What Qualifies a Nonprofit for Tax Exemption?

Nonprofit Tax Exemption
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Are All Nonprofits Tax-Exempt?

The answer to that question is complicated because there are several types of nonprofits.  

First, let's clarify what tax-exempt means. A fully exempt nonprofit may be exempt from most federal income taxes and some state taxes, such as sales and property taxes.  Also, its donors may be able to take a tax deduction for their donations to the organization. 

Some nonprofits enjoy the first exemption but not the second.

That's because there are 29 types of nonprofit organizations within the tax code. For instance, your local Chamber of Commerce probably is a 501(c)(6). Your recreational club may be a 501(c)(7). And your child's day care is likely a 501(k).  

The charitable nonprofits that we are so familiar with are 501(c)(3) organizations under the U.S. tax code. They receive income tax exemption, and their donors may take a tax deduction for their donations. 

The tax situation can be murky, however, since some activities that 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. 

Likewise, individuals can only take a tax deduction when they donate to a charity 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. And some charitable activities and groups do not apply because they are small or temporary. Some charitable organizations choose to be unincorporated nonprofit associations which often do not apply for tax exemption. Churches and religious organizations are treated a little differently than "public" charities.

This is all to point out that nothing is simple, especially when it comes to the US tax code.

Charitable nonprofits that wish to become 501(c)(3) tax-exempt must meet three tests:

1. The Organizational Test

Tax-exempt nonprofits must be organized for a lawful purpose in one of these categories:

  • Educational
  • Religious
  • Charitable
  • Scientific
  • Literary
  • Testing for public safety
  • Fostering certain national or international amateur sports competitions
  • Preventing cruelty to children or animals

2. 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 the behalf of any candidate or make expenditures for political purposes. There are 501(c) groups that can engage in these activities, but not 501(c)(3) organizations.

3. The Asset Test

A nonprofit's charter must state that it prohibits 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.

The Bottom Line

In summary, there are many types of nonprofit organizations.

Not all are charitable nonprofits. Only 501(c)(3) organizations receive both favorable tax treatment plus tax deductions for their donors.

Charitable organizations must apply to the IRS for 501(c)(3) status and they must meet the three tests that define charitable organizations: the organizational test which has to do with mission; the political test that has to do with political neutrality; and the asset test, which requires that the organization's assets be used for the public good.

Learn more and how to become a 501(c)(3).