Nonprofit Does Not Mean Tax Exempt

Understanding the steps to 501(c)(3)

Non ProfitA common misconception in the field of philanthropy is the notion that an organization is exempt from paying taxes simply due to the fact that it has been organized as a nonprofit. Unfortunately, with very few exceptions, this particular misunderstanding could leave an organization facing tax debt with both the IRS and their state franchise tax board.

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, in fact, come with certain privileges, such as eligibility for state and federal tax exemption, however this exemption is far from automatic. It may be best to liken tax exemption to a driver’s license- if you choose to request the privilege, you must apply, pass the test, and then, most importantly, follow the rules. For those organizations that choose not to pursue this privilege, payment of annual corporate taxes is required.

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, done at different times, and by different government agencies.

To apply for federal tax exemption, you need to have been granted nonprofit status first. Further, not all nonprofits are eligible to receive a tax exempt certificate. For example, to qualify for exemption under 501(c)(3), a nonprofit must fall into one of the following categories:

  • Religious
  • Charitable
  • Scientific
  • Testing for public safety
  • Literary
  • Educational
  • Fostering amateur sports
  • Prevention of cruelty to children or animals

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, charities 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, and be mindful to pay required taxes on any unrelated business income.

As I mentioned, there are 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 and ask for exemptions from state taxes.

There are a total of 27 exemptions existing under the federal tax code for different purposes, and some community organizations might find one of them 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, as it isn’t allowed under that statute. So a group heavily involved in social welfare that wants to lobby extensively for political candidates, for example, might find 501(c)(4) status (which deals uniquely with social welfare organizations) more appropriate for their purposes.

Therefore, before deciding to become 501(c)(3), it’s a good idea to sit down and study other possibilities with an expert. Together you can decide on the type of exemption that best meets your needs. That way you won’t be trying to push a square peg into a round hole.

Ready to move forward with a non profit organization?

For more information regarding the tax exempt process, please visit our 501(c)(3) Tax Exemption page or Contact Us at 407-857-9002


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