By Oren Heiman, Esq., Sasha Bau, Esq., and Danielle Comanducci, Esq.
Starting a nonprofit organization can be a heartening way to help address an identified community need. However, there is no “one size fits all” approach to structuring a nonprofit organization and it is important to understand the various steps and legal issues involved in the process before proceeding forward. Many assume, in error, that all nonprofit organizations have the same tax benefits, such as federal tax exemption, tax deductibility of donations by donors, access to grant funds and other benefits. While many nonprofit organizations obtain federal tax exempt status, the term “nonprofit” and “tax exempt” are not synonymous. Becoming a nonprofit organization and becoming a “tax exempt” nonprofit organization are two separate and distinct processes, each involving different steps, timelines and considerations.
What is the difference between a “nonprofit organization” and a “tax exempt 501(c)(3) organization”?
Simply put, a “nonprofit organization” is corporation, trust or an association that does not operate for profit. Instead its purpose is to work for a public good. This doesn’t mean nonprofits cannot have or make money. Nonprofits can raise funds, make money off of goods and services, own property and even invest funds in order to generate more money. However, unlike a traditional “for-profit” business, nonprofits do not have owners and do not distribute “profits” (i.e. there are no dividends paid, no shareholders, no excessive salaries). Instead, monies made by the nonprofit must be used only to support the mission of the nonprofit and pay the reasonable expenses of the nonprofit in order to allow it to continue its activities. It is important to note that a nonprofit organization is a creature of state law (i.e. the federal government does not grant a “nonprofit” status, although it can recognize that an organization is a “nonprofit” as discussed more below). Many nonprofits are formed as corporations by filing a document called a “Certificate of Incorporation” with the state (similarly to how for-profit corporations are formed). The laws applicable to nonprofits vary by state so it is critical to be familiar with the specific laws of the state in which the nonprofit will be formed, as well as the laws of the states in which the nonprofit solicits funds or has operations. Please note that there are other types of nonprofits such as trusts and unincorporated associations that are not discussed in this article.
A “tax exempt 501(c)(3) organization” is a nonprofit organization that has been recognized by the federal government and has been granted federal tax exempt status under a federal law called Section 501(c)(3) of the Internal Revenue Code. In order to qualify for such a 501(c)(3) tax exempt status, the nonprofit must be formed and operated for specific purposes that are “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.” The term “charitable” includes “relief of the poor, the distressed, or the underprivileged”; “advancement of religion”; “advancement of education or science”; “erecting or maintaining public buildings, monuments, or works”; “lessening the burdens of government”; “lessening neighborhood tensions”; “eliminating prejudice and discrimination”; “defending human and civil rights secured by law”; and “combating community deterioration and juvenile delinquency.” Once a nonprofit has been granted a “501(c)(3) tax exempt status” by the Internal Revenue Service (“IRS”), it can, among other things, solicit donations and such donations will be tax deductible for the donors to the maximum extent provided by law.
This article focuses only on nonprofit 501(c)(3) tax exempt organizations. However, it is important to note that, depending on their intended activities, nonprofits can be granted other types of exemptions under U.S. federal tax laws (other than 501(c)(3) organizations). What type of exemption is appropriate for a nonprofit depends on the mission and activities of the nonprofit (e.g. if the nonprofit wishes to substantially engage in lobbying then such nonprofit will not be qualified to be a 501(c)(3) tax exempt organization, but may qualify to be a different type of nonprofit organization called a “social welfare organization” under a different federal law).
When does a nonprofit need to apply for 501(c)(3) tax exempt status?
When a specific nonprofit should apply for 501(c)(3) tax exempt status depends on a variety of considerations. One thing to consider in making this determination is the nonprofit’s desired donor base.
On one hand, if the nonprofit wants to be eligible to receive grants or attract large contributions from donors then this would weigh heavily in favor of applying for 501(c)(3) tax exempt status. As detailed more below, one of the key benefits to obtaining 501(c)(3) tax exempt status is the tax deductibility of donations for donors. Nonprofits that do not have a 501(c)(3) tax exempt status may have difficulty attracting major donors or competing for grants simply because foundations and other sources usually only provide grants to tax exempt organizations.
