phone icon 888.881.1139 M-F: 6am - 7pm PST · Sat & Sun 9am - 1pm PST
Menu Toogle menu

Understanding Nonprofit and Tax-Exempt Status

If you are one of the many people who has referred to a nonprofit organization as a "tax-exempt group," this article is for you. This common misconception is rooted in a misunderstanding concerning the meaningful differences between a nonprofit and tax-exempt status.

Do not feel alone if you have made this mistake, as it is common even for those in the nonprofit sector to use these two terms interchangeably. This article will provide an in-depth look at these two separate and distinct concepts, helping you better understand how to incorporate a nonprofit and navigate these legal complexities.

With this information in hand, incorporating your business and filling out essential business formation documents will be far easier to achieve.

What Is Nonprofit Status?

Right off the bat, it is helpful to understand that nonprofit status is a concept based on state law. The term 'nonprofit' itself typically refers to organizations created to benefit and/or serve the public interest in some meaningful capacity, as opposed to existing to provide financial benefits to a person, corporation, or other entity.

Effectively, nonprofits will not distribute profits to shareholders, and any organizational surplus remains with the organization to be used for the organization's expressed purposes. Since nonprofit status is given by states, each state will have its own nonprofit corporation laws that provide guidelines, regulations, and similar information on how nonprofits in the state are to be organized and structured.

How Can a Nonprofit Be Structured?

The ideal way to structure a nonprofit organization will depend on the organization's goals and what the state allows. Generally speaking, nonprofits can be set up in the following legal formats:

  • Nonprofit corporations
  • Unincorporated associations
  • Charitable trusts
  • Limited liability companies

Secretary of State

For more precise information and guidelines, visit your state's Secretary of State website for exact information on the allowed legal formats and business structures for a nonprofit organization.

Also, be advised that you may incorporate a nonprofit organization in a state outside of your state of residence. For some states, nonprofit corporations in particular can be formed by filing articles of incorporation or a certificate of formation, which are the same forms used to create a for-profit corporation.

What Is Tax-Exempt Status?

While nonprofit status is a concept based on state law, tax-exempt status is a federal concept that relates to federal income tax exemption. Since tax-exempt status is tied to federal taxation, you will be unsurprised to know that the IRS is the federal authority tasked with granting tax-exempt status.

Organizations seeking exemption from federal income tax must do so based on relevant sections of the Internal Revenue Code. If you have ever heard the term '501(c)(3) nonprofit organization' or something similar, the term '501(c)(3)' merely refers to a section of the Code that allows the nonprofit organization to be exempt from paying federal income tax.

Does Tax-Exempt Status Make a Nonprofit Exempt from All Taxes?

It is important to clarify here that tax-exempt status does not mean exemption from paying all taxes. As stated, tax-exempt status refers only to federal corporate income tax exemption. Even then, the federal exemption applies solely to income that was generated from activities that are substantially related to the organization's purposes that were granted federal tax exemption.

Any income that is unrelated to the nonprofit's tax-exempt purposes will still be subjected to federal income tax. Nonprofits that meet federal tax-exemption standards can typically use this exemption to also be exempt from state corporate income tax, but exceptions can apply.

Still, nonprofits will still be expected to pay the following taxes:

  • Federal payroll taxes
  • Real estate taxes
  • Personal property taxes
  • State unemployment taxes
  • Sales and use taxes

With these basic facts in mind, it is time to take a closer look at what will qualify a nonprofit for tax exemption.

Qualifying for Tax-Exempt Status as a Nonprofit

Tax-exempt status is not applied automatically, as nonprofits must apply to the IRS for tax-exempt status. There are 29 types of nonprofit organizations within the IRS tax code, all of which have different requirements to meet; for example, 501(c)(23) status applies to veteran-owned organizations and 501(k) status applies to childcare organizations.

How Charitable Nonprofits Obtain 501(c)(3) Status

501(c)(3) status is perhaps the most common way for a nonprofit to obtain federal tax exemption. This section of the Internal Revenue Code pertains to tax-exempt status for charitable nonprofits.

