An Overview of 501(c)(3) Provisions and Purposes

A business organized under Section 501(c)(3) of the U.S. Internal Revenue Code is one used for charitable purposes. The business is exempt from federal taxes and must be a nonprofit. A 501(c)(3) organization may be a private foundation, public charity, or a private operating foundation. The entity may be a trust, corporation, LLC, community chest (such as United Way) or unincorporated association.

501(c)(3) nonprofits have many more provisions and purposes than other entities. First, it is exempt from federal taxes. If you are eligible at the federal level, you may be eligible for exemption from state taxes. The other major provision is that donations may be tax deductible. If you have to pay state taxes, donations to a 501(c)(3) nonprofit may also be deductible from your state taxes, depending on your state's laws. Also, the post office offers special bulk rate postage discounts for nonprofit organizations.

A 501(c)(3) nonprofit may also be eligible for private and public grants. When you become a nonprofit exempt under Section 501(c)(3), you may also solicit charitable donations from the public. Often, government agencies and foundations will limit their charitable contributions to public entities.

Provisions

The Internal Revenue Code states that a company must organize under Section 501(c)(3) for “exempt purposes” to be tax exempt. The Internal Revenue Code spells out certain activities in which a 501(c)(3) nonprofit is not allowed to participate:

  • It may not try to influence legislation
  • It may not participate in campaign activity for or against political candidates
  • It must abide by the private inurement doctrine

The inurement doctrine states that the organization cannot use its earnings for certain things, such as compensating an insider where no upper limit exists, creating a compensation agreement that is performance based, paying more than the fair market value to an insider for goods or services, and several other scenarios. The inurement doctrine restriction also does not allow for private individuals to receive benefits.

Purposes

An entity organized under Section 501(c)(3) of the Internal Revenue Code must be used for certain purposes, as follows:

Charitable

A “charitable” purpose is the catch-all that includes purposes that are not specifically listed. Any organization that falls under one of these definitions of a charitable category must be for the good of the public. These include:

  • working against juvenile delinquency and the deterioration of the community. This may also be combined with preventing cruelty to animals or children;
  • providing relief for the underprivileged, poor, or distressed, as long as it is for the public good;
  • for education or scientific advancement;
  • the defense of legally mandated civil rights and human rights;
  • to lessen the burdens of the government;
  • to advance religion;
  • to lessen neighborhood tensions;
  • to eliminate discrimination and prejudice; and
  • to maintain or build public monuments, buildings, and other works.

Religious

The First Amendment to the United States Constitution gives people the right to freely practice religion and speaks to the separation of church and state. However, the courts have determined that allowing religious entities to be governed by Section 501(c)(3) creates less of a relationship between the government and the church than if the federal government were to collect taxes, according to 7.25.3.6.1 of the Internal Revenue Manual. Additionally, the court ruled that although separation of church and state is part of the constitution, if a religious entity wishes to benefit from Section 501(c)(3), it must also abide by those laws (id.At 7.25.3.6.2).

Additionally, a religious entity bears the same burden of proof as any other entity applying for Section 501(c)(3) status. The entity must show that it is entitled to the exemption granted by the section (id. at 7.25.3.6.3). However, the Internal Revenue Service cannot make a judgment on whether an entity applying for religious exemption qualifies on the merits of the organization's beliefs (id. at 7.25.3.6.4).

Educational

Educational purposes cover several subcategories. The basic rule is that an organization must be operated for only educational purposes. Pursuant to id. at 7.25.3.7, the regulations under Reg. 1.501(c)(3) through 1(d)(3)(i) define education as, “the instruction of training of the individual for the purpose of improving or developing his capabilities,” and, “the instruction of the public on subjects useful to the individual and beneficial to the community.”

Institutions and/or entities include:

  • primary or secondary schools;
  • colleges;
  • professional or trade schools;
  • daycare centers;
  • an organization that is an integral part of a school, such as a university bookstore, cafeteria, high school interscholastic athletic program, law review journal, certain faculty-run organizations, alumni associations, housing for college students, and alternative education organizations;
  • student clubs;
  • fraternities;
  • certain organizations that provide services to educational organizations;
  • vocational training organizations;
  • certain organizations that are affiliated with professions or businesses if the educational activities are geared toward that business, such as study courses for banking institution employees or post-graduate educational organizations for medical seminars for a practicing physician;
  • organizations that promote the arts;
  • education of the public;
  • organizations that publish educational material;
  • certain youth programs;
  • childcare organizations; and
  • hobby clubs with education as the principal purpose.

Scientific

Regulation 1.501(c)(3)-1 states that a scientific organization must serve a public interest, not a private interest. The terminology also includes scientific research, as long as it is in the public interest. Additionally, for scientific research to be eligible for the 501(c)(3) exemption, it must further a scientific purpose. This does not include testing and/or inspection of products or materials for buildings or equipment, nor does it include the design or construction of buildings or equipment.

