Creating a nonprofit organization can be an incredibly rewarding experience. But, it may surprise you to learn that not all nonprofits are treated the same when it comes to taxes. This is important because you want to make sure that your organization can maximize the resources available to support its mission.
Now, if you’ve formed one of these organizations in the past or have donated to a charitable cause, you likely have come across the term “501(c)(3) organization”. This simply means that the nonprofit has been granted tax-exempt status from the IRS, and is eligible to receive important benefits not available to other businesses.
Benefits of 501(c)(3) Status
As you might expect, the major advantage of 501(c)(3) organizations is that they are exempt from certain taxes. Specifically, these nonprofits aren’t responsible for sales tax or corporate tax. However, keep in mind that your organization would still be on the hook for other taxes, including payroll taxes.
Further, it’s important to note that the rules are different when it comes to so-called “unrelated business income”. This is income that is generated through efforts not part of the exempt purpose of the organization.
For example, if a school opens a candy store to make money for the school, this income would be considered unrelated to the organizational purpose, which is education. In this case, the nonprofit would be responsible for paying taxes on this particular income.
Another benefit of 501(c)(3) status is that donations made to the nonprofit are considered tax-deductible to the donor. This is particularly important when it comes to larger donations, and you will often be required to verify your organization’s tax-exempt status on grant applications.
What Are the Requirements for 501(c)(3) Organizations?
With these advantages in mind, you may be wondering what it takes to obtain 501(c)(3) status. First and foremost, your organization must truly be formed for reasons other than profit. In other words, your mission must be to serve a public purpose and not the interests of an individual.
Further, the income the nonprofit generates must be used for the mission. The organization is not allowed to pay out dividends or otherwise distribute profits to owners, shareholders, or the like. In addition, the nonprofit must be organized for what is known as an “exempt purpose” under the Internal Revenue Code. The following is a list of the types of organizational purposes that qualify:
- Religious
- Educational
- Scientific
- Literary
- Fostering amateur sports competition
- Testing for public safety
- Preventing cruelty to children or animals
- Charitable – covers a variety of purposes, like the relief of poor or underprivileged, or lessening neighborhood tensions
Bear in mind that there is a limit on the amount of political and legislative activity that your organization can engage in. Exempt nonprofits may undertake a small amount of lobbying, but note that this cannot be the organization’s main purpose.
Filing for 501(c)(3) Status
If you are interested in pursuing tax-exempt status, the first step in the process is to create the organization at the state level. However, as mentioned, this does not automatically make you a 501(c)(3) nonprofit. Instead, most organizations must file with the IRS.
The document you would file is Form 1023. In this form, you will demonstrate to the IRS that you meet the requirements of an exempt organization. Note that some nonprofits, such as churches and other religious organizations, are not required to complete this paperwork. However, in practice, many churches do file so that they can verify exempt status to any potential donors.
Now, once you have received the exemption, this status becomes retroactive to the date your organization was formed. This means that if your application is approved, your nonprofit would not be responsible for back taxes.