On the other hand, if the nonprofit’s foreseeable operations are very small in nature and only require small contributions then it may not be necessary to apply for 501(c)(3) tax exempt status, or at least not right away (e.g. if a separate 501(c)(3) organization with similar views agrees to act as a fiscal sponsor and provide funds to a non-tax exempt nonprofit, often for a fee). However, as a nonprofit’s desired operations grow so will the need for additional donors and thus the need to apply for 501(c)(3) tax exempt status. Generally speaking, it is recommended that a nonprofit apply for 501(c)(3) tax exempt status within 27 months from the date that the nonprofit was formed (as long as the nonprofit applies for tax exemption within 27 months of legally forming, and is granted such tax exempt status, the tax exemption recognition will be retroactive to the date of formation of the nonprofit. With some exceptions, failure to file within the 27 month period can affect the extent of retroactivity of the tax deductibility of the donations received).
Another factor to consider when deciding when to apply for 501(c)(3) tax exempt status is what type of income the nonprofit plans to bring in and from what types of activities. For example, if the nonprofit plans to derive income from an activity that is not related to its purposes, that income will, subject to certain exceptions, be taxable even if the nonprofit has obtained 501(c)(3) tax exempt status. This type of tax is called the “unrelated business income tax” (UBIT) and is a tax on monies derived from any trade or business activity that is performed on a regular basis that is not substantially related to the nonprofit’s exempt purposes. Accordingly, if the nonprofit plans on deriving substantial money from unrelated business activities, then having a 501(c)(3) tax exempt status may not shield the nonprofit from taxes (and in some cases this can even jeopardize the nonprofit’s tax exempt status).
Bottom line, in deciding when to apply for 501(c)(3) tax exempt status, a nonprofit should examine its short-term and long-term goals, its desired donor base, the activities that will generate income for the nonprofit and should always consider the tax implications that could come from these activities. Although 501(c)(3) tax exempt status comes with certain restrictions, in many cases, it can be the right move for the nonprofit as such tax exempt status confers numerous benefits.
Key benefits of obtaining 501(c)(3) tax exempt status
There are numerous benefits to becoming a 501(c)(3) tax exempt nonprofit organization. Some of these key benefits are:
- Tax exemption. Qualified nonprofits that are granted 501(c)(3) tax exempt status are generally exempt from federal corporate income taxes (with a few exceptions such as the UBIT tax discussed above). Exempt nonprofits can also become exempt from similar state and local taxes (e.g. sales tax, income tax, property tax – depending on the specific laws of the state in which the nonprofit is formed or operates). In many cases, having a 501(c)(3) tax exempt status opens the door to state and local exemptions.
- Attractiveness to donors. Once a nonprofit has obtained 501(c)(3) tax exempt status, it becomes much more attractive to donors because their contributions to the nonprofit are then tax-deductible to the maximum extent provided by law. In addition, having a 501(c)(3) tax exempt status granted by the IRS provides a certain legitimacy to the nonprofit in the eyes of the public, a factor that is attractive to potential donors.
- Can apply for grants and other allocations only available to 501(c)(3) tax exempt organizations. Many foundations and government agencies limit their grants to recognized 501(c)(3) tax exempt organizations. Having such a status can allow a nonprofit to be eligible and apply for such grants directly.
- Discounted rates. The United States Postal Service gives 501(c)(3) nonprofits the option to take advantage of special bulk mailing rates. In addition, many media outlets often give free or discounted rates for announcements and press releases from nonprofits.
Some considerations to keep in mind before applying for 501(c)(3) tax exempt status
Although obtaining a 501(c)(3) tax exempt status confers many important benefits, there are certain considerations that should be kept in mind prior to applying for such status. In addition to considering the nonprofit’s desired donor base and planned activities (as discussed above) nonprofits should consider the following:
- More paperwork and initial costs. Applying for 501(c)(3) tax exempt status involves an application and qualification process that requires payment of multiple fees and costs (e.g. IRS filing fees, attorney fees, accountant fees).
