It's easy to be confused about nonprofits and the IRS tax code. There are many types of nonprofits in the federal tax code, not all of which are totally tax-exempt.
To complicate matters more, all 501(c)(3) organizations are divided into public charities and foundations.
In this article, we will focus only on the requirements for becoming a 501(c)(3) charitable organization, also called a public charity, and how one achieves tax exemption.
What Does It Mean to Be Tax-Exempt?
First, let's clarify what tax-exempt means. Many nonprofits are exempt from most federal income taxes and some state taxes, such as sales and property taxes. Also, donors may be able to take a tax deduction for their donations to these organizations.
Some nonprofits (those designated 501(c) in the tax code) enjoy the first exemption but not the second one. For instance, your local Chamber of Commerce probably is a 501(c)(6), which is tax-exempt. Your recreational club might be a 501(c)(7), which is also tax-exempt. But neither of these organizations receive donations and thus cannot provide a personal tax exemption to members. They are membership-based organizations, and membership dues are not tax-exempt.
The most well-known tax designation for charitable nonprofits is 501(c)(3). These organizations receive income tax exemption, and their donors may take a tax deduction for their donations. Certain other organizations may also receive tax-deductible contributions.
Are All 501(c)(3) Activities Tax Exempt?
There are some activities for which a charitable nonprofit could be taxed, typically as an unrelated business activity. That could occur when a nonprofit runs a business venture to supplement its income, and when that activity is not related to the nonprofit's core mission or purpose.
Likewise, individuals can only take a personal tax deduction when they donate to a charity that is qualified and if they itemize their deductions on their tax return.
Charitable nonprofits must apply to the IRS for 501(c)(3) status. It is not conferred automatically.
Some charitable activities and groups choose not to apply for 501c3 status because they are small or temporary. These charitable organizations choose to be unincorporated nonprofit associations.
Also, churches and religious organizations or faith-based nonprofits are treated a little differently than "public" charities. For instance, they do not have to file annual tax forms.
In short, nothing is simple, especially when it comes to the US tax code.
Becoming a Charitable Nonprofit
Charitable nonprofits that wish to become 501(c)(3) tax-exempt must meet these qualifications:
The Organizational Test
Tax-exempt nonprofits must be organized for a lawful purpose in one of these categories:
- Testing for public safety
- Fostering certain national or international amateur sports competitions
- Preventing cruelty to children or animals
Qualifying as Publicly Supported
Public charities must receive at least one-third of their income from public sources. Public charities serve the public and must be supported by the public.
The IRS defines public support as "... from governmental units, from contributions made directly or indirectly by the general public, or from a combination of these sources."
The financially stable charity should have a basket of income that consists mostly of public funding.
The Political Test
Organizations seeking 501(c)(3) status must state explicitly in their organizing papers that they will not participate in any political campaign on behalf of any candidate or make expenditures for political purposes. There are 501(c) groups, such as the 501(c)(4), that can engage in these activities, but not 501(c)(3) organizations.
Your organization could lose its tax-exempt status if these regulations are not followed.
The Asset Test
A nonprofit's charter must state that it prohibits the distribution of assets or income to individuals (except as fair compensation for their services). The organization must also explicitly state that it will not be used for the personal gain or benefit of its founders, employees, supporters, relatives, or associates.
In conclusion, before you begin your journey to tax-exemption, make sure you understand what type of organization you'll be applying for and make a study of all the requirements before you start.