilityfor state and federaltax exemption, however this exemption is not automatic. It may be best to compare tax exemption to a driver’s license. if you choose to request the privilege, you must apply and pass the test, and then follow the rules. For those organizations that choose not to pursue this privilege, payment of annual corporate taxes is required.
Nonprofit organizations can be set up in several different legal formats, depending on your state. Since this is considered a state concept, applications would need to be filed at the state level. Some different types of legal formats may include:
- Nonprofit corporation
- Unincorporated associations
- Certain charitable trusts
A nonprofit corporation is the most common choice for community organizations. For incorporation, the organization must be structured according to specific state law. These laws include having a document filed that’s known as the articles of incorporation, charter, certificate of formation, and rules of operation which are commonly known as bylaws. Usually, there is a board of directors and officers, and state laws usually limit the liability of members in varying degrees.
An unincorporated association is a group like a corporation and often has similar bylaws and purposes. Although the name seems to suggest otherwise, it is still a formal process with an official structure. However, a constitution or other policies may take the place of the articles of incorporation, and there is no protection against personal liability. Additionally, much less reporting to the state occurs.
A charitable trust has more narrow interests than a corporation or an unincorporated group. Many laws that govern trusts are created with charitable trusts or groups that give away money in mind. Because of this, becoming a trust is rarely appropriate for a community group.
Nearly all organizations that are nonprofit wish to be tax-exempt as well, so the terms are often confused. Many charitable organizations, for example, are nonprofit organizations and are recognized by the federal government as being tax-exempt under 501(c)(3). However, becoming a nonprofit and becoming tax-exempt are different processes that are done at different times, and by different government agencies.
To apply for federal tax exemption, you need to hold a nonprofit status at the state level first by filing incorporation paperwork. Further, not all nonprofits are eligible to be tax-exempt. For example, to qualify for exemption under 501(c)(3), a nonprofit must fall into one of the following categories:
- Testing for public safety
- Fostering amateur sports
- Prevention of cruelty to children or animals
Under The 501(C)(3) There Are Sub-Sections Based On Characteristics Which Include:
Publicly supported charity, 509(a)1
This section includes the entities that the public generally associates with non-profit, 501(c)3 status. This can includ schools, hospitals, religious organizations, and other charities that receive their public support primarily from gifts, grants and contributions from the public.
Exempt purpose activity-supported charities, 509(a)2
Similar to 509(a)1 charities, these include the charities typically associated with non-profit status. Specifically, these organizations usually receive their support from a combination of gifts, grants and contributions and fees for their exempt services.
Supporting organizations for 509(a)(1) or 509(a)(2) charities, 509(a)3
These are not publicly supported themselves but are closely tied to non-profits that are publicly supported. Examples of supporting organizations include certain university or hospital foundations, foundations created to support libraries or elementary schools, and foundations created to support fire departments and police stations.
Public safety charities, 509(a)4
These charities are exclusively dedicated to testing for public safety. And though not many organizations fit in this category but the ones that do are required to fill out additional paperwork to maintain their status. An example of a public safety charity is the American Fireworks Standards Laboratory.
If a charitable organization doesn’t fit in any of the above categories, it may be a private foundation. While the mechanics of a private foundation tend to be complex, it is generally: a charitable organization, usually funded by one source rather than by the public.
These types of organization that are approved under the 501(c)(3) will receive income tax exemption and their donors may take a tax deduction for their donations.
The road to tax exemption, for most nonprofits, is paved with compliance. Organizations must be familiar with all processes and procedures, and be prepared for detailed reporting. In addition to the provision of particular clauses in the organizing document that precedes an extensive application process with the IRS, charitable organizations must be mindful of state and local tax exemption and registration requirements. Additionally, organizations that have been granted exemption must be aware that that not all income received is eligible for exemption. Be mindful to pay required taxes on any unrelated business income. At times, a tax-exempt organization will run a business venture to supplement its income. When that activity is not related to the nonprofit’s core mission, taxes will need to be paid to the IRS on that income.
There are however, a few rare exceptions to the rule. Some organizations are automatically recognized as having 501(c)(3) status without filing a formal application for recognition of the exemption. These groups include:
- Subordinate organizations that are covered by a group exemption. However, it’s important to note that group exemptions require a unique application process. Existing 501(c)(3) organizations cannot simply choose to add other organizations to theirs and create a group
- Churches, parts of churches, or associations of churches
- Organizations that are not private foundations and normally have gross receipts of not more than $5,000 total per year
Even though these groups are automatically tax-exempt, they may choose to file anyway, in order to have the official letter of determination on file. This often makes it easier to solicit contributions from individuals and be eligible to apply for grant funding from private foundations that will require the approval of the IRS. In addition, many states will require the approval of the 501(c)(3) to apply for exemption from state and sales tax.
There is a total of 27 exemptions that currently exist under the federal tax code for different purposes, and some community organizations might find one more appropriate than others. For example, a group that is involved in heavy lobbying or political advocacy work would be unable to apply for 501(c)(3) status because isn’t allowed under that statute. A group heavily involved in social welfare that wants to lobby for political candidates, for example, might find 501(c)(4) status more appropriate for their purposes. The 501(c)(4) deals uniquely with social welfare organizations.
Some Of The Most Common Types Of The IRS Section 501(C) Of The Tax Code:
- 501(c)(1) – These are corporations organized under an Act of Congress. Federal Credit Unions are a good example of this type of nonprofit. These nonprofits do not have to file an annual return. Tax-exempt contributions are allowed if they are made for exclusively public purposes.
- 501(c)(2) – These are holding corporations for exempt organizations. That is, they can hold title to the property of an exempt group.
- 501(c)(5) – Labor, agricultural, and horticultural organizations fit under this classification. They are educational or instructive, with the goal of improving conditions of work, and to improve products and efficiency.
- 501(c)(6) – These organizations are business leagues, chambers of commerce, real estate boards, etc. They seek to improve business conditions.
- 501(c)(7) – These organizations are social and recreation clubs. They promote pleasure, recreation, and social activities.
- 501(c)(8) – This category includes fraternal beneficiary societies and associations. They provide for the payment of life, sickness, accident, or other benefits to members.
- 501(c)(9) – These are voluntary employees’ beneficiary associations. They provide for the payment of life, sickness, accidents, or other benefits to members.
- 501(c)(10) – Domestic Fraternal Societies and Associations. A lodge devoting its net earnings to charitable, fraternal, and other specified purposes. No life, sickness, or accident benefits to members.
- 501(c)(11) – Teacher’s Retirement Fund Associations. Associations for payment of retirement benefits.
- 501(c)(13) – Cemetery Companies.
These are some of the 27 exemptions that exist under the federal tax code. Organizations will need to submitting either a 1023 or 1024 application along with the appropriate filing fee and attachments to receive tax exemption under the IRC. In addition, organizations will need to ensure to stay compliant by filing the appropriate forms on an annual basis.
Therefore, before deciding to become a nonprofit organization or tax-exempt organization, or both, it’s a good idea to sit down and study all possibilities with an expert. Together you can decide on the type of exemption that best meets your organization’s needs.
If you are not sure whether your organization is a nonprofit organization or meets the requirements to become a tax-exempt organization with the IRS, please contact CharityNet USA. You can speak to one of our nonprofit experts at 407-857-9002 or firstname.lastname@example.org. We can help guide you and your organization in the right direction.