For charitable nonprofits applying for 501(c)(3) tax-exempt status, three tests must be met. First, the tax-exempt nonprofit must be organized for a lawful purpose. For the purposes of 501(c)(3) status, a lawful purpose exists for nonprofits in the following categories:

  • Educational
  • Charitable
  • Scientific
  • Religious
  • Literary
  • Testing for Public Safety
  • Preventing Cruelty to Either Children or Animals
  • Fostering Either National or International Amateur Sports Competitions

If this test is passed, the organization must then also meet a political test by stating in the organization's organizing documents that the organization will not spend on political purposes or involve themselves in a political campaign on behalf of a candidate. If an organization wishes to engage in such activity, then a 501(c) exemption may still be obtained, but not a 501(c)(3) exemption.

This political test is meant to ensure that charitable organizations receiving federal income tax exemption remain politically neutral. A certificate of incorporation is often used to express the purpose of an organization, which can make this document especially valuable for meeting this second test.

Finally, the charitable nonprofit must meet an asset test within the nonprofit charter. The charter should state that the distribution of assets or income to individuals, except for the purposes of providing fair compensation for the individual's services, is prohibited. Additionally, the organization should clearly state within the charter that the nonprofit is not to be used for the personal gain of the following people:

  • Organizational founders
  • Employees
  • Relatives
  • Supporters

If these tests are met, then the nonprofit will have achieved the rare benefit of receiving favorable tax treatment as well as tax deductions for donors. Only 501(c)(3) organizations enjoy both of these benefits in tandem.

There are many other paths toward tax-exempt status, each having their own requirements for the organization to fulfill.

Tax-Exempt Status Is Not as Easy as It Seems

For organizations that apply for tax-exempt status and obtain it, the exemption is not a lifetime award, naturally. To maintain tax-exempt status, the organization will need to submit annual information filings every year, just as for-profit corporations are typically required to do. There are some exceptions to this general rule, such as churches and some political organizations.

For most nonprofits, however, failing to submit the annual filing can lead to fines, penalties, and even the loss of the organization's tax-exempt status. In short, tax-exemption is something that can go south very quickly if the organization does not provide the required annual updates.

The Benefits of Tax-Exempt Status

The most obvious benefits of tax-exempt status are the federal income tax and state income tax perks, but there are other benefits to consider as well; for example, 501(c)(3) nonprofits enjoy the unique benefit of providing donors with the ability to deduct their donations on their taxes. Similarly, some grants and public allocations are only offered to 501(c)(3) organizations. Depending on the nonprofit's mission, these grants can make a world of difference for the expressed purpose of the organization.

Another real-world, significant benefit of tax-exempt status is the public's perception of the organization. Obtaining tax-exempt status as a nonprofit gives the organization a tangible boost in its public profile and credibility in the public eye. Any nonprofit that is officially recognized by the IRS gives the organization an added sense of legitimacy, which helps gain public trust.

Depending on the state, a tax-exempt nonprofit may even be exempt from certain state taxes as well, such as sales and property taxes. Do your due diligence to determine whether these benefits may extend to the state in which you have chosen to set up your nonprofit.

Brief Roadmap toward Obtaining Tax-Exempt Status

After all this discussion about the difference between nonprofits and tax exemption, you may be left wondering what the best path toward obtaining the benefits of tax exemption is. Here is a general guideline, even if it is by no means a "one size fits all" template.

  • Step One: Incorporate – As we discussed, nonprofit incorporation is handled at the state level. This is the first step toward receiving a federal exemption. To incorporate your nonprofit organization, file articles of incorporation or a certificate of formation with the state. Also, make sure you have a proper business plan in place.
  • Step Two: Provide a Clear Explanation of the Organization's Purpose – Within the articles of incorporation, you need to clearly lay out the organization's purpose. To do so for the purposes of tax-exempt status, make sure your explanation is detailed and clear based on the requirements outlined by the IRS. Your explanation of organizational purpose should be created to speak directly to the classification of nonprofit that you hope to receive. Recall that there are 29 types of tax-exempt organizations, so plan accordingly.
  • Step Three: File Form 1023 and Pay Filing Fees – This form is quite long and detailed, but it is a crucial step toward obtaining tax-exempt status. Filling out and filing Form 1023 is well worth the time, even if it can take the IRS as long as one year to approve. This step also requires that your organization pays a filing fee for Form 1023. Nonprofits that either expect or have already had a gross revenue under $40,000 for their first four years as an organization can pay a reduced fee of $350. All other nonprofits must pay the standard fee of $750.
  • Step Four: Complete Your State Application – Some states may have a separate application for state-level exemption. Many states do not have this application, however, so do your due diligence and complete this form if it is necessary in your state. With these final tips in mind, a nonprofit organization will be well on their way toward tax-exempt status.