What Is a 501(c)(3) Tax-Exempt Organization?

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What Is a 501(c)(3) Nonprofit?

Nonprofits, in general, are called 501(c) organizations. They are covered by Section 501(c) of the United States Internal Revenue Code. Under that code, 29 types of nonprofits receive some exemption from federal income taxes.

The most common type of nonprofit organization, the 501(c)(3) covers a lot of ground. This kind of nonprofit is the one we are most likely to think of when we imagine a “nonprofit.” That’s because they are the charities to which we turn for help and support with our charitable donations.

They are commonly called “charitable organizations.”

A 501(c)(3) nonprofit enjoys several benefits, besides exemption from federal income tax, if it has these purposes:

charitable, religious, educational, scientific, literary, testing for public safety, fosters amateur sports competition, prevents cruelty to children or animals.

Examples of qualifying organizations include nursing homes, parent-teacher associations, charitable hospitals, alumni associations, schools, chapters of the Red Cross or Salvation Army, Boys' or Girl's clubs, and churches.

501(c)(3) Nonprofits Fall Into Two Categories

The first is a public charity. The IRS defines a public charity as “not a private foundation.” Public charities receive most of their income from the general public or the government. Public support must be broad rather than limited to a few people or families.

The second is a private foundation. It receives its income from investments and endowments rather than the general public.

Private foundations are subdivided into operating and nonoperating. Nonoperating foundations are the best known because they use their income to make grants to other nonprofits that in turn carry out the charitable aims of the foundation. An operating foundation uses its income to run its own programs that address various charitable goals.

In this article, we discuss the public charity. Learn more about private foundations at The History and Types of US Foundations.

The Requirements for 501(c)(3) Tax-Exempt Status

To receive the benefits of tax-exemption, a 501(c)(3) organization must fulfill several requirements beyond serving the charitable purposes listed above. These are:

  • It must be organized and operated exclusively for exempt purposes.
  • It must not be organized or operated for the benefit of any private interest. Its net earnings may not inure to the benefit of any private shareholder or individual. Nonprofits can make a profit,  but that profit must be used for charitable purposes only.
  • It is restricted in its political and lobbying activities.

What Benefits Do 501(c)(3) Nonprofits Enjoy?

It is advantageous for a nonprofit organization to seek tax exemption. The benefits include:

  • It may be able to receive special postage rates, nonprofit advertising rates, and other discounts.
  • Protection from lawsuits. Since a charitable organization usually incorporates before seeking tax exemption, lawsuits can only be filed against the corporate assets. Thus, staff and board members may be protected legally. That protection is not universal or blanket, so nonprofits should also buy certain types of insurance as well.

Are There Drawbacks to Becoming a Tax-Exempt Nonprofit?

Yes, nonprofit status isn’t for everyone. Disadvantages are usually the flip side of the advantages.

For instance, some groups may feel that not sharing profits with directors, officers, members or staff is unfair.

Also, income producing activities that are not related to the group’s nonprofit purpose are restricted. Unrelated income is examined carefully by the IRS, and, if it is substantial, can incur taxes and penalties.

Should the nonprofit go out of business, its assets (after payment of debts) must be distributed to another tax-exempt 501(c)(3).

How Do You Apply to Become a Tax-Exempt Nonprofit Organization?

If you have not incorporated in your state as a nonprofit, then you will need to do that first. (If you do not want to incorporate, consider becoming an unincorporated nonprofit association.)

Once incorporated you may use one of two possible applications.

  1. Most nonprofits use Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code.
  2. If your organization is small, you may qualify for Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Filling out the Eligibility Worksheet will help you determine if you qualify for this shorter, simpler form.

When Do You Apply for Tax-Exemption?

To receive a tax-exemption dating from the date of your incorporation, you need to file IRS Form 1023 or 1023-EZ within 27 months of your incorporation.

If you file after 27 months, your exemption will only be effective from the application's postmark date.

You can file for an extension of the 27-month deadline by attaching to your 1023 a statement providing the reasons why you failed to complete the 1023 application process within the 27-month period after your incorporation.

You can find the acceptable reasons in the instructions for 1023. They include bad advice and inadequate information from a lawyer, accountant, or IRS employee.

NOTE: Three groups are not required to file Form 1023: churches, public charities that do not have gross receipts of more than $5000 in each year, and subordinate organizations exempt under a group exemption letter.

Read more about the two forms of application, the fees involved, and how long it might take to be approved by the IRS.

Resources:

IRS Publication 557 contains information on qualifying for and applying for 501(c)(3) status.

How to Form a Nonprofit Corporation (National Edition): A Step-by-Step Guide to Forming a 501(c)(3) Nonprofit in Any State (How to Form Your Own Nonprofit Corporation), Anthony Mancuso, Nolo, 2015.

This article is just for informational purposes. It is not intended to be legal advice. Check other sources, such as the IRS, and consult with legal counsel or an accountant.

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