Scientific research is eligible for an exemption if the results of the research are available to the public if the research is done for the United States, or a state, county, city, or other political subdivision. The research must also benefit the public.

Examples

Examples of eligibility include scientific research for scientific education of university or college students; the gathering of scientific information for publishing as a thesis, treatise, or trade publication; to find the cure for a disease; or by attracting a new industry to help a community or other geographical location.

Literary

In order for a publisher to qualify for federal tax exemption under Section 501(c)(3), according to Rev. Rul. 67-4 A, “a publishing organization must be operated exclusively for charitable purposes.” This includes educational and religious purposes and literary and scientific publishing. Rev. Rul. 67-4, 1967-1 C.B. 121 states that four criteria must be met:

  • The content contained in the publication must be “educational.”
  • Materials must be prepared by following methods that are “generally accepted” as “educational.”
  • The material that is distributed is necessary to achieve the exempt purposes of the organization.
  • The way the material is distributed must not be the same as regular commercial publishing.

A publication does not meet the criteria for exemption if it is only educational; it must meet the additional criteria.

Testing for Public Safety

If an organization tests consumer products to ensure they are safe for public consumption, it may be eligible for exemption under Section 501(c)(3). For example, a company that tests electrical products to determine safety could be tax exempt. The Insurance Institute for Highway Safety, which tests vehicles for public safety and then publishes the results of those tests, is another example.

Fostering National or International Amateur Sports Competitions

Those organizations that are set up and operated only for the purpose of fostering international or national amateur sports competitions are also exempt from federal taxation under Section 501(c)(3). However, those organizations are not allowed to furnish athletic equipment or facilities.

Just because an organization is geared toward amateur sports does not mean that it is eligible for tax exemption under Section 501(c)(3). The organization must also meet one of these three requirements (id. at 7.25.26.2):

  • The organization must teach sports to youth or it must be affiliated with an educational organization that is exempt.
  • If the organization combats juvenile delinquency or it lessens a government burden in conjunction with amateur sports, it may qualify for an exemption.
  • The organization is involved with national or international amateur sports competitions and none of its activities include the provision of athletic equipment or facilities.

Preventing Cruelty to Children or Animals

If an organization is created to prevent cruelty to animals or children (id. at 7.25.3.10.6), it may be eligible for tax-exempt status. This includes protecting children from working at dangerous occupations that are in violation of any state laws or in work conditions that are unfavorable.

Additionally, an organization dedicated to the protection of animals from cruelty is also eligible for exemption under Section 5.01(c)(3). The organization may be one that encourages high standards of care for laboratory animals or an organization that is formed to prevent the birth and suffering of unwanted animals by subsidizing neutering or spaying for those who cannot afford the procedures for their animals.

Restrictions and Application

Any organization that earns federal tax-exempt status under Section 501(c)(3) is highly regulated. The organization must adhere to the rules. Furthermore, none of the activities of a nonprofit agency exempted from paying federal taxes may benefit the officers and directors of a company, nor may it benefit any one private individual.

To apply for 501(c)(3) status, you must include certain items in the application to create your business, whether it is a corporation, limited liability company, or another allowable entity. Once your organization is registered with the chosen state, apply to the IRS for recognition using Form 1023 or Form 1023-EZ. Be prepared to provide financial data and comprehensive information about your organization.

Disadvantages to Creating a Tax-Exempt Nonprofit

While there are some disadvantages to having an organization created under Section 501(c)(3), the advantages clearly outweigh them. However, anyone ready to create a federal tax-exempt organization should be aware of the disadvantages. The cost of creating a nonprofit does take money. It also takes time and effort, which is more money. Depending on the financial status of your organization, the application fee ranges from $275 to $850 or more, plus the fees you pay the state to register the business.

Businesses must keep paperwork regarding their finances; however, an exempt organization must keep detailed records. It must also submit annual filings to the IRS and the state, in addition to the regular business filings. If you miss a filing, you could forfeit your tax-exempt status.

The control of your organization is limited, compared to the control you have over a non-exempt company. A tax-exempt nonprofit organization is subject to the company's articles of incorporation plus state and federal laws and regulations. Depending on your state, you may be required to have several directors. The directors are the only people who are able to elect officers who determine policy. When creating your articles, be sure to take this into consideration when creating the corporate bylaws and when determining who you wish to have on the company's board of directors.

Finally, a tax-exempt nonprofit organization is always in the public eye. Since the organization may only be exempt from federal taxes by being for the good of the public, the public sees all financial information and organizational information, among other company information. Anything that is filed with the state or the federal government, including the IRS, is available to the public. Thus, the public is able to see salaries and the expenses of the company.