- Compliance with strict legal requirements. 501(c)(3) nonprofits are highly regulated entities and there are specific rules that apply to both their activities and their governance. Failure to abide by the rules can jeopardize the nonprofit’s tax exempt status. For example, no part of the activities or the net earnings of the nonprofit can unfairly benefit any director, officer, or any private individual, and no officer or private individual can share in the distribution of any of the nonprofit’s assets in the event the organization shuts down. Further, federal law imposes strict prohibitions and limitations on certain activities of 501(c)(3) organizations. Exempt nonprofits must not engage in any substantial lobbying or other legislative activity. Intervention in political campaigns (either for or against a candidate for public office) by an exempt nonprofit is strictly prohibited. In addition, exempt nonprofits must comply with certain registration, reporting, record-keeping and disclosure requirements and must retain full discretion and control over their funds. For example, 501(c)(3) nonprofits that provide financial support to other organizations (e.g. “American Friends” nonprofits that raise funds in the U.S. to support foreign organizations) must retain discretion and control over their funds and must keep appropriate records of the decisions relating to the grant of any monies to other organizations. Failure to do so could result in the nonprofit being deemed a “conduit” (i.e. an organization that funnels monies to another without maintaining discretion and control over the grant and use of such funds) and this could jeopardize such nonprofit’s tax exempt status.
- Public inspection. Being an exempt nonprofit comes with certain transparency requirements. A nonprofit’s 501(c)(3) application and its finances are open to public inspection (meaning the public may obtain copies of the nonprofit’s state and federal filings to learn about salaries and other expenditures).
In many cases, however, the benefits conferred by obtaining 501(c)(3) tax exempt status can outweigh other considerations. Nonprofits considering whether or not to apply for 501(c)(3) tax exempt status should consult with an attorney who will be able to guide them through the various considerations and the application process.
Applying for 501(c)(3) tax exemption
The process of applying for 501(c)(3) tax exempt status with the IRS has several steps. Briefly, the steps typically involved are:
- Hire an attorney and an accountant. Consult with an attorney who can help guide the nonprofit through the legal process, help determine whether the nonprofit is eligible for tax exempt status, and assist with ongoing legal requirements. In cases where the nonprofit has not yet been formed, an attorney can assist in determining what type of organization is best suited on a case by case basis and can assist in forming the entity, preparing specific documents containing federally required language (organizations that want to apply for 501(c)(3) tax exempt status are required to have specific language in their formation documents) and obtaining a federal Employer Identification Number (EIN) for the entity. It is critical for the nonprofit to also hire an accountant. An accountant will be able to assist the nonprofit with required yearly filings, both on a federal and state level.
- Drafting of internal documents. Organizations seeking tax exempt status should adopt certain internal policies (resolutions, conflict of interest policy, bylaws and other additional documents to the extent required).
- Preparing and filing a 501(c)(3) application for tax exempt status with the IRS. In order to apply for 501(c)(3) tax exempt status, the nonprofit must complete and submit an application (IRS Form 1023) to the IRS along with certain documents relating to the nonprofit and its activities. Depending on the amount of the nonprofit’s expected annual gross receipts, there is a filing fee payable to the IRS ($400 or $850 depending on the amount of the gross receipts of the organization). Once the IRS receives the application, an IRS agent will review the application and, in some cases, can either approve the tax exempt status of the nonprofit, can issue a letter asking for additional information, or in some cases (if the nonprofit does not qualify for 501(c)(3) status) can deny the application. It can take several months to over a year in some cases for the IRS to return its decision, depending on whether or how many questions the IRS has about a particular application.
- Ongoing compliance. It is important to comply with all required registration, reporting and other requirements. For example, all 501(c)(3) nonprofits must make annual filings with the IRS (usually on Form 990 or some version of this form depending on the nonprofit’s gross receipts for that year). States also have their own reporting and registration requirements. These requirements vary by state but in many instances, if a nonprofit plans to solicit funds in a state, it must register with and make annual filings with such state’s agency that regulates charitable organizations and charitable solicitations (usually the Attorney General). An attorney or an accountant can assist the nonprofit in complying with such requirements.
In summary, there are many important factors to consider in determining when and whether to apply for 501(c)(3) tax exempt status. At Shiboleth LLP, we have vast expertise in the complexities of the 501(c)(3) application process and the knowledge to guide our clients to make informed decisions on what best fits